Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 569

Have value investors been hindered by this quirk of accounting?

A couple of weeks ago I wrote an article on why so few fund managers have managed to replicate Buffett’s success in the professional arena. The article was inspired by listening to a recent podcast appearance by Robert Hagstrom, author of The Warren Buffett Way.

Hagstrom’s return to the podcast circuit wasn’t a coincidence. The fourth edition of his book recently landed. The big draw of the new edition – launched to celebrate the book’s 30th anniversary – is a new Buffett case study to follow earlier ones on Geico, Coke, Amex, Heinz and IBM.

The new case study is Buffett’s purchase of Apple in 2017. I won’t give too much away, but Hagstrom spends a fair bit of time talking about Michael Mauboussin’s assertion that accounting conventions have failed to keep up with economic reality.

Is the denominator broken?

For decades – maybe even a century or more – investors have relied on ratios like price-to-earnings and price-to-book as a barometer of relative value.

If a stock’s P/E is far higher than that of the general market, it is common to see the shares being written off as overvalued. If a stock trades at a far lower P/E ratio than the market average, investors seeking a bargain might jump in.

I’d argue that there is a lot more to value investing than buying stocks with cheap P/E ratios. But it is undoubtedly the general understanding of the strategy – even if simplistic. The ratio is so ingrained that many investors experience knee-jerk reactions once a P/E passes a certain point in either direction. A P/E of under 12 and the so-called value investor leans in on instinct. Anything above 25 and they instantly write off the shares.

One problem with P/E is that it is often based on last year’s earnings, while investing is all about what is going to happen in the future. For that reason, a stock with a high backwards looking P/E can actually be very cheap. Another problem, and the topic of today’s article, is that the denominator – reported net income – is heavily influenced by accounting rules.

According to Mauboussin, those rules no longer match up with how value is created in many industries. His paper Intangible assets and earnings (written for Morgan Stanley) argues that accounting conventions were built to fit industrial businesses dominated by tangible assets. They are not made to accommodate companies that invest more in intangible assets like R&D and customer acquisition.

These companies, Mauboussin suggests, end up reporting lower profits than they could have done otherwise. Why? Because their intangible investments, which are as essential to them as trucks and drills are to a miner, are expensed from profits straight away. This is very different to the treatment of tangible investments, which are recorded as an asset on the balance sheet and depreciated over several years.

Accounting rules are simply a universally agreed and applied mechanism to report financial results. As investors we are buying businesses and there is science involved in the process of evaluating businesses – but there is also a good deal of art as well.

Adjusting reported earnings for modern reality

In his paper, Mauboussin references a study by Iqbal and co, a group of accountants trying to estimate what percentage of common income statement expenses could be considered as ‘intangible investments’ – and therefore moved to the balance sheet.

The paper focused on SG&A (sales, general and administrative costs) and R&D (research and development). In their pre-amble, they note a rule of thumb that 30% of SGA and 100% of R&D could be considered as investments rather than expenses. I hadn’t heard this before and, like the paper’s authors, thought it sounded far too arbitrary. Iqbal and co’s goal was to reflect the different nature of various industries through different adjustments to R&D and SGA.

I am not completely sure how they arrived at the numbers they did. There is a mathematical explanation in the paper that is beyond my level of left-brain intelligence. The results, though, are pretty clear. For some industries, they think a lot of costs currently taken to the income statement could be capitalised on the balance sheet instead. Here is a sample of the numbers they arrived at:

Industry

% of SGA with capitalisation potential (years of useful life)

% of R&D with capitalisation potential (years of useful life)

Pharmaceuticals

85% (3.3 years)

91% (4.8 years)

Medical Equipment

90% (3.6 years)

93% (4.5 years)

Consumer Goods

72% (4.4 years)

88% (1.9 years)

Coal

62% (3.6 years)

3% (4.2 years)

For companies that spend a decent percentage of sales on SGA and R&D, making these adjustments to the reported earnings would leave them with far higher reported earnings. In turn, this would have a big impact on how expensive their P/E multiples would look on an adjusted basis. It would also increase the book value of these companies and make their price-to-book look cheaper.

I would, however, raise a couple of potential issues. Number one is that gauging the correct level of adjustment seems extremely hard. You would need intricate knowledge not only of the industry but also the specific business. The weighted average adjustment (69% for SGA and 87% for R&D) covering all of the industries in the study is high. Could this be used as an excuse to pay more for any stock?

The effects of these adjustments are also biggest in the first year you make them. This is because the new ‘intangible investments’ account we create on the balance sheet gets bigger each year and leads to higher charges from that account in future years. Unless a company’s revenue and profits grow rapidly ahead of the amounts previously invested, the positive impact of the re-shuffling decreases.

As an example, I applied these adjustments to the results of a well-known ASX share. Fiddling with the 2023 results alone added over $750m to what they reported as pre-tax profit. Assuming the same effective tax rate, the P/E of the stock falls from over 30 to 18 on an adjusted basis.

But look what happens when I start these tweaks in 2021 and roll them forward. The depreciation charge rises and the uplift in pre-tax profit by the time I reach 2023 falls by almost $300m. As a result, the “new” P/E ratio is 21.5 instead of 18. The company still looks cheaper than the standard P/E ratio, it’s just something to keep in mind if someone tries to dazzle you with adjusted numbers.

Of course for a company’s adjusted P/E to be useful on a comparative basis, you’d need to adjust the earnings of several other companies too. Oh, and don’t forget that my example took 90%+ adjustments to R&D and SGA as gospel. I don’t take them as gospel and was just trying to illustrate a point.

Do we need an accounting overhaul?

If Mauboussin, Iqbal and co are right about intangible investments, do we need an overhaul of accounting rules to suit modern business? Or will investors simply need to be more thoughtful about the ratios and shortcuts they choose?

Maybe this quirk of accounting goes some way to explaining why systematic low P/E, low price to book strategies haven’t worked as well as they did in the past. A whole swathe of companies may have been excluded for being too expensive when they weren’t. A lot of companies only look cheap in hindsight and never at the time.

I assume that quantitative value funds have tweaked their algorithms to account for this. Potentially by using cash flow metrics rather than earnings. Maybe even by adjusting what they include in book value. Investors still relying on P/E as a quick gauge of value, however, may need to look a little closer.

 

Joseph Taylor is an Associate Investment Specialist, Morningstar Australia and Firstlinks.

 


 

Leave a Comment:

     

RELATED ARTICLES

Is crypto a currency or a collectible?

After 30 years of investing, I prefer to skip this party

Coronavirus and a roadmap for infected investing

banner

Most viewed in recent weeks

An important Foxtel announcement...

News Corp's plans to sell Foxtel are surprising in that streaming assets Kayo, Binge and Hubbl look likely to go with it. This and recent events in the US show the bind that legacy TV businesses find themselves in.

Welcome to Firstlinks Edition 575 with weekend update

A new study has found Australians far outlive people in other English-speaking countries. We live four years longer than the average American and two years more than the average Briton, and some of the reasons why may surprise you.

  • 29 August 2024

The challenges of building a portfolio from scratch

It surprises me how often individual investors and even seasoned financial professionals don’t know the basics of building an investment portfolio. Here is a guide to do just that, as well as the challenges involved.

Creating a bulletproof investment portfolio

Is it possible to build a portfolio that performs well in any economic environment? So-called 'All Weather' portfolios have become more prominent of late, and this looks at what these portfolios are and their pros and cons.

Why I'm a perma-bull on stocks

Investors overestimate the risk of owning stocks and underestimate the risk of not owning them. In the long run, shares crush other major asset classes, yet it’s one thing to understand this, it’s another to being able to execute on it.

Welcome to Firstlinks Edition 578 with weekend update

The number of high-net-worth individuals in Australia has increased by almost 9% over the past year, and they now own $3.3 trillion in investable assets. A new report reveals how the wealthy are investing their money.

  • 19 September 2024

Latest Updates

Investing

Where to find good investment writing and advice

Investors are exposed to so much information that it’s often hard to filter the good from the bad. This looks at how to tell the difference between the two and the best sources of investment writing and advice.

Investment strategies

Are demographics destiny for the stock market?

Demographics influence economies and stock markets, but other factors like technology and policy can overshadow their impact. Diversifying across income-producing assets can help mitigate demographic-driven challenges and build wealth.

Shares

Are we reaching the end of Transurban's gravy train?

You can only push monopoly power so far before it triggers a backlash. Transurban might have finally pushed too far, raising big questions for investors.

The dawn of wicked asset classes

Collectables and other non-traditional assets often rally late in the cycle. But you should only buy them with a clear purpose and with money you can afford to lose.

Property

This property valuation metric needs a rethink

Capitalisation rates, commonly known as ‘cap rates’, are a fundamental metric in Australian property investing.  However, this seemingly simple and ubiquitous measure can be far more complex to use when comparing different types of properties.

Superannuation

Improving access to account-based pensions

Research suggests that 50,000 Australians who are retiring over the next year may not be able to access an account-based pension because they do not meet minimum application requirements of their super fund.

Do sanctions work?

Sanctions are losing effectiveness due to increasing economic polarisation, with many countries increasingly circumventing restrictions. Examples include China, Iran and Russia, whose industries have adapted despite sanctions.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.