Motley Fool Hidden Gems Investing - Hand-Wavy Finance

Episode Date: July 15, 2023

S&P 500 companies mentioned “artificial intelligence” more than 1,000 times in the latest quarter, which is more than double from last year. Ricky Mulvey and Anand Chokkavelu took a look at the techniques behind “hand-wavy finance,” and how companies like to capture your attention. They discuss: - How Apple repeatedly “blew away” Wall Street analysts - The big bath strategy for reporting bad news - What previous hype cycles can teach investors about the latest, shiny new thing Companies discussed: AI, KR, GE, AAPL, META Host: Ricky Mulvey Guest: Anand Chokkavelu Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

So what he'd do is deliberately lower Wall Street expectations so that Apple could just utterly blow them away each quarter to do this just repeatedly. And it's amazing that he could keep lowering expectations after a blowout quarter. And, you know, if happiness equals reality minus expectations, Jobs' reality distortion field helped create some seriously happy investors each and every quarter. I'm Mary Long, and that's The Motley Fool's Anand Chakravallu. Ricky Mulvey caught up with Anand to uncover the techniques of hand-wavy finance. They discuss how companies draw attention away from bad news, the reasons why businesses like to adjust earnings, and one investment that's the opposite of hand-wavy. Anand, before we get into it, what is hand-wavy finance? This is not an economic definition you can look up. No, not at all. And it's squishy as it should

be. It's hand wavy. Yeah, it is squishy. There's something in between. It's not an outright fraud, but it's also not just like buying an index fund. It's somewhere in that like in-between land where you start seeing the hand wavy finance. This is, in my opinion, you see it a little bit in earnings calls. A lot of it is when you're seeing investors or CEOs trying to draw attention to a very specific thing in order for someone to not pay attention to another thing. Yeah, it could be misleading, but it doesn't have to necessarily be. It could be just focusing on the future, far out future, but just something that distorts reality a bit, right? Yeah. So I think one example you brought up, it's when you see a little bit of hand-wavy finance,

that's when someone's talking about the shiny new thing. Absolutely. We're all talking about, how many times did they say AI in this? And it used to be crypto and used to be whatever, 3D printing, anything like that. And it's kind of got that teacher telling a parent, your kid is special. It's telling us what we want to hear. You're into AI? Great. Thank you, Coca-Cola or whoever. Yep. We're all into AI. So I looked into this. Basically, on earnings calls, ESG is out on it and AI is in. So FactSet looks at mentions of these things. 156 mentions in quarter four of 2021 of ESG. That's been cut in half in the first quarter of this year. However, when we're looking at AI mentions, that's 2x from last year, about

400 mentions in quarter four of 2022, and then over 1,000 mentions in the latest quarter of 2023. There is institutional thinking in hand-wavy finance because there's one way to spot it is there's usually not a lot of like unique perspectives. You're like, oh, I'm seeing this again. Yeah, I'm actually surprised it's just that, just a thousand, you know. Just 2x? I would buy on more mentions of AI in the next quarter. You also brought up, and I think this is interesting, the full commitment of HandWavy, which is in many cases, we're rebranding our company. Right. Anyone can just mention the word a few times on a conference call, But it takes a little more to just totally pivot your company and name it.

I mean, we all remember or at least hear about the old late 90s tech bubble where you just add a .com and all of a sudden your stock triples. More recently, there's a company, C3 AI, but previously it was C3 IoT. It's also got the AI stock symbol, which is huge. Yeah, shout out. Would that be their investor relations department? That's a pretty good one. Yeah, I don't know. I mean, I would think it would be Siebel, the founder, CEO. But yeah, maybe it's just some person at the company.

Whoever thought of it, I guess brilliant in the hand-wavy space. Yeah, I mean, that's the question. One question is, does Meta count as this now, right? We're no longer Facebook. We are a full Metaverse company, even though we just dropped a pretty game-changing social media app in the name of Threads. Now, I know I'm combining two events that happened years apart. However, it does seem like that was a company that makes its money doing something very, very specific, which is advertising. But don't think of us as that. Don't think of us as that, Anand. We're a metaverse.

We're a virtual reality company now. I'll definitely say the vision is hand-wavy, although you have to give Zuckerberg credit where you're not going to – you don't want to totally discount him or anything like that. But there is some real stuff where they're spending a lot of money each quarter on it. So you can't say it's completely hand-wavy, but the question for us is, looking back 10, 20 years, we'll know if it was hand-wavy if it worked. But then again, it's also taking a risk. To me, hand-wavy is also, you can see it in repositioning. And I would say this is the more harmless hand-wavy type of stuff.

And you mentioned it with the AI in conference calls. You're seeing that with Kroger. The grocer got a lot of heat for where CEO Rodney McMullin brought up AI eight times in the latest call. And Rodney did not need to do that. If all he said was just data science and machine learning, because it was basically about their stocking programs for grocery stores and their reward systems for shoppers, which they have pretty good data science teams working on that so they can recommend you Oreos or give you 10 cents off a gallon of gas to encourage you to shop a little bit more. But he didn't say data science as much as he should have. He said artificial intelligence. And then the stock drops a little bit. And then

it creates an image that you don't want to see on that beloved grocery franchise or grocery chain. It is the perfect example, right, of Kroger where we're all like, oh, that brings it home where, I mean, again, it's computers, right? It's just computers have progressed, and we just call it different things over time. I mean, machine learning was the AI before AI, right? Yeah. And, you know, it goes back to using that smartest-sounding language you possibly can. So I've got a buddy who did the Rubik's Cube now, and he amazes my kids, and it's great.

And he was talking about it. And he started saying, algorithm. I'm using an algorithm to do it. And he wasn't trying to sound smart. He's the opposite of the guy. But you're like, yeah, you know what? That sounds a heck of a lot better than process or step-by-step instructions. Or I watched a YouTube and just did that. Algorithm. That sounds good. Yeah, I like that. I'm going to steal that, actually. Why did you do that? I did it because of the algorithm. You can question YouTube. You can question your step-by-step instructions, but it's harder to question the algorithm.

Even better if it's your algorithm, my algorithm, my personal algorithm. One other way to spot some hand-wavy stuff in investing and finance is to look at where the bad news is and how companies address that. Right on. basically right you want to see it in the headline but this is kind of the president lincoln attends our american cousin award right and you just you see it all the time where the best is you just put it in the headline and get it out of the way the worst is you've got a headline that just kind of says something positive that isn't you know isn't anywhere

near and i know we've got we're going to talk about some of these um you know do you want to talk about your adidas example on this let's talk about adidas because i think this is the best way this is okay so first of all adidas and i keep going back to it i think it is one of the most just unhinged earnings calls that i've ever seen that i've ever seen or read i i adore it ceo comes out and so so for context right now adidas is dealing with essentially a lot of loss of uh they have to they have an inventory problem they uh they saw they had a deal with yay the rapper formerly known as Kanye West. After enough pressure, they had to break ties with him. This was the main profit engine for the company. And so now you have multiple problems. One,

how do you make up for that lost profit? And then also, you have a lot of these just shoes sitting in a warehouse. What do you do with them? They've elected to sell them and then donate some portion of the proceeds to charity. But anyway, in the latest earnings call, CEO Bjorn Golden just comes out strong. He says, quote, I think it starts actually with the front page where here you see the jerseys that we have made for all the teams that will play in the World Cup for women in New Zealand and Australia this summer, end quote. Don't worry about our inventory problems. We're making some sick jerseys out here for Adidas. After that, but then if you look at the numbers and I'll quickly go through them, 5.3 billion euros in sales, which is basically flat. And then

as we have to look these days at the missing Yeezy. But we're actually up 7% without that. But then if you look at the gross profit, we've lost about 5%, which is not good. But that's also because of discounts and write-offs of inventory. Below that, we get to the fact that they've missed top-line sales in North America, which according to the CEO, quote, it seems dramatic, and it is, but it's also what we planned, end quote. And then it is only after the celebrity collaborations, the music festivals, a small gain in OpEx, an e-commerce miss, a streetwear line that we get to this point about inventory, which the CEO says, quote, just a quick one on that. As you can see, we have about 6 billion euros. The easy part of that is 500 million euros. And if you remember

back in quarter four, it was 400 million euros. So it tells you there was another 100 million euros that came in. And it is what we told you when the contract was broken. We had these things in production, that we continued, not to what I should say, have the people in the factory lose their jobs. As you can see, the 100 million euros has been delivered into our inventories, also on the books in quarter one, end quote. Anand, I will stop there. And I know that was a long one, but that to me is, that is hand wavy at his waviest finest. Yeah, that is 100 million in inventory problems. That's a big thing. And everyone, knew about the Kanye West thing, and that's what you're tuning in for, right? Not Jersey promotions.

And there's also, you brought this up, which is the way that CEOs use comparison baselines. And that can often be used for some hand-wavy finance stuff. Give yourself a small denominator, and you can make those increases seem a lot better. Yes. This is the I'm 27% taller than I was in fifth grade category. All true. I'm still 5'6". So this is Nautilus, you know, the exercise equipment maker that's not Peloton. uh right uh they were they were saying their first meaningful line in their in their press release uh for the q4 was direct segment net sales of 139 million up 16 percent versus pre-pandemic fiscal 2020 okay that sounds pretty good i don't know what that so that's like the 2019 going into early 2020 yeah i think yeah yeah basically it's the yeah yeah um before the panic because their

their fiscal year ends early in the year uh so basically you're thinking okay up 16 versus some period of time ago two three years uh but then 339 words later they talk about their their actual net sales in the fourth quarter and how it's down 42.9 versus last year oh that's really what happened in that quarter, right? They're down 43%, but headline is up 16%. Give yourself low expectations and you'll never be disappointed. The one place where it would seem like it would be harder to hide this hand wavy stuff on it is the earnings statement. But companies have ways of adjusting that. Right. That's the numbers, right? So the basic thing of earnings is net income, right? Well,

well, if that doesn't work, companies go to operating income or EBIT, earnings before interest and taxes, which is actually useful in comparing companies because it ignores debt, where some companies have debt, so they'll have that interest payment, some won't. So you can kind of normalize that. But to be clear, we're still pretending that there are no interest charges or taxes in that thing. But fine. If that's not great enough, EBITDA. Now, this is very, very popular with folks, and that's adding back depreciation and amortization to the EBIT number. Now, remember, you still have capital expenditures which don't show up on that income. So that's the equivalent of depreciation. You're kind of ignoring CapEx

that you need to do. So that's the stuff that you need to invest in your factories, your equipment, that sort of thing. And as you make those big purchases, you're able to slowly write off the value of that expenditure. Correct. Now, if that still doesn't work, you can adjust EBITDA, right? Now you can add back things like stock-based compensation and restructuring or one-time charges. That gets really tricky. And then if that still doesn't work for you, adjusted EBITDA, you can promise adjusted EBITDA profitability at some point in future. 2025, 2026, we've got a plan. Let's go back to the hardcore finance stuff, though, which is financial engineering and the ways that companies can use some of the hand-wavy

stuff for and against Wall Street analysts. Absolutely. Let's talk about three of them right now. One is sandbagging. Steve Jobs used to do this for those who used to even vaguely follow Apple back in the day. So what he'd do is deliberately lower Wall Street expectations so that Apple could just utterly blow them away each quarter. He used to do this just repeatedly. And it's amazing that he could keep lowering expectations after a blowout quarter. And if if happiness equals reality minus expectations, Jobs' reality distortion field helped create some seriously happy investors each and every quarter. So that's sandbagging. Another one is- Can we stay on sandbagging for a second?

Yeah, please. Because that ends up creating a problem for Apple because the expectation becomes them blowing out predictions every quarter. And this becomes a problem down the road for Apple when it becomes a company of a certain size and it becomes a little more difficult to just blow out sales goals every quarter. This is kind of in contrast to what Jack Welch did at General Electric, which is, I will meet those expectations to the penny. And this is what you can expect. And this is what I will deliver versus what Jobs did, which is, I'm going to blow it out every quarter. Yeah. And both have issues, right? Like, it's like, well, how did you, we'll talk about that in a bit of like, well, how do you get to

that exact number each time once you promise it. But I'll say Apple, right, it's been pretty much flawless in almost every way in the last 15 years, at least as an investor. And what happened there was eventually when Tim Cook took over for Steve Jobs, maybe the best transition ever. I mean, unfortunately, Steve Jobs died to make that transition where you don't have him kind of second guessing what Tim Cook's doing, but they're very different people, right? Tim Cook was a logistics guy and he's a lot more deliver what I promise. And a few years later, they just pretty much in one quarter just said, nope, we're not doing that anymore. We're just going to give you reasonable guidance and we're done. And they transitioned well and they've been fine.

Let's move on to the next one, which is what you call the big bath. Right. Like, you know, I don't hear it used as much anymore, but the big bath theory used to be that, you know, so to give you like the real life example, right? I keep crashing my car. But if you crash your parents' car, it might be a good time to slip in the, oh, here's my report card, you know, versus doing it and then a week later getting dinged for your report card, your negative report card too. But for companies, it's, oh gosh, this one-time item or this whatever is going to be really bad this quarter. Let's throw all the bad stuff so that future quarters look great by comparison and management can write a comeback story. You probably see a lot of this during the COVID stuff is an amazing big bath opportunity if you time it right. Do you think that's something investors should watch then, which is, hey, is this company just throwing all of the bad news in at once so it can just get it out of the way for future quarters?

Or is this a dangerous way to bet on turnarounds? Yeah, I guess it really doesn't change the calculus there, right? You either believe in management and what they're doing in a turnaround situation or you don't. And if you do, then you actually want management to do this because it'll take the stock price even if you're buying, take the stock price even lower in the near term. And if you recognize that, oh gosh, all this stuff's going to turn around in the next year and they're not going to have these headwinds, they're going to become tailwinds, that's an amazing time to buy a turnaround. And I think one key, I would say, flag that the big math move is going on is anytime a company is cutting its dividend, because that's essentially the worst news it could deliver

to its investors. So maybe see what other news is going on as they deliver that. And then smoothing earnings. This is some more financial engineering that maybe can be a little hand-wavy. Yeah, and this may be some of the stuff GE would have to pull back in the day. There are lots of accounting games management can play to kind of hit their various incentives, as you were talking about with GE. But for example, banks, there's a whole range when you really look at how they account for bad loans. It's pretty wide because you have to make a lot of estimations on which loans are going to default or which group of loans. And you can be aggressive or you can be conservative on it. So a savvy CEO might be extra conservative, which is a term we

think of as positive, during a particularly good quarter. So now you've kind of made your rainy day wiggle room to prop up a future bad quarter, and you can kind of smooth things along pretty well there. And that's just one example. And I still don't know if that's a bad or a good thing, which is the ultimate hand wavy. This is what we're looking for in hand wavy finance on it. That's right. I liked this example you also brought up of hand waviness, which is the admission to past mistakes. Yeah. It's that our pizza used to suck strategy that we tout from Domino's where they have that commercial where they're like, hey, it used to suck. They're not saying that our current pizza stinks, right? It's easy to admit those past mistakes. It's very rare

to admit real mistakes in the moment, right? Everyone used to be an awful dresser in high school. But this particular track suit that I'm wearing right now is awesome. And it won't be bad in time. But the question is, you know, we talked about this a little earlier. Do we actually want these people to tell the truth in real time, right? If I'm a hiring manager and I'm hiring someone, I don't want to hear, yeah, I was really spectacularly bad at my last job, which by the way has very similar roles and responsibilities to what I'm interviewing for. You know, I'd be thinking, well, I like the honesty, but what else do you not get about human interaction? As a manager, am I always going to be putting out fires?

And as investors, do you really want the CEO who's just telling the god-awful truth at every moment when they need to be executing against things and having people kind of file behind their vision and their employees to be doing work that they think is meaningful every day? Yeah. Guys, things are really bad right now. Right, right. You definitely need to be the optimist as a CEO. I don't want this to be completely about hand-wavy stuff. I think it's worth finishing off maybe by talking about a non-hand-wavy investment, non-wavy style of investing. To me, this goes to Vanguard. You can make investing as complex or as hand-wavy as you want,

but you can also just buy the entire stock market for a low-cost index fund and save your money in there automatically. The ticker is VTI. It's the Vanguard Total Stock Market index fund. It's one that I've used for some of my savings. And you just get the entire stock market, all of the hand waviness, all of the sales, all of the gains, it's captured into this exchange traded fund. And you don't have to worry about the finer details in some ways. Yeah, you get Tesla, you get all the hand wavy AI companies, you get the ones that do not talk about AI and just execute, you get it all. And if there is an antithesis to hand wavy, it's Vanguard. If you've ever read a Jack Bogle book, oh my gosh, it's brilliant, but it's dry.

It's just, it's because it's just telling you very simple things, right? Eat well and exercise, buy an index fund, just buy all the companies and invest in the American economy or the world economy and be done with it. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long, thanks for listening, we'll see you tomorrow.