Data Scrubbing, the Buffett Way

Debashis Basu 15 April 2016

Companies with high ‘clean surplus’ returns beat the market averages

Dr Joseph Belmonte was a marine engineer. One of his voyages was on a ship carrying grain from the US to the former Soviet Union. The ship had entered the Mediterranean Sea through the Strait of Gibraltar, when a Liberian freight carrier rammed into the first ship, shattering her hull “like paper and smashed into the engine room above our heads.” Five men died.

Dr Belmonte was lucky to live, thanks to the brave and quick-thinking chief engineer, to whom he dedicates this book. Dr Belmonte decided to quit his career on the high seas and started taking interest in finance and investing. During the next 10 years, he made a living from real estate and stocks. He learned about technical analysis and covered option writing. After becoming successful in investing, he wanted to teach and share his knowledge. He wrote an investment course and submitted it to a university that was close to where he lived. They politely told him that he was ‘only’ a bachelor of engineering (BE) and what did a BE know about investing? He was asked to get a PhD in finance, if he wanted to teach investing.

Dr Belmonte did his master’s programme in finance and then a PhD during which he came across a simple process of stock selection which relied on “Clean Accounting Surplus”—the subject of this book. The main parameter that separates an exceptional company from an ordinary one is a high return on equity (RoE). RoE is calculated by dividing net profit by shareholders’ funds (which includes capital and reserves). Now, net profit can, often, be marred by extraordinary or exceptional items. This can distort comparisons between companies. If a company has written off an exceptional item in one year, its net profit will be depressed and so will be shareholders’ funds, making nonsense of any comparison with another company that has no exceptional items. Hence, taking the reported net profit as the basis for RoE is not correct. Clean accounting surplus, which Dr Belmonte advocates, takes the net profit before exceptional items, making comparison and predictability of profits a bit easier. Shareholders’ funds also should be shielded from the impact of exceptional items. This will give us a ‘clean RoE’.

Dr Belmonte suggests that we should buy stocks of clean RoE companies. It’s a process that Warren Buffett uses. But do portfolios with above-average clean surplus RoEs outperform market averages and does the clean surplus RoE have any correlation with the future returns of portfolios? Dr Belmonte’s doctoral dissertation attempted to statistically answer these questions. The results were encouraging. In a back-tested study, companies with high ‘clean RoEs’ did far better than the market average Dow and S&P 500. Dr Belmonte’s work shows that every portfolio selected from the S&P 500 index with above-average clean surplus RoEs outperformed the S&P 500 average during the test periods from1987 to the present. His study of two test periods, comparing returns from ‘Clean RoEs’ with S&P 500 formed his doctoral dissertation.

The superiority of clean RoE is the core of the book. The book also has guidance on rules for structuring a great growth portfolio, how to select stocks for growth and dividend, how to avoid stocks with declining RoEs and how to earn money writing covered calls (an option strategy). It is the latter part of the book which describes these strategies that are more useful. The first part of the book, that explains clean RoE, should have been restricted to just two chapters. Instead, it is spread across 14 chapters, repeating the same thing over and over again. Also, I am not aware of any analyst, fund manager or any serious individual investor being blindsided by exceptional items.

Dr Belmonte claims that there is just one academic reference to clean accounting. But cleaning up reported data is a common practice. In India, a corporate database provider like Centre for Monitoring Indian Economy cleans up data on various parameters; it does not compile and present them as reported.

Dr Belmonte also charges that 98% of fund managers in the US cannot beat the market because they don’t seem to rely on clean surplus accounting. I find this claim unbelievable. Not only do analysts make numerous adjustments to reported data, but they make a very detailed refined analysis of not just financial performance but product sales by market segments and geographies as well as raw materials and other cost analysis. In fact, their underperformance could be due to a paralysis of analysis and behavioural mistakes, rather than lack of knowledge of clean surplus accounting.

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