New Michael Mauboussin paper

[InmanRoshi]

A new paper released by Michael Mauboussin last week that I found pretty interesting, possibly why so many non-profitable “junk companies” are over performing. Yuval has hit on many of these same topics on his blog and the P123 blog.

There has been a substantial transformation in the way companies invest over the past half century. An
investment is an outlay today that creates an asset that is expected to have positive economic value based on
future cash flows. Tangible assets, such as factories, machines, and inventory, were the dominant form of
investment in the 1970s. Intangible assets, including research and development (R&D), brand building, and
employee training, are the dominant form today.

This is important because investments in tangible assets are recorded on the balance sheet and intangible
investments commonly show up on the income statement. Sorting expenses and investments was easy when
most of the expenses were on the income statement and most of the assets were on the balance sheet. But
categorization is a challenge today because income statements conflate expenses and investments.

One consequence of the shift to intangible investments is that more companies are reporting negative net
income than what we have seen in the past (see exhibit 5). To be clear, companies can report losses because
their expensed investments exceed current earnings, which is good if the investments promise attractive
economic returns. Companies can also report losses when their expenses exceed their sales, which is bad if
the business is fundamentally unprofitable. Separating expenses from investments has never been so
important.

article_marketexpectedreturnoninvestment_en.pdf

So most investment used to run through the cash flow statement as capex. You build a factory for $10 million. You think it will last for 10 years. Your cost expense is $1m per year. But if you’re building out intellectual assets like a new sales system and you spend $10 million, there is no amortisation and just take the $10 million hit up front and report negative net income.

Given the further digitalization of the US economy, I’m not sure we should look at the last ~2 years that have broken many quant models of quality metrics as outliers that will eventually go back to the way they were before.

Mauboussin then goes on to give recommendations for better ways to snuff out profitability and quality while capitlization of intellectual assets, including a Market-Expected Return on Investment calculation to reclassify an expense as an investment. These are technical suggestions which I’m still digesting, honestly. But it’s definitely worth a look.

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[yuvaltaylor]

I’ve spent a lot of time with this article in the last few days. One way to approach this is the following, which I haven’t tested, but which seems to get at the spirit of what he’s saying. Add to net income: 0.76SGandAA + 1.2RandDA - 0.6SGandA5YAvg - RandD5YAvg. And add to assets or invested capital: 1.8SGandA5YAvg + 3*RandD5YAvg. You’ll get mostly NAs from this so you’ll have to insert IsNA(xx,0) for a lot if not all of these items. Here’s the math.

Mauboussin says that about 60% of SGandA expenditures should be classified as investments, and all R&D expenditures should too. (I find both of these debatable, but let’s run with it for a moment.) And let’s say you capitalize these expenses over five years.

So every year you’d compensate for deducting the entirety of your intangible investment expenditures from your income by adding those back and instead deducting the amortized expenditures from the previous four years. That’s 0.6SGandAA + 1RandDA - 0.2*[same for previous four years]. Since 5YAvg = 0.2*[this year’s total] + 0.2*[last 4 years’ total], if we subtract 5YAvg we have to add back an additional 0.2*[this year’s total].

As for the assets, you’d be adding to them 100% of this year’s expenditures, 80% of the previous year’s, 60% of the year’s before that, etc. That averages to 60% per year, so a very rough shortcut would be 35YAvg. You could, of course, be more accurate and add RandDA + 0.8RandDPY + 0.6*RandD(2,Ann) etc but using 5YAvg is a handy shortcut.

Now you can revise your ROIC accordingly . . .

And then there’s the rest of the paper, which is a monster. I’m definitely not going to try to calculate MEROI.

[InmanRoshi]

Yeah, the 60% SGandA expenditures are investments and 100% of R&D assumptions kind of throws me off too. As someone who doesn’t have any real world experience in accounting or corporate finance, I feel like a big hole in my knowledge is what type of intangible assets are typically put in which bucket on the income statement. So I’m guessing a new sales system would get put under SGandA and employee training would get put under R&D? I know these things things can be discretionary, but I’m just kinda of curious what he basis those estimates on.

[Jrinne]

Interesting. Thank you Cary.

[yuvaltaylor]

Yeah, the 60% SGandA expenditures are investments and 100% of R&D assumptions kind of throws me off too. As someone who doesn’t have any real world experience in accounting or corporate finance, I feel like a big hole in my knowledge is what type of intangible assets are typically put in which bucket on the income statement. So I’m guessing a new sales system would get put under SGandA and employee training would get put under R&D? I know these things things can be discretionary, but I’m just kinda of curious what he basis those estimates on.

I wrote about this on the P123 blog last summer (How R&D Expenses Can Help You Pick Outperforming Stocks - Portfolio123 Blog). Here’s the pertinent stuff:

When a biopharmaceutical company spends money researching and developing a new drug, that’s R&D. When an energy company spends money researching and developing a new place to drill or a mining company spends money researching and developing a new place to dig, that’s a capital expenditure. The FASB (Financial Accounting Standards Board) has made a generalized exception for extractive industries so that all activities unique to those industries are capitalized rather than being treated as R&D.

And when it comes to non-extractive industries, not all R&D is classified as R&D. If you build a data center, that can be capitalized. If you build a laboratory, that can be capitalized. Labor costs for running (as opposed to building) the data center and laboratory can’t be capitalized, though, so most R&D expenditures are actually salaries.

What is the difference between R&D and a capital expenditure? The FASB is clear: “At the time most research and development costs are incurred, the future benefits are at best uncertain. In other words, there is no indication that an economic resource has been created.” A capital expenditure leads pretty directly to sales while an R&D expense is entirely speculative. Therefore they are treated entirely differently by accounting rules. R&D expenses are deducted from income all at once, at the time that they are spent; capital expenditures are depreciated so that the cost is deducted little by little over a period of years. . . .

Aswath Damodaran, whose valuation methods and deep thinking about accounting have been tremendously influential, has long advocated capitalizing R&D expenses when valuing a company. His argument is as follows. One can classify all expenses as either operating expenses (which are deducted in full at the time they are incurred), financing expenses, or capital expenses (which can be capitalized and thus deducted over a longer period). Damodaran takes a very different approach to this distinction than does the FASB. “Capital expenditures are defined as those expenditures that are likely to create benefits over multiple periods,” he argues, while operating expenses, “at least in theory, provide benefits only for the current period.” R&D should therefore be classified as a capital expenditure and should be capitalized, whether or not an economic resource or asset has been created thereby.

Damodaran points out that prior to 1975, companies were allowed to capitalize R&D expenditures, and that outside the US, development costs are still allowed to be capitalized, though most companies do not do so.

There are strong arguments to be made both in favor of Damodaran’s position and in favor of the FASB’s. I tend to agree with the FASB. How many projects funded by R&D actually become commercially successful? Evidence suggests that it’s well under fifty percent. In addition, most R&D expenses are labor costs, and those are only capitalized if the labor is directly involved in the creation of a capital asset. Lastly, the FASB is always issuing “invitations to comment” and is concerned about keeping current with business standards, and they have not changed this particular accounting standard in 45 years. If there were a good reason to change it one would think they would.

As for Mauboussin’s source, see https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2715722. I haven’t read this paper yet, but plan to.

I have two additional thoughts about this.

1. If you’re using cash-based accounting (operating cash flow, free cash flow, etc.) for your valuation, then it makes absolutely no difference whether you expense or capitalize these expenditures. From a cash-flow basis it’s exactly the same. The only reason it really matters for Mauboussin is that he uses NOPAT rather than operating cash flow as the basis for his valuation.

2. The reason so many people are so focused on R&D expenditures these days is because companies that spend heavily on R&D have been doing extremely well lately. It’s entirely possible that due to sector rotation, companies in the industrial, materials, financial, and/or staples sectors will outperform in the next decade. We have no way of knowing. If that happens, then all this talk about capitalizing intangible expenses may go away. That’s just my own opinion–I think most investors would consider me in denial. But maybe it’s worth considering. Personally, I only have 10% of my portfolio in tech stocks and another 1% in health care; my biggest concentrations are in materials and industrials.

[InmanRoshi]

Thanks for the clarificaiton on what qualifies as R&D yuval, that’s good to know.