capitalizing, expensing and the internet (ii)

Back when I entered the stock market, and when the CFA Institute was run by professional investors, that organization published an industry-by-industry guide to securities analysis written by veteran industry specialists.

The section on technology was a real eye-opener.  It was a litany of virtually every accounting fraud known to man.  The abuses ran in two related areas:

–capitalizing (and therefore delaying recording as expense) almost everything, especially research and development expense, and

–setting unrealistically lenient schedules for depreciating or amortizing these balance sheet accounts.

The result (and intent) of this chicanery was income statements that showed profits far in excess of the “real” amounts–even paper “profits” when a company was actually bleeding red ink.

The abuses were so blatant that the accounting rules were changed in the US to force virtually all companies to expense R&D costs as incurred, rather than store them up on the balance sheet.  Virtually all companies still write off against income the cost of their plant and equipment much more slowly in their financial reporting to shareholders than they do in their tax reporting to the IRS.

Fast forward to the present.

What effect does the long-ago change in accounting rules for R&D have on today’s publicly traded companies?  For hardware-dependent firms, not that much.  Yes, computers may wear out or become obsolete much faster than, say, a cement plant.  But the presentation of profits to actual and potential shareholders of a semiconductor foundry, a server farm or a steel mill allow for a more or less apples to apples comparison.

Not so for software-oriented firms.

Let’s take AMZN as an example and do a back-of-the-envelope calculation.

During the first half of 2013, AMZN spent $2.97 billion on technology and content.  If we assume that all of that were capitalized instead of expenses (an aggressive assumption) but that any resulting financial reporting profits were subject to tax at the very-high US rates, then I figure AMZN would have shown earnings of $4.50 per share so far in 2013 instead of the $.46 actually reported.  This would suggest, in ballpark figures, $10 a share in EPS for the full year.

Maybe the multiple isn’t so crazy.

Just as important, the same adjustment should apply to any other R&D-centric firm.   R&D may be creating important long-term intellectual property assets for a company, but the accounting rules (for sound historical reasons) portray this activity as a minus.



capitalizing, expensing and the internet (i)

finitude and stocks

I’ve been having memento mori thoughts recently.

No, not about me personally or anyone I know.  Instead, I’ve been thinking about the role of value investing in today’s world.

Several things have turned my mind in this direction:

–as I travel, I can’t help but notice the increasing numbers of businesses that are giving up the ghost in rural and suburban areas–restaurants, inns, whole strip malls either shuttered or never opened

–I realize that I’m part of the problem as, to my wife’s dismay, I order increasing amounts of stuff through Amazon

–I sometimes wonder what investors are thinking when they pay over $300/share for AMZN, a company whose book value is under $20 and whose high-water mark for earnings was $2.53/share, pre-Great Recession.  Don’t misunderstand me–I’m not saying there aren’t reasons for buying AMZN (after all, I own SPLK (Splunk–great name).  I don;t own AMZN, though.).  I just wonder whether people have thought through what they’re doing or whether they’re just going with the flow.

value investing

What does this have to do with value investing?

When a company spends money, it has two basic choices about how to account for the expenditure.  It can:

–record the money as an expense against current earnings.  In this case the money appears on the income statement as a cost–e.g., raw materials, marketing expense, salary…–and then disappears forever, or

–record the spending as an asset on the balance sheet and dribble the amount as a cost into the income statement over a long (possibly very long) period of time.  The fancy name for this process is capitalizing and it’s normally done only with assets that have long useful lives, like office buildings, stores or factories.  (The company will disclose the rules it uses for the gradual writeoff of asset value in the footnotes to its financial statements.)

The money has already left the building in either case.  The difference is a decision about what revenues to use to match what costs to.

is capitalizing a problem?

I think so.

Value investors like to look at per share book value (also called shareholders’ equity, or net asset value)–i.e., the value of the assets listed on the balance sheet minus any liabilities–and compare this with the stock price.  They consider a stock trading at a discount to book value to be a potential bargain and one trading at a premium (or, like AMZN, at 15x book!) to be potentially overvalued.

The rationale behind this is that:

–the asset base is a defense against competition.  A potential rival would presumably have to spend a similar amount just to enter the business.

–book value is based on the actual prices paid, and is not adjusted for inflation.  A company with a long history may well have assets whose value has increased over time but whose cost has already been partly or completely written off against income.  Therefore, book value may significantly understate the actual value of the company’s assets.

I have two concerns

In the current time of deep social and technological change, having a lot of capital sunk into yesterday may not be such a great thing. After all, it didn’t help Toys R Us or Borders or Circuit City.

Also, my experience is that US companies are very reluctant to decrease the balance sheet value of not-so-hot assets.  And auditors are not inclined to push the issue.  The more dead real estate I see, the more I wonder whether corporate balance sheets are as up-to-date as they’re supposed to be.


Amazon is the polar opposite of the book value enthusiast’s ideal stock.  How much of that is reality, how much accounting quirks?  That’s tomorrow’s topic.

the strange struggle for control of Dell Inc. (DELL)

the emphasis is on strange

I’m not a DELL fan and haven’t been for a long time.  I’m relieved to not be in the position of having to decide what to do with my DELL shares, since I don’t own any.

The control struggle, so far:

Michael Dell, the founder and holder of 16% of the equity, thinks he–and his partner, Silver Lake Management–can breathe life back into the husk of a once-powerful company.  Their price for doing so, however, is all of the upside.

They are being opposed by investment manager Southeastern Asset Management, which had accumulated a large position in DELL (apparently at higher cost) and by corporate buccaneer Carl Icahn.  These two appear to believe that DELL is a treasure trove of undervalued assets that would be worth significantly more than today’s share price either under better management or in an orderly sale.  They balk at both the Michael Dell description of the DELL malady and the price of the cure.

I don’t have an opinion.  My hunch is that technological change and Asian competition have undermined the DELL edifice much more than Southeastern thinks.  I’m not persuaded by Southeastern’s published valuation.  But I haven’t done the work that might back up my hunch  with facts.

The strange stuff?   …two things:

1.  ISS

ISS is a proxy voting advisory firm.  It exists, in my view, mostly because the Federal government requires investment managers to cast votes for all the shares that they have in their portfolios for all corporate actions–and to do so in a way that benefits their clients best.

If management companies made the needed voting decisions in-house, they’d have to hire staff.  No matter what they did, they’d still run the risk of second-guessing by Washington.  So, they’ve outsourced the job to third-party firms like ISS, who collect data, analyze and make voting recommendations.  This saves mutual fund and pension managers time and money.  And ISS deflects potential blame from them   …sort of like an insurance policy.

In this case, ISS is recommending that clients vote in favor of the Michael Dell buyout proposal.

The strange thing is that, if the New York Times is to be believed, ISS’s rationale is that, like me, it’s skeptical that the Dell ship can be righted.  The Times quotes ISS as making the oh-so-British analogy that Michael Dell’s bid to buy DELL may be akin to “trying to catch a falling knife.”  In other words, it’s a bad idea and one where he’s likely only to hurt himself.  (For fans of British equity research prose, he may also be viewed as in the process of “grasping a poisoned chalice”, thinking it’s “a nettle.”)

For ISS, $13.65 a share is at or above the point where there’s any reward to holders for accepting the risks of a failed turnaround.

My translation: ISS thinks both buyout groups are crazy.

2.  failed proxy solicitation

DELL’s board of directors has approved the Dell/Silver Lake bid and called for a shareholder vote on it.

Two ground rules agreed to by all parties:

–Mr. Dell’s stock doesn’t get a vote, and

–any shares that don’t cast a ballot will be counted as voting “no.”

No big deal, I thought.  Institutions will vote the way ISS says.  And individuals always enthusiastically back anything that management recommends, no matter how loony or contrary to their interests it may be.

But no!!!!!!

In this case, individuals are resisting the blandishments of proxy solicitation firms (who call you up at dinnertime, plead their case and take your vote, then and there) in a way they never do, and are declining to vote.

Mr. Dell has asked to have the vote tally postponed   …twice.  There’s no reason to do so other than that he doesn’t have enough votes to win.  And now he’s telling the board he’ll toss in another $.10 a share if they change the rules so that non-voting shares aren’t counted as doing anything.

It’s hard to see what individuals gain by not voting.  It may be that they find it too hard to decide and have opted to take whatever fate brings them–although, as I mentioned earlier, generally individuals never have trouble backing management.  My hunch is that most holders have a loss and find it too difficult psychologically to take an action that will cause that loss to be realized.


selling a stock (iii): it’s done its work

To the extent that we, as individual investors, hold specific stocks rather than an index ETF or fund, each stock should have a specific purpose.  Most times, it’s that we think the stock in question will outperform the index.  (That’s not always true.  Some investors, for example, will hold stocks that pay a large dividend.  For them, the stock is a substitute for a bond.)

The rationale for holding an individual stock generally falls into one of two patterns:

1.  the company is mature and slow-growing.  For one reason or another, it has fallen out of favor with Wall Street and is unusually cheap compared with either its breakup value or its future earnings prospects.  This routinely happens with companies whose businesses are highly sensitive to the business cycle.

Here the analysis is pretty straightforward.  You establish a target price and sell when (or if) the stock reaches it.

You might, for example, think that Barnes and Noble has a breakup value of, say, $25 a share (I don’t, but clearly some people think the number is at least that high).  If so, you would presumably have sold it when the rumor surfaced in TechCrunch that MSFT was preparing a bid for the Nook division.

Or you might observe that, say, a farm equipment maker typically trades at 8x peak earnings during an upcycle and that it’s trading today at 5x your estimate of peak earnings.  So you buy in anticipation of a 60% gain–and sell if/when the stock hits your target price.  (That’s typically long before earnings hit their peak level.)

2.  the company is small, fast-growing and, many times, trading at a high multiple of today’s earnings.  Here the sell decision is more subjective and less clear-cut.  At one time, WMT was a stock like this, as was IBM, ORCL, CSCO, MSFT or CHS (Chico’s).

In each case, there’s a qualitative or “story” aspect to the name.  In WMT’s case, it was that it made a ton of money by building superstores on the outskirts of US towns that had a population of under 250,000.  At some point–long before the financials began to signal a slowdown in growth–WMT began to run out of small towns to build new stores in.  That “qualitative” deterioration is usually the time to sell.  The sell decision is a little more complicated in each case, but that’s the general rule.

two notes

Even if you sell at the perfect time, that doesn’t mean that the stock doesn’t continue to go up.  If the overall market continues to advance, that movement will drag just about every stock along with it.  The “losers” will be stocks that don’t rise as fast as the market.  But they too will have higher prices.

The two types of stocks I’ve described above are typically called value stocks (#1) and growth stocks (#2).  You can read lots more about their characteristics by searching for “growth” or “value” on this blog.


selling a stock (ii): found a better one

A valid reason for selling a stock in your portfolio is that you’ve found a similar one with better risk-return characteristics.

Sounds straightforward:  you own one that you think can go up by 25% and, perhaps by studying the industry further, have found a competitor with a better product that you think can go up by 50%.  So you switch.  What could be simpler?

Strangely (to me, anyway), it’s not what people–even investment professionals–always do.

Consider this situation:

You find a stock trading at $100 a share that you think can go to $120, a 20% return.  You buy it.  Instead of going up, however, it drops to $90, even though the company’s prospects haven’t changed.  So the stock now has a return potential of 33.3%.

You find a close substitute, again trading at $100 a share.  But this second company has the potential to go to $150, a 50% gain.

What do you do?

Decide before you read further, please.

Believe it or not, virtually every securities analyst I’ve ever trained to be a portfolio manager says he’d wait for the first stock to rise to $100, then sell it and use the proceeds to buy the second.

Why is that the wrong answer?

Forget that you already own the first stock.  That’s irrelevant.  You can sell it in an instant at almost no cost.

You have a choice between a stock that can go up by 33.3% and one that can go up by 50%.  Both have similar risk profiles.  You should be holding the second, not the first.

Why do people want to continue to hold the first?  …it’s because their judgment is colored by the fact that they have a loss on it.  They’re more concerned about being right in their initial judgment than they are about making the highest profit.  So they don’t fully process the new information they develop.  The second stock isn’t going to wait at $100 for you to satisfy your ego.  Besides, in a taxable account, a recognized loss has at least some tax value.