100 Ways to Beat the Market #8: Maximize Portfolio Earnings

In his 1991 shareholder letter, Warren Buffett wrote that investors should focus on building a portfolio that maximizes look-through earnings ten years into the future. Look-through earnings are your share of the earnings of a company whose stock you own. For example, if you owned 100 shares of Acme Corp. and it earned $1 per share this year, your look through earnings this year would be $100. Focusing on future look-through earnings is rational because your success as a long-term focused investor will be driven primarily by the economic performance, i.e. future earnings, of the businesses in which you invest.

As Buffett points out, this will force you to think about the long-term prospects of the business, rather than where the company's stock will be in twelve months. It will also cause you to focus on a number of other important questions about the company's earnings.

What portion of the earnings comprise free cash versus earnings that need to be re-invested to either maintain or grow the company?

What are the prospects for re-investing the company's earnings and at what rate of return?

Is the management skilled at capital allocation and can it be trusted to put shareholder's interests first?

How susceptible over the long-haul is the company's position to competition?

How much are you paying today for your share of the earnings?

The answers to these questions will determine your estimate of earnings ten years from know. Of course, it is not possible to make this estimate for many businesses either because of the nature of the business or your lack of expertise.

Using this framework also allows you to determine you odds of outperforming the S&P 500 over the next ten years. Once you've plugged in your estimates of where your portfolio companies will be in ten years, you can compare them against your assumptions for the S&P 500′s earnings.

Given that the S&P's economic performance is largely driven by the U.S. economy, start with your assumptions for nominal GDP growth, for example 3% real growth and 3% from inflation, along with something for dividends. You'll also want to plug in your assumptions of where corporate profits stand as a percent of GDP and whether you expect that percentage to increase or decrease. Finally, you may choose to make an adjustment for the growing portion of S&P companies' earnings that come from outside the United States.

If you can put together a portfolio whose look-through earnings will be higher than what you could expect to get ten years from now by investing in an index fund of the S&P 500 and you build in a margin of safety, you'll have a pretty good shot at beating the market.