Yet Another Value Podcast - More Than a Numbers Game: A Brief History of Accounting (Fintwit Book Club January 2025)

Episode Date: January 15, 2025

In this bonus episode, Andrew and Byrne Hobart from The Diff discuss the 2008 book More Than a Numbers Game See Byrne's writing at: https://www.thediff.co/ More Than a Numbers Game on amazon: https://amzn.to/4ajREfe See our legal disclaimer here: https://www.yetanothervalueblog.com/p/legal-and-disclaimer

All right. Hello. Today, I'm Andrew Walker, host of Get Another Value Blog. Today, I'm happy to have on. One of my favorite authors, Bern Hobart. I say, have on. This is just the test gate. Burn Hobart from the Dith. We're thinking about doing a monthly Finchwood book club. We read on Byrne's suggestion more than a numbers game. We'll include a link in the show notes. But, Byrne, I'll talk over to you. You chose more than numbers game. So why don't you quickly, I love having the hard copy. Why don't you quickly say why you chose it, your thoughts on the books and everything. Yeah, yeah. So I basically, part of the reason I read this book was that I was reading, I think I was reading Super Money and it mentioned, so that book was written in the early 70s and was, it's by the same guy who wrote The Money Game. It's a really fun book, among other things, really early interview with Warren Buffett. And it talks about how investors vary in how sophisticated they are. And one of the things it says is, some investors are so anxious to do the work and do the research and know their companies that they don't just read the annual report, they literally go to the SEC and read this weird thing called a 10K, and it has the stuff you won't find in the annual report. That was interesting. And the other thing it said was something to the effect of some investors don't even wait for the annual earnings number.

They literally look for the quarterly numbers instead. And to me, this is like saying some investors calculate what they think the stock is worth before buying it or like some investors use limit orders like, this is. This is like really, really obvious stuff. And so, but then, you know, if you go back far enough, if you're reading 19th century trading anecdotes, anecdotes, it's totally reasonable to think, okay, these people did not really know what earnings were, like, did they know what depreciation was? Maybe, maybe not.

And I realized, like, we've made a lot of progress in accounting. And even though there's probably more progress to be made, like we are in a much better situation than we were in the distant past. We're in a much better situation than we were when I first started looking at financial statements in the early 2000s, and I wanted to know where that had come from, how it had happened. And I also had this general sense that a lot of accounting judgments seem superficially wrong until you try to come up with a better alternative. And then you decide that, okay, this is maybe not great.

Like maybe we could have done it another way, but this is actually a pretty good idea. And so that's stuff like, I don't know, hold. So I think like the first accounting change that I remember reading about was the end of goodwill amortization and that there was a Buffett letter when I first started reading Buffett letters that talked about this change and Buffett thought it made sense and that if you were to acquire all of Coca-Cola, it wouldn't make sense to depreciate the Coke brand down to zero. But it also struck me that this stuff is kind of arbitrary. Like the financial statements, the cash flows are not changed, but the numbers that you as an investor see do change. And then you and I talked about this a little

bit over email just before the show that sometimes the numbers investors see, even if those numbers don't really correspond to cash flows, those affect their decisions, they affect how they value the company, that affects how the competitors of that company behave. And so good accounting is actually very, very socially useful because it's not just a scorecard for any one firm. And, you know, you can take the libertarian view, and I think it's fine. If you run your own business, do your accounting whoever you want. And if you happen to run out of money and you didn't realize that that was going to happen. That's, that's your loss. And maybe, maybe you learn why some accounting principles are generally accepted and some aren't. But if you run a public company,

I think there is some obligation that if people are going to look at your financial statements and respond to them, it's very important to society that these financial statements accurately reflect reality. And so this book is just the story of how people made that happen. I'm just going to yes and a few things there. But first, I'm going to devolt, you know, sometimes I'll get emails from listeners. They'll be like, hey, I love the podcast. But when you talk, I need to listen on one X speed. And when your guest, talk, I speed up to one and a half speed. And I think you and I might be the first example of two people are so passionate and fast spoken. People might need to turn this down to 0.75 times speed if

they're going to do it. But to yes, and everything you said, I really liked everything you said there, you know, I love the point you said where people used to go and he'd be like, these crazy people will go and read the 10K instead of just the annual part. And it reminds me of like in the 30s before Ben Graham came around, like everybody was just buying stocks kind of like crazy. And then Ben Graham said, let's calculate the asset value. And like the, you know, Today, if you were like, I'm buying this stock at eight times price earnings, I will always say, unless you've got more insight behind that, you're probably going to get your face ripped off. But let's go with the last thing you talked about.

I love that point because the anecdote, I think my favorite anecdote in the whole book is WorldCom, it's towards the end. WorldCom is capitalizing their line expenses. In this book, it should be noted, is released in 2008, and I want to ask you questions about that later. But WorldCom is capitalizing the line expenses, and because of that, they look much more profitable than AT&T. their competitor. I believe the book says AT&T looks like a lazy dinosaur or something. And AT&T who is expensing their line expenses. And if you capitalize something, you know, basically divide by 10, 20, whatever, you're going to report much higher margin

than someone who's expensing. AT&T looks stayed and they go on a, they fire 20,000 people and they buy a ton of cable companies for over $100 billion and almost destroy AT&T. And I had just never heard of a company almost getting destroyed by a competitor's fraud before. So I thought it was so interesting there. Everything you said where I know I call management teams all the time, I'm like, hey, your margins are 5%. Your competitors margins are 8%. Why the discrepancy?

You need to get up there. You're lazy. You need to fire people. And it kind of really drove home. Hey, fraudulent accounting statements, yes, it can mess up with the company, but it can really mess with other companies, competitors, everything. It has real impact. So I'll pause there.

Anything you want to say on that. Yeah, I think that's true. Like there is this weird dynamic where, I recently read this anecdote that, you know, but the story of the mechanical Turk, not the Amazon project, but the thing it's named after, where it's like this fake chess playing robot. There was really just a guy under the robot moving the chess pieces. But apparently there was a British inventor, Edmund Cartwright, who saw the mechanical Turk, and he fell for it. But he thought to himself, if it's possible to build a machine that is sophisticated enough to play chess, and surely you should be able to build a machine that can weave. And so he built an actual power loom, early prototype of a power loom. So sometimes the fraud does force people to step up their game. They're like, how can we possibly beat these people? We have to work much harder. They do work much harder. And it turns out that the fraudiness was very slight. I think that is also something just worth noting on a lot of accounting frauds. Like there are a handful of frauds where it's just

the plan from the beginning is we're going to lie up our numbers and rip people off. But the way a lot of them happen is that just this one time, just this quarter, we are going to front load just this one transaction and we'll hit our numbers and, you know, we know we're capable of hitting our numbers, so it's not really a big deal. And in fact, some of the 90s accounting frauds, they did start with, with hiding profits. And Enron did some of this, too, because their trading desk was just so wildly profitable that, one, they wanted the cookie jar, so they could offset future write-offs. But two, they just really didn't like the optics of, you know, California is in the dark because the power companies are

We're milking them for all their worth, absolutely, yep. Yeah, yeah. So, I think generally it is grossive to have different yardsticks that look like the same yardstick from the outside, but that actually are measuring different things. And because I think that is part of the purpose of accounting. And the book talks about this is that you want to be able to compare different companies.

And you don't just want the CEO of the New York Central saying, we're the best railroad looking at our dividend and the head of the Penn Central. or yeah, like the head of the Penn Central saying the same thing. Like you actually want to have some kind of way to quantify who owns what, what return are they getting and what is driving that return. So I think it does come from a really good place. But then accounting is this attempt to take a really messy world of abstractions and then turn it into something concrete and rules driven where you want a situation

where if you had two accountants prepare the same firm's financial statements, they would have exactly the same number. And I don't know if anyone has ever tried that, but I assume that there's like a very small limit of like company size after which that you basically never get the same number from two different people. It's funny because the through line, one of the three lines throughout the book is Arthur Anderson has mentioned five times. Or it's mentioned tons of times.

But five times they say Arthur Anderson was the place the most where they wanted every accountant to give the exact same number. Like no discretion. Everyone plays and follows by the exact same rules. And when you said that, like I think that might have been, in the 90s, the place that was most likely where everyone would get you to the same rules. And part of that, and there was obviously a hundred brother of this stuff, but it clearly seems like that desire and that culture is ultimately one of the many things that led to their demise.

I'd put it at like, if there were 100 issues, I'd say it's probably number six on the list or something. Yeah. I think what happens is it, I think any accountant, any good accountant would say that accounting approximates economic reality. It does not perfectly correspond to economic reality. So there will always be a gap. And if they say that, then part of their discretion is potentially giving the company more credit than the strict application of the rules would do.

And some of it is saying, you know, look, guys, like, it is very obvious that if you own just enough of this special purpose entity to not consolidate it on your balance sheet and you're doing business with that same entity and it's collateral for the derivative rights to you is a derivative on your own stock that you're also explicitly designing so you don't have to report that. Like, they, you'd have to look at that and say, this, this vehicle has no purpose other than moving risk off the balance sheet, but the risk is still there. But if you are sufficiently rules driven and it complies with every single one of the rules and your, you know, Enron has hired really good accountants of its own who know exactly what the limits of those rules are, then maybe you are stuck saying that just per our ethics statement, we absolutely must approve this particular instance of lying to your shareholders. You know, when you say that, it's like they hire really good accountant who know who know how to take the rules. the exact limit. It's like if they had come along 20 years later, they probably would have been so rich like trading crypto or prop trading like very specific. I think about something, will the U.S. government market shut down on polymarket? You know, when they reached the deal, I think it dropped towards no for a second. And then enterprising traders read the fine print

and said, oh my gosh, like the U.S. government will technically default for an hour. This is a yes. Like Enron's accountants would have been so perfect at that. It's like, no, in one life it's fraud. in the next life, they would have been great prop traders. Yeah, although I think that you can almost view prop trading as like the pro-social application of the same skill that allows you to commit accounting fraud. Because if you, like some prop trading is you find an interesting pattern and you find the most cost-effective way to exploit it. And sometimes it is like you reason really carefully about how this, either how this asset

your trading is structured or how you yourself could structure this trade. And you find the one detail that other people are not thinking about, like the one thing where, hey, if you don't pay attention to the correlation between these two assets and a derivative that touches both of them is worth X. And if you do pay attention to that correlation or you pay attention to how that correlation would change in different scenarios, then the value of the derivative is something totally different. So they are sort of doing this distributed bug bounty program where if someone has put together an asset that just doesn't make very much financial sense and isn't actually going to blow up, the prop traders are the ones putting some of

the downward pressure on that asset's price. And they do keep things in a slightly better equilibrium. So in that adversarial scenario, that skill set is actually really valuable and does make the market more efficient and does keep people from making dumb mistakes. But in a scenario where you're cooperative, then it's tricky. And actually, the book talks a little bit about this question of who's going to pay for the accountants, who's going to pay for the audit, and how that question has evolved. And there are just no good answers. If investors pay for the audit, you either have one audit per investor and then you have a ton of duplicated work, or you have one investor pays for the audit and then everyone uses the audit, in which case

the biggest investor is basically paying a tax to keep the rest of the market informed. And so maybe the least bad option is you have the company pay for the audit and you make sure that, you know, in overtime investors have just learned that there are auditing firms that are a really good signal, there are auditing firms that are kind of a neutral signal, there are auditing firms where you actually want to have an alert. Like you want to scrape, you want to subscribe to the RSS feed of new S-1s and have an alert that triggers every time a particular auditor is involved in companies going public.

And then you immediately add it to one of those watch lists that displays the borrow cost right there. You know what's going to happen. Yeah. I'm laughing because if the top investor pays for the audit, I'm laughing. You could have a scenario where burn owns 100,000 shares, I own 100,000. in one shares and then I'm like, I sell down to 99th, you sell down to 98,000 because we're trying to pass that bill back and forth. I like also your audit costing, right? One of the through themes

of this book and one I really wanted to talk to you about is, you know, how cyclical finance can be, right? An audit cost. Hey, who should pay the investor or the company? Obviously, the company pays there can be mismatched. How much this book was released in middle, early 2008? How much does that remind you of the ratings agencies issues that would spring up like literally as this book is getting published where people were debating, oh, isn't it kind of strange that the companies pay rating agencies for their ratings and then like investors, especially credit funds rely on it? So we can talk about that or I was just struck by there are a thousand of the other examples of hey, in the 20s, you know, people are relying on dividend payments to estimate earnings.

That sounds a lot like yield codes in the 2010s to me. Hey, in the 70s, one of my favorite is, In the 70s, banks come to the account board. It's like, hey, if we've got a loan that's had credit issues, but we can modify it so we still expect full repayment. Can we not take a right off because it would destroy our capital base? Like, it had so many rhymes to the health and maturity things that destroy Silicon Valley Bank or even kind of some of the market to market issues in the 2000 crisis, 2008 crisis, where everyone goes. So I wanted to ask you like, what did you think about those through lines and that cyclicality? And I'll have a counselor example to that to follow up on. Yeah, yeah. And I think another thing that is it wasn't structured this way, but economically

it was equivalent to this, was that if you think about sell-side investor compensation before the 2003 settlement, in effect, the companies were paying for coverage because the cell-side researchers get bonuses based on the underwriting that their bank does, and that underwriting is partly a function of, did they put a buy rating on a company that issues lots of stock and lots of convertibles. And so in effect, like if you look at just the flow of the flow of incentives, it is pretty economically equivalent to companies pay for coverage and they pay for good coverage. And that didn't work. But what it did mean was that there was a lot of coverage and it was pretty widely available. And now we have this situation where it's much harder for firms to engineer

things so they get really good coverage to the extent that they can. They're actually paying in kind by doing management meetings at conferences hosted by the banks. that who's analysts they get along with, and it's just really easy to get along with someone who thinks you're a swell CEO, whose stock has tried to be undervalued. It's just, you know, great to have something like that in common with someone.

So now, but what we really have is a system where the institutions are paying for the research, and it turns out that they're perfectly happy to pay for research, most of which is the research they're paying for that is distributed internally. So there's still a lot of really great equity research out there, but it's not very far out there. It gets forwarded to half a dozen people within one firm.

They make the trade. That's how the research is monetized. So in some ways, when you have a setup for paying for information and the information will be widely available, if you align incentives really well such that information, so there's a really strong incentive for that information to be accurate, you're also creating an incentive for that information to not be widely distributed. And I think in the case of the firms just paying their auditor to audit, you know,

to audit it, to have some stamp of approval. And part of what that does is it means that the auditors know that their value to every other company is contingent on their willingness to say no to whatever client is closest to the line. And it seems like the structure of the industry, it doesn't really support that there would be multiple firms where you can actually stack rank their reputation. It's just really hard to be the second most reputable of the big firms. It seems more, it's a lot more feasible for there to be this,

cluster of big companies where it just means you've got approval from big company and then smaller companies where it means some combination like smaller editors where it means some combination of one yeah you just can't afford to pay EY that much money right now would not be a good use of shareholder funds but two maybe you you can't afford to have someone from EY looking at your books and asking themselves whether or not it be good for their firm's franchise if they if your firm got a clean opinion did you see super micro i think you wrote it up so i think you did you see super micro that one of the most fascinating things so for those who weren't following super micro was a growth darling i think i calculated it it was like the russell was up 10% last year and 1.5% of it i think

was super micro so like from january to mark super micro stop 5xs or something and then it graduates from the russell 2000 to the smp 500 russell 2 000 kicks it out and then super micro has all these accounting issues like tons of accounting issues inside of trading there's a short report all this sort, sorry, not inside trading, some allegations of self-dealing, there's a short report, all this sort of stuff. And the stock gets dropped 80%. So it's funny because I have been wondering if it had been in Russell 2000 for the entire year. I think it would have dragged Russell 2000's returns like from 10% last year to 7.5, but neither here nor though. The interesting thing for the discussion you just had was super micro's accountant resigns in kind of like fiery accounts in fashion,

right? It's one of those things where you read it and didn't know anything about accounting you'd be like, that's normal. But if you read it and you had read like 100 audits, I'd be like, oh, my God. This was the one where they're like, we, we think you can rely on paragraphs one through seven and also paragraph nine and, you know, paragraph 15 through 20. Like, when they were just saying point by point, like, this is the part you should not trust. Yes, yes. That's pretty bad. And the interesting thing about that was, A, because it was a fiery letter and the stock was going crazy. But the other, like, that was a big four firm that resigned. And this is a super micro is still a 50 billion EV company, but a big four EV firm resigned with the company on fire and with that dramatic letter, like, who can step in?

Because if you're the firm that steps in, then is it because you think you'll take like more risk around the edges than that other firm or are you flat out saying the other firm was wrong? Are you creating a reputation as like kind of a monetizable place? Like, hey, pay us a little extra and we'll let you like skirt around the edges because that's, that might be a disaster for the rest of your business. And the solution probably was obvious in hindsight, but it was like, if there's a big four and then there's a middle 10, like one of the lower rung middle 10, I think, took it. But I just thought that was a crazy example of everything you're saying. I'll kind of toss it over to you. Yeah. Yeah.

I think in a situation like that, you know, if there are that many outstanding accounting questions, I think the thing to do to make the business a viable large cap again is you actually just basically say you're hiring the new auditor to confirm that everything the previous auditor said was right. and you do a massive restatement and you pay that new auditor a lot of money because you are going to drop them for a big four as soon as you have a chance to do so. But I think both sides understand that and if, you know, that Big Ten company like for the duration of that client relationship, they at least get to say in their presentations to other clients that we do audit one member of the S&P 500 and, you know, we're hoping to expand that franchise and, you know, you hope you don't get too many follow questions. But I think something, yeah, it is really tough to get out of accounting messes. And I think a lot of them do start out with just honest mistakes. And part of when the book is describing just

what companies did even internally. And that's, I guess that is another point to bring up about the book is that it's part of what makes modern accounting so annoyingly complicated. It's actually two schools of thought that got merged into one. And one school of thought was, I am a London-based investor. And because I like growth and I like excitement, I am lending money to the hot tech stocks of the day, which are American railroads. And because I, you know, I don't want to be sailing across the ocean every so often. I need accurate financial statements. I need to know what my money is getting. But since I'm a bond investor, what I care about is I put a million dollars into this company. Do I have a million dollars worth of assets? And I know that as long as that's true, my

my investment is pretty secure, and yes, there will be cash flows, but I don't have access to the upside of those cash flows. I just get whatever, you know, I just get the money that I contractually guaranteed to get. So they cared about that. And then the other piece was just controlling cost and understanding product mix from the perspective, usually of a manufacturer, where you are general motors, you make a bunch of different kinds of cars. They all use different components. And you just want to understand, should I, should this assembly line stop making this model and make the next model or not. And what is the payoff if I make it out of this material versus that material, et cetera? And those are just really different questions. Like one of them is

actually looking at a stock of just, you know, a set list of assets. And then one of them is looking at a flow and looking at the interrelations between those flows. But you do need to answer both because the stock is the accumulation of flows over time, especially if the company is not paying out all of its earnings as a dividend. So they kind of had to merge those two schools of thought, But it's just two different groups that are thinking very differently. And one group is thinking about maximizing profit and upside. One of them is thinking about controlling downside and having some liquidatable collateral that backs some loans. But to have a, you know, if you produce a series of balance sheets, you have to link them with P&L and with cash flow statements.

So you kind of have to do both. But if they start with different assumptions and different goals, then it's tricky to tie them together. But that is to say that when you look through this history, there are just a lot of cases where people had to make judgment calls. They had to think about those judgment calls. Actually, one of the pieces I really liked in this was the anecdote about when the U.S. government was giving companies a tax credit for capital investment. There were actually really good arguments for the two different account of treatments, one of which is, okay, you bought a million dollar machine, you get a $60,000 tax credit. Therefore, you actually spent $940,000 on this machine. So depreciate it as if that's what you'd paid.

And then the other school of thought was, no, you got a $60,000 check in response to something you did for your business. So that's revenue. And you can kind of see it both ways, but it was also true that you, I think one of the reasons that accountants do tend to just choose the more cautious of the two equally defensible viewpoints is that you never want to give someone an incentive to do something more aggressive than they really want to. You never want to give them financial statements that reward just maximum risk taking even and reward it similarly to just the outcomes of more prudent decisions. You know, I think that goes nicely to my next question, which was my overall takeaway from the book, I think maybe as like somebody really practices it. But throughout the book, almost every chapter, you will have an example of companies, investors screaming at their accounts that's, hey, you can't do this. like, you know, debt that used to be off balance sheet. You'll have an example of an accounting regulation that would require them to bring it on.

And they'll be like, you can't do this. Our investors will go crazy or, you know, expectancy stock comp, all these examples. And for every example, except for one, the one is maybe EPS shares in the 90s is the one example. But for every example, but one, companies like, you're going to destroy the capital market, you'll destroy us. And then he kind of dryly follows it up with capital markets. care there have been studies capital audiences are off balance sheet on balance sheet expands capitalized like capital markets get there and maybe one company can like fool the market but on the whole it doesn't

really change i i was really impressed by that and i thought about that i want to ask you about that and then i want to ask you again the book stopped in 2008 so i do wonder let me ask you about that and then i'll follow up with the present day yeah yeah so i think you know part of that is actually to the credit of these companies where they are arguing with their accountants they are saying this change is going to destroy us. And for that not to happen, it has to be the case that they were actually behaving pretty economically rationally. Like they were, if they were gaming it, then absolutely would destroy them.

And like this comes up like stock-based comp. Yeah. Like with stock-based comp, there was this funny tweet a couple weeks ago for someone saying, like, you know, sophisticated investors don't debate this. And I couldn't tell which side it was taking. I couldn't tell if it was taking the side of just ignore stock-based comp entirely or just treat stock-based comp as if it were a cash. expense and pretend that the company is continuously doing secondary issuances to pay employee

salaries if they're paying those salaries in stock because those are economically equivalent. And it is the case that there are some companies where just, you know, the price makes a lot more sense if you pretend that stock-based compensation isn't real. But then you look at the long-term chart for those companies and you're like, well, if I had bought this because the valuation made sense because I ignored stock-based comp, I would not be in a happy place right now. like Snap. Snap has been very generous with its shares, and the shares have not really appreciated over time. But, you know, the other thing is you talk to these companies, because it's generally

tech companies that you're talking about, about this, right? And you talk to Snap or Twitter was very much in this place as well. It's like, look, man, we're competing against Facebook and Google. Like, you are the average engineer versus the super above average engineer, the above average engineer, like, there's a huge difference. We compete with them. And it's like, what do you want us to do? I mean, I've literally had them ask me this. It's like, what do you want us to do? Yeah, we're spending 8% of sales on stock. Our stock goes down all the time, so it's not like it ever comes out. And if we don't do that, then we're never going to hire an engineer again. They're kind of like, damned if you do, damned if you don't.

And I guess the correct answer might be short them long, the mag seven and go sit on a beach. Yeah, I mean, I think, I think that is often the answer. It's like if, because someone like meta or Zoom, like both of them have moved much for more towards its cash. Like, we're doing cash comp and we're not, it's just, there's too much confusion about our economics and also we can afford it because we have cash flow. So, yeah, if you're competing against a company, like you, you know, you have an engineer, you really want to hire them, you have to pay 800K to beat the meta offer and meta can do 800K in cash or stock and you can only do 800K in stock. Well, to the extent that that works, it has to be the case that either

a, you, like someone has to be misvalued the stock. And if it is like, you, you, like, someone has to be misvalued the stock. And if it is like employees are going to overvalue the stock, they're going to assume that it always goes up, then maybe that is actually economically rational. But it should still be something where if it's economically rational to spend money this way, you should be willing to disclose it. And I just, like my thought experiment is always that if you, if you imagine a company that just switches from half cash, half stock based compensation for its employees to all cash compensation and we're going to issue enough stock to pay all that cash, that has no change in the economic value of the company other than, one, if

employees are more incentivized by the stock, and two, if the underwriting fees are higher than whatever the administrative cost of just giving employee stock options is. So if there's any change in how you value a company, if they say that they're doing that, then something is wrong with your accounting. Well, you know, that answer might be, hey, do you like accounting or do you like making money? You know, that's how it feels the answer is sometimes. I mean, I've never heard someone say that during a bear market. That's a great point. Let me, I think that discussion of stock comp, which we could have had in the 90s, I mean,

there's a big section about the 90s.com. We could have had post.com crash or we could have it today, which I think speaks to how cyclical these things could be. Let me fast forward that today because one of the debates I have a lot with my companies, with other investors is, I'll just give a specific example. There is one company in industry that recently, they switched their financing from a way that would finance their inventory off balance sheet to on balance sheet so it brought on a decent bit of debt this is a pretty asset inventory heavy it

brought in decent bit of debt and most of the other companies in their industry have that sitting off balance sheet there's no no no no funny business here just like the terms and everything that's how they works and I know a lot of investors partially myself included were like dude this is bad for this company like how are they ever going to get out of this doom loop they screen with more debt disaster for quants disaster for screening and a and a and a world of passive, how is this good? And the company's like, hey, we can save 50 basis points a year on hundreds of millions of dollars. Like, that's pretty meaningful. So economically, it's better

for them. But I guess my question to you, and I will admit, I kind of lean towards the economics, just to tell, maybe I'm biaseding the witness. I kind of lean towards that economics, but I can see in a world where today it's all quants and all index are the most, do you think that the, you know, screaming that for 100 years companies put up, you destroy our optics, you destroy our company, do you think that's more meaningful today than it was throughout this book's life cycle? I don't actually think so. I think a lot of those quant strategies, like, yes, it is true that if you change something about your economics such that you do actually produce more free cash flow, but also it looks like you have more leverage, but you actually had that

leverage all along. That, yeah, there will be some systematic strategies that are selling. But those strategies, they're, you know, long 600 stock, short 800 stocks or something. So it's incremental. It does add up because there are a lot of them and a lot of them are using very similar signals for the good reason that those signals do tend to work. But if you, one thing the company is doing is it's actually engineering this turnover in its shareholder base where proportionately more of its investors are going to be people who care about cash flow and economics and fewer of its investors are going to be the quants and indexers. Are those people, people with a higher cost of capital, right? Like a person, let's say I run a 10 stock fund and all of it is like

deeply research. My cost of capital is going to be much higher than the quant strategy that's long 500 short 500 and just like kind of playing the statistics. Isn't that right? Just because I need some return of my time. Isn't my cost of capital higher than that? So that's actually a tricky question because you, I think the the quants would think about capital a little differently from the way discretionary investors do. And typically, I think at least my perspective starting as a discretionary investor was that the default portfolio is 100% net long, 100% gross long. And then anything you do beyond that is something extra you do. So like I mentally benchmark everything to am I doing more or less, now that I've gotten more quantitative, I think about am I trying to have more volatility

than the S&P 500 or less? And what's my beta versus versus the FEP? And what's the incremental contribution of this position to my overall volatility and structure? But the, so if you're running one of those quant strategies where you, you are massively diversified, you're using lots of different signals. You have a position in basically everything liquid. And because of that, because of all that diversification, you can lever up. You wouldn't want to think of the cost of capital in terms of what is, you know, what is the prime broker charging them for the incremental capital? You do sort of want to think of the cost of capital in terms of if they take on this much more risk than how much more equity do they need, like how much collateral do they need to send over their prime broker.

And I think that that, in that case, your cost of capital difference is probably not that. that high. And also, like the cost of equity capital is sort of what is what is the return that you're missing out on if you don't do this. And that is something that the quants can probably calculate a lot more accurately than discretionary investors can. But it's also something where the quant number is probably going to be higher and it should reasonably be higher. Like they should target a higher return because they can actually, they have more historical data and have a better sense of what is the actual return on the equity slice of what you're doing from this particular set of strategies.

So, yeah, I don't, I also think that if you're thinking about the cost of capital for individual discretionary investors or for discretionary investors generally, you also do want to think about just the return on time function is a little bit tricky because, one, you do get some level of upside from researching one company and understanding more about its overall industry. And I'm actually here at a company where part of the, part of the thesis, is, hey, they are kicked out of an index, so that's bad, you know, for their stock price temporarily.

And the other is that they, the core business is one of those nice, fairly high margin industrial companies, but they also, they decided to become a big conglomerate. So they bought a distributor. And so the distributor added a huge chunk of revenue, a tiny amount of profit. And now if you screen them, the industry classification is still machinery, but they suddenly look like a kind of average margin machinery company, but it's actually that, or it's not machiner. It's like industrial stuff. They're just a polished manufacturer.

You have, what's the Leonardo decaprio line from Janko and Trade? Like, you had my, I'm going to be hitting you up for that company. Okay. Yeah, no, it's, like, it's an interesting one where basically, like, what I'm, part of what I think is like if a rogue asteroid destroyed the distribution company, I think the stock would probably go up over the next year relative to counterfactually, because suddenly they'd look like a high margin, like a more interesting company. But so that's, that's a case where they don't, because I was asking like about companies that

screen poorly and you're saying, hey, this is a company that did a weird deal. Now they screen as something that they're not in this case. And if you just hide that off, the market's inefficient enough to go up. Isn't that proving my point on, hey, these companies, my inventory debt example, like if they just took it off balance sheet, economically be a poor choice, but their stock might go up because they screen better. Aren't you kind of like? So, yeah, I'm talking to that in the short term, but I think the thing that offsets that is

private equity, where they do care about cash flow. They fixate on cash flow. They are very good at modeling balance sheets and P&L and cash flow statement. And they are very good, at least when they control the company at making the choice that does improve cash flow, even if it makes the accounting numbers look bad. And like pretty much every S-1 I look at for a P.E-owned company, it's reporting a gap loss. It has been persistently reporting gap losses. And when you read the letter from the chairman and read their description of the business, they're clearly describing an actual good viable business that's generating cash flow and that is accruing value over time. So they're fine with it. And they, it's a large asset class. So I agree with you.

They eventually take things out. In the, in the infinity, that is, that is the fix, right? But I think, I do think in the short to medium term, because the company you described, if private equity bought it today, they would have no problem with the margins. The company I described, they'd keep it the exact same way. But in the short to medium term, like when you're looking for alpha or undervalued stocks, I do think it's interesting because, look, look, private equity can't buy every company. And I know, like I have a lot of friends of private equity, they don't go hostile on companies, right? They need like an, they need the royal carpet rolled out like, hey, we would like you to buy us. So you could have a company

that's trading inefficiently, in my hypothesis, you could have them been trading inefficiently for three, five years until really an activist comes in and either forces them to sell or makes it so uncomfortable for the board that they sell. So agreed in the long term, like private equity will do it. And there are all sorts of other reasons why, you know, levers will get pulled for it to be efficient, but I do think it's still an interesting question in the short to medium term about it. I do. I think like I guess the nice thing about some level of diversification is that if you have a diversified set of long-term bets, it's always somebody's short term, right? So there's always some, some case where it's actually working out pretty

nicely. And and yeah, I think it's just, I think it's, it is very, very hard not to make money. If your analysis is correct and you understand why someone is selling a particular kind of company and you understand why that's the wrong decision, it's very hard at scale to actually lose money taking care of that transaction. In fact, like going back to the prop trader thing, that is sometimes that's what they're looking for is who is trading this with an other than economic motivation and how can we step in and exploit that? My favorite example of that is looking at the sharp ratios of buy-and-hold strategies for corporate credit by credit rating where the highest sharp thing to do is buy the highest rated junk bonds and the

lowest sharp thing to do, the very lowest sharp thing to do is by just like triple C rated things that are just about to default. That's for a lottery ticket reasons. But the other the other low sharp thing is buying triple B rated bonds because everyone who has an investment grade mandate knows that that's where all the action in their universe is. And then companies know that if they optimize for exactly that credit rating, they will be investment grade and be as levered as they can be while being investment grade. And there's just infinite appetite for that particular kind of paper. So if you have, and I presume that the reason this gap doesn't close is that it would be hard to actually get cheap enough funding to lever up this portfolio. But if you could do a

massively levered portfolio of long, long double B, short triple B, I think you'd get some, you get an interesting return profile. And you do periodically have upgrades that, immediately push something into the overbought rather than oversold category and you just you monetize that by selling. I suspect you'd also have sizing problems where like the size of the triple B universe is probably one-tenth of the size of the, sorry, the size of the double B is probably one-tenth of triple B. So it's like, cool, you want to do this trade and you're quickly running into liquidity, sizing,

all those sort of stuff. It is interesting you mentioned because they had, they mentioned Milken a few times in this book. And they had an anecdote that I had never understood before. like they mentioned milk and obviously fasting guy fast example i didn't realize this is their suggestion but i believe they suggest hey a lot of milk and success success and this is true for a lot of people who are successful a lot of milk and success come from a few tailwinds and they specifically point to some tailwinds in the tax code i believe in 81 they allow something to be deductible that hadn't been deductible for or no it was accelerated depreciation and they points a few other

examples that like really right when he's getting big really like set the tailwinds on fire for his thing. And I just never heard of those specific tailwind. So I was very interested in that, and that relates to the high yield example you lay out. Yeah, yeah. Milken, you did actually have some pretty good timing. Like if you get into fixed income when rates are high and there's a recession and then your, you know, the economy grows and rates go down. And that's pretty good. And yeah, there were some other. So I reread Predator's Ball a couple weeks back, or a couple months back at this point. And it was really fun. And one of the things I did point out was that, He was, his brother was actually really good with taxes and that at the time that Milken was active and earning a lot of money, there was this provision in the tax code where if you, if you bought a treasury bond, you could allocate that and then you sold different pieces of it, like you sold the principal or you sold the interest rate component.

You could actually allocate your cost of capital as you wish between those. So buy treasury, sell a zero coupon bond, and you've immediately taken a capital loss and, you know, treasuries are yielding 15%. It's a pretty substantial capital loss. And so it's, you know, he was compounding money pretty fast in gross terms. And then in after tax terms was probably compounding about as fast at that point. I mean, that's so crazy because you could do that. That's basically an infinite money machine. Like you could be reporting negative short term. Nothing's tax advice. We shouldn't. in a thousand years, but, I mean, looking at the historic historical tax code stuff, there is a lot of stuff where it was just like infinite money machine and either people didn't know about it or they actually felt like there was just not a large enough population of really rich people who were actually willing to exploit it that way.

But stuff like oil depreciation allowances where you could basically write off some of the revenue from oil as the cost of the oil not being in the ground. And there was no symmetry where if you drill for oil and discover oil, you have to realize a massive capital gain on all the other ground. No, you just depreciate that capital that you got for free, sort of. Do you think the reason that these existed in the 70s, whatever, and I don't, to my knowledge, I mean, maybe there's the secret rich cabal that knows a lot of them. And there are like good taxes, tax loopholes and stuff.

But the reason they were seeing more prevalent than, do you think it's supposed hindsight bias? Like we hear of the five people who made a billion dollars doing these and we don't hear of the thousand. I want to ask hindsight bias is different. Or do you think it's because, hey, there was no internet. Capital was a lot slower back then. So if you were really up and coming, you could really study these and take advantage. But today, if that happened, there would be a Reddit board saying, hey, look at this famous money hack. And either the government would shut down because so many people would do it or that's probably what would happen. But do you think it was, I guess, lack of information or do you think just it's hindsight bias that you did that?

So I think those both matter a lot. Like Control F is just a wonderful technology. If I wanted to maximize my network, that I could bring one computer tool back in time to 1955, Control F, and then just having a digital version of the tax code, then I, yeah, pretty much infinite money. I'd probably end up in prison somehow. But yeah, in the meantime, lots of fun. But I think the other one is that there is this co-evolution between what the tax code tells you to do and what you end up doing. And my favorite example of this is Ronald Reagan destroyed the Midtown Dynamo,

scene because he changed the tax deductibility of dining and entertainment from 100% deductible to 50%. And if you think of 100% deductible entertainment, top marginal tax rate in the late 50s of 92%. That means that if you take someone out for drinks as business, it's a 92% off happy hour versus just going out and having fun on your own. So that's where the three martini lunch came from, is that these were really, really affordable martinis in after tax terms. with a massive tax art. And, you know, I think there had to be some point at which people just didn't do that. And then some point at which they realized that this is like the only, like, you should not really

be, you know, except for special occasions. You should not be going out to eat without some business purpose in mind because it is so much more affordable. And then suddenly a lot of business culture revolves around this. And you start to realize, like, the tax code is actually this massive cirrhosis subsidy and is causing a lot of people to be pretty dysfunctional starting at 1 p.m. and also isn't, you know, it's not collecting that much revenue. And so we can reallocate some of society resources away from midtown dining establishments

and towards other socially useful things if we say, okay, we're going to cut the top marginal rate, but also all these games you're planning, you've got to stop planning these games. And also, like, corporate perks used to be a lot better at that time because those were also fully deductible. And I think some of that was just the IRS not asking some questions it should ask. Like, you know, what is, what is the business of purpose of this apartment, of this car, you know, all of this, all this corporate travel? Like, I'm sure they could have, they could have had some awkward conversations had they chosen to. But, yeah, in an information scarce environment where you're one of the overworked, beleaguered IRS people and you get this massive document from General Electric, are you actually going to go through every line item and figure out if everything's a legitimate expense or not? probably not. You're probably going to look at the line that says real estate and not, you know,

the list of every apartment that GE rents for executives and try to figure out which of those are actual, you know, things for someone who's temporarily in the city and needs a corporate apartment to stay in versus someone who is just getting their housing paid for with pre-tax with an acratax dollars. I think just, I think it was you who said, hey, like the three-drink policy, it basically formed the plot for Madman, right? Without that IRS could we wouldn't have had madman, the TV show. I want to ask two more things. So one of the things as I'm reading this book, you know, you see, and I think it's with the benefit of hindsight, but you see so many crashes coming, right? One example is, hey, in the 70s, they go for the loan things I talked about earlier

where, hey, if we've got a loan that had even credit trouble, if we dismiss interest payments for one year and push it out by two years, as long as we'll get paid par, we can keep it marked at par. And obviously that's a disaster, and they argued that sets up the savings and loans crisis. And there are plenty of others. You know, the other one I use is, hey, how many times do you see somebody saying, hey, this market reminds me a lot of 1929? You'll never hear about any of them except for the one person who calls it right. So I just want to ask, you know, when you read this book and you see all of these parallels to today or things you saw, do you think that's because of perfect hindsight bias? Or do you think like I said it's an economist call nine of the last five recessions, hindsight bias calls 10 of the last one crashes?

Do you think that's hindsight advice, or do you think it is possible, like, in the moment to kind of use these historical parallels to actually help you avoid shenanigans? Yeah, I would say if you're looking for just a carbon copy, you won't find it. Like, there's just not going to be another company that starts out owning natural gas pipelines, creates these special purpose entities, has a really profitable trading division, and then loses all of its money on dumb stuff and has a run of the bank. You're not going to find that. But you will find cases where they find a way to follow the letter of the law such that their net income looks. good, their cash flows don't seem to correspond to that net income. And they've found some case where they can make their business look better than it really is. But also, with a lot of these, it's, for me, it was really useful to try to take the other side of these arguments and try to

figure out, well, you know, aside from just they want their P&L to look better or they want their earnings to be smoother, like, did they have a reasonable justification? And I think specifically the chapter where they talk about inflation, it started making me think about inflation and how you should account for it. Because they give an example of, let's say you buy a truck and it generates some revenue and the cost of trucks is rising really fast such that the economic depreciation is higher. The replacement cost of the new truck means that your trucking business is actually a net destroyer capital. But what I realized was, one, insanely hard to actually model all of this stuff. Like you just, you know, you need to have like the more narrow the CPI component is, the more

the person you're talking to can say, well, that's, that is weighted to a slightly different kind of truck than the kind that we buy. And so we want to use a different number. So just like infinite debates, unless you just say, we're going to use nominal values. But also, a lot of companies' obligations are in nominal terms. So they don't borrow in CPI-linked bonds. They borrow in bonds whose interest rate bakes in some assumptions about, about inflation. And when they pay people, like part of the reason that inflation is, you know, little inflation is something economists like, is that a little bit of inflation means you give everyone a continuous pay cut, and the only people who are maintaining their standard of living are the ones who are getting raises.

And that's just a lot easier than having a totally flat price level that doesn't rise over time and having to tell people once a year, hey, we're cutting your salary by 3% because you're just not as good as you thought you were. Or because everything's getting more productive, efficient, and yeah, on your... To me, like, on that, like, that actually felt like, you know, of all the ways you could do this, just using nominal stuff and not adjusting for inflation is actually the one that just leads to the fewest arguments. And it means that since everyone knows these are nominal numbers, the higher inflation is the more the equity analysts are thinking about inflation, the more the credit analysts are asking themselves, okay, what is the replacement CAPX for this? And what does that do to cash flow

over time? So you have the analysts asking good questions for how do we actually price this. And then you have accountants asking good questions for what is this? Like what does the company actually own and what is a number that everyone can agree on. And so in some sense, like the economist, or the accountant's job is to choose an answer that is like 85% right, but everyone can understand the logic versus 99% right. And we can spend forever debating the logic. No, look, I'm completely with you. I like the trucking example, but you know what came to mind when I was reading that? If you look at the department stores and the department stores are probably the number one destroyer of value investors capital over the past 15 years, there might be another,

it'd be hard, especially famous value investors. You know, you think about Sears, you think about JCPenney. But I always look at the department stores, and once a month, I will have a friend email me and be like, hey, Macy's market cap is about $5 billion. And if you look, everyone agrees their real estate is worth between $8 to $14 billion. And my argument is very along the lines of the trucking argument. Like, hey, yes, that's correct. But they're reporting a profit of, if their market cap is $5 billion,

they're reporting a profit of $400 million. So it looks very cheap. But what it is is you have $10 billion of real estate, which probably would generate $800 million on its own, right? Supporting a negative $400 million enterprise value. So supporting a negative $400 million retail business, if you kind of do that math quickly. Yeah.

And your issue is until you unlock that real estate, the retail business destroys value. The management team there doesn't appear like they're in a hurry to because they'll put them out of their job. They're a retail business. they sell the real estate. So that trucking example you have, and I believe they do make this example, it can lead to all sorts of perverse incentives where it seems like the company's doing great when you're reporting anomaly in profit, management's getting big bonuses, but actually

they're destroying tons of value. And they give a few more simple examples, but that was just one that came to mind on the inflation. Yeah, I think it's a division of labor thing. Like, it is probably the case that, you know, 100 shares of Macy's is expensive and 10% of Macy's shares outstanding is cheap because with 10% you get someone on board and you tell them yeah so but and i think there are a lot of companies like that there's been a few shareholders who have tried to disaster results yeah and i you know then you start just thinking you know like trying to trying to ask yourself okay why why does this gap persist like why doesn't you know has the board never told management hey like we're we're going to give you the world's most generous change in control

provision for your severance. We're going to vest 300% of your equity if you please sell the company. They could do something like that. They could give the management an incentive to leave or if the board is just going to resolutely refuse to stop burning $400 million a year opportunity cost on the retail business, someone out there is willing to buy it. And maybe the actual conclusion you reach is, you know, Amazon would love to have permission to buy Macy's. They would pay double the current share price just to get the real estate. they would turn it all into either Macy's branded but run by Amazon or Amazon branded and just rule Harold Square.

But if all the buyers can't actually buy it and if selling it piecemeal means you worry that you get halfway through selling it before there's another downturn in that kind of commercial real estate, then maybe it's actually pretty fairly priced and maybe maybe it's fairly priced because that price is the equilibrium between really high number if you look at what the mark to market value of real estate is, negative number if you mark the actual cash flows of the business to market, and then you average those and you get market cap. I also think there is, you had this with US Steel.

If US Steel had been named anything else, I think that deal to Nippon would have gone through. And Macy's, not that the Macy's name itself, but it is so high profile. you know, I think if you had Macy's sells to anyone, right? Yeah. It's a real estate firm who's going to shut down Macy's. They sell it to a real estate firm who's wink, wink, not going to shut down Macy's. Right.

There's going to be so much political pressure. So I think they're almost locked into everyone knows it's inefficient. Everyone knows the real estate's worth more. But there's just not really a way to extract it, you know? So you know what? This is why Macy's can't mark up the value of their brand name and have it reflect all the brand equity. Because right now, that brand name is clearly a liability. They would pay billions of dollars not to be Macy's, not to have the star.

I found out a while ago that the star was actually a tattoo that the founder, Mr. Macy had, because he was a sailor. Yeah. The Macy's logo is a tattoo. You know, the other thing is the Macy's Thanksgiving Day parade. I think if I remember correctly, now it's getting $200 million to be broadcast by NBC Peacock. And you think about that, $200 million for, I think it's 20 years, that's probably worth $2 billion MPV, you know, slightly more slightly this.

Macy's as a whole is worth $4.5 billion right now. So just their parade, now I don't know if they're getting it or who owns the freight or something, but it's interesting. Last question I want to ask you. If you read this book, there are hot button issues in every decade, right? So 70s, we mentioned inflation, inflation, especially around the oil embargoes, big one. 90s to 2000, Sarbanes Oxley, the accounting scandals, there's stock comp. But if you read this book, there's, if I said, hey, As you and I sit here, beginning of 2025, if there was a book in 2035 released,

what do you think the hot button issue in accounting that it would point to today would be? So I think the real answer, it's an answer that doesn't actually qualify for hot button treatment. It's just not something people get agitated about. But I think that more big tech companies in particular should, like it is more realistic to understand their business if they capitalize more of their intangibles. it is like every year it gets a little bit harder to look at return on equity numbers and it gets you know the market's price to book value tends to drift up over time there's that nice turn of the book which feels very nostalgic from once it yeah yeah it used to be it used to be one to two

and then there's this weird aberration where it goes one to six you know goes to six in the 90s and yeah we're we're back and but I you know investors understand that I think the other thing so I wrote this piece a while ago about how capital intensity is a feature of where you are in the cycle and not of the industry. Because if you look at a lot of the capital, the great capital light companies, they end up finding that the best way to expand the capital light business is to do some pretty heavy capital expenditures. Like Amazon, there was the debate in the 90s over whether Amazon or eBay was the

better econ business. And for a while, eBay traded at a premium because they were so asset light. Their customers are the ones who are storing all of the stuff and the customers are handling all the logistics. And then it turned out that because of that, they just could not guarantee the same speed of shipment and the same selection that Amazon could and that that speed of shipment and selection mattered a lot more than capital intensity. So in some ways, it's a self-correcting problem. But it just, it feels like if I could look at, if you could look at the true economic balance sheet of Google, it's more like a 10% return on equity business. And, you know, a huge chunk of that equity is the algorithm and the brand name.

and, you know, the internal cohesion of the employees and, like, the culture or stuff like that. Like, that all has value, and they're getting a return on that value, but it's all capital that they had to accumulate. But, you know, that's, no one, no one is going to be furiously testifying before Congress asking, why didn't Apple put, why, why isn't the Apple brand worth $800 billion on the Apple balance sheet? And, like, why is it, Enidia capitalizing Jensen's vibe, and depreciating that over time as he gets older or whatever? But I think that's when I analyze companies, that is part of my looking at it's like how valuable are the intangible assets and then can they turn $1 of dollars into more than $1 of intangibles? And if they can repeatedly do that and then they are getting this return of the intangible asset and that intangible asset raises the return of the tangible asset, then they have a nice formula and they'll keep growing and they will they will outer in their cost of capital. I hear you, but I think the book Cougar and the argues, like, the issue is how do you put that

intangible there, right? Because I'll just give you, Google, you said it, I think it's a 10% return on equity business, but like, okay, Google two years ago is a 400 billion market cap. Today, it's a trillion dollar market cap. So are you going to argue they threw on 600 or five, whatever trillion of intangible without investment, right? But just because of the market cap, like it gets really cyclical and that's why the accountants. And, you know, if they ever did that, you would absolutely like every time it come every time we had a 2022 and every big cap company drops by 30 yeah and they're all like that's the issue so i definitely hear what you're saying and it's obviously a shortcoming of accounting but i just feel like it's settled math right like they've had

yeah i think it is and you know i'm exaggerating a bit but i think you know one way to do it is just you you capitalize more of the r and even marketing expenditures and um like that is that is in effect how people look at a lot of SaaS companies is they implicitly capitalize the sales cost and just depreciate it over the life of the contract. So in some ways, that does actually line up with how companies make decisions internally and how investors are valuing the outputs of those decisions. And those are your two constituencies. It's what is the company deciding to do?

That's like the operations and control legacy. And then it is what is the market deciding to do? And that's the British investor investing in an emerging market like the United States philosophy. Like, if they both agree that this is an asset that you cap, and you depreciate over time, then I think it does, it does make some sense. Like, I don't, I don't actually think it's worth doing. Just, you know, the last time there was even like a moderate tweak to SaaS accounting. It was just a pain for everyone to update all their models.

And everyone is already taking the models and basically trying to, like, trying to have the, the unit economics machine of how, what return do they get, how are their cohorts evolving, and how fast can they jam money into the adding logos, you know, adding new customer logos machine, such that they continue to add customers who have good net dollar retention and will cause revenue to drift upwards. So like, you know, I guess I don't have like, I don't think I have a really strong, you know,

here's where the accounting is bad. I wish I did. Like maybe, you know what, SPAC warrants, okay? they should not actually have to mark them to market. That is just the SEC messing with people. Just, you know, they couldn't advance back so they did the next best thing. Look, I thought for 15 minutes trying to think of one, and I spent all my time in financial statements, and I couldn't think of one.

So I was putting you on this. There's a softball question that was 101 mile per hour fastball question. But I will give you one other interesting one, and you can comment. You mentioned the price to book ratio chart, which I relate. And for those who haven't read the book, haven't seen the chart, it's from like 1920 to 1990, the Dow traded for between one to two times book pretty regularly. And then in the 90s, it trades up to six times book. And you know, that's bubble ethic. But then it comes back down to four. And his argument was, hey, it's because we're getting more intangible heavy companies.

And now we're probably way past six with Nvidia, Google, all these things and there. But I was thinking about that. And then everybody loves to quote the Buffett indicator, which was market cap to GDP. And for years, it was if you get over one-to-one market cat's GDP, you're in a bubble. And now we're way past that. And that's because, guess what? A lot of these firms are international. And I was just thinking like, there's two indicators, which for 50 years, if you had been using them, you could have kind of like traded around them.

What is the indicator now? And these are market level, not firm specific, but what is the indicator now? And I was wondering like, hey, maybe price to earnings because we're having so many companies, you know, with AI, they're frontloading so much of their expenses. Maybe price to earnings is broken these days. I don't know. Like, ultimately, I'm a value investor. I do believe like fundamentals will reflect cash flows in the long term.

But what are some rules of thumb that investors have always used that might be breaking? It is an interesting way to think about because as investor, if you can find broken rules of thumb, that is where there is a lot of alpha, either on the long side or, you know, for years, people said Netflix subscription businesses can't go past $30 billion was the rule of thumb. If you knew Netflix for X, Y, Z reason, was going to break that. What is Netflix not an 800 billion market? I can't remember last time, but you would have made a heck of a lot of money. I'll pause there and let you have last thoughts on that.

Yeah, yeah. So I think you could actually take two related rules of thumb and say they are both breaking. One is the earnings things where it is just you, especially if you're looking at a high growth company that has recurring revenue, like basically the higher the quality of the recurring revenue, the more you can predict next year's revenue based on this year's revenue, the less this year's PE tells you anything. but the other piece of that is that I think looking at price to sales and growth and basically assuming companies will grow into a decent high margin business at scale. I think that's also breaking down

because the model for a ton of SaaS companies is we are going to sell something to customers who are growing fast as they grow, our business with them will grow along with them. That if you are Zoom and you sell to a company that's growing 50% a year, they're growing their sales team 50% a year, they will need 50% a year,

percent more seats in their Zoom license per year. But that also means that company is not growing into a new margin. Like they're always paying Zoom some proportionate toll of their business. So my line in an older diff piece was one company's net dollar retention is another company's lower steady state gross margin. And I think that that means that you could have a lot of these companies where because the software ecosystem has gotten so good, because there are so many things that you would have had to build a bad version of internally, but you can buy a really slick version of externally, that there's steady state margins are actually lower. And then with AI, people are very aware of this at this point, that an AI business, it may be a software

business, it does not have software margins. Like there is an incremental cost to every user interaction. It's pretty high. So that also means that you can't just say, well, every software business eventually reaches 90% gross margins and stays there. And then there's eventually cost leverage on the R&D side and cost leverage on the marketing side. And so you eventually expand to some steady state of 20 or 40% EBITDA margins depending on, you know, how much of a superstar business it is. So, yeah, both of those go away. And if some software companies end up looking a lot like subscale manufacturers where they make a dollar of revenue and, you know, 20 cents goes to employees and 65 cents goes to suppliers and, you know, there's something left over for shareholders,

but it's just not that much. And it's a lot of work and their short product cycles and things. you know, a lot of these companies, they end up, it ends up looking from a balance sheet and P&L and cash flow statement perspective, you feel a lot more like you're investing in a steel mill than in Microsoft circa 1994. It is interesting, though, you know, the only thing is like, I just, maybe it's because I've had 20 years of it ingrained to me, but it's like, hey, even if that's the case, isn't there somebody down the line who's going to buy them, be like, oh, we can rip all those costs out?

And I guess with seal mill, you kind of had that, but with a software company, just because it's like, you can't rip all the costs out of a plant, but you can fire. a lot of people in the software company. Well, those are the costs where they do expect to get the leverage, and they still will. But I think a lot of the incremental costs of, you know, you're probably not going to build a better Zoom, and Zoom knows it, and maybe Zoom and Google meet, compete a bit, and Teams is there, too. But for a lot of these, like a lot of these companies also recognize that there's someone else,

some other big software companies that sells the same feature set. And so what they're always trying to do is get as many integrations as possible. So if you got a Slackbot that pings you two minutes before the Zoom meeting and it pulls the relevant files from your Dropbox and, you know, if it sees that you haven't logged in, it, you know, detects that you're still at another meeting and automatically sends an email to someone and that's sent through superhuman or something. If you have all these integrations, then switching providers is just this giant technical lift. And so that is, again, intangible asset does not show up on, the inconvenience of switching off Zoom does not show up as an asset on Zoom's balance sheet, but it is absolutely a source of positive. you know, it's a source of incremental DCF dollars. The book has, he works at IBM with Lotus Notes for a while, and it mentions that as an example of intangibles.

And I was laughing because, you know, in the 2000s, everybody knew Lotus Notes was terrible, but there are still big firms, even I believe to this day, who are still on Lotus Notes despite the fact it's a disaster of a system. Because as you're saying, once you get all those integrations, it's very, very difficult to be like, we've got 100,000 employees. We're all switching to Gmail, you know,

like just destroys all of those integrations. burn we are way over an hour uh we're going to chat a little bit after this but this has been great this was our sample podcast if you got suggestions anything for burn we'll see how this goes but i i really had a fun time so this has been awesome this was our book club and uh hopefully we're doing another one next month yes and do all ready