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Moats to Get Excited About 

The Tarpon Folio increased by 7.0% during September compared to an increase of 3.6% in the S&P 500. Since inception last November, the Tarpon Folio is up 92.3% through the end of September, and is outperforming the S&P 500 over the same period by 61.1%.

Most investors probably would not think that something as straightforward as the definition of a company's earnings could be controversial. Welcome to Wall Street, where obfuscation is intentional, clarity is rare and earnings are not always earnings.

Publicly traded companies in the U.S. are required to publish their financial results in accordance with generally accepted accounting principles, or GAAP. A company's profit under GAAP rules is considered to be "reported earnings." However, many companies emphasize a different version of earnings to their investors. Management teams often refer to "operating earnings" under the pretense of better capturing the underlying trends in their businesses.

That idea makes sense when intentions are sincere. Referring to operating earnings in lieu of true reported earnings isn't necessarily a bad thing, as the GAAP definition of earnings does include some slop. More specifically, GAAP earnings can include items such as write-offs, gains on asset sales, restructuring charges and goodwill write-downs that are one-time events with no bearing on the company's core operational results. So when it comes to gauging a company's true progress, GAAP earnings aren't perfect.

The problem with relying on adjusted operating earnings, however, is that they can be seriously misleading. There is no industry standard that defines the term. Management teams can literally exclude whatever they'd like to in the operating earnings figures they publish.

An overemphasis on operating earnings, sometime called "Street earnings," "core earnings," or "pro-forma earnings" is not new. Analysts usually exclude items that are not part of a company's normal operations in analyzing the businesses they follow. Since the early 1990's companies have often emphasized operating earnings over reported earnings to their investors. What is new, however, is that the operating earnings of many public companies now appear to be either excluding items that they should not be or that are not really non-recurring – to a historic degree.

In other words, companies are claiming things that happen routinely are one-time events in order to prop up the earnings figures they highlight to their investors.

Lately, many individual investors have felt pressure to get back into the market out of fear they will miss out on further gains. Much of that motivation is fueled by pundits and talking heads insisting that "the market is still cheap based on historical earnings." Investors should understand that while the market as a whole may be attractively priced based on operating earnings, it's a far different picture when looking at companies' true earnings.

The difference between true earnings and operating earnings has never been bigger than it is right now. Standard & Poor's recently reported that GAAP earnings per share for the 500 biggest public companies is $7.21 per share, while operating earnings are $61.20. That $54 gap is an all-time record.

Why does it exist? Much of it can be explained by huge write-downs in the financial sector in addition to a high degree of write-offs in other industries address as more companies deal with their own impaired assets, too. Job cuts and declining production explains more of the gap. But to be clear, some companies appear to be abusing the notion of operating earnings, too.
 
Take the case of Alliance Data Systems, a Texas company that manages customer loyalty programs and provides private label credit cards. You'll notice in the subheading of its most recent quarterly earnings release that the company highlights "cash earnings per share" and not GAAP earnings.

How does Alliance define cash earnings? By taking GAAP earnings and adding back certain expenses, including the cost of stock compensation given to management and employees. It also adds back a chunk of the premiums it pays to acquire credit card portfolios and customer lists. While GAAP considers such premiums the cost of doing business, Alliance considers them an intangible asset – meaning it can amortize them. And because Alliance adds back amortization expenses to get to its touted "cash earnings," the earnings figure the company is highlighting grows larger - despite the fact that it is an expense that actually reduces profit.

Alliance's "cash earnings" for the second quarter were 95 cents a share, but GAAP earnings in the period were 51 cents a share. The gap between the two figures was even wider in the first quarter, when Alliance reported "cash" earnings of $1.19 a share compared with GAAP earnings of 45 cents.

Only on Wall Street can a company take expenses, add them back to profits, point to that number as the primary indicator of serious business progress, and then see its shares hit a 52-week high. And would you care to guess what the primary metric is that Alliance uses when awarding its executives with company stock?

Unfortunately, Alliance is not alone in emphasizing non-GAAP earnings. Pfizer is another company with operating earnings that do not provide a picture as clear as you might be lead to believe. Pfizer prefers to publish "adjusted earnings" - ostensibly to ignore the impact from acquisitions - and the Street follows unquestioningly. Pfizer acquires firms every year, though, and even with the big hole in its pipeline that Pharmacia seems to fill, it seems likely that it's still going to have to acquire growth pretty consistently in the future. If part of a business' operations is consistently acquiring other firms, shouldn't that be treated as a regular expense?

Kodak might also be considered a serial offender, in that constant restructurings and repeatedly closing factories over multiple years are not truly one-time expenses. Last year Kodak also adjusted its pension fund assumptions and, surprise, it happened to boost their earnings.

In the telecom world, QualComm historically received a hefty percentage of its earnings from investments, as opposed to coming exclusively from the companies' operations. Those investments had not been doing too well early this year, highlighting yet another reason why investors need to pay attention to the quality of company's reported earnings.

Why does this distinction matter? Because, as described eloquently here, while the market has increased by more than 50% over the last few months, the actual aggregate GAAP earnings of companies have declined by 6%. Given the gap between actual earnings and the operating earnings figures used by many market commentators, there could be unpleasant surprises in store for investors who blindly buy into the market thinking that it is cheap.

It is not, and knowing the difference is critical.

Q. On the Accounts Overview page in my FOLIOfn account, it shows the Tarpon Folio and also some separate cash.  What is that, and is it there for a reason?

A. That cash is there to basically serve as a little over two years worth of fees for both FOLIOfn and IIM.  It's computed as 2% of the initial amount you invest, and I leave it separate so that we don't have to incur any tax consequences or reduce any potential growth in the portfolio.  More specifically, it's there so I don’t have to sell something and increase your tax bill just so FOLIOfn and I would get paid every quarter, and/or so we can let the invested portion of the portfolio grow as much as possible without having to trim anything back just to pay fees.

Ideally, every other dime in your account is invested in the market, it grows over time, there are minimal changes to the portfolio and those fees just come out of that cash for the next two years.  If things become screaming cheap in the market again, there may be a time when I reduce that 2% to as low as 0.5% just to put every dime possible to work and forget about the tax impact, but we're not there these days. Having that cash is also different than a mutual fund, which doesn't keep the cash separate but instead charges you literally every day so the mutual fund company is sure to get it's take.

If you've checked your account lately, you probably also noticed that inside the Tarpon Folio itself is another 10% in cash. That's a result of selling some companies, as per the discussion earlier in this letter, and I'm in the process of putting that to work. So that number will be close to 1% eventually, too, in terms of cash held inside the Tarpon Folio.  

With a total of 3% cash in the portfolio, that leaves more than enough for fees for a couple of years without having to sell at all - which may be idealistic, but is a useful benchmark.  And some stocks we buy could come with a commission payable to FOLIOfn, too, to make the trade.  We don't pay any commissions to buy/sell shares in any companies right now, but in the event we did, that's all the more reason for a little slack cash in there. 

If you have any other questions, please let me know.

The Tarpon Folio is an innovative, investor-friendly alternative to the traditional actively managed mutual fund. It's built on a model we call a spoke fund. 

It is more transparent, takes more concentrated positions and is significantly less expensive than the vast majority of mutual funds. The portfolio is managed for long-term growth using value investing principles. 

Fees are 0.90% of assets annually, assessed on a quarterly basis. Turnover, taxes and trading are minimized in the fund, and investors can customize their accounts in several key ways, including tax preference. Each Tarpon Folio account is also protected by three types of insurance for a maximum of up to $11.5 million

For more information, visit our website.  

Here is our privacy policy, our Form ADV and our Fiduciary Oath.

The historical performance data contained above represent performance results as reported by the portfolio listed. The performance results are for illustration purposes only. Historical results are not indicative of future performance. Positive returns are not guaranteed.

Individual results will vary depending on market conditions and investing may cause capital loss. The S&P 500, used for comparison purposes, is significantly less volatile than the holdings of the funds listed. The performance data is “net of all fees” reflecting the deduction of advisory fees, brokerage commissions and any other client paid expenses. The performance data includes the reinvestment of capital gains. 

The publication of this performance data is in no way a solicitation or offer to sell securities or investment advisory services.