Is GAAP Fooling You? Deep Dive into Value Investing
Finding Company Real Value Beyond Accounting Numbers
Hey friends!
Hope you’re doing well and getting through the week smoothly. Today, we’re going to dive into one of those topics that might seem like a snoozefest at first – GAAP (Generally Accepted Accounting Principles) and why they matter in value investing.
Yeah, I know, not exactly the stuff that makes your heart race, right?
But here’s the thing: understanding GAAP and why Warren Buffett and Charlie Munger, the investing legends we all admire, are so critical of it, can actually be a game-changer when it comes to value investing.
Let’s break it down, no fluff, just the good stuff – and don’t worry, I’ll try to keep it as entertaining as accounting talk can be (bear with me, please!).
Buffett and Munger's Love-Hate Relationship with GAAP
So, what’s the deal with GAAP? It’s supposed to be the gold standard of accounting, right?
But here’s where Buffett and Munger come in – they’ve been around the block a few times and have some strong opinions about it.
In their eyes, GAAP is kind of like looking at a company through a foggy window.
Sure, you can make out some shapes and get a rough idea of what’s going on, but you’re not seeing the whole picture
They argue that GAAP, while giving us a structured way to look at financials, often hides the real performance of a business.
Take amortization and depreciation, for instance. These are non-cash expenses that GAAP insists on including, but for value investors like Buffett and Munger, they’re not always useful in figuring out how a company is actually doing.
It’s like looking at your bank account balance but ignoring the cash you actually have in your pocket.
Buffett has often been heard saying something like, “I don’t care about amortization and depreciation. They’re not real cash expenses.”
He’s more interested in something called operating earnings – which is basically how well the business is running day-to-day.
Think of it like checking under the hood of a car. You’re not just interested in the paint job (GAAP earnings), you want to know if the engine (operating earnings) is still purring like a kitten.
Now let’s talk about EBITDA – oh boy, here’s where it gets juicy. Buffett absolutely hates this metric.
He thinks it’s completely misleading because it skips over important costs like depreciation and taxes, which can give you a way-too-rosy view of a company’s profitability.
In his own words, “EBITDA is like telling someone you’re losing weight but conveniently forgetting to mention you still eat a tub of ice cream every night.”
Okay, maybe that’s not a direct quote, but you get the idea. He’s just not buying it, and neither should we.
GAAP and Why It Matters to Us (AKA, Why Should You Care?)
So you might be thinking, “Alright, cool, but what does this have to do with me and my investments?” Well, I’m glad you asked.
The real key takeaway here is that not all numbers are created equal. GAAP gives us a starting point, but if you really want to understand a business, you’ve got to dig deeper.
Instead of focusing only on GAAP earnings, think about cash flow and the long-term health of the business.
Buffett and Munger have spent decades preaching that cash is king, and for good reason.
If a company is bringing in consistent cash flow, that’s a good sign it can weather a storm. GAAP earnings?
Those can be manipulated (not always on purpose), but cash flow doesn’t lie.
Take it from Buffett: he doesn’t care about short-term fluctuations in earnings. He’s focused on the long haul, and that’s what we should be doing too.
So, when you’re evaluating your next investment, don’t get caught up in the accounting smoke and mirrors – look at how much cash the business is actually bringing in.
The New School of Value Investors – Pabrai, Spier, and Lu
Now, let’s not just take Buffett and Munger’s word for it. There are other heavy hitters in the value investing world that echo these sentiments, and they bring their own spin to the table.
Let me introduce you to Mohnish Pabrai, Guy Spier, and Li Lu – three of the sharpest minds in value investing today
Mohnish Pabrai is known for keeping things super simple. He’s famous for his advice to stay within your circle of competence.
In other words, don’t invest in stuff you don’t understand. It’s like going to a restaurant and ordering something in a language you don’t speak – you have no idea what’s going to end up on your plate.
Pabrai’s strategy is to focus on a few businesses that he knows inside out, and it’s worked wonders for him.
And then there’s Guy Spier. He’s not chasing every flashy new stock on the market. No, Spier is more about cash flow and long-term stability.
Like Buffett and Munger, he knows that GAAP numbers only tell part of the story, and he’s always on the lookout for businesses that can generate solid cash flow even during tough times.
He’ll hold onto a company for years, waiting for the real value to shine through, and that patience pays off.
Finally, Li Lu, who’s often called “the Chinese Buffett.” Li Lu is all about intrinsic value – that’s the real worth of a company, not just what it’s trading for on the stock market today.
Like Buffett and Pabrai, he’s also a fan of concentrated investing. He’s not out there buying up every company under the sun.
Instead, he’s focused on a handful of companies that he believes are massively undervalued, and he knows them inside out.
What About the Big Business Titans?
Let’s pivot for a second and talk about the big guys: Jeff Bezos, Jack Ma, and Pony Ma. These titans are running some of the largest companies in the world, and they have a slightly different take on GAAP.
For Bezos, it’s all about cash flow. He couldn’t care less if Amazon posts a huge GAAP profit or a small one – what matters to him is how much cash is coming in.
And that’s what he’s been preaching for years. When Amazon was growing like crazy but showing little profit, people thought he was nuts. But Bezos knew that in the long run, cash flow is what keeps the engine running.
Jack Ma and Pony Ma (no relation, by the way) are similar. These guys understand that in the tech world, traditional GAAP numbers don’t always capture what’s really happening.
User growth, engagement, and ecosystem health are the real drivers of long-term success for companies like Alibaba and Tencent. GAAP is important, sure, but it’s just one part of the equation.
Wrapping It All Up
So, here’s the deal. If you’re serious about value investing, you’ve got to go beyond the surface-level numbers that GAAP gives you.
That means focusing on things like cash flow, operating earnings, and long-term growth potential. Look at the company’s fundamentals, not just what the accountants are telling you.
And one more thing – this isn’t me giving you investment advice. These are just some ideas to chew on as you think about your own strategy.
We’re all on this investing journey together, learning as we go. So grab a coffee, dig into those financials, and remember to keep it simple.
Until next time,
Eugene Alexeev
•All information in the article is sharing my own experience and is not a financial advice. It is only for educational and entertaining purposes.