Speaker 1: Hello, and welcome to another episode of the All Thoughts podcast.
Speaker 1: I'm Tracy Allaway and I'm Joe Wisenthal. So, Joe, we
Speaker 1: are in the midst of yet another earning season, which
Speaker 1: means everyone is spending their time examining all the income
Speaker 1: statements that big companies are publishing. Right. Yeah, it comes
Speaker 1: four times a year, and it's one of the you know,
Speaker 1: one of the most exciting times of the year, especially
Speaker 1: if you're a stock investor, because it's when you know,
Speaker 1: the companies reveal all of the stuff that they did
Speaker 1: in the last quarter, the revenue, how much they made,
Speaker 1: how much their balance sheet, highlights of the quarter, and
Speaker 1: it's when you really have a chance to dig in
Speaker 1: because you have a fresh snapshot of the state of
Speaker 1: the company. Right. But there's a lot of work that
Speaker 1: goes into estimating earnings results even before they come out, right, Like,
Speaker 1: analysts will be tweaking their models ahead of results season,
Speaker 1: and then they'll be tweaking them after. Everyone is sort
Speaker 1: of digging into the numbers to try to determine how
Speaker 1: well or how badly a company is doing. Absolutely, and
Speaker 1: one of the things that I think a lot of
Speaker 1: people don't get if they're not really active in markets.
Speaker 1: Is that there's no such thing is objectively good or
Speaker 1: bad earnings, because in markets everything is about relative to expectations.
Speaker 1: So you can have a company that doubled their earnings
Speaker 1: and made a billion dollars this year versus a billion
Speaker 1: more than last year, but if the market was expecting
Speaker 1: them to make one point two billion dollars more than
Speaker 1: the stock might tumble. Conversely, you can have companies that
Speaker 1: lose a ton of money, but if people were impressed
Speaker 1: by some you know, their revenue growth, or people were
Speaker 1: impressed that they were expected to lose more, uh, they
Speaker 1: the stock might surge. And as such, it's the sort
Speaker 1: of like the classic kynesie and beauty contest. You don't
Speaker 1: just try to figure out the company is gonna earn,
Speaker 1: but we also try to figure out what the crowd
Speaker 1: thinks the company is going to earn and how the
Speaker 1: actual results match up to expectations. Right, And some people
Speaker 1: say that things have gotten even more complicated in recent
Speaker 1: years because you have companies that sort of try to
Speaker 1: talk down expectations before their results and so inevitably they
Speaker 1: end up beating already low forecasts. So there's lots of
Speaker 1: moving parts to this isn't there. But Joe, what if
Speaker 1: I told you that digging into earnings is a useless exercise.
Speaker 1: If you told me that it was a useless exercise
Speaker 1: to dig in like this, I would be completely crushed
Speaker 1: because a part of my job is to talk about
Speaker 1: this and be One of my first jobs was doing
Speaker 1: equity research for a small portfolio management company, and that's
Speaker 1: what I spent hours and hours going through every one
Speaker 1: of these lines. So please don't tell me now. I'm
Speaker 1: sorry to get scared. Why are you? Why are you
Speaker 1: hinting that maybe it's all the waste of time? Don't
Speaker 1: be scared, Joe. What I mean is it might be
Speaker 1: useless to dig into those earning statements in a sort
Speaker 1: of traditional sense. Basically, there are some people out there
Speaker 1: who think that the way we use current accounting rules
Speaker 1: are the way that accounting rules have been implemented, doesn't
Speaker 1: really match the realities of our modern economy or our
Speaker 1: modern business environment. Okay, so let's get your I'm still
Speaker 1: a sort of waiting for the build up here. You'll
Speaker 1: be fine, You'll be fine. Okay, We're going to talk
Speaker 1: to Baruke Love. He's professor of Accounting and Finance at
Speaker 1: Stern School of Business and Fenggu Associate Professor of Accounting
Speaker 1: at Sunni Buffalo. They put out a paper which was
Speaker 1: fantastic on this exact subject, basically arguing that our accounting
Speaker 1: standards haven't really kept up with big, big changes that
Speaker 1: have overtaken the economy in recent years. So let's get
Speaker 1: over to them. Buruke and Fang, welcome to the show.
Speaker 1: Thank you, thank you, Thank you for having us. So
Speaker 1: was that intro accurate? Is the some of your work
Speaker 1: essentially that accounting methodology hasn't really adjusted to modern realities.
Speaker 1: I would say the intro is very accurate. It's not
Speaker 1: just that we claimed that earnings don't matter. We actually
Speaker 1: prove it. Uh. In a recent article we published, we
Speaker 1: show for all companies that even if you had the
Speaker 1: dream forecasting machine, meaning that you could focus, you could
Speaker 1: identify all the companies that we meet or beat consensus
Speaker 1: analysts focused next quarter. You're not longer to make anybody.
Speaker 1: You're not going to make any money from this. You
Speaker 1: used to in the past, big money, but no longer.
Speaker 1: And most people are not aware of the demise of
Speaker 1: earnings as an indicate of company performance. Evaluated of manager's capabilities.
Speaker 1: So we actually prove it both in a recent book
Speaker 1: that we wrote and in in the article. And this
Speaker 1: is this is really I would say earth shattering, but
Speaker 1: it's effect. This is indeed earth shattering. I mean, this
Speaker 1: is in fury. This blows up the premise of so
Speaker 1: many of our conversations, which as we say, okay, Facebook
Speaker 1: earnings are coming out, or GM earnings are coming out,
Speaker 1: and they're expected to earn a dollar and a penny
Speaker 1: per share, and they earn only nineties seven cents. And
Speaker 1: as you say, we try so hard to get this right.
Speaker 1: Let's say, maybe let's start from thinking, so, where did
Speaker 1: the if it's not right, where did it come from?
Speaker 1: Where did we get this idea of how we traditionally
Speaker 1: talk about earnings. The centrality of earnings comes from the
Speaker 1: work of Graham many years ago. He was the celebrated
Speaker 1: teacher of warm Buffett, and since then earnings are the
Speaker 1: center of all the models that analysts are using. Everything
Speaker 1: is aimed at predicting forthcoming earnings. Managers are pestor to
Speaker 1: provide some guidance for forecasting earnings. Everything revolves around earnings,
Speaker 1: and the reason, of course, a reason why so many
Speaker 1: so much money goes to index fund and to automated
Speaker 1: investment managed funds are not doing well, and we claim
Speaker 1: that the main reason why they're not doing well is
Speaker 1: because their focus on earnings is completely misplaced. Right, And
Speaker 1: you have, like you said earlier, if if someone built
Speaker 1: the perfect earnings prediction machine, there was a time when
Speaker 1: you could have made big money from that, and now
Speaker 1: it doesn't seem to be the case. So what exactly
Speaker 1: has happened there? What happened is that it used to
Speaker 1: be that earnings really indicated performance of companies. Thirty forty
Speaker 1: years ago, earnings basically indicated revenues minus real costs. Since then,
Speaker 1: there was a revolution in the business models of companies
Speaker 1: from tangible to intangible assets. You don't make money anymore
Speaker 1: from machines and equipment and building. You make money from
Speaker 1: patents and brands and information technologies and human resources. Everyone
Speaker 1: knows it, everyone uses it, except for accountants that were
Speaker 1: really asleep at the wheel and still are. And all
Speaker 1: those huge expenses of companies in intangibles are expensed in
Speaker 1: the income statement, meaning they are charged against earnings. So
Speaker 1: the earnings that you get today are completely misstated. For
Speaker 1: some companies, they are overstated. For other companies they are understated.
Speaker 1: Just think about the Amazon in the last four or
Speaker 1: five years, they missed half their consensus earnings. Nothing happened
Speaker 1: to them. That's of course a marvelous companies with a
Speaker 1: huge market value. Think about Tesla, incredible brand, with accumulated
Speaker 1: losses of one and a half billion dollars because they
Speaker 1: are forced to expense all their investments. A much smaller,
Speaker 1: less known company like Kite Farmer, which works on very
Speaker 1: advanced cancer research. You look at the financial reports accumulated
Speaker 1: losses of six hundred million dollars. They were just a
Speaker 1: week ago bought by gilly Out Sciences for twelve billion dollars.
Speaker 1: I mean, the financial reports completely mistaked the picture of
Speaker 1: the company, the performance of the company, the future prospects
Speaker 1: of the company. And that's where we are now. And
Speaker 1: that's why, that's the reasons of the failure of the
Speaker 1: traditional analges of companies focusing on earnings. Again, these are
Speaker 1: not just claims that we make article. We demonstrate that
Speaker 1: the lass of earnings relevance over time is really driven
Speaker 1: by companies that invest a lot of money intangible assets.
Speaker 1: So Over time, investors eventually realize that the earnings information,
Speaker 1: the profit laws, and the balance and information investors look
Speaker 1: at is no longer relevant for evaluating the performance and
Speaker 1: the value of these companies. So to be clear, just
Speaker 1: to clarify that a little further, there was a point
Speaker 1: in which that magic earnings oracle would have made you
Speaker 1: a lot of money had you had it. And you
Speaker 1: demonstrate in your paper that the value of that information
Speaker 1: in advance has declined. Can you talk us through a
Speaker 1: little bit that's sort of the quantitative evidence you show
Speaker 1: that that isn't useful information anymore. Sure, Going back to
Speaker 1: the late eighties and early nineties, um, the gains from
Speaker 1: this dream machine of perfectly predicting future earnings would allow
Speaker 1: you to earn access profit in the magnitude of twenty
Speaker 1: five percent each year. This is in access of market
Speaker 1: and risk adjusted returns. So those were the good days
Speaker 1: of playing this earnings prediction game. Now, moving to the
Speaker 1: current time, as off the end of two thousand fifteen,
Speaker 1: the same process would earn you no more than two
Speaker 1: percent of access return. And there are of course a
Speaker 1: lot of treating strategies that can earn you even better
Speaker 1: access returns at much lower cost. Before we get into
Speaker 1: you know, I will obviously I want to talk about
Speaker 1: what we should be looking at instead of the traditional earnings.
Speaker 1: But before we get into that, it's still you know,
Speaker 1: it makes me uncomfortable because even with all of the
Speaker 1: changes in business models an intangible assets, it still seems
Speaker 1: like an intuitive basis that the measure of a company
Speaker 1: is like, okay, but did you make money or not
Speaker 1: in this quarter? And how much money do you have today?
Speaker 1: And how much money do you have three months from now,
Speaker 1: and that ultimately, for as weird and as different as
Speaker 1: business models get, profit is still the point of business.
Speaker 1: It sits in a little bit uneasy with me that
Speaker 1: ultimately it still wouldn't come back to just how much
Speaker 1: money they made. You're right about the importance of how
Speaker 1: much money you're you're making now and of course even
Speaker 1: more important, how much money you'll make in the future.
Speaker 1: What we claim is that earnings measured according to the
Speaker 1: accounting rules today don't even reflect this. That's why, for example,
Speaker 1: in our in our recent book The End of Accounting,
Speaker 1: we show that if you base your analysis on cash flows,
Speaker 1: you will be better off then if you'll do it
Speaker 1: on earnings. So you're perfectly right. It's of course of
Speaker 1: great importance how much money you make, but reported earnings
Speaker 1: don't measure how much money you make by the way
Speaker 1: managers know it, and that's the major reason why they
Speaker 1: release all those non gap earnings which are so derided
Speaker 1: by our people. Some of them are, of course a
Speaker 1: little massage manipulated, but by and large this is a
Speaker 1: manager will response to the inability of currently measured earnings
Speaker 1: to reflect what actually happens in corporations. Right, So it
Speaker 1: feels like every earning season we get a news article
Speaker 1: about how reported gap figures are veering away from adjusted earnings,
Speaker 1: and lots of people have problems with adjusted earnings because
Speaker 1: they think they're they're vulnerable to manipulation either by managers
Speaker 1: or analysts might read too much into them. But you're
Speaker 1: arguing that there are more accurate representation than traditional gap accounting,
Speaker 1: or that they feel a sort of gap left by gap.
Speaker 1: I guess again, it's not. It's not just my argument.
Speaker 1: It's the result of lots of research projects that are
Speaker 1: confirmed that investors react more strongly, most forcefully to non
Speaker 1: gap earnings than gap earnings. So investors find by enlarge,
Speaker 1: non gap earnings is much more informative than gap earnings.
Speaker 1: That's again effect. These are things that are very easy
Speaker 1: to research, and these are the findings. Thing I think
Speaker 1: you mentioned Amazon, or maybe we're talking about Amazon and Tesla,
Speaker 1: and of course Amazon is sort of famous for people
Speaker 1: discarding their earnings or even their non gap earnings that
Speaker 1: you can have these quarters will they'll lose money and
Speaker 1: the stock shoots up, or they'll give a guidance range
Speaker 1: that's so wide is to be laughable, but it doesn't
Speaker 1: really matter to people, and people keep buying. The story
Speaker 1: that pundits like to tell about Amazon is that Jeff
Speaker 1: Bezos has done such a good job training Wall Street
Speaker 1: to not care about quarter to quarter profits that they
Speaker 1: can get away with huge investments and huge losses from
Speaker 1: time to time. But it sounds like what you guys
Speaker 1: are saying is that the way we characterize Amazon is
Speaker 1: a little too pat and that actually Wall Streets response
Speaker 1: is not about some training or anything like that, but
Speaker 1: essentially about investors just sort of understanding, like in any company,
Speaker 1: the numbers that really matter, and that earnings aren't really it.
Speaker 1: That's that's absolutely true. So what we have advocated in
Speaker 1: a book as well as the article, is this notion
Speaker 1: of strategic assets. What really matters to accompany success and
Speaker 1: the competitive at UH is not just current quarters earnings
Speaker 1: of profit. It's UH their strategic asset that give them
Speaker 1: long term value in market competition. So for a company
Speaker 1: like Amazon, what investment has delivered to them is the
Speaker 1: growth of their strategic asset. If you think about their
Speaker 1: market share, their expansion into more and more market territories,
Speaker 1: that's the proof that they're growing their strategic assets very strongly.
Speaker 1: And the investors certainly understand this. At the end of
Speaker 1: the day, they're not just going to look at the
Speaker 1: quotally profit or loss or Instead, they're going to pay
Speaker 1: a lot of attention to amazon strategic assets. All the
Speaker 1: assets have been investment, invested, deployed, and what kind of
Speaker 1: value has been created by these assets. To interject the
Speaker 1: cautionary note here, we are speaking about Amazon and Tesla,
Speaker 1: and investors definitely understand these companies because they are led
Speaker 1: by extremely articulate and charismatic leaders and the men search
Speaker 1: is clear. But there are thousands of companies out there
Speaker 1: without Jeff Bezos and other charismatic leaders that their message
Speaker 1: is not well understood and investors don't see the truth.
Speaker 1: They are still relying on the reported numbers, which are
Speaker 1: misleading them. So that's why I think our message is
Speaker 1: so relevant today. If investors knew everything, we would even
Speaker 1: write this article now, but they are not. It's only
Speaker 1: for a few companies with those very effective CEOs or
Speaker 1: CFOs that can spread this message. The other thing I'm
Speaker 1: wondering is your findings. You know about this perfect earnings
Speaker 1: estimator and the fact that it wouldn't be much of
Speaker 1: an edge in the market nowadays. Does that say more
Speaker 1: about how the market is functioning than the deficiencies of
Speaker 1: the accounting rules themselves, because one of the criticisms of
Speaker 1: the current market is that valuations no longer matter. You know,
Speaker 1: people aren't really investing on fundamental terms. They're just sort
Speaker 1: of following the money and it's all momentum based. So
Speaker 1: you're right, there a lot investing on the fundamentals or
Speaker 1: less than a fewer and fewer people are investing on
Speaker 1: fundamentals because it faces them. I mean, they see the
Speaker 1: results quarter of their quotas and it's it's really not working.
Speaker 1: What we are saying is, don't abandoned fundamental analysis. You
Speaker 1: still have very good information out there. You're focusing on
Speaker 1: the wrong information, but you can shift and focus on
Speaker 1: the right information and you will be much better off. Okay, well,
Speaker 1: you know, before we wrap up, we have to talk
Speaker 1: about what these things are. So okay, you mentioned that,
Speaker 1: for example, it makes sense to not he too closely
Speaker 1: to traditional gap earnings. You also talked about the importance
Speaker 1: of having strategic assets. But for many companies that sounds
Speaker 1: like it would be something that you know, it's unquantitative
Speaker 1: or something fuel based. Let's talk what are the things
Speaker 1: in an earnings report, in anything else that we should
Speaker 1: really be focusing on instead to start building a mental
Speaker 1: model of what a company is worth. So I'll give
Speaker 1: you a couple of examples. If you're talking about pharmaceutical
Speaker 1: and biotech companies and you have a huge number of
Speaker 1: these companies, what they earned last quarter or last year,
Speaker 1: it's completely irrelevant to the future. What is relevant is
Speaker 1: what's called the product pipeline, the drugs, the instruments that
Speaker 1: they are developing. And all companies are providing very detailed
Speaker 1: information page of the page of the page. It's not
Speaker 1: required by accounting rules, but they are doing it on
Speaker 1: the product pipeline. So if the company has products in
Speaker 1: advanced stage of development, is two clinical tests, face three
Speaker 1: clinical tests, they are close to the market, high likelihood
Speaker 1: that new products will come out of them. This company
Speaker 1: is at a very good stage. I would invest in
Speaker 1: such a company. I don't care about the earnings of
Speaker 1: such a company. Talk about my second example, Internet companies,
Speaker 1: even insurance companies, media and entertainment. There's main strategic assets
Speaker 1: are customers. Look at the main data. Look at how
Speaker 1: many customers are being added every quarter. Look at the
Speaker 1: churn rate, which most people are not aware of. Churn
Speaker 1: rate meaning the center of customers they lose every quarter.
Speaker 1: That's what indicates the future, not the current earnings last
Speaker 1: earnings that they report. Basically, for every industry you have
Speaker 1: those fundamental strategic asset that create the you. For most companies,
Speaker 1: this information is given and the focus should be on
Speaker 1: the performance of these assets, the potential of these assets.
Speaker 1: Just just to play Devil's advocate, though, you talk about
Speaker 1: companies with drugs and stage two trials, But even then,
Speaker 1: to value that drug, don't you still have to come
Speaker 1: up with some model of how big the addressable market
Speaker 1: could be how much profit that drug is going to
Speaker 1: I mean, doesn't it still just come back to that
Speaker 1: being a tool to come up with some estimate of
Speaker 1: future earnings. Yes, you can do it and actually think
Speaker 1: and I developed such a model because they are they
Speaker 1: are quite reliable data on the likelihood of drugs in
Speaker 1: phase to get into the market, and then you have
Speaker 1: the market size for the drug. So ultimately you can
Speaker 1: come up with prediction of revenues from the drug. But
Speaker 1: the focus of analysis is not trying to predict just
Speaker 1: the revenues, but looking at the fundamentals what creates the
Speaker 1: value in all tasks. With this new mesthology, we actually
Speaker 1: have seen evidence showing that this different way of evaluating
Speaker 1: from suitable companies fundamental actually produces information signals that lead
Speaker 1: changing their market value. In other words, um, we can
Speaker 1: actually see the change in the value of their product
Speaker 1: pipeline before investors actually realize scenes are becoming different. Well,
Speaker 1: I'm sure we could talk about accounting all day, but
Speaker 1: we have to leave it there. That was baruque love
Speaker 1: and thank Goog, Thank you so much for joining us.
Speaker 1: Thank you, thank you so Joe, does that make you
Speaker 1: feel better or worse? About your previous career as a
Speaker 1: financial analyst. Well, you know, I'm no longer a finance
Speaker 1: chill analyst, So I guess it makes me feel good
Speaker 1: that I left that, you know, had I had. I
Speaker 1: just stuck to trying to estimate EPs and all that stuff.
Speaker 1: But uh no, in all seriousness, it is really interesting.
Speaker 1: I mean, one of the things I wonder is, like,
Speaker 1: to what extent do investors, you know, already sort of
Speaker 1: let these other factors determined I mean, the value of companies.
Speaker 1: It's not like all companies have the same PE ratio,
Speaker 1: the same port forward pe ratio. To some extent, it's
Speaker 1: pretty clear that things like network effects or an internal
Speaker 1: company culture that allows it to produce great drugs you
Speaker 1: would imagine, is already being reflected in a lot of
Speaker 1: people thinking about these companies, right, And you do have
Speaker 1: some pretty big companies out there that are highly valued
Speaker 1: that haven't necessarily had that successful um earnings quarters. I
Speaker 1: guess I think I think what it comes down to
Speaker 1: for me, I think our guests they've identified a problem
Speaker 1: which definitely exists. I think you can say the accounting rules,
Speaker 1: for sure, are not well equipped to deal with the
Speaker 1: realities of an economy that's increasingly about research and development
Speaker 1: and you know, brand value and information technology as opposed
Speaker 1: to um, you know, machinery and manufacturing. I'm not sure
Speaker 1: about the solution, because again, it's one thing to say, oh,
Speaker 1: investors should consider these strategic assets of a company, but
Speaker 1: at some point you do want to see those strategic
Speaker 1: assets converted into some sort of revenue, right, And that's
Speaker 1: sort of like, you know, it seems like a theory
Speaker 1: you should be able to square the circle and say, Okay,
Speaker 1: it's great to have these strategic assets, but you know,
Speaker 1: a strategic asset is only so good unless it produces
Speaker 1: revenue and income. But what I think is valuable here
Speaker 1: to me is like maybe we there's still it's like
Speaker 1: we have so many tuitive understanding that for all companies,
Speaker 1: whether it's an Amazon on one end, or whether it's
Speaker 1: a more standard industrial like a Honeywell or a g
Speaker 1: E on another end, that there's this whole spectrum of
Speaker 1: business models, and we sort of have this intuitive understanding
Speaker 1: that the sort of network effects or the customers are
Speaker 1: the attention of some companies matters a lot more for others.
Speaker 1: But maybe we still overrate the importance of a traditional
Speaker 1: earnings company for for traditional stock, even when it's not
Speaker 1: particularly appropriate, and that we have to sort of adjust
Speaker 1: our dial to recognize that it's not the same thing,
Speaker 1: looking at a sort of P n L statement for
Speaker 1: a traditional industrial versus a P and L statement for
Speaker 1: an Amazon or a Facebook. Yeah, I think that's right
Speaker 1: in any case. It's clearly a complicated topic, but something
Speaker 1: we can all keep in mind as earning season rolls on.
Speaker 1: And I'm very excited to read their book. I have
Speaker 1: it in front of me, The End of Account and
Speaker 1: the Path Forward for Investors and Managers by Baruke Lev
Speaker 1: and Fengu So thanks to them for joining us, and
Speaker 1: maybe we'll I'll read this and I'll get some more insight.
Speaker 1: All right, This has been another edition of the All
Speaker 1: Thoughts Podcast. I'm Tracy Alloway. You can follow me on
Speaker 1: Twitter at Tracy Alloway. And I'm Joe Wisenthal and you
Speaker 1: can follow me on Twitter at The Stalwart. And I
Speaker 1: want to thank our producer Sarah Patterson, who's on Twitter
Speaker 1: at Sarah patt With two Teas. Thanks for listening.