Podcast Summary
Adapting Value Investing to Today's Market: Value investing strategies must evolve to remain effective in today's market, which includes redefining value and employing a 360-degree perspective for identifying opportunities.
The traditional definition of value investing may need to evolve to remain effective in today's market. Principal Asset Management, a real estate manager, employs a 360-degree perspective, combining local insights and global expertise to identify investing opportunities. Meanwhile, in the world of stocks, the outperformance of tech and new economy stocks has highlighted the challenges for value investors. The dominance of these stocks, which were once considered expensive, has continued to grow, while stocks that appear cheap seem to get cheaper. This situation raises questions about the effectiveness of outdated accounting rules and the need for value investors to adapt their strategies. Whether it's waiting for a catalyst or redefining value, the approach taken ultimately depends on the investor's perspective. The recent creation of a new value-driven ETF in South Korea, which includes companies like Amazon, Alphabet, and Facebook, illustrates the importance of redefining value to fit today's market. In the end, the success of value investing hinges on its ability to adapt to the changing landscape.
The debate over measuring intangible assets continues: Intangible assets like R&D are crucial, but their measurement and understanding remain debated in the investment community, impacting value vs growth investing decisions
Intangible assets, such as research and development, are increasingly important in today's economy, and the accounting rules surrounding their classification and measurement continue to be a topic of debate. Michael Moverson, the head of Consilient Research at Morgan Stanley Investment Management, explains that intangible assets have become more prominent over time, and there is ongoing discussion about how to measure and understand their characteristics and implications. Consilient Research, as the name suggests, aims to unify knowledge and bring ideas from various areas together to shed light on important topics. In the context of the debate between value and growth investing, the measurement and understanding of intangible assets are a significant issue. The research question is whether we can do a better job of measuring intangible investments and understanding their implications for businesses and investors. This is an ongoing conversation in the investment community, and it highlights the importance of casting a wide net and considering all aspects of the world to make informed decisions.
From balance sheet items to income statement items: Historically, investments were balance sheet items, but now include intangibles on the income statement, making it harder for analysts to track and requiring focus on free cash flow for accurate valuation.
The way investments are recorded in financial statements has significantly changed over the years, moving from primarily balance sheet items to income statement items due to the rise of intangible investments. Historically, investments like factories and machines were recorded on the balance sheet and had a modest influence on the income statement through depreciation. However, with the increase in intangible investments such as brand building, research and development, and customer acquisition costs, these are now being recorded on the income statement, leading to a mix of earnings and investments on the bottom line. This shift has made the job of analysts more challenging as they need to track down where the investments are being made and how they will impact future cash flows. The accounting rules, such as the one from 1974 regarding the treatment of research and development, have played a role in this change. The implication for investors is that they need to be aware of these accounting quirks and focus on free cash flow, the lifeblood of corporate valuation, to gauge future profitability. The way investments are recorded can significantly impact how investors perceive a company's financial health and future prospects.
Beyond Traditional Metrics: Valuing Intangible Factors: Investors should evaluate intangible factors like R&D, branding, and customer relationships to make informed investment decisions, even if they don't show up on traditional accounting statements.
Investors need to go beyond traditional accounting metrics and consider the intangible factors that drive a company's value, even if they're not reflected in the income statement or balance sheet. This is particularly important for companies with significant investments in research and development, branding, or customer relationships, which may show negative cash flow or losses on the income statement but still contribute to long-term growth and value. The market has already recognized this trend, and investors who understand how these factors are valued can make more informed investment decisions. The ongoing debate is about how to account for these intangibles more accurately and consistently, but investors shouldn't wait for accountants to make the changes. Instead, they should learn to evaluate these factors themselves and reverse engineer the market's valuation to determine whether a company is a good investment opportunity.
Beyond Income Statement: Evaluating Intangible Assets: Investors need to adjust financial statements to account for intangible assets like R&D and recognize maintenance vs value-creating expenditures for a more accurate financial assessment. This approach led to a 15% increase in earnings and 80% increase in invested capital for Microsoft.
Evaluating a company's financial health requires looking beyond the income statement and considering intangible assets like research and development. Traditional financial metrics, such as net operating profit after tax (NOPAT), can be misleading if these intangibles are not accounted for properly. By making adjustments to financial statements and recognizing the difference between maintenance and value-creating expenditures, investors can gain a more accurate understanding of a company's true financial position. For instance, using the example of Microsoft, these adjustments led to a 15% increase in earnings and an 80% increase in invested capital. This framework is particularly important for younger companies and those in competitive industries where research and development plays a significant role. It's essential to understand that not all research and development spending is solely focused on generating future profits; some investments are necessary for maintaining a company's competitive edge. By considering these intangibles, investors can make more informed decisions and avoid comparing apples to oranges when evaluating companies.
R&D spending for established digital companies: Maintenance vs future growth: Established digital companies often allocate a significant portion of R&D spending towards maintenance, while younger firms focus more on future growth. Brands are expensed immediately and not reflected as assets, leading to potential accounting absurdities.
When it comes to research and development (R&D) spending for established digital companies, a significant portion may be considered "maintenance" rather than discretionary spending for future growth. This is different from younger companies where a larger chunk of R&D spending is likely to be for growth. The accounting framework for expensing investments includes assets like factories, which depreciate over time and are reflected as expenses on the income statement. However, building a brand is treated differently. Brands are expensed in the year they are incurred and do not appear as assets on the balance sheet. This difference can lead to absurdities, such as a company spending its entire advertising budget on the last day of the year and having it show up as an expense with no recorded value. In mergers and acquisitions, the value of a brand can be recognized, but in the normal course of business, it is not reflected on the balance sheet. Ultimately, the key distinction is between spending for maintenance and spending for future growth.
Assessing the value of intangible assets is a challenge: Companies estimate customer acquisition costs and lifetime value to determine how much to spend on acquiring new customers for intangible asset-heavy businesses. Intangible assets' value should be considered for informed investment decisions.
Intangible assets, such as brands and customer relationships, have become increasingly significant for companies, surpassing the value of tangible investments. However, assessing the value of intangible assets before they become profitable is a challenge. Using subscription-based businesses as an example, companies make estimates of customer acquisition costs and lifetime value to determine how much they're willing to spend to acquire new customers. This is a judgment call, and similar analysis is applied to other intangible asset-heavy companies. Despite the accounting differences between acquiring intangible assets through M&A versus developing them in-house, the importance of intangibles does not necessarily encourage more companies to grow through acquisitions. Instead, companies focus on acquiring capabilities or particular business lines. As investors, it's crucial to consider intangible assets' value, both in retrospect and in anticipation, to make informed decisions.
Rethinking Accounting's Impact on Value Investing: Accounting rethinking can enhance value investing by improving signals and addressing intangible assets, leading to better performance.
The debate around rethinking accounting and its impact on value investing is a complex issue. Accountants argue that they lack the knowledge to treat intangible assets differently, and judgments regarding these assets are currently being made during M&A deals. Value investing, defined as buying something for less than its worth, remains relevant. However, the statistical factor of value investing, which has been under pressure, can be improved with adjustments. A paper by Baruch Lev and Anoop Srivastava supports this, showing that these adjustments lead to better signals and that the value factor's effectiveness improves. The debate around the coexistence of value investing and the efficient market hypothesis is ongoing, but value investing can be seen as identifying potential mispricings in the market. Overall, the accounting rethinking and its potential impact on value investing is a significant topic, with ongoing research and debate.
Value Investing: Debating Efficiency and Human Behavior: Value investing remains effective despite market inefficiencies, driven by human behavior and intangible assets' transferability. An expectations approach is essential for valuing tech stocks and companies.
While markets may not be perfectly efficient, value investing continues to be a valid approach to investing. The debate in the academic community revolves around whether the value factor is just compensation for risk or if there are behavioral factors at play. Regardless of which camp one subscribes to, human behavior remains a constant factor in market inefficiencies. Valuing intangible assets, such as brand value or customer lifetime value, can be more difficult, but the basic framework for analyzing a company's ability to make money remains the same. The key lies in understanding a company's intangible assets and their transferability. When it comes to valuing tech stocks or any company, an expectations approach is crucial to determine if prices have overshot the future value of the company. Despite the challenges, the fundamentals of value investing remain relevant in today's market.
Assessing Intangible Assets and Market Values: Investors can gain insights by understanding intangible assets and justifying market values, even for seemingly overvalued companies. Value investing, which focuses on undervalued companies, can be challenging and may require reconsidering traditional metrics.
Understanding the value of intangible assets and attempting to justify market values, even for seemingly overvalued companies, can provide valuable insights for investors. Michael Jansen emphasized the importance of determining a company's basic unit of analysis to assess returns on investment. While markets can be wrong, it's essential to consider the market's perspective when evaluating investments. Value investing, which involves identifying undervalued companies, can be challenging, and the traditional metrics may not always be effective. It's possible that, in the future, value investors may reconsider their approach and start viewing tech companies as value stocks. However, it's important to remember that markets can be unpredictable, and even the last value investor standing may not necessarily be the most successful.
New Podcast: Money Stuff by Matt Levine and Katie Greifeld: Matt Levine and Katie Greifeld's new podcast, Money Stuff, brings their popular newsletter to life every Friday with in-depth discussions on Wall Street finance and related topics. Subscribe now on Apple Podcasts, Spotify, or wherever you get your podcasts, and follow them and their guests on Twitter for more insights.
Learning from this episode of the Odd Lots podcast is the announcement of a new podcast called Money Stuff. Hosted by Matt Levine and Katie Greifeld, this new podcast will bring the popular Money Stuff newsletter to life every Friday. Listeners can expect in-depth discussions on Wall Street finance and other related topics that have made Matt's newsletter a hit. Be sure to subscribe to Money Stuff on Apple Podcasts, Spotify, or wherever you get your podcasts. Additionally, the hosts encourage listeners to follow them and their guests on Twitter for more insights and updates.
