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ARE BALANCE SHEETS WRONG? a Roundtable Discussion of Goodwill and Intangible Assets Edited by Bob Schmidt, Manager, Brandes Institute

ARE BALANCE SHEETS WRONG? a Roundtable Discussion of Goodwill and Intangible Assets Edited by Bob Schmidt, Manager, Brandes Institute

ORIGINAL RESEARCH FOR INQUISITIVE INVESTORS

ARE BALANCE SHEETS WRONG? A Roundtable Discussion of and Intangible Edited by Bob Schmidt, Manager, Brandes Institute

BRANDES.COM/INSTITUTE | [email protected] A ROUNDTABLE DISCUSSION OF GOODWILL AND INTANGIBLE ASSETS

Executive Summary

The rising level of goodwill and intangible assets for U.S. companies has been a topic of discussion and debate for various members of the Brandes Institute Advisory Board (BIAB) for more than two years. But what does this phenomenon mean for companies and how they are valued—especially when using book values? In this roundtable discussion, select Board members were joined by investment professionals at New York-based Donald Smith & Co. The following reflects conversations that were shared over three different sessions, as well as email exchanges and third-party research and opinions. Ultimately, we hope this roundtable accomplishes the following goals:

y raises awareness of this phenomenon and potential risks

y encourages investment professionals to conduct their own investigations

y underscores the benefits of fundamental analysis on a company-specific basis

Accounting lies at the heart of a discussion of goodwill. Escalating merger and acquisition (M&A) activity over the past several years has boosted goodwill levels. But what does that mean? Some investors tend to downplay or dismiss goodwill levels and focus on a company’s overall operations. Other investors may view goodwill with suspicion.

The Standards Board (FASB) has changed the rules for how companies can for goodwill. In 2014, FASB noted companies must “test” goodwill at least annually for potential impairments. (Goodwill is recorded on the , but an impairment would show up on the , making impairments more visible. See page 9 for a discussion of Kraft Heinz and its

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$7.3 billion goodwill impairment earlier this year.) While FASB has changed accounting rules for goodwill over the years, the consensus among roundtable participants was practitioners shouldn’t wait for further guidance. Participants said investment professionals need to thoroughly investigate businesses to understand the balance sheets and the pros and cons of intangible assets, including goodwill. “There is a science and art Beyond the rise in goodwill, more and more U.S. companies are reporting increases in the value of other to . intangible assets such as brand value, , algorithms, company-specific databases and training With that in procedures. The rise in intangible assets has been spurred in part by many technology-based companies. Beyond disrupting business practices in diverse industries, technology advances are disrupting the mind, a number practice of analyzing and valuing businesses. How does one effectively determine the value of a brand of panelists name or a customer database that’s been built over decades? This is where the science and art of questioned the valuation work come into play. efficacy of rules- With that in mind, a number of panelists questioned the efficacy of rules-based or factor-based investing based or factor- approaches that may seek to identify opportunities based on a single metric such as price-to-book based investment ratio or a combination of metrics. Participants in this discussion noted the importance of evaluating approaches….” companies’ management teams and incentives, competitive advantages, price-to- flow and other metrics; many also stressed the need for thoughtful, rational, long-term-focused investment decisions.

Defining Goodwill

Goodwill can be an oddball among balance sheet numbers misvalued, there will be goodwill even in the absence of growth. because it usually arises in the wake of acquisitions—and Consequently, the more existing assets are misvalued, the it is driven by a mismatch between two ways greater the goodwill and potential write-offs. value assets. 2. Growth potential: Goodwill will be larger when you acquire a “While internal investments made by a firm get recorded at firm with greater growth potential, since the market value will historical , acquisitions are recorded at market value,” reflect this growth potential but will not. explains Aswath Damodaran, a professor of at NYU’s Stern School of Business and member of the Brandes Institute’s 3. Overpayment by the acquirer: There is substantial evidence Advisory Board. “Goodwill then reflects the accounting attempt that acquirers overpay for target firms and this overpayment is to make things whole again.” In other words, goodwill may attributed to multiple factors—managerial self-interest and reflect the difference between the higher price a company paid hubris, overconfidence on the part of managers, and conflicts of to make an acquisition and the lower, actual value of that interest. If this overpayment occurs, it has only one place to go acquired business. and that is goodwill.

More specifically, in hisblog , Damodaran describes the goodwill Goodwill is an intangible of surprising variety. The that shows up on an acquirer’s balance sheet as a combination following items could be recorded as intangibles: patents; of three components: customer databases and client lists; brands and logos; algorithms; and . 1. Misvaluation of existing assets: If existing assets are

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ROUNDTABLE DISCUSSION Now some people will ask, “So what?” They may Bill Raver: This topic holds particular fascination for say, “What really counts is earnings and .” me. As an investment fiduciary and former corporate When you look at the return on tangible of treasurer, I have tripped over the accounting and the S&P 500, some companies are earning in excess economic implications of goodwill and intangibles of 50%. So what are we so worried about? “What startles me many times. Exhibit 1 on the next page shows the rise in levels is that almost no Banks won’t lend to a corporate balance sheet they of goodwill and intangible assets among U.S. one I encounter don’t fully understand. Shareholders react negatively companies. It combines goodwill and intangible assets in our industry to large acquisition write-offs and institutional as a percentage of equity for the 1,000 largest U.S. investors deserve to know that their managers companies (as measured by market capitalization). speaks with any perform adequate due diligence on the so-called Well, we’ve been in this long-term upturn in world specificity about “soft assets” they acquire when they buy a . economies. You don’t know how much risk there either goodwill or What startles me is that almost no one I encounter in is to the earnings and book value until you have intangibles.” our industry speaks with any specificity about either a downturn. As we saw in 2008, tangible equity is something bankers still look toward when they – Bill Raver goodwill or intangibles. One exception for me is the team at Donald Smith & Co., who incorporates these evaluate the financial creditworthiness of companies. assets into its investment process. In addition, Duff & Phelps studies impairments Rich Greenberg: Thanks, Bill. Well, of course, we and, on average, says they total roughly $30 billion a tend to agree with you. While we acknowledge year. But if you go back to its original study done in the world has changed, you still really need to be 2008, it was $188 billion of impairments. There are concerned about the on-balance sheet goodwill and industries where book value is understated and book intangibles. value may be wrong, but we think in most industries, tangible equity still counts for something. Back in the 1980s, less than 5% of the stated book value of the S&P 500 Index was goodwill and Bryan Barrett: The bookCapitalism Without 1 intangibles. Now, of the $7.5 trillion in total equity addressed several of these points quite well. of the S&P 500 at year-end 2017, about $4.8 trillion In terms of credit risk, Bill brings up an interesting was goodwill and intangibles—that was about 64%. point—how do you lend to businesses that don’t What’s been particularly concerning is we’ve seen a have hard assets? The topic of growth in debt levels huge increase—about $1.3 trillion—in goodwill and gets plenty of coverage, but if that is happening intangibles just since 2013. while there is a change in the composition of the

Round Table Participants Donald Smith & Co.: BIAB Participants: Richard Greenberg, CFA Mauricio Abadia Bill Raver John Piermont, CFA Bryan Barrett, CFA Kim Shannon, CFA Dr. Aswath Damodaran Tham Chiew Kit

Bob Maynard Dr. Geoff Warren

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universe, is lending becoming more risky because John Piermont: You could say that balance sheets the collateral is less tangible? How is that being are wrong. That might get people’s attention. But, to “How do you lend adjusted for? In terms of book value and the broader be fair, balance sheets are wrong in both directions. to businesses that point about accounting—from the practitioner’s Some issues are overstated because of goodwill and perspective, I think we have already accepted intangibles that result from increased M&A that has don’t have hard that accounting sort of fails us. Practitioners have happened on a really large scale and continues to be assets?” to make adjustments like capitalizing research a reflection of accounting. But you could also argue – Bryan Barrett, and development (R&D) since these important that there are companies that don’t engage in M&A investments can have a useful life of much longer that have real intangible assets that don’t show up on CFA than one year. It makes me wonder how well factor the balance sheet. investing, which has gained such prominence, makes Kim Shannon: It makes me think price-to-book these types of adjustments. (P/B) value is becoming a dodo bird tool for value Bill: I agree. In a day and age when factor investing investors. Valuations are so high based on P/B is popular, I wonder if soft assets are an overlooked overall. And tech have no book value to speak driver of investment returns. There is ample evidence of. It’s all becoming very distorted. of forced write-offs of these assets by companies Exhibit 2 on page 7 illustrates the widening gap in the U.S. and overseas—so much evidence that between price-to-tangible book value and Duff & Phelps annually publishes a review2 of the price-to-book value for the S&P 500 Index. goodwill and intangible write-offs, suggesting that the size and nature of these earnings hits should be Aswath Damodaran: Balance sheet-based valuation part of any assessment by accountants, regulators is reaching the end of its tether because accounting and investors. has lost its way. Acquisitions and buybacks are

Exhibit 1: The Rise of Goodwill and Intangible Assets/Equity (12/31/89 to 12/31/18)

MEDIAN GOODWILL AND INTANGIBLE ASSETS AS A PERCENTAGE OF TOTAL EQUITY | Source: Wolfe Research and FactSet, as of 12/31/18. Largest 1,000 U.S. companies and top 20% by market cap.

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ravaging balance sheets. The other reason book Aswath: We don’t need accountants to fix the value is falling apart is every time you do a buyback problem. We can fix it ourselves. In fact, waiting for and retire the associated shares, your book value accountants to fix the problem is the worst solution collapses. My estimate is 1/8th of all U.S. companies possible. At the start of every year, I re-compute had negative book value in 2017. If you’re a value book value for every company by capitalizing leases investor, you don’t even know what to do if your and R&D; I’ve been doing it for 25 years. Last year, primary tool is P/B. I think P/B has been long due accountants were going to capitalize leases; it’ll this demise, but it’s now time to ask the question: take them another 25 years to do the right thing should we be looking at book value when we do with R&D! I make two simplistic assumptions: I valuation or should we be focusing on cash flows and capitalize R&D with an amortizable life and I get income statements? My gut feeling is that balance more reasonable book values for technology and sheets are becoming very difficult to base valuations pharmaceutical companies. on. You’re seeing that with P/B. Exhibit 3 on page 8 provides a breakdown of Goodwill can be Bob Maynard: In discussing tangible and intangible goodwill and intangible assets divided by equity an oddball among assets and goodwill, it’s vital to understand how we’re across each sector. defining these terms. There’s a wide range of things With my approach, you compare the P/B using the balance sheet that may go into M&A that don’t properly reflect stated book value and the P/B with my adjusted numbers because hard accounting numbers, but they’re much different book value. You can see the sectors where it makes categories. To me, it’s category confusion. It’s like it usually arises the biggest difference. It’s not just P/B that’s affected calling both chess and football a game. Consider two by this. We’re overstating return on equity and in the wake of companies bidding for a third. Both are overbidding return on invested capital in pretty much every one acquisitions. what the company is worth because they’re looking of these companies. to keep the other company from getting it. That’s a different type of vs. a competitive The ripple effects of these accounting issues show moat, R&D, training or getting more data like up in (DCF) analyses; they Facebook. They carry different types of risk. show up in multiples. We can’t wait for accounting to do the right thing. We have to do it ourselves. Bob Schmidt: Haven’t there been proposals for The data is there; it’s not difficult to do. We might updating accounting measures? want to mechanize the process so when we get a raw

Duff & Phelps Report2 Highlights

Based on research by Duff & Phelps, merger and acquisition “Total goodwill impairment (GWI) recorded by U.S. public (M&A) activity by U.S. publicly traded companies “…was companies climbed 23% [from 2016], reaching $35.1 billion in extremely robust in 2017, with a 9% increase in deal volume 2017, despite a strengthening global economy. The corresponding [vs. 2016] and a 3% uptick in deal value. Historically, 2017 was number of GWI events increased marginally, from 288 in 2016 to one of the top years for M&A activity. This led to $319 billion of 293 in 2017. This implies that the magnitude of impairments has goodwill being added to U.S. companies’ balance sheets, the generally become larger, with the average GWI per event rising by highest level since we began tracking this information in 2008. 21% in 2017, to $120 million.”

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database, we actually do the fixes very quickly before Rich: We really don’t know the ultimate importance “...it’s absolutely we start using it.3 of all the goodwill and intangible assets that are being taken on. But to us, Professor Bruce true that Kim: But to what degree is the transformation of Greenwald at Columbia had alternative asset accounting throwing investors toward it right when he said, “Eventually, everything alternative asset classes which do not have to do classes look less becomes a toaster.” We agree that most things fair value accounting as frequently or to the same eventually do become commoditized. There should risky than they degree? To me, it’s making alternative investments be a relationship between the equity invested by a truly are....” look more attractive because they look less volatile. company and the return that’s generated. Industries – Aswath Aswath: It’s not just fair value accounting; it’s the with very high ROE [returns on equity] should Damodaran frequency of updating. If you have a public stock, attract competition. its share price updates every second. If you have a Now, there can be companies that over time have fund that holds investments in private sustainably high ROE and maybe you don’t get the companies, the updating happens every quarter—if regression to the mean that I’m talking about, but we that. And it’s biased and it’s skewed. would argue there are fewer of those companies than No matter what the rules of the game are, the private most people realize. A lot of investors are focusing equity (PE) or hedge fund can play a role in how on franchise value and that’s what we’re talking about those assets get re-appraised. So, it’s absolutely true here—a company that can retain high ROE is the that alternative asset classes look less risky than they definition of a franchise. We are skeptical of them. truly are because the updating is not as frequent and Bryan: Rich and John both hit on the nuance of this it’s biased. Are investors fooled by it? Absolutely. topic. If you were to say a health care or services Especially in good times. In bad times, I think it will business is trading below tangible book value, come back to haunt these PE investors. that would be far more surprising than a bank. It’s

Exhibit 2: Differences in Price to Tangible Book Value (P/TB) and Price to Book Value (P/B) for the S&P 500 Index (Jan. 1990 to Jan. 2019)

S&P 500 PRICE/TANGIBLE BOOK AND PRICE/BOOK | Source: Wolfe Research and FactSet, as of 1/31/19. One cannot invest directly in an index.

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incumbent on the fundamental analyst to dig in and pictures because there are management teams find out where the accounting isn’t keeping up with that specialize in acquiring fantastic businesses at the business and also a change in the composition horrible prices. We want to make that distinction in the investment universe over time. It’s a complex when appraising companies. topic. Rich’s comments on sustainable returns on Bryan: There is a lot of judgment in that process capital certainly highlight the importance of the which makes me circle back to that question about “Analyzing returns fundamental valuation process and the potential factor investing; I don’t know how company- on capital with risk involved in making incorrect or unsustainable reported data is adjusted under some of these assumptions. and without approaches. Also, how are indices, especially style intangibles really Mauricio Abadia: We spend a lot of time reviewing indices, calculated? I think price to book is still a a company and looking at its historical returns on meaningful input in how value is defined and Rich could give you capital on a tangible basis, but also fully loaded, brought up how book value has changed significantly very different including goodwill and intangibles as part of the over time. That would seem to mean that aggregated pictures....” invested capital base. We may consider adding back book value doesn’t mean the same thing over a impairments and M&A related to long data set. – Mauricio Abadia recalculate returns on invested capital in order to get Aswath: If style indices are created using only P/B, a better assessment of how management is deploying that’s a very lazy benchmark if you ask me. The very capital and whether it is creating or destroying notion that you’re a value investor if you buy low shareholder value in the process. Ultimately, P/B stocks suggests that has lost its analysts want to distinguish between the quality of way. That’s not the way I would think about value management and the economics of the business. investing, but it’s become this short cut we’ve used to Analyzing returns on capital with and without separate value from growth—but that short cut is not intangibles really could give you very different going to work that well.

Exhibit 3: Median Goodwill and Intangible Assets/Equity by Sector

MEDIAN GOODWILL AND INTANGIBLE ASSETS BY SECTOR, LARGEST 1,000 U.S. COMPANIES | Source: Wolfe Research, FactSet, as of 12/31/18.

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Warren Buffett Abandons Book Value

In February 2019, Kraft Heinz Co. (NASDAQ: KHC) announced a $7.3 billion goodwill impairment, according to The Wall Street Journal (WSJ). The WSJ* cited Duff & Phelps in calling the impairment “…the largest such write-down in the U.S. consumer staples industry in at least a decade.” Shares of Kraft Heinz fell about 27% following the announcement. To be fair, in addition to the impairment, the company also revealed it missed consensus earnings estimates for the fourth quarter of 2019, “…delivering an adjusted profit of $0.84 versus consensus of $0.94. It delivered less cost savings than it had planned, projected a roughly $700 million decline in adjusted EBITDA” [earnings before interest, taxes, and amortization] and “…slashed the quarterly by 36% to $0.40 and announced that it was being investigated by the SEC, which had questions about its accounting policies and internal controls in procurement,” based on a research report by Argus Research Company, published Feb. 26, 2019.

“This goodwill impairment alone is greater than that entire sector over the last three years,” said Carla Nunes, a managing director at Duff & Phelps, in the WSJ article. In addition, “The food maker’s write-down places it second behind General Electric Co.’s $22 billion goodwill write- off among the 10 largest write downs reported last year,” said Nunes.

In 2015, Warren Buffett’s Berkshire Hathaway, a co-owner of Heinz with a Brazilian private equity firm, merged that business with Kraft to create Kraft Heinz. Buffett briefly touched on the recent developments for KHC in his annual Berkshire shareholder letter, published Feb. 23, 2019. He noted Berkshire-Hathaway had a “…$3.0 billion non-cash loss from an impairment of intangible assets (arising almost entirely from our equity interest in Kraft Heinz).” Perhaps more interesting was Buffett’s more elaborate explanation of his decision to discontinue what had been a staple in his shareholder letters:

“Long-time readers of our annual reports will have spotted the different way in which I opened this letter. For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per-share book value. It’s now time to abandon that practice.

“The fact is that the annual change in Berkshire’s book value—which makes its farewell appearance on page 2—is a metric that has lost the relevance it once had. Three circumstances have made that so. First, Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses. Charlie and I expect that reshaping to continue in an irregular manner. Second, while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years. Third, it is likely that—over time—Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases its simple: Each transaction makes per-share intrinsic value go up, while per-share value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality.”

*Shumsky, Tatyana. “Kraft Heinz’s Goodwill Charge Tops Consumer-Staples Record.” The Wall Street Journal. Feb. 22, 2019.

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Mauricio: There is the conception that value discounted cash flow (DCF) analysis becomes the investors traditionally anchored on price to book, natural vehicle. Here, care needs to be taken to link but for value investor practitioners today, I wouldn’t the cash generation potential down the track to be surprised if the majority are using primarily competitive advantage, market power, etc., while a form of adjusted earnings or cash flow-based fully accounting for all the cash that needs to be valuations to approximate economic reality. P/B spent to get there. From what I can see, the former is could still be relevant with a few industries—namely, often done too simplistically—multiplying potential those that are capital intensive like banks or utilities, market by a target market share by a target margin. but even in those instances, book value might still The cash spend required to get there is not given not be as solid as it used to be. nearly enough attention.

You could go further and argue there are also Tham Chiew Kit: There are many conceptual and shortcomings in the way earnings are reported in the practical pitfalls in applying top-down valuation “…the price of income statement for valuation purposes, especially metrics, especially those in simple ratio form and for companies in knowledge-intensive industries as especially when using them as a tool for calling a company is Prof. Damodaran pointed out. For these companies, market direction—for absolute valuation rather related to the R&D represents a significant but also than relative comparison with recent history and a source of competitive advantage and “hidden” with related industries. Most of these pitfalls have to future cash flows intangible assets. But they are being required to do with the metrics attempting to compare market it can generate. expense R&D in the period in which it was incurred, prices (stock prices) with proxies, and at times bad The implication which lowers the reported accounting earnings proxies, for forward-looking fundamentals like compared to companies that invest primarily in estimates of future earnings and cash flows. In view is that a shift is tangible assets and depreciate over their estimated of this, as an investor, I would remind myself of the required in how useful life. Imagine if you were to look at the entire pitfalls and apply such top-down metrics in a fit-for- companies are investable universe historically using CAPEX [capital purpose manner. These challenges are heightened in expenditures] instead of depreciation, valuation sectors/industries that are undergoing rapid changes analyzed and multiples would have looked more expensive on and where competitive advantages are less tangible ‘value’ is defined. this price-to-cashflow metric compared to the more and not really quantifiable, like technology and …discounted commonly used price-to-earnings ratio. At the communications and everything they touch. end, you should value companies based on future Perhaps these are two sides of the same coin: cash flow (DCF) expected cash flows—because even the income difficulties in estimating the in a statement has distortions and the price-to-earnings analysis becomes DCF for stocks in such sectors or industries and ratio is not as informational as it could be. the natural difficulties in estimating intangible value of such vehicle.” Geoff Warren: The shift to less tangible assets companies. Of course, knowing this does not make impacts accounting-based metrics like P/Es, book it less of a challenge in assessing the fair value of a – Dr. Geoff Warren value, ROE and so on largely because spending is ‘growthy’ tech stock. Nevertheless, it is important expensed that is more in the nature of investment to identify the critical uncertainties, assumptions such as customer acquisition, system/network and judgment calls that go into a value-based call, development, R&D, etc. However, the basic concept whether at the stock or index level. doesn’t change that the price of a company is Geoff: Many people criticize DCFs on the fact that related to the future cash flows it can generate. terminal value is a large portion of total value, and The implication is that a shift is required in how is subject to the high uncertainty related to what companies are analyzed and “value” is defined. will happen in the long run. While true to some Ratio-based analysis becomes much less useful and

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“Sunlight is the best disinfectant. It’s before the write-off occurs. And that’s one area we haven’t talked about yet, but it’s a key element in this trend: incentives. To me, it comes down to management incentives, including compensation and how to manage balance sheet risk.” – Mauricio Abadia

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degree, this misses the main point. The terminal We understand the argument about platform value is better seen as a ”capitalization” of the free companies today. There are a number of technology cash flows generated in the final forecast period. companies that seem able to scale—and that is very The main requirement is that those cash flows different than the old world. But we remain skeptics reflect a sustainable stream. They should be struck on there being that many franchise companies in the on plausible return on capital, with capital properly technology industry or in the world as a whole. measured, allowing for the competitive dynamics of John: When comparing today to the Nifty 50 era, I’d the situation, and should not implicitly incorporate say history doesn’t repeat, but it does rhyme. I think “…we remain any value creation beyond the forecast horizon people tend to overcapitalize the earnings streams without good reason. In this respect, they are not too skeptics on with companies and ascribe too much value to the different to using a P/E to value sustainable earnings franchise businesses. Now, there are some fantastic, there being that one to three years out, except that you have extended world-class companies that may continue to generate the horizon where this calculation occurs. This many franchise cash and earnings well in excess of what you’d expect view also leads one back to focusing on competitive companies in just by looking at their balance sheets. And that’s advantage, industry structure, etc. Here, Kit’s point because, as we touched on today, the balance sheet the technology that this is harder to forecast when industries are may not reflect some competitive advantage. At the changing rapidly is spot on. industry or in the same time, there are companies that perhaps have world as a whole.” Rich: Several years ago, we looked back at franchises. capitalized the earnings stream too much. We’d – Rich Greenberg, We asked what are the ultimate franchise companies argue that having the balance sheet there and really and went back to the 1972-74 period and the Nifty understanding the competitive dynamics of an CFA 50. We somewhat arbitrarily defined a franchise as industry and the downside protection is important. a company that could maintain a ROE in excess of As we saw with the Nifty 50, there is likely an element 15% [for] 80% of the time. How many of those Nifty of risk because people don’t look forward far enough. 50 companies were able to achieve that? We found They look too much at the current environment; that 70% of them did not meet that definition. And in was probably the case back then, too. a number of cases, not only did they not meet the Kim: If you’re trying to find an interesting analogy franchise tag, they went bankrupt.

Capitalism Without Capital

The final chapter of the bookCapitalism Without Capital 3. These characteristics contribute to challenges for financing. summarizes its key points. Here, we paraphrase and highlight Debt finance is less appropriate for businesses with more sunk a few investment-related notions. Authors Jonathan Haskel and assets; public equity markets appear to undervalue at least some Stian Westlake contend: intangible assets in part due to underreporting of such assets but also due to the uncertainty around intangibles. 1. There has been, and continues to be, a long-term shift from tangible to intangible investment. Investors will have to find information well beyond the current financial statements that purport to describe current businesses. 2. Much of that shift does not appear in company balance sheets because accountants tend not to count intangible spending as an investment, but rather as day-to-day .

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to the Nifty 50, Bernstein did research recently on Bryan: Financial markets have a history “…the value the P/E ratio of the expensive quintile of stocks vs. of capitalizing what in retrospect becomes factor is still the cheapest quintile. [The analysis was done on “unsustainable economics” for certain businesses. cheap and it’s MSCI USA Index constituents.] Usually, it’s the That seemed to be the case before any change in cheapest P/E group that stays pretty steady through the composition of the investment universe toward the growth that time; the research goes back nearly 70 years. The intangible assets. Think about the railroads; they everyone’s excited most expensive group has bounced around a lot. The have hard, tangible assets and they went through about that’s spread now is pretty wide—and wider than during a bubble. That bubble reflected capitalizing the Nifty 50 era. It’s hinting that in a world where unsustainable economics. Compare that with our expensive.” most asset classes are fully valued, the value factor is discussion of whether it’s different this time because – Kim Shannon, still cheap and it’s the growth that everyone’s excited the business model is fundamentally different. CFA about that’s expensive. That happened in the dot.com bubble, too. These “platform” or franchise businesses that John pointed Barron’s featured a condensed version4 of Bernstein’s out—some appear to be excellent businesses with research, concluding: “…the [Bernstein] team strong competitive positioning that should have recommends investors buy value stocks rather than some sort of sustainable advantage. How much and the entire market. Valuation spreads in the U.S.—the for how long? That’s a difficult question to tackle, but difference between valuations of cheap and expensive I think being fair in distinguishing these things is stock on a price/book basis—are close to their widest important. point in 70 years, offering support for value-oriented stocks.” Bill: That makes me think again of proper due

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diligence and some of the comments I made earlier. 70-90% of them fail. We are very careful with Today, some plan sponsors are being sued—mostly companies that we sense are acquisitive. We will over investment or portfolio fees. But I think the push management. We will tell them we prefer SEC should be looking at investment fiduciaries companies that grow organically and buy back their who pay no attention at all to goodwill, intangibles own stock that sells at a discount to book value. and the size of write-offs. This is publicly available We will tell them right up front that if they go the “To the extent information. If you’re a fiduciary and you’re not acquisition route, we will vote against the team and that you are an tracking this activity and don’t hire investment firms the entire board. We’ve gotten into some pretty active manager that incorporate these matters in their process, that’s aggressive discussions but we believe it’s beholden on not good. the to hold management’s feet to the fire. trying to use Mauricio: Actually, if I could push back a little, John: Again, this is a nuanced conversation to have. balance sheets I don’t think the write-offs are the issue. In fact, You could buy back stock at large multiples and it as a quantitative I think you want them to be as forthcoming as still could pay off. Take Microsoft, for example, in tool to assess possible. Sunlight is the best disinfectant. It’s before 2010; management was buying back stock and even the write-off occurs. And that’s one area we haven’t though it was nowhere near book value, that was still the earnings and talked about yet, but it’s a key element in this trend: a fantastic move. staying power of incentives. To me, it comes down to management You could look at the cable industry where incentives, including compensation and how to a business, GAAP companies truly had moats. They had competitive manage balance sheet risk. It’s not the write-off itself. pricing power and they’ve grown through accounting fails When write-offs are announced, I believe share acquisitions and they have no tangible equity, but prices tend not to react aggressively because the you. You need to those buybacks were also really good. But you writing has been on the wall. adjust the also could look at companies trading at discounts balance sheets.” Bryan: Agreed. That point about incentives brings to tangible book and it was a bad buyback. Look up a lot of interesting behavioral topics. Share at Sears. If it was buying back shares below book – John Piermont, repurchases help EPS [] growth, value, it would have been a disaster. It’s a nuanced CFA which helps incentive compensation. M&A builds argument; you can’t just say buying back shares above the pool, with which you’re compensated book value is bad. That’s not intellectually honest. and that might build the clout of the management I touched on the idea of balance sheets being team. I think everyone knows of a study that says “wrong” a little earlier. To the extent that you are most acquisitions don’t add value. That knowledge an active manager trying to use balance sheets as a has been in the marketplace for quite some time— quantitative tool to assess the earnings and staying but the behavior hasn’t changed. Human beings power of a business, GAAP [Generally Accepting remain good at setting themselves apart and saying, Accounting Principles] accounting fails you. You “I can be in the minority who actually can add value.” need to adjust the balance sheets. What we do is Rich: I have to get this out there: the market is the conservatively say, “Let’s get rid of goodwill and ultimate arbiter. Yes, a great majority of acquisitions intangibles.” We focus on tangible book value. We fail and, generally, you see stocks fall when they think that’s a useful starting point. announce big acquisitions. The market knows

BRANDES.COM/INSTITUTE | [email protected] PAGE 14 1 Haskel, Jonathan and Stian Westlake. Capitalism Without Capital: The This material was prepared by the Brandes Institute, a division of Brandes Rise of the Intangible Economy. Princeton, NJ: Princeton University Press. Investment Partners®. It is intended for informational purposes only. It is 2018. not meant to be an offer, solicitation or recommendation for any products or services. The recommended readings were prepared by independent 2 A copy of the “2018 U.S. Goodwill Impairment Study” by Duff and Phelps sources which are not affiliated with Brandes Investment Partners. Any can be downloaded here: https://www.duffandphelps.com/insights/ securities mentioned reflect independent analysts’ opinions and are not publications/goodwill-impairment/2018-us-goodwill-impairment-study recommendations of Brandes Investment Partners. The views expressed 3At Dr. Damodaran’s YouTube channel, he describes his data and by Brandes Institute Advisory Board Members and other roundtable methodology. Following this link to his site offers more details. At his site, participants do not necessarily represent the opinions of Brandes click on the “blog” and then look at “2019 Data Update 3.” Investment Partners or the Brandes Institute.

4 Kapadia, Reshma. “It’s Time to Buy Global Value Stocks, Bernstein The information provided in this material should not be considered a Strategists Say.” Barron’s. March 6, 2019. recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings or sectors discussed were or will be profitable. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and The S&P 500 Index with gross measures equity performance of political changes; such risks may result in greater share price volatility. 500 of the top companies in leading industries of the U.S. economy. Please note that all indices are unmanaged and are not available for direct The MSCI USA Index measures the performance of the large and mid cap investment. segments of the U.S. equity market. Brandes Investment Partners does not guarantee that the information MSCI has not approved, reviewed or produced this report, makes no express supplied is accurate, complete or timely, or make any warranties with or implied warranties or representations and is not liable whatsoever for regard to the results obtained from its use. Brandes Investment Partners any data in the report. You may not redistribute the MSCI data or use it as does not guarantee the suitability or potential value of any particular a basis for other indices or investment products. investment or information source.

Price/Earnings: Price per share divided by earnings per share. Past performance is not a guarantee of future results.

Price/Book: Price per share divided by book value per share. No investment strategy can assure a profit or protect against loss.

Price/Tangible Book: Price per share divided by tangible book value per Copyright © 2019 Brandes Investment Partners, L.P. ALL RIGHTS share. RESERVED. Brandes Investment Partners® is a registered of Brandes Investment Partners, L.P. in the United States and Canada. Users Book Value: Assets minus liabilities. Also known as shareholders’ equity. agree not to copy, reproduce, distribute, publish or in any way exploit this material, except that users may make a print copy for their own personal, : Total cash flow from operations less capital expenditures. non-commercial use. Brief passages from any article may be quoted Tangible Book Value: Book value minus the value of intangible assets (such with appropriate credit to the Brandes Institute. Longer passages may as goodwill). be quoted only with prior written approval from the Brandes Institute. For more information about Brandes Institute research projects, visit our Return on Equity: divided by shareholder’s equity. website at www.brandes.com/institute. Return on Invested Capital: Net income minus dividends divided by total capital; used to assess a company’s efficiency at allocating the capital under its control to profitable investments.

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