The Primacy of the Income Account

Have you ever listened to an earnings conference call or read a transcript from one of those calls? If you have, you will know that these calls usually have a question and answer session following the prepared remarks, In the Q&A sessions, sell-side analysts that cover these stocks can ask management about anything that is on their mind. 

I remember when I started following conference calls, how weird I thought the questions posed were. To me, the questions were unusually specific. It wasn’t until I realized what a sell-side analyst does, that the questions started to make sense. The analysts are simply trying to fish for inputs into their valuation models. They build these models, primarily by using discounted cash flow analysis, to come up with price targets for the stocks that they employed to cover. 

The Problem with DCF-Analysis

When you build a Discounted Cash Flow Model, you need to make a bunch of assumptions. By how much will the company grow its revenues in the next few years? How much capital expenditure will it require to maintain that growth? What is the cost of capital? Etc, etc, etc. 

DCF models can be very useful and it is imperative for business analysts to understand the possibilities as well as limitations of a DCF analysis. DCF analysis is useful when cash flows are stable and relatively predictable. DCF analysis gets difficult to use if the companies that are being analysed have extremely high growth rates or if they create value by other means than by consuming cash to generate earnings. 

Capital Allocation and Balance Sheets

The late Marty Whitman, a legendary value investor, often talked about the Primacy of the Income Account. In his opinion, analysts and other investors where too preoccupied with the income statement and earnings of companies. As a result, the wealth creation that happen through the balance sheet was often overlooked. 

I heard a great example of this the other day. I don’t remember which podcast it was, but the interviewee gave the following example:

Imagine if you had run a discounted cash flow analysis of Berkshire Hathaway shortly after Warren Buffett took over as CEO. You would have totally missed the point, since Buffett created value through capital allocation and by utilizing the balance sheet. 

A normal DCF model would nerver have captured this.

The Implied Meaning of a Market Cap

“Apple is worth $2,000,000,000,000. That is a lot of money” said Anthony Pompliano on Twitter the other day. Dave Collum promptly corrected him: “priced at.” This is a very important and warranted distinction. We talk about the market capitalizations of companies all the time, but less often we think about what it actually implies. 

For Every Buyer there is a Seller

The current price of a publicly traded stock is the most recent point where the most willing seller and most eager buyer matched. So when Apple stocks ended a trading day at $498, the last buyer and seller that were matched were willing to do business for that price. For someone to buy, someone also has to sell. 

But the market price only gives us some information about the marginal sellers and buyers. One an average day, somewhere between 100 to 200 million shares of Apple stock will change hands. That’s a lot of shares. On particularly busy days, this will exceed 300 million. On a slow day, however, as little as 50 million shares will change hands. But Apple has 4.35 billion shares outstanding. So, even on the most hectic days, less than 7% of the outstanding shares will change hands.

The 7% figures is likely deceptive as high frequency trading and other forms of day trading and market making might overstate the fact that the majority of stockholders will not sell on a given day. 

Therefore, the market cap and stock price of a company will tell you where it is priced at by the market. it won’t tell you where the stock is valued at by the market.

The Net Benefits of Gaming

Is the video game industry a net benefit or a cost to society? Does it do more harm than good? If you were to perform a cost-benefit analysis of the video game industry you would go about trying to quantify the economic benefits (job creation, research and development, etc) against the societal costs (addition, power consumption, etc).

From a qualitative perspective, I would image that the effect of the video game industry on societies would be somewhat similar to wars. Wars have a huge cost to society. They take up huge resources both in terms of labor and capital but more importantly is the destruction of human lives and the irreparable damage it can leave on its participants.

Wolfenstein 3D" Graphics Compared to "Wolfenstein: The New Order ...
Castle Wolfenstein (1981) vs Wolfenstein: New Order (2019)

At the same time, wars have been known to accelerate the advancement of certain technologies and scientific discovery. Often, these advancements will have applications far beyond than just some wartime utility.

In the same vain, there are undoubtedly victims of the video gaming industry. Games are hyper-optimized to reward the user of playing and video game addiction is well recorded academically. Countless hours are spent daily on video games, that could otherwise have been deployed to more productive uses.

Yet, the video game industry is also a hotbed for technological advancement. There are countless examples of technologies that were originally developed for the gaming industry, which subsequently found application elsewhere. Slack – a public company with a $16 billion market capitalization as I write this – was originally developed as an internal chap application for a gaming company.

Cost-Benefit Analysis of the South Korean Digital Game Industry

In this cost-benefit analysis of the South Korean Gaming Industry, the researchers attempted to estimate the economic costs and benefits of the digital game industry. Addiction to digital games induces economic costs such as increase in crime, facilities investments for curbing addiction, increase in counselling costs and other welfare losses. The digital game industry in South Korea which is known to have one of the highest rates of game addiction.

The annual cost of game addiction is estimated to be approximately $3.5B while the annual benefit is approximately $24.3B ($3.7B for addicted user market). The proportion of the total costs to total benefits from the game industry is an alarming 14% (95% for addicted user market).

Should Companies be Philanthropic?

On August 10, 2020, GAMCO Investors proudly announced via a press release a “Shareholder Designated Charitable Contribution” of $7 million. The contribution was equal to $0.25 per GAMCO share, a 25% increase since the year before. According to the program, a registered shareholders in GAMCO Investors would be able to communicate which charitable organization they wanted to donate their pro rate allocation to.

Donating to charities is undoubtedly a noble act, but you might ask your way on earth a company is donating on behalf of its shareholders. GAMCO’s particular program is modeled after a similar program that Berkshire Hathaway implemented from 1981 to 2003.

In a letter to shareholders in 1981, Warren Buffett explained the rationale behind Berkshire Hathaway’s Charitable Giving Program: “In a widely-held corporation the executives ordinarily arrange all charitable donations, with no input at all from shareholders […] A common result is the use of the stockholder’s money to implement the charitable inclinations of the corporate manager, who usually is heavily influenced by specific social pressures on him. Frequently there is an added incongruity; many corporate managers deplore governmental allocation of the taxpayer’s dollar but embrace enthusiastically their own allocation of the shareholder’s dollar.“

I can certainly agree with the view, that owners should have a say in deciding how the charitable giving of a company should be allocated. The giving should not be seen as a perk for management. I can also see the light in the tax efficiency of having the philanthropy happen inside of the company than post-dividend.

But at the same time – and this particular case is illustrative of this – I can’t help to think that in certain situations, programs like this will cause more aggravation than goodwill among shareholders.

You see, had you bought GAMCO Investors stock in August 2015, each share would have cost you about $32. Five years later, the GAMCO’s share value is around $13. GAMCO’s earnings per share for the last twelve months was $2.25. This implies, that GAMCO is devoting about 10% of the companies operating profits to charity.

The company gives more to charity than it pays its shareholders in dividend.

I can’t help to think of that story of Karl Marx’s wife saying to him that perhaps he should have spent less time in thinking about how to divide Das Kapital and more to thinking about how to earn Das Kapital…

Largest S&P 500 Single Day Drop

One of the things that has preoccupied my mind lately are the underlying differences in approach between active investing and passive investing.

Imagine the two following hypothetical money managers: One of them is an active investor. He performs bottom-up fundamental research of companies, trying to determine their “intrinsic value”.

The other investor is passive. He uses quantitative analysis in order to find factors would have lead to out performance compared to a specific benchmark (these strategies are called “smart-beta” as they are passive in nature, but still aim to outperform the benchmark).

Analytical vs Statistical Approaches

For lack of better terminology, lets say that the active investor has an analytical approach, while the passive investor has a statistical approach.

The active investor is focused on the future cash flows of the company. He is tries to understand the business model of the company he is analyzing how the company creates value. He might try to study historical transaction multiples or how similar public compare in terms of valuation ratios. But primarily, the fundamental investor is trying to analyse future events.

The quantitative investor, however, is looking at a universe of stocks. He mines datasets to find a relationship between factors and performance. He designs different strategies and uses backtesting to see how these strategies would have performed.

The Limits of History

But what is data? Data is history.

Consider the following: Suppose you ask the investors about the largest single day drop in the S&P 500. The quant tells you that the largest single daily drop of the S&P 500 occurred on October 19, 1987, when the index fell by 20.47%.

The fundamental investor, however, tells you that the largest single day drop hasn’t happened yet.

Leverage + Arbitrage

I like reading books on business history and biographies of business people. One thing that I feel is often a common thread in there stories is that substantial wealth creation often seems to stem from some combination of leverage and arbitrage.

I’ll elaborate. Often, the initial businesses are created around some sort of arbitrage. The arbitrage might be that the entrepreneurs have some information or ideas that others don’t. But an arbitrage usually doesn’t sustain. Once the word is out the trade gets crowded, which in turn erodes the profitability.

Some arbitrage are more sustainable than others and cane be ridden for longer. And I suapect that there are plenty of business people out there that found powerful arbitrages to take advantage of and did so for a long time. The reason we never heard about them, is because they were constrained. They were not scalable. They couldn’t not be levered.

If you have an arbitrage, however, that is defensible and has the potential to be leverad to a larger scale, you have the components of substantial wealth creation.

Here are a few examples:

  • Sam Walton realized that by buying cheap and pricing low, he would create operating leverage, by maximizing inventory turns. He realized that the big stores would not go to smaller towns, an opportunity that he was able to arbitrage for a very long time.
  • Kirk Kerkorian built his initial wealth through a unique albeit limited arbitrage. After WWII, Kerkorian borrowed money to bid on surplus bombers which he picked up abroad and flew home. At the time, there was a shortage of jet fuel and Kerkorian was able to sell the remaining fuel in the bombers’ fuel tank. Selling the fuel raised enough money to repay the loans he had taken. He essentially got the planes for free.
  • Sam Zemurray made a fortune in the banana trade. In his early days, he took advantage of a brilliant arbitrage opportunity. When banana cargo came to New Orleans, bananas that were spotted were deemed unfit for the travel to metropolitan locations and were discarded at the port. Zemurray bought the ripe bananas very cheaply and sold them locally to grocers within a day of New Orleans. To get the bananas to grocers fast, he leveraged the train system.

What is Inflation Anyway?

I feel like we have made inflation deceptively simple. We have this exact number for it. The Bureau of Statistics will declare something like “last month, the inflation was 2.46%, annually adjusted.” It will do so with an number that is so precise that at will have at least two decimals, implying the surgical accuracy employed to get to that particular number.

We don’t seem to ask ourselves how we come up with these number, do we?

Do We Even Know What Inflation Is?

The great Milton Friedman did not have even a shadow of a doubt: “Inflation is always and everywhere a monetary phenomenon.” Well, here is what the equally great Robert Solow said about Milton Friedman: “Another difference between Milton [Friedman] and myself is that everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of my papers.”

In Japan they have been expanding the money supply for decades. They can’t seem to produce inflation, no matter how hard they try. If we ask the European Central Bank what inflation is, they say something like “inflation occurs when there is a general rise in prices.” (They will also ask if you have seen the inflation monster and offer you to watch a cartoon about price stability).

If inflation is just general rise in prices, then why do prices rise or fall? Most would say, because changes in supply and demand. Don’t prices of products and services tend to drop over time? How do we even measure this?

How to Measure Inflation?

This seams to me an exceptionally tricky undertaking. If inflation is supposed to measure changes in the price of the stuff we buy over a period of time, what happens when we start buying different stuff over time? Our behaviors and preferences are constantly changing? Imagine a lab scientist that has to test his experiment on rats one day and then repeat the experiments with hamsters.

Do you see the problem here? The stuff we buy is not constant. Take mobile phones for example. How can you realistically measure the inflation in mobile phones from one year to another? Or even, how do you compare the price inflation of mobile phones to a period 20 years ago, when there were no mobile phones?

What about all the stuff we don’t pay for yet derive some benefit from? How do you factor in the change in cost of consuming Google searches into any inflation measurement? Should you measure the increase and decrease in paid ads displayed with organic searches? 

And there there are substitute products. If pork rises in value, relative to beef, you might be inclined to consume more beef and less pork. But the baskets of goods and services will take that into account.

So next time, when you see an inflation number with a couple of decimal points. Ask yourself how it was measured and how accurate that measurement could be.

Strawman & Steelman Valuations

A strawman argument is a frequently used tactic in rhetoric and oratory debate. It’s used in business, in politics and Twitter arguments alike. It’s simple and effective. You basically pick an argument of your opponent and rephrase it in a way that makes it easy to refute. Strawman arguments are not real arguments. They don’t even have to be true. 

Peter Thiel argues that for decision making, you should really steelman your opponents arguments. If you try to find the strongest and most compelling reasons for your opponents stand, it allows you to improve your side of the argument or even discover flaws in your own reasoning. 

The same should apply to valuation. You should always try to steelman the potential risk factors that you apply to your investment thesis. 

Covid-19 and Corporate Darwinism

On August 10, 2020, small company in Columbus, Ohio issued a press release announcing its second quarter financial results. There is nothing particularly special about that. Core Molding Technologies, a so-called dark company that trades over the counter, does this every quarter.

In this particular press release, the company disclosed to the world, just like any other public company on the planet, how it was being affected by the Corona-virus Pandemic. So, nothing particularly special about that either.

But what came next was, to me at least, something that caught my attention. The quote, which comes from David Duvall, President and Chief Executive Officer of Core Molding Technologies says “When customers reopened in June and revenues rebounded, to approximately 85% of first quarter’s average monthly revenues, we recorded our highest monthly operating profit of the past five years. It is a clear statement that we have created a stronger company and more resilient organization.”

The underline was added by me.

Darwin’s theory was that the fittest survive. Not the strongest, but the fittest. The fittest for its particular environment. And when the environment changes drastically, the fittest are the ones with the most adaptability.

Every company on this planet has been desperately trying to adapt fast to a new reality. In their struggle to survive, they try to eliminate any excess in their being. Some will go extinct, many will survive.

In many cases, the survivors will have similar things to report as Core Molding. They will be leaner. They will be meaner. And their streamlined costs structures will make them more profitable.

How to Value Your Job

The worst career advice that you get from people is when they say stuff like “you need to take control of your career, you need make sure you get what is coming to you, no one is going to care about you the way you do, so you need to make sure you fight for all of this stuff”, etc, etc. Those are all terrible advises. 

Your job, whatever your job is, is to add value to your employer. It is not your job to try to extract value from your employer and try to get as much of it into your pocket. Rather, your job is to add as much value as you can for the employer and then you can capture some of that value. 

Contrary to what most people think, being underpaid is a very powerful position to be in. Because, if you are adding more value than you are costing then it means also means that you are a very valuable employee. And if your employer is rational, you are going to be treated well.

Nobody has ever gotten fired for creating too much value for their employer. And nobody keeps a job very long if they are getting paid more than they are worth. 

This text was adapted from a podcast interview with legendary investor Bill Miller on Master in Business. The whole podcast is well worth the listen