Investment style
Accounting earnings can be skewed significantly
No investor can doubt that the world is changing at a rapid pace. We are well advised to make sure our approach to investing accommodates these changes. I will attempt a few thoughts on that subject in this post.
We can start with a quote from Professor Aswath Damodaran’s new book titled The Corporate Life Cycle – Business, Investment, and Management Implications published in 2024. He concludes Chapter 16, a discussion of investing in mature companies, with this:
“To rediscover itself, value investing needs to get over its discomfort with uncertainty and be more willing to define value broadly, to include not just countable and physical assets in place but also investment in intangible and growth assets” (Damodaran, 2024) p420 (Emphasis added)
There is a lot packed into this statement. What is investing? What is value investing? What is value? What are assets? What are physical assets in place? What are growth assets?
Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. His area of focus is corporate finance and equity valuation. He has been described as the world’s foremost expert on the subject of corporate valuation.
What is investing?
Damodaran distinguishes between investors and traders. He writes: “Investors…assess value, try to buy at a price less than that value, and make money from convergence. Traders…play a simpler game, buying at a low price and selling at a higher one, using whatever tools they can to harness momentum strength and shifts.” (Damodaran, 2024) p525
What is value investing?
In discussing the two customary approaches to investing ‘value’ and ‘growth’ Warren Buffett confesses to earlier fuzzy thinking and says:
“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. 1998) p85 (Emphasis added)
Buffett also tells us:
“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a ‘value’ purchase.” (Buffett, 1998) p85 (Emphasis added)
Pulling this together – Investing
It probably would make sense to do away with the term ‘value investing’. Buffett says the term is redundant. Damodaran says investors (not just value investors) try to “buy at a price less than value”. I invite readers to go back to the first quote above and change the words ‘value investing’ to read simply ‘investing’, as in “To rediscover itself, {….} investing need to get over its discomfort with uncertainty…..”
Pulling this together – Assets in place and intangible and growth assets
Damodaran tells us that in 2024, today’s modern world, to assess value we need to take into account not only countable and physical assets in place but also intangible and growth assets. Let’s dig into what he means and what the problem is. Physical assets are things you can touch and feel. Think plant and equipment, even computer hardware and software the company has acquired.
Intangible and growth assets are tougher to get your mind around. It’s important. Something like 80% of the market capitalization of the S&P 500 is made up of intangible assets. Only a fraction of that appears on balance sheets. You can’t touch and feel intangible assets. It’s not only that balance sheets don’t reflect these assets. The income statement is also distorted. Companies invest huge amounts in intangibles of lasting value but they expense that money and so artificially depress their reported earnings. This is all legal. It’s actually required under accounting and tax rules.
Damodaran writes: “While the accounting return (return on equity or capital) is easy to compute and reflects data that should be easily available for any business in its financial statement (earnings and book value), its weaknesses lie in its accounting roots.”
He goes on: “When accountants misclassify expenses…as they continue to do with R&D expenses, a capital expense if you follow first principles but one that is treated as an operating expense – the accounting earnings can be skewed significantly.” (Damodaran, 2024) p.132 (Emphasis added)
Back to intangibles and growth assets
Coming back to the quote we started with, the challenge for investors in today’s world is how to value intangibles and growth assets. The starting point has to be a measure called Return on Invested Capital (ROIC). The challenge is to adapt our thinking and our calculations for a world in which an increasing share of company investments are in intangibles of lasting value. And note, not all intangibles are of lasting value.
Let’s turn to Warren Buffett on this one. He has written: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” (Buffett W. E., 1998) p86
In short, Buffett is looking for companies that (a) produce substantial excess cash, and (b) can employ this excess cash at very high rates of return. Both of these qualities tend to be present in companies that produce a great Return on Invested Capital (ROIC).
Not just high free cash flow
Note, some companies produce significant free cash flow but have few opportunities to invest it at ‘very high rates of return.’ So, companies identified as having high free cash flow are not the best businesses to own as they may not have opportunities to invest that cash at very high rates of return, their excess capital remains “free”. On the other hand, identifying companies that produce lots of operating cash but have to invest all that cash just to maintain their position in their market are also not the best businesses to own. Their excess capital is not “free”.
One doesn’t have to predict future earnings so much as identify companies that have the excess Cash Flow to invest for future growth. This is the important first step in determining whether this is a business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Many investors focus on the statistic of five years of historical growth in revenue and earnings rather than examining the root return on invested capital and excess Cash Flow. Historic growth tells us almost nothing about the future.
ROIC helps
Next comes the second step. The analysis is essentially a business analysis. High ROIC helps. As noted, a very high ROIC suggests a company has the capacity to invest excess cash at very high rates of return.
The problem is this. You use operating earnings derived from net earnings or reported earnings in your calculation of ROIC and will get an artificially depressed number if the company’s reported earnings are reduced by large investments in intangibles that are expensed. At the same time, if you use the book value of equity in your calculation of Capital, this number may be artificially depressed because the valuable intangible assets of lasting value do not appear on the balance sheet. The inputs need to be adjusted to take these factors into account.
The bottom line is to find companies with the excess cash flow and also with opportunities to invest at very high rates of return that will lead to future growth
These two steps can lead the investor to Damodaran’s intangible and growth assets.
Conclusion
My objective in this post has been to identify the issues. In a rapidly changing world of investing, it is a challenge to understand and work with (1) financial statements that misclassify investments as expenses rather than capitalizing them thereby distorting reported earnings and (2) financial statements that fail to show valuable intangible assets on the balance sheets. As for value investing, I am inclined to agree with Warren Buffett that the term is redundant. Investing is simply investing. Further reading is offered for readers wishing to dig deeper.
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These things ain’t what they used to be
For readers wishing to dig further, I’ve written a number of posts touching on these issues:
The emergence of a new model of capitalism
Investment in intangibles has wreaked havoc on the meaning of multiples
The fading usefulness of book value
Be wary of using Return on Capital (ROC)
Stock valuation in an age of intangible assets
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Further research
For readers wishing to dig into the subject of intangible assets, a number of posts can be accessed through this link:
I have written a number of posts about ROIC. They can be accessed in this link:
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