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:
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Industry
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% of SGA with capitalisation potential (years of useful life)
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% of R&D with capitalisation potential (years of useful life)
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Pharmaceuticals
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85% (3.3 years)
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91% (4.8 years)
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Medical Equipment
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90% (3.6 years)
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93% (4.5 years)
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Consumer Goods
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72% (4.4 years)
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88% (1.9 years)
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Coal
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62% (3.6 years)
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3% (4.2 years)
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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.