Using the Wrong Framework

I am starting 2016 with a new resolve. This year I will articulate mistakes that I have made and, more importantly, that I am prone to. Warren Buffett, my standing hero, talked about needing to write reports more frequently if he were to start confessing his mistakes. I figure if I just start to blog about the Biggest Mistake of the Day, I'll be on a good start to a book.

Mistakes is a big category - as they say, errors of omission and commission. I am focusing first on errors of commission, although I am not going to give a financial impact tally. All mistakes are costly, unless they lead to greater insights. So here goes - making stepping stones out of all these stumbling blocks.

In financial analysis, the starting point is gathering a tremendous amount of data. Most of this is already gathered for us in the form of quarterly and annual financial statements that are filed with the SEC. This accounted for data becomes the information that we rely on to get to actionable ideas. As financial statements get longer, as information gets more complicated and as life gets busier, we begin to rely on shortcuts or simple frameworks to save time and energy or simply out of sheer laziness.

I don't think my latest Biggest Mistake of the Day was out of sheer laziness, but it was out of a lack of thoughtfulness. In the analysis of financial statements, it is usual for the company and for me to start with a study of the income statement that details the revenues, expenses and net profits of the company. After familiarizing myself with its content, I start to study ratios, such as "operating margin." This is a measure of how much profit (before "external costs" like taxes) is in every revenue dollar. The higher the operating margin, the more likelihood that the company can withstand the brutal forces of capitalism.

Normally the balance sheet follows the income statement. The balance sheet details what the company owns and what it owes and what the difference is - equity. The reason the balance sheet follows the income statement is that the balance sheet is the means of providing the services of the business. However, there are companies in which the balance sheet is not the means of the service, but is the service itself. I believe that companies whose business is the balance sheet should provide that statement first - and sometimes that does happen (although oddly some companies whose balance sheet is the means of the service puts it first; I don't get that).

When a company provides its balance sheet as the service, ratios like "operating margin" do not matter. For example, the margin of profit between a bank's interest income from borrowers and its interest cost for depositors is not really important. If a bank receives $1 million of income and $ .5 million of cost, the $ .5 million does not really tell us anything. Instead, this information must start with the balance sheet by setting the income and expenses as a % of assets. In banks this is regularly done.

However, in the case of insurance companies, which are also balance sheet service providers, the investment community spends a disproportionate time on "operating margin" issues(aka, "combined ratios") which are not really useful. Instead, as in the case of banks, insurance companies should have revenues analyzed as a percentage of assets. In this way, the truly leveraged nature of insurance companies can be grasped and the sensitivity to small changes can be understood.

I personally fell into this trap as I used "debt" measures, "operating margin" ratios Price to Earnings ratios and "combined ratios" to understand and assess the value of many insurance companies. Instead, it is more important to dissect the Return on Assets and connect it to Return on Equity and, finally, to understand its connection to Price to Book ratios. By using the right framework, the sources of an insurance company's strengths and weaknesses should become more apparent.