Michael Mauboussin is one of the biggest brains in finance. Since this Alphavillain got hold of his book More Than You Know back when we were just beginning to learn the market ropes, we’ve always devoured his academic work, interviews and writing on the occasions it’s appeared in the public domain.
So, of course, we were pleased to find Mauboussin’s latest for Morgan Stanley in our inbox this morning: Market-Expected Return on Investment Bridging Accounting and Valuation. (Catchy.)
We won’t go into the meat of the report — which mainly focuses on the tools investors and corporate managers can use to understand market expectations for businesses better — because, to be quite frank, it is extremely technical. To the point even that even us boffins here at FT Alphaville took an hour or so to digest it.
But what we will flag is this chart from the section on intangible assets (page five onwards), a hot topic in investing due to the increasing attention investors are having to pay to them in our brand-and-technology-driven age.
First, here’s the chart:
Looking at this, you might expect us to say “This is nuts, when’s the crash?” or something to that effect. After all, something must be broken in capital markets if this many loss-making companies are gracing the American indexes, right?
Well, according to Mauboussin, perhaps not. Here’s his rationale:
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.
So, to elucidate: most investment used to run through the cash flow statement as capital expenditure, and then be amortised through the P+L over the asset’s useful life. You build a factory for $20m. You forecast it will last 20 years. So the cost is $1m per year. Simple.
When it comes to research and development, however, it gets trickier. Typically, R&D costs and advertising costs are full expensed. Spend $20m on developing a new gadget, and it’ll fall straight through to your bottom line. No amortisation or capitalisation necessary. Therefore, a natural distortion is created. A hard asset investing-industrial — like General Motors, Lockheed Martin or Caterpillar — will naturally look a lot more profitable than a technology company, purely because its flavour of investment can be spread over a multi-year period.
Bear this in mind, and you can begin to understand the chart above. It may be the case that more companies in the US are struggling to turn a profit, or it may be simply be a combination of a quirk in the current accounting rules and companies becoming far less hard asset-focused. Both are likely to be true to some degree.
But therein lies the issue: knowing the balance between expenses and investment. After the fact, it’ll be relatively easy to work out which companies today were generating $1.20 for each $1 of investment, whether that money was spent on building new sales systems, a factory or in-house software.
But in the here and now, with a stock market seemingly willing to bid on any company that claims — on a Spac slide-deck, of course — to have proprietary tech, systems and product, it’s arguably lot to trickier to work out.