Billionaire investor Warren Buffett thinks he “made a mistake” when he “overpaid” for Kraft Heinz. It’s hard to disagree with that assessment, since he made it a week after Kraft Heinz’s stock dropped by nearly 30% in a single trading session. It’s probably better to spot problems before the collapse, though, not after.
Our two U.S. equity indices, VCUSX and FLAGLSX, did spot the problems before the collapse. Both indices gave the stock a 0% weighting, and one of the reasons we never invested in the company is, although we do subscribe to Buffett’s philosophy of buying cheap, we tend to take a more skeptical view of reported earnings when we determine whether a stock truly is cheap.
That’s the thing that Buffett and the other pure value investors keep missing. Of course, buying something when it's cheap is a good strategy. "Cheap" means that the price is low relative to the earnings. PE ratio is the most used metric, and that’s the price of the stock divided by the annual earnings -- which is to say, this is how many years of earnings it takes to compensate you for the initial price of the stock.
But here's what Warren and other value folks miss -- what if the E is a lie? If we value stocks based on the price relative to the earnings and we simply take the reported earnings for granted, then we leave ourselves and our clients vulnerable to manipulative financial reporting. Kraft Heinz looked like it was cheap in comparison with its earnings. It looked like it was 'on sale'. But in reality, it wasn’t, because those reported earnings did not represent reality. That's why, even though we like to buy companies when they are at bargain prices, we did not own Kraft.
It's like this: Someone sells hamburger for $2 per pound, which is a great price. The part that’s true is the $2, but it's not really a pound of hamburger, it's half a pound of hamburger. The rest is ground horsemeat and sawdust. Not so cheap after all. Kraft Heinz looked like its earnings were cheap, but now we can see the horsemeat and sawdust. That's why we didn't own it, because there are lots of little signs that the earnings reports have been adulterated. We had this company flagged for a couple of those, so we looked at the alleged bargain price and said, “When we take a close look at the goods, you are no bargain.”
The chart below shows just that. These are the forensic accounting metrics for Kraft Heinz back in September of 2015, well before their recent troubles. Our model indicates that their official financial reporting did not represent the underlying reality.
(Source: FLAGLSX, Bowyer Research)
Where did we learn this investing principle? The Torah teaches the importance of just weights and measure. The Gospels, especially the parables, teach that stewards can either be faithful or unfaithful. Almost all Wall Street investing simply takes for granted that the stewards of shareholder assets -- the board and the upper management -- are faithful. But quite often, they are not.