Motley Fool Money - 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

This episode is brought to you by Colagard. Do you know what's really scary? Not screening for colon cancer when you turn 45. The Colagard test is non-invasive, requires no special prep or time off work, and ships right to your door. In just three simple steps, Colagard takes the scare out of colon cancer screening.

If you're 45 or older and at average risk, ask your health care provider about the Coligard test. Colagard is available by prescription only. Learn more or request a prescription today at colagard.com slash screen. 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 Onend Chalkavalu.

Ricky Mulvey caught up with Onent 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. Audit, 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, it's, you see it a little bit in earnings calls. This is when 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, 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, right? We're all talking about, like, 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, you know, telling a parent, your kid is special. You know, 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 end, and AI is in. So FACSET looked at, like 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's institutional thinking in hand-wavy finance because there's one way to spot it is there's usually not a lot of unique perspectives. You're like, oh, I'm seeing this again. Yeah, I'm actually surprised it's just that, just a thousand. 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 hand wavy, which is in many cases the 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 dot 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 Cable, 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, you know, 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 is that on it. We're a metaverse. We're 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 them 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 like the AI in-conference calls. You're seeing that with Kroger, the grocer got a lot of heat for where CEO Rodney McMullen 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, like, stocking programs for grocery stores and their, like, reward systems for shoppers, which they have, like, data science. 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, whether it's, 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.

You know, 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. Yeah. 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. I did it because of the algorithm. You can't, 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, some hand-wavy stuff in investing in finance is to look at where the, 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, you know, just 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 or read. I adore it. CEO comes out. And so for context, right now Adidas is dealing with essentially a lot of loss of, they have to, they have an inventory problem. 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 like the main profit engine for the company. And so now you have to, 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 in 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 easy, 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,

an op-x, an e-commerce miss, a streetware 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. The easy part of that is $500 million. And if you remember, back in quarter four, it was $400 million. So it tells you there was another $100 million 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 and quarter one. End quote. On it, I will stop there, and I know that was a long one, but that to me is, that is, that is hand wavy at his wavyest finest.

Yeah, that is, that is a hundred million in inventory problems. That's a big thing. And everyone, you know, everyone knew about the Kanye Westing, 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 five, six. So this is Nautilus, the exercise equipment maker that's not Peloton. Right. They were saying their first meaningful line in their press release for the Q4 was direct segment net sales of 139 million up 16% versus pre-pandemic fiscal 2020. Okay. I don't know what that. Actually, 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. Before the panic, because their fiscal year ends early in the year.

So basically you're thinking, okay, up 16% versus some period of time ago, two, three years. But then 339 words later, they talk about their actual net sales in the fourth quarter and how it's down 42. 2.9% versus last year. 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, if that doesn't work, you know, companies go to operating income or EBIT, earnings before interest and taxes, which is actually useful in comparing companies because it ignores debt, where, you know, 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. 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 the future. Yeah. In 2025, 2025, 26, we've got to plan. 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. The 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's 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. So that's sandbagging. Another one is- Can we stay on sandbagging for a second? Yeah, please. 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. 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, you know, 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, 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 it 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. 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. I think, and I think one key, I would say, flag that a big bath, the big bath move is going on as any time 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. Yes. And then smoothing earnings. This is some more financial engineering that maybe can be a little handwavy.

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, you know, 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. Okay. 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 pass

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?

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 rules and responsibilities to what I'm interviewing for. 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. You want your, 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. And 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. It'd 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 handwavy AI companies. You get the ones that do not talk about AI and just execute. You get it all. And, you know, if there is an antithesis to handwavy, 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 ourselves stocks based solely on what you hear. I'm Mary Long. for listening. We'll see you tomorrow.