A Few Random Thoughts
Quick Scheduling Update
Next week starts another round of chemo on Monday, so there is about a 75% chance of a new post (or is it a 72% chance?). If I DO post next week, I’ll probably take the following week off.
Morgan Housel Featured in the 100th Episode of Random Loops
Since we just did a feature on Morgan Housel, I wanted to mention two quick items. One, if you’d like to see/hear him talk, you can do so with the Infinite Loops podcast. You can watch it on video here
Or you can listen to it here. Two big takeaways from the podcast are that (a) Morgan is a huge believer in the power of stories and (b) he’s got a new book coming out in about a year! The part about stories should not be a surprise as it was a major theme of last week’s episode. However, I thought it was interesting in how he talked about his book “The Psychology of Money”. He really tried to tell it in a story format rather than just repeat the facts. The reason for this was because he knew how important that part of the puzzle was going to be to the book’s success.
The second part — a new book — is going to be on the common mistakes people make. There are already quite a few good books out there on behavioral finance, but it sounds like he’s going to hit some of the themes from his “How People Think” post in a lot more detail. He didn’t say that, but just a quick impression that I took from the conversation. I’ll be buying that one for sure.
Morgan Stanley — Intangibles and Earnings
Warning…this segment gets a bit into the weeds, but is important to understanding valuation. Especially how value is determined by multiple-based models instead of discounted cash flow models.
The new article by Michael J. Mauboussin and Dan Callahan, CFA “Intangibles and Earnings: Improving the Usefulness of Financial Statements” looks at the issue of properly capitalizing investments in intangible assets. Tangible assets are physical items like factory equipment, delivery trucks, or assorted other types of traditional assets. They are depreciated over time. The advantage of this is that if I spend $60,000 on a new delivery vehicle that I am depreciating over 10 years to zero salvage value, it would lower my expenses each year by $6000 per year. This is important because it spreads the cost of the item over the item’s useful life, better matching the expense with the revenue it generates.
Alternatively, intangible assets are non-physical assets that create value. Things like R&D, training programs, etc. that are expensed as the item occurs. For example, working in a university setting (technically a non-profit, but over the last couple years there was a bit more focus on things like Return on Investment) we had a very understaffed Center for Teaching, Learning, & Technology. Their job was to train faculty on new software and technology (Learning Management Systems, Zoom, Open Educational Resources, etc.) being used by the university. The idea is that they would provide training, often over multiple sessions, to bring faculty up to speed on what they could do with courses. Of course, this meant paying the CTLT faculty. The idea is that these “expenses” would generate revenue through improved enrollment and donations over time from satisfied students. However, the item is not capitalized even though it may allow a professor to “add” an extra couple thousand per year to the university’s “earning” power (better teaching, experience for students, etc.) for the next several years. Instead, it is merely expensed. In other words, the expense comes out annually, even though the benefits will be generated over upcoming years. This creates a bit of a mismatch between the expense and the revenues generated.
Therefore, investments in better employees, developing technology in-house (R&D), improved customer relations, or many other expense-related items are treated differently than buying new delivery trucks.
Unfortunately, this creates a potential accounting problem. Let’s look at it through a $1000 investment in R&D vs. a $1000 investment in a 5-year delivery vehicle (and let’s not worry about where you are going to find a delivery vehicle that will work well for 5 years on $1000 🤣).
For simplicity (we’ll dive into this more in a minute), let’s assume both investments generate a 30% rate of return (we earn $410.58 in each year for 5 years on the $1000 spent).
In finance, we typically use a Year 0 and Year 1 approach to identify time, but in an accounting sense they are both year 1 (just different times of the year). So, my EPS in year 1 is going to reflect the $1000 expense (R&D is an intangible asset) and the $410.58 in revenue for a net loss of $589.42.1 The investment in the tangible asset (delivery van) is going to be depreciated at $200 per year over 5 years and show a profit of $210.58.2 Since we don’t just invest once every 5 years, these issues will roll through the income statement and balance sheet, distorting our earnings and book value. This will impact the PE and PB multiples that we see for companies. Companies with few intangible assets relative to their tangible assets will have higher profit margins, especially if they are growing rapidly.
So, one useful tool would be to consider which industries are more likely to have higher intangible assets, as they are likely to have lower reported profit margins. However, the lower profit margins are misleading. They are higher than stated. As the authors of the article state
Given the assumptions we use, the capitalization of intangible investments would lead to net income for the S&P 500 that is about 12 percent higher than what is reported. These figures suggest great caution in comparing earnings or multiples over time.
The last line is especially important because the difference is based on both the industry AND the individual company. We can estimate this to some extent (you can see the tables on pp. 8-9 of the text), but there is still quite a bit of guesswork involved. Don’t assume that all Wholesale firms have exactly an 80% R&D expense and 4.0 year useful life. One might be 65% and another might be 86% or one might be 3.0 years and the other might be 4.5 years. Obviously the higher the numbers, the more powerful the potential mistatement will be. Also, don’t assume that the “as-reported” and “modified” book values are all going to be $8.55 and $16.67. These are averages. Some will be closer and some further apart.
What this means is that in order to really understand a company, you’re going to need to dig under the hood quite a bit (and have some luck on your side). Obviously, this is not true if you are indexing (as we’ve repeated a few times, this is likely a much better decision). However, if you are going to be actively managing a portfolio? Yep, it’s a lot of additional work.
Jim O’Shaughnessy on a Warm Shower
Let me close with a thought from Jim O’Shaughnessy’s podcast “Infinite Loops” with Morgan Housel. This is something Jim has shared before on other podcasts, but deserves a mention due to how important it is. Morgan and he were talking about appreciating what we have and he discussed the power of a warm shower. It’s a long quote, but worthwhile to read (scroll all the way down to p. 35 of 36)
Jim O’Shaughnessy: And you should know a little bit about that because it's going to make you more tolerant. It's going to make you understand how... One what of the things that I do. When I take a hot shower, I have been doing this for five years. Whenever I take a hot shower, I say, "Thank you." Because not only did I see how many people in Africa didn't have that luxury, but then you think about history, man. It's like, "Do we realize how lucky we are to be alive right now?" 150 years ago, a cut on my hand could kill me.
Morgan Housel: Yes.
Jim O'Shaughnessy: And so the shower thing happened when we were actually in Africa and we were in the bush and there was no hot showers. And when I got back to the camp and there was, I was just shouting to my wife, "I have never, ever understood how much I should be rejoicing that I get to take a hot shower."
Morgan Housel: Totally. My wife had a similar experience. She did a medical mission in Nicaragua a decade ago. And for seven days, she ate nothing but rice and beans, cold rice and beans for seven days. And she came home and she was like, "I will never view food the same way ever again for the rest of my life."
Jim O'Shaughnessy: Yeah. And to be aware of that and to notice that I just think makes you a better person, because it opens your eyes to A, are you kidding me? Stop complaining and stop with all of your bitching and moaning and look at the fact that I won the cosmic lottery man.
Here is a quote from an APNews article:
The most affluent buyers keep plunking down big money for new vehicles, including the least fuel-efficient among them — trucks, SUVS, large sedans.
Among all purchases of new autos last month, nearly 79% were trucks and SUVs. A decade ago, that proportion was just 52%.
When see people complaining about costs and inflation, take a second to step back and think about what we’re (because I’ve done this to) complaining about. Life is REALLY, REALLY good for so many of us. You can usually take a hot shower and eat something other than cold rice and beans.
If the $15 sandwich, $4-$5 a gallon gas (national average is currently $4.10 as of 4-19-2022), sitting in your climate-controlled house, watching a 60” (or bigger) flat-screen TV, and having the entire Internet available on your cell phone (did you happen to get the green iPhone 13?) is causing you concern…then it might be you who has the problem. We have SO MUCH at our disposal! Unfortunately, this may cause us to fall into the trap of questioning what is wrong. Instead, take a second to think about what is right! We are beyond fortunate — and you’re not even having to adjust the rabbit ears on your TV or act as the remote control like I did as a kid.
This is from someone who is approaching his mid-50’s. If you are in your 20’s, life is going to be even better. Or, if you have kids, think of all that they will see in their life. It boggles the mind!
Watch this ad of LeBron James (okay, if you watch sports at all, you’ve probably seen it 1000 times already) and realize that the intention is to show a teenage LeBron talking to an older LeBron (try creating this video 30 years ago!).
Young LeBron: Alright, so cordless headphones, you can watch movies through your phone? And y’all got electric cars?
Current LeBron: Yeah
Young LeBron: The future is crunk!
As the t-shirt says “Life is Good”. Keep working to make it better, but recognize that we are among the most fortunate people alive…even when we’re having a bad day.
It is never this smooth. R&D expenses occur throughout the year and may receive payback in year 2 or in year 5 depending on the type of R&D expenses and the company. Also, firms don’t just make one decision at the start of each year and adjust physical and intangible asset investments throughout the year. Finance is messy.
Note that in year 2-5, the R&D expenses will be $0 and the R&D company will have higher profits. However, companies that are growing rapidly will be spending more on their R&D, training, customer service and other factors. Thus, it won’t reverse the next year.