ORIGINAL RESEARCH FOR INQUISITIVE INVESTORS ARE BALANCE SHEETS WRONG? A Roundtable Discussion of Goodwill and Intangible Assets 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 Financial Accounting Standards Board (FASB) has changed the rules for how companies can account for goodwill. In 2014, FASB noted companies must “test” goodwill at least annually for potential impairments. (Goodwill is recorded on the balance sheet, but an impairment would show up on the income statement, making impairments more visible. See page 9 for a discussion of Kraft Heinz and its BRANDES.COM/INSTITUTE | [email protected] PAGE 2 A ROUNDTABLE DISCUSSION OF GOODWILL AND INTANGIBLE ASSETS $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 valuation. intangible assets such as brand value, patents, 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-cash 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 accountants 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 cost, acquisitions are recorded at market value,” reflect this growth potential but book value will not. explains Aswath Damodaran, a professor of finance 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 asset 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 trademarks. 1. Misvaluation of existing assets: If existing assets are BRANDES.COM/INSTITUTE | [email protected] PAGE 3 A ROUNDTABLE DISCUSSION OF GOODWILL AND INTANGIBLE ASSETS 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 cash flow.” me. As an investment fiduciary and former corporate When you look at the return on tangible equity 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 stock. 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 book Capitalism Without 1 intangibles. Now, of the $7.5 trillion in total equity Capital 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 BRANDES.COM/INSTITUTE | [email protected] PAGE 4 A ROUNDTABLE DISCUSSION OF GOODWILL AND INTANGIBLE ASSETS 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.