Odd Lots - Michael Mauboussin On Valuing Intangible Assets

Episode Date: November 5, 2020

Measuring a company's book value is a classic practice among investors seeking to understand how much a firm's actual assets are worth. But what happens when a firm's assets are not things like buildings, factories, and land, but intangible assets, such as intellectual property and brand value? How does that change the task of analyzing a company's intrinsic worth? On this episode, we speak with Michael Mauboussin, Head of Consilient Research at Counterpoint Global (part of Morgan Stanley) about valuing these assets, and how investors can use this information to get a better read on their investments.See omnystudio.com/listener for privacy information.

On April 4th, 2023, around 2 in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering, the Killing of Bob Lee, beginning April 16. Oh, and welcome to another episode of the Oddlots podcast. I'm Joe Wisenthall. And I'm Tracy Allaway. So Tracy, obviously we've had this extraordinary stock market comeback this year, not even really just a comeback because we're so far ahead of where we started the year despite the pandemic.

And a lot of different sectors have rallied, but there's no question that tech sort of new economy types. stuff, however you define it, has really led the way. I mean, the NASDAQ is just having a sort of ridiculous year. Yeah, we've talked about this before, but to some extent, it feels like the coronavirus crisis that we've seen this year has accelerated long-running trends in a bunch of things. So, you know, for instance, the dominance of online retail, but also the outperformance of the thing stocks and tech in general. It feels like the big just get big. or stocks that were considered expensive, you know, five years ago are even more expensive now. Yeah. And I'm glad to use that word expensive because, you know, it sort of does have a

an implied judgment expensive, like people are overpaying and, you know, people talk about value stocks, which has, have this implied idea that you're getting a good value. You're getting a good deal. It's cheap. But we have had this phenomenon where stocks with high multiples, continue to do extremely well. And the stocks that on paper appear to be cheap just seem to get cheaper and cheaper, which is not great if you own them. Yeah. And of course, this goes back to the whole value

versus growth debate, right? Why has value been underperforming as a strategy for so long? And there is an argument that a lot of this comes down to accounting and the notion And that maybe we have outdated accounting rules that don't actually do a very good job of reflecting the world as it is today. And we started out this conversation by talking about 2020. You could certainly argue that accounting rules that were imposed back in the 1970s probably

aren't doing a very good job of reflecting what's going on in 2020 in the midst of global pandemic. Yeah, it seems like if you're a value investor, If you're a self-characterized value investor, there's sort of two approaches that you can take. One is to sort of say, okay, we must be at some turning point. There's going to be some catalyst, maybe some economic regime change, and then value stocks will do better. And then the other approach is just to redefine value and say value has done well if you define value this way and you sort of change your screens so that you can sort of fit more stocks into the value. book. Yeah, there was a really, there was a kind of funny article from one of our Bloomberg colleagues out recently about a, I think it was a South Korean font firm or asset manager or something that

created a new value driven ETF, but it, as you said, redefined what value actually was. And on that basis, I think its base holdings ended up being Amazon, alphabet, and Facebook. So, yeah, it's all about the definition, isn't it? Yeah, that's a very easy way for value investing to do well. Just say we're allowed to buy Amazon and Netflix and all that. But even still, like, it does raise the question. And, you know, one of the sort of classic screens, one of the classic tests for what counts as a value stock,

is to look at price to book, so how much you're paying for the company relative to its assets. But if you only have a conception of assets as being factories and land and other things like that, you are missing sort of, you know, other extremely valuable assets such as, say, the network of connections that Facebook has built. That is hard to replicate anywhere else. It's not an asset in the traditional sense like a piece of equipment is, but no one would actually dispute that it is an asset. Right. And this is where the accounting rules come in, right? Why do we put certain. things in certain places on an income statement versus somewhere else. Like why does a factory statement go here, but research and development goes someplace else entirely? Yeah. Yes. So we've

talked about this a couple of times in the past, but it continues to sort of gain urgency again, I think, in light of what we've seen in the market this year. So we're going to talk about this topic some more. I'm really excited about our guests. We've had them on the show, I think, at least once before. Michael Mobison, he is a managing director at Morgan Stanley, but a long time career in finance, having worked at Blue Mountain Capital, Leg Mason, and so forth. His title and his current job is the head of consulate research on counterpoint global at Morgan Stanley Investment Management. So I'm going to introduce Michael, but first I'm going to ask him, what is a consilient research at counterpoint global men? Well, first of all, Joe and Tracy,

great to be with you guys again, always lots of fun. It is an unusual name. By the way, it's probably not a good idea to have a title that people have to look up in the dictionary, but that is the case here. There's a book I read in 1998 that was very much for me called Consilience by E.O. Wilson, famous biologist. And the argument very simply was that while science has made major advances over over last few centuries by reductionism, he argued that many of the vexing important problems in our world were at the intersections of discipline. Concilience itself is the idea of the unification of knowledge.

Taking ideas from disparate areas and having them, using them to solve problems. So when I was at Credit Suisse many years ago, I started a newsletter called the Consilient Observer, and the idea was to write these short essays trying to bring ideas from various areas together to try to shed some light on a particular topic. So Dennis Lynch, who runs Counterpoint Global,

where I am was a reader of that. And so when he invited me to join Counterpoint Global, which is part of Morgan Stanley Investment, he said, hey, why don't we call this conciliant research? So that's where we went back at. But it's this idea that we need to cast a wide net, by the way, which is a really good even introduction to the topic, as you guys were talking about as we think about the world. Are we thinking about things as expansively as we should to try to understand to make sense of the world?

And so that's where that comes from. Thank you for that explanation. It is a very interesting job title, I got to say, and it is quite wide-ranging. I guess, just to begin with, why, well, you recently published a topic on intangible assets. Joe and I sort of set the scene for why this comes up nowadays in the debate between value versus growth, but maybe just to give us a little bit more color, how much does this crop up in conversations with investors, how worrying or how much of a debate is this at the moment? Well, Tracy, I think it is a big one. And, you know, to state the obvious, this idea that intangible to become more prominent is not new. And I think many people have pointed this out over time. The reason, you know, we try to roll up our sleeves a bit and discuss this was sort of

three big reasons. One is, can we do a better job of measuring this? And the, I think to me, the centerpiece of that piece of research, we can talk more about it is an attempt to bring some of the measurement issues up to date and to get a really good sense of how big these intangible investments are relative to things we're more familiar with like CAPEX and R&D and so forth. The second is, and I think Joe touched out, I think you guys talked about this in your intro is one of the characteristics of knowledge goods versus intangible goods versus tangible goods. And just I want to underscore very strongly that there's nothing,

economists have understood all these concepts for a very long time, but it's probably taken on more prominence and understanding so things like, you know, scalability and so forth. And then the last thing is exactly what you guys are talking about, which is what is the implication? So, you know, if I look at a company and it loses money, is that necessarily bad or how do I think about that with more subtlety? So I, you know, again, that's why I called the report one job, which was your job as an investor, as an analyst, hasn't changed. It's figuring out how much. which company is investing and what the returns on that investment will be and what that means for future cash flows. But as you pointed out, Tracy, even in your observation about where things

are getting recorded, your job's got a little bit more challenging because you have to go, you have to track down where the investments are and they're not where they used to be. You talk to us about that a little bit further. There's a line in your, in your report that caught my eye and I'll just read it. It says it used to be that earnings were on the income statement and investments were recorded mostly on the balance sheet, the rise of intangible investments means that the bottom line is now a mix of earnings and investment. Sort of like break that down. That really jumped out at me and this idea that looking that sort of things that were on one part of the income or financial statement moved to another. Why is this important? Why is this interesting?

Yeah. And so, you know, I think, Joe, the answer is that historically the kinds of things we thought of as investments. So think about factories and machines and inventory and so and so forth. Those were classically recorded on the balance sheet. So they didn't show you they showed up on the income statement through things like depreciation, but they were essentially recorded on the balance sheet and had relatively modest influence on on the income statement. And again, those rules were laid out, by the way, incredibly valuable, right, dual entry accounting, very valuable. But in an ear that was very different than what we live in today. So increasingly, the kinds of investments that company makes that are valuable, things like brand building or research and development or

customer acquisition costs, these are all just classically defined. They are also investments, right? These are things, they're outlays today in the hope and expectation for future cash flows, but now those are being recorded on the income statement. And, you know, I think Tracy mentioned in the opening about sort of these accounting rules, there's a very, there's obviously a very interesting one from 1974 where the financial accounting standards boards was debating about how to treat research and development, right, which is sort of this classic in-between thing. And, you know, they actually looked at, you know, should we capitalize this? Should there be rules for how to think about capitalizing it or should we expense it and so forth? And then they ended up saying,

we're going to expense it. Right. And the name, it was in the name of being conservative, which is we just don't know what the returns are going to be. So we're just going to plunk it all in here. And as you know, like you think about a young biotechnology company or even historically big pharmaceutical companies, companies spending substantial percentage of their revenues on R&D to state the obvious that's an investment, right? They're doing that in a hope for future returns, but that's obviously wiping out sort of it's hitting their earnings, you know, 100 cents on the dollar. So that that's really the issue. And so over time, we've seen this morphing from investments going from primarily balance sheet related to now income statement related. And so now we have.

all these ideas about capital light businesses and so forth. Well, in a sense, they're capital light because there's not a lot of stuff recorded on the balance sheet, but it's not like they're not investing. They are investing. So just where it shows up is different. So the concepts behind investing doesn't change, but where it shows up. It is quite amazing that because of an accounting rule change, the way investors can think about a whole bunch of companies automatically changes because the investors are trying to gauge future profitability, I guess, and all of that comes down to the numbers that are presented on the earnings statement. Can you maybe elaborate a little bit on how you see those accounting quirks changing or affecting investor behavior?

So it's a great question, Tracy. And the first thing I'll, and there's obviously a lot of chatter about this in the accounting community and so forth. The first thing I'll just say is, and just to keep our eye on the ball here, is that notwithstanding all the adjustments you want to make, free cash flow, which is sort of the lifeblood of corporate valuation, which is really ultimately the cash in versus the cash out free cash flow is unperturbed by these adjustments. So that doesn't really make any difference. And one of the reasons we, you know, I opened the report with sort of this, you know, choice between two different investments.

Of course, it was the same company. And one, it was Walmart. But one showed, you know, sort of a steady profitability and actually growing a very nice clip and so forth. and the other showing, you know, rising debt and dwindling cash balances and so forth. And the key to Walmart was that it was, this is from the early 1970s through the mid-1980s, that Walmart was profitable, but had negative free cash flow, right? And all that means is they were investing more than they earned. And since their investments were really high return, you know, you want them to do that.

You know, knock yourself out. That's fantastic. So now you say a very similar company would also negative free cash flow, but investing on the income, they would show losses on them, right? they would show losses on the income statement, and we all of a sudden say that that doesn't look good. So I think that there are sort of this ongoing discussion about are there things we should do to change the nature of our accounting? The one, you know, the obvious one is research and development. By the way, the other thing is interesting is this does happen in mergers and acquisitions, right?

So if you built a great company that has a wonderful brand and a great customer list and so forth, and my company acquires yours, all of a sudden, those, there will be some goodwill, but the intangibles will reflect it on my. my balance sheet and then I'm going to amortize them over some period of time. So they get acknowledged, but only in mergers and acquisitions and they just don't get acknowledged in sort of day to day. So that's the ongoing discussion. Now, I'm not going to wait around for accountants to change the rules. It's a very conservative bunch and I think I'm sympathetic to them being conservative. And my argument is that investors need to get on this without whether without the accountants. The other thing that, and you guys mentioned this in the opening as well, and I'm not going to sort of justify any evaluations, but I think that the market understands these things. So this is not

being lost on the market. So in a sense, as an investor, thinking about this whole issue in a clearer fashion, I think get you more in step with how the market's already operating versus, you know, putting you ahead of everybody else. Right. So so the market, I think, has already sniffed this out in a major way. So I, you know, again, there are things like, you know, customer lifetime value calculations and research and development and branding. There's, there have been, for long, decades, discussions about how to treat those from an accounting point of view. And again, this weird thing about if you're your own company versus if you get acquired, they get treated differently and so forth. So yeah, it's an ongoing discussion. But I'm saying,

like, don't wait around for the accountants to make your, you know, to try to, in quotes, make your life easier, figure it out yourself, right? And that's why I called it one job. I'm like, look, this is what you have to do. These are the cards that have been dealt and play them. So it's like, if we look at some software company and it's trading at 30x revenue, and we're like, that's crazy. It's a bubble. And the idea of basically what you're saying is not that this approach will necessarily tell you whether the stock is a buyer or sell or overvalued or not, but that at least we can appreciate how the market is valuing the company and then from there make further, do further analysis to say whether it's a buyer or sell.

That's right, Joe. And you know that about 20 years ago, I published a book called Expectations investing, my co-author was Al Rappaport. And the argument we made there was, you know, what you should do is start with the stock price and the market value and then reverse engineer, what has to happen for that to make sense. Right. Right. So you might ask the question, you know, if it's a software company, what would sales be in retention, so on and so forth. And I still think that's a very sensible way. So again, I'm not here to defend any of the valuation for any particular company, but by the same token, this, you're exactly right. you, in other words, a very high percentage of companies is that 40 to 50% of companies listed

companies in the United States lose money. And if you just said to yourself, gee, losing money is bad, you'd maybe throw all those things out and you're not acknowledging. And that would be like saying free cash flow, negative free cash flow is bad. No, that's not true. It's a much more subtle issue. You have to understand the magnitude and return on investments. And only with that additional insight will you be able to make a sort of measure judgment. I'm June Grasso, inviting you to join me for the, the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions

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That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. I know you just, you literally just said that you're not here to, to make judgments on any particular company's valuation. But could you maybe give us your opinion on one of the fang stocks or what would the fang stocks look like through the framework that you've just explained to us? Like how different does something like an Amazon or an alphabet look once you start to factor in things like intangibles and research industry? development. So Tracy, I think that the one I feel most comfortable with is Microsoft, so it's in the same neighborhood probably, and that's the example we used in the report.

I'll just underscore, again, this is not an investment. There's no investment implication going on about to suggest. But what we did is we went through and made these adjustments. And again, there's a lot of judgment as to how to make these adjustments in terms of what items should be intangible versus the regular expense and what is the amortization period and so forth. But there was a professor named Charles Holton who had done a paper on Microsoft who had laid out a framework. So we just said we're going to follow the Holton framework.

So to answer your question more directly, what happened was the technical term is net operating profit after tax. We basically think the cash earnings in the company after these adjustments went up by about 15%. And the invested capital, so the amount of money invested in the business, went up by about 80%. Right. So again, when you reverse these expenses and put them on the balance sheet, two things happen just to take the obvious. One is that earnings go up. And second is the amount of capital invested goes up. So for Microsoft, and again, Microsoft's a very big, very profitable, very successful company. And that was a 15% lift to their earnings and about, again, 80% increase in their capital. You might imagine quite easily that for much smaller company and younger companies and earlier in their difference. development, the impact would be even more profound. So that gives you some sense. So automatically, you start to say, well, people use historical PE multiples or so forth. You're just getting, you're comparing apples to oranges if you start to do those kinds of things or take them too seriously. So just on the example of Microsoft and going back to research and development, you mentioned

that FASB, the U.S. accounting standards setter back in the 1970s made this decision to expense R&D because they wanted to be conservative. When you look at research and development today, is it all about generating future profits or when it comes to a company like Microsoft in a very competitive industry is some of it just about, I guess, like keeping up and maintenance rather than betting on the future? Yep. So let me make two points. First of all, we talk about this directly in the report, Tracy. It's a very good question. One way to think about, if you just want to say, I want a rough way to sort this in my own mind, is exactly what you said, which is like, how do I think about what's an investment versus what is

necessary to run this? It's precisely that. So say to yourself, and you might, you know, this would be a great question for executives, right? You say, all right, what's spending on our income statement and specifically selling general administrative cost? What spending do we need just to keep this thing going, right? We'll call that maintenance. And then what spending is truly discretionary that is in pursuit of growth?

we'll call it value-creating growth, right? So that segregation is really just the simple way to think about this. And as I mentioned in the Holton, and usually people talk about this for RD, they often will make it 100% intangible. And for like a young pharmaceutical company or biotechers, and that's probably reasonable. But very much to your point with the argument, and we draw this out in the report,

but for large, older, more established digital companies, it makes sense that a chunk and maybe even a meaningful chunk of our is just, in quotes, maintenance, right? So, you know, when you get your automatic Windows updates on your computer, a lot of that spending to support that was in R&D, that's not, that's not, you know, discretionary. That's something they have to do just to maintain the current business. So, so you're exactly right. So again, lots of judgment required here. It's more relevant for older and more established companies than the younger ones, but you're exactly right. that's that you have to. So the big broad defining differential is probably this what do I need to

maintain versus what am I spending that's discretionary to grow in the future. So I want to just get back to for people who maybe aren't as familiar with accounting terminology, just some of the words and ideas that we're discussing, including the idea of expensing investment. So just to help people conceptualize it. Let's say a company builds a one billion dollar factory. And it's expected to, you know, be in production for 20 or 30 years, and so they spend a billion dollars, but that becomes a $1 billion asset that they have on their balance sheet, and then over time that depreciates, and they get some sort of that affects their income and taxes and so forth. Two questions that come to mind. So A, just, is that the right framework? B, how is it different if a company,

say, spends $1 billion on building a brand? How does that look? And how in the accounting framework do you adjust for the fact that, look, if you build a $1 billion factory, that factory is probably never going to be worth more than $1 billion to you. But if you spend a billion dollars over time, say, building up a brand, that could become a $10 billion brand over time if it catches fire. Let's just be methodical about this. So the factory, as you said, you spend a billion dollars that goes on your balance sheet, right? It's going to be net property plant equipment. And then you're going to depreciate that over time. And so years at the end of that would be 20 years.

And what investors would see a straight line depreciation. So literally 1 20th of it would then be reflected as an expense on the income statement. So it would flow through the income statement. But again, a relatively small 5% of it. Right right to 20 year. I said like 5% shows up on your concern each year and predominantly shows up the balance chain. By the way, in the balance sheet, you're also reducing the value by that appreciate depreciation amount. Right.

Now that value, that asset could be worth more. I mean, presumably if you build this billion dollar asset and does incredibly profitable, and you sold it to somebody else, they would pay for that profitability. So it could be worth more than a billion dollars. But as you point out, you know, it's hard to, it's often not going to be five or ten times that amount. If you're building a brand and you're spending a billion dollars, and usually you wouldn't do it all in one fell swoop, right? You do it over time. But those, let's just use things like marketing, right, or advertising.

Those are going to be expense. And so the 100% of the cost of that in that particular period will reflect. on the income statement and it just goes away, right? You never see, there's no recorded value for it. And so you might imagine, you know, like crazy, you know, you spend your young company, you blow your whole advertising budget on December 31st of a year, right? And with the accounts would say, is that value, that thing's worth nothing. But of course, the next day, hopefully you'd get some positive benefits from that. So just you can see the absurdity of it from that, from that particular point of view. And as you said, as you, now again, we're, you know, sort of a litmus test for

the virtues of doing this is in mergers and acquisitions. So if you build, you know, Joe Inc. and you build this great brand and my company tries to take over your company, I'm going to pay you for those benefits that you've built or you accrued. And that will show up then on my balance sheet, right? So in the sense, if there's a transaction, it'll show up. But in a normal course of business in terms of how you built the business, it would not. So that's, and again, you know, if we keep our eyes on the cash flows, we're going to be fine.

But these are really, these can be very significant. And obviously the reason we're having this conversation today is because you go back in time. I mean, in 1970s, for example, tangible investments were doubled those of intangible investments. And today intangible investments are one and a half times tangible investment. So we've seen in a couple of generations a real flip in the significance of these particular items. And that distortion, again, has to be reversed, essentially, as we think about. things as investors. So here's something that I'm curious about in this conversation more broadly, which is that is there any way to think about the value of intangible assets ex ante? I mean,

we can obviously see that a great brand like, say, Lulu Lemon or Adidas or something, that's a brand, that's an, those assets throw off incredible amounts of money. Is there any way to not just sort of figure out the value of intangible assets in retrospect, or is it inherently something that has to be done only once we sort of get a feel for how profitable they are? Well, I mean, Joe, I'll try to go to a kind of convenient example of this, but it's a big one, which is things like subscription-based business. Okay. Okay. So you think about, you know, whatever it is, your Netflix subscription or your Verizon or whatever it is, right? And so the classic model to understand that is the company has a they call it customer acquisition cost, but an acquisition cost.

So they say, we want Joe and it's one of our customers and we're going to spend to get him or Tracy. And we're going to, you know, through advertising or marketing or some sort of promotion, right? So that they're going to absorb an expense to get you on their, get to get your numbers. And then over time, you're going to spend X per month and you'll stick around for a period of time. So that's a class example is that there are big frameworks for thinking about customer acquisition and lifetime, customer lifetime value. when companies are obviously making estimates of those values as they think about how much they're willing to spend to acquire new customers. So there's a fairly concrete example where again, it's still a judgment. You don't really know the answer, but people are making those kinds of calls.

And so, I mean, and you just go right down the line of some of the stock today that are, you know, things like the Pelotons, the world, the Netflix's of the world. These are really sort of the hot issues as investors look at these things is to think about how many customers can they sign up, what would the economic flight for customer and so forth. That's all this kind of stuff that we're talking about. A lot of short daily news podcasts focus on just one story. But right now, you probably need more. On Up First from NPR, we bring you three of the world's top headlines every day in under 15 minutes.

Because no one's story can capture all that's happening in this big, crazy world of ours on any given morning. Listen now to the Up First podcast from NPR. I have a slightly weird question, but just going back to the different treatment. of intangibles when a company does M&A versus when it develops them itself. Do you think that that different treatment encourages companies to do more MNA or to grow via acquisition nowadays, given the importance of intangibles to many companies? It's an interesting question, Tracy. I actually don't think so.

It was not, they don't think about it at all, but I don't think so. I do think that probably most of the M&A that relates to these kinds of things is to require either, you know, capabilities or particular business lines rather than than thinking about the accounting treatment per se. But sort of an add-on thought, though, is that one of the arguments that accountants make as to why they can't or shouldn't be thinking about these intangible assets differently than they are today, expensive them, is that they don't really know how to treat them. And I mentioned even in my little Microsoft example, there's a lot of debate as to what, even in your question about R&D, there's a lot of debate about how much should be considered intangible versus investment versus maintenance and so forth. And then amortization periods, these are all up to date.

But it turns out that when there's an M&A deal, those things happen, right? There are intangible assets that are put onto the balance sheet of the acquirer, and those are amortized over some period of time. So those judgments are being carried out by somebody now. So that's the other interesting point. But I don't think it's a motivator for M&A per se. There are a lot of other things that are interesting that would be, that they come into play there. But it does show you that at least in that setting, those judgments are being made by accountants right now. So in the intro, we talked about this idea of can a rethinking of accounting sort of rescue value investing.

And so in other words, instead of value investors sort of waiting around for, or maybe bank stocks or energy stocks to catch fire. The whole field can sort of be salvaged by just rethinking the screens, what counts is value. Where do you stand on that? And is that cheating? Is that a legitimate thing? Like, how significant is this?

And if sort of more people appreciate at this point, would sort of, would there be a role for people who come at investing from a quote, value mentality to thrive even in environment? You know, and Joe, you put your finger on just another very hot topic. I should mention one of, you know, one of my side things is I'm an adjunct professor at Columbia Business School and I'm part of the High Open Center program and dot investing. So very much part of that value investing tradition. And I think that one of the things just to keep our eye on is to think about, is to pose the question, what is value investing? And I think you said this even, Joe, in the introduction, there are two ways to think about it. One is buying something for less than what it's

work. And then the second is, and this was, I think, very much popularized with Gene Fama and Ken French's paper in 1992 is statistical factors, right? So low price to book, low price to earnings and so forth. So the first definition of value investing hasn't gone away at all, right? Buying something for less than a word that, you know, and we could have a conversation 10 years from now or 100 years from now, and I'm hopeful that we'd still have the same definition. The statistical factors, though, is the one I think that's been under pressure to some degree. And so there has been a slew of research. By the way, there are people who counter this, but there's been, I think, the balance of the research would suggest that with adjustments, as we've described, and obviously when you're talking about lots and lots of companies, you have to use fairly blunt instruments. But even with those blunt instruments, those adjustments allow you to get better signals. So I will draw your attention to a very interesting paper about value investing by Baruch-Lev and Anup

Shavastava. And it made the rounds, you know, came out in the fall last year. year and they revised in the spring of this year. And they made a couple of points that were really interesting. One is if you make these adjustments, the companies that fall into those categories of glamour, which is high, high valuation versus value, which is low valuation. The companies in those categories shuffle all around, right? So like a substantial percentage of them fall out of those bins. And the second is the signal you get from this value factor buying cheap things actually improves, they believe improve quite markedly when you introduce these.

kinds of adjustment. So this debate, and again, again, there may be, there may be more overarching themes about value that the value factor, as we know, all factors, by the way, tend to be episodic. Can value investing coexist with the efficient market hypothesis? This is something I've always wondered, but if you assume that the market does a reasonably good job of allocating capital to companies that show good potential, then, like, what is value? investing actually doing? Isn't it just basically saying that the market is wrong at any point in time?

Well, definitely. So just to take a step back, there's no, markets can't be perfectly efficient, right? Because there's the cost of gathering information and reflecting the prices is the consequence. There always has to be some sort of excess return. Lossi Pedersen calls this, you know, markets are efficiently inefficient, right? So there has to be enough to keep people trying to do this thing.

Now, value investing, if you go to sort of the academic community, there's a debate about what is at the core here. And there's sort of two different camps. The first camp is, gee, this is just, you know, value, the value factor is just compensation for risk. So our traditional models for measuring risk, which is usually based on the capital pricing model and some measure of volatility, we're just not capturing something that's important. And by introducing the value factor, we're now more completely capturing risk. The second camp, where I think the balance of the evidence lies, by the way, I think it's here, is that there are behavioral factors. And so as human beings, we tend to go to, we over extrompulate, we tend to go to

excesses, both on the greed and fear side. There's a consequence from time to time things become inefficiently priced in the sense that their fundamentals are not as strong as, or are off versus their expectations. So that, I mean, I'm not sure that debate has been resolved, but the premise of that at least, so you have to put yourself in one of those two camps and maybe it's a blend of the two, but if you believe in the behavioral effect now, I'll just say my own personal view is of that, you know, one thing that has not changed, we could have all the accounting stuff we want, one thing that is not changing just the nature of human behavior, right? So I think that's a very hard thing for us to change.

And so I suspect many of the kinds of patterns we've seen in markets, which, by the way, are not novel today. They've been around for literary centuries. I would anticipate will continue to be the kinds of patterns we see, at least for the foreseeable future. No one's serious has ever claimed that they have are perfectly efficient because they can't be. But I think that would be how I think about the value piece of that. I have one more question. So I know we've been thinking a lot about the big tech stocks in this

conversation. But I guess I have two questions actually. So one, does the emphasis on intangible assets, you know, things that we can't see or feel, things like brand value where you really have to put a lot of forecasting and estimates into figuring out how much something like that is worth. Does that make it even trickier to value a company nowadays? Is there more of a likelihood that we get it wrong? And secondly, when it comes to something like the tech stocks, what should investors be looking out for to see whether or not prices have truly overshot the future value up the company even when including things like intangibles. Right.

So on the, the first discussion is, you know, is it trickier to do this? What I always like to do as an investor is break things down to what I would call the basic unit of analysis, which is how does this company basically make money and thinking about that as carefully as possible. Now, you know, you sort of mentioned some of these things seem like they're more, you know, abstract to some degree. But look, a lot of intangibles, you know, your pharmaceutical company develop a new drug. It's not, you know, that's, and it's got a patent for.

example, that's not abstract. That's pretty clear and that's got value and that you can model those things pretty accurately or customer lifetime value calculations. We could debate about the details, but the basic framework seems to make a lot of sense. So can they be more difficult, perhaps? I think the bigger issue that comes up is this idea, it's been an academia they call it sunk in this, which is if you develop intangible assets for your own company, they may be less transferable, also the harder value in that way. But no, for the most part, I think that it's the same basic story. And then on the tech stocks, or just in general,

like how do we know that we're overpaying? That's where I would go back to this expectations approach. And again, I have no answers about any specific company or even the market today, but I would just say that it is important to say, what do I have to believe for this thing to make sense, right? Michael, that was great. Really appreciate you joining us.

Always a pleasure and fascinating. stuff, really helpful to sort of think through what these things mean in a concrete way. My pleasure, guy. Thanks, as always. Love the questions and I love the conversation. Thanks, Michael. I found that really helpful, Tracy. I mean, you know, this idea that intangible assets has grown in importance is sort of obvious. Everyone can figure it out. You look at, you know, the companies that are really valuable and you sort of recognize that they're not the sort of factory-heavy companies of your, but how that actually fits into a sort of valuations framework, I thought Michael explained really well. Yeah, I also liked his idea of looking at a basic unit

of analysis. So how does the company actually make money and sort of zeroing in on that to determine how important or how much of a return you would get on investment for a particular company? So, you know, I guess if you're, if you're operating like a retailer, then your investment from creating a new store is going to be very different from if you're operating a big tech company, for instance, and you develop new software and what your investment is or what your return on that particular investment is. Yeah. You know, one of the things that I sort of, as a journalist, and thinking about markets is obviously markets can be wrong. Assets can be overpriced or underpriced and there are bubbles and manias and peaks of pessimism. But by and large, I think it's a

valuable practice to get into the habit of sort of at least trying to justify a market value for anything at any given point. So you look at something like the pricing on Netflix or Tesla or some of these crazy names. And it's very easy to just say like, that's a bubble. That's overvalued. And they may be, and, you know, it's like bubbles really do happen. But I really do think that you should, one should always sort of attempt to sort of, I guess I would say, see it from the market's perspective, even though the market is not a person. And I do think that this is a way to get there, at least to some extent, with some of these names. Again, it's not to say that the market's priced right or that they're not overvalued or that they're not going to fall. But at least it can sort of, you can start building a framework in your head about how, you're, you're not.

some of these valuations might make sense. Now, I agree. And I think it's sort of that aspect of it is even more important for the undervalued companies or, you know, this is where I start to think that value investing is actually quite arrogant because you basically think you're smarter than the market and you're sort of rooting out companies that the market's view of is wrong. I don't know. I don't want to say the market is always right, but like it does seem like you're setting yourself up for disappointment if you're just sort of like running counter to it all the time. Yeah. No, I mean, I agree that. You know, another thing I was wondering about is like, okay, so as we established that there's sort of two ways to think about value investing, there's like the sort of statistical factor, which is the sort of part that hasn't done so well in recent years. Because if you just look at traditional. metrics like price to earnings or price to book, companies with low multiples. They haven't really done well.

And I just like wonder if like there will ever be a day where everyone sort of throws in the towel where no one is sort of left arguing that it's a good idea to buy a stock because it's sort of cheap on the traditional metrics. And everyone who considers themselves as a value investor eventually capitulates and starts coming up with reasons why actually Facebook and Netflix and Alphabet are actually value stocks. I feel like at some point that's going to happen. Maybe that'll be a major turning point in the market. Yeah, I think you're right. I keep thinking the last value investor standing would be a really good title for a book or some sort of like short fiction story or something like that. We should write it.

Basically, everyone is just going to own software and one person is going to own all the banks and oil companies. They're the last one to do it. They'll probably do well. That's right. And they're like camping out on a hill somewhere. somewhere. All right. Yeah, I like that. We should make a short film about it. Okay. Shall we leave it there? Yeah, save it there. All right. This has been another episode of the Odd Lots Podcast.

I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway. And I'm Jill Wisenthall. You can follow me on Twitter at the stalwart. And you should follow our guest, Michael Mobison on Twitter. His handle is M.J. Mobison. Follow our producer Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts at Bloomberg under the handle at podcast. Thanks for listening.

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