Company economic performance
What’s left over is Owner Earnings
It goes against the grain to think that a company losing money might be a really good investment. But that is what the rise of company investment in intangibles over the last 40 years has led us to.
It’s a topsy turvy world when there can be good losses and bad losses; when the cherished P/E ratio becomes unhinged; when P/B can work backwards; and when ROC is distorted. But, that’s what’s happening.
Don’t take my word for it
A recent report by Morgan Stanley titled ‘Good losses, bad losses’ written by Michael J. Mauboussin and Dan Callahan explains what is happening. See here.
The report refers to a study which shows that in the twenty years to 2017, companies losing money, (when accounts were correctly prepared in accordance with GAAP), delivered higher total returns than profitable companies!
The authors explain that “the underlying driver of the trend is the rise of intangible investment.”
Here’s where it gets interesting
At first blush there seems to be a contradiction in the Morgan Stanley report.
They say: “The key is to calculate free cash flow, defined as net operating profit after taxes (NOPAT) minus the investment in future growth. Free cash flow is the lifeblood of corporate value as it measures the cash that a firm can distribute to its creditors and shareholders. Note that negative free cash flow is not only fine, but desirable, in cases when the return on investment comfortably exceeds the cost of capital and the company has access to capital.”
In other words, free cash flow is key but negative free cash flow can be just fine.
As is often the case, Warren Buffett got there first. To understand how negative free cash flow can not only be fine but desirable in some cases we need to understand Buffett’s concept of Owner Earnings.
The concept of Owner Earnings is Warren Buffett’s invention. In his 1986 Chairman’s letter to the shareholders of Berkshire Hathaway, Buffett wrote:
“If we think through these questions, we can gain some insights about what may be called “owner earnings”. These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume….
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”” (Emphasis added)
The simple point is that when looking at a company we are not limited by GAAP numbers that lead to typical calculations of free cash flow. We have to make our own assessment based on our view of capex required to not only maintain the company and its competitive position. What is left over after that is Owner Earnings. It is capital that can be allocated by management to grow the company.
Opportunities for profitable investment
Mauboussin and Callahan tell us in their report: “The main message is that an investor should focus on understanding a business’s investments, return on investments, and opportunities for investment.”
This ‘main message’ hones in on the idea of growth. It’s not just growth in sales which is what a lot of investors focus on. Let’s see what Buffett says:
“Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” (Buffett, 1998 The Essays of Warren Buffett: Lessons for Corporate America) p86. (emphasis added)
He adds: “…the best business to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return.” (emphasis added)
A caution needs to be added here. ROC and ROIC and ROCE are all distorted by intangibles and can produce ratios that are unduly flattering to the company. See my posts Profound errors in interpreting and using ROE and ROC and Be wary of using Return on Capital (ROC)
Can we adjust the financial statements?
Company investment in intangibles does appear on the financial statements. Much of it shows up in selling, general, and administrative (SG&A) expense. That is, it is expensed and thereby reduces reported income. Mauboussin and Callahan suggest the financial statements can be adjusted to capitalize the intangible investment. In this way it would appear on the balance sheet and be amortized. The problem with this is that it is hard to tell whether the money the company is spending on intangibles is creating something of lasting value. And, if it is of lasting value, over what period should it be amortized. This dilemma is the reason the accounting rules have not been changed to treat investment in intangibles the same as investment in tangible assets.
I think the best solution is Warren Buffett’s ‘vaguely right’ assessment as to whether the company is generating owner earnings and whether they can be invested at high rates of return.
Conclusion
We live in a strange world when there can be good losses and bad losses and when companies that make GAAP losses can be better investments that those that make GAAP profits. It a good idea to try to understand it.
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To dig into the impact company investment in intangibles is having on the world of investing take a look at the following posts. Note, even CAPE has been thrown a curve ball by it:
The emergence of a new model of capitalism
Stock valuation in an age of intangible assets
Heart of stock valuation: subtleties of free cash flow
The best approach to choosing common stocks
How to identify great companies to invest in – Part l
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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