Your potential alpha isn’t just where
the map differs from the territory. It’s where the map differs from the
territory and where other investors are misusing that map.
Continuing in the wake of the previous memo, let’s examine the
Counting the Whole Balance Sheet
Equity and debt investors are the
most common sources of capital, but they aren’t the only ones.
Warren Buffett introduced many
investors to the concept of insurance float — cash collected in advance from
customers that is akin to a 0% loan. In a way, insurers are estimating the
acquisition cost and default rate of these 0% quasi-loans.
You can extend Buffett’s thinking to categorize
each balance sheet line item by the relationship it represents: customers, suppliers,
employees, investors, and the government.
Categorizing the Balance Sheet by Relationships
If you characterize these float sources as 0%
loans, you should analyze them with a debt investor’s mindset. These
quasi-loans can be useful or risky depending on their credit, maturity, and
liquidity profiles. For example, supplier financing through accounts payable
has been a cheap capital
source for Costco but a source of pain for some factor
Inventory and fixed assets don’t fit this quasi-loan mold. They more closely resemble real call options. A company buys inventory with the expectation that this real option will end up in the money — that a future customer will buy the goods. Suppliers typically have no obligation to return the cash if the inventory doesn’t sell, so it’s not a quasi-loan. Fixed assets work in much the same way. It’s a fun intellectual exercise to model writeoffs, depreciation, and amortization as decay on those real options, but so far I haven’t found this to be a material source of alpha.
Rethinking the cost of capital may be
WACC Should Include All Liabilities
Cost of capital is a tenuous concept.
Charlie Munger amusingly calls it a “perfectly amazing
Different people have different capital sources and opportunity costs. Why do we assume that every investor should use the same discount rate? Moreover, a company’s cost of capital is path dependent at the company level and the macro level. Why do we project one static discount rate instead of simulating many potential paths for cost of capital?
But if we insist on using this formula, we should at least count all of the capital sources that companies tap. To start, here is the current definition of the weighted average cost of capital (WACC):
Weighted Average Cost of Capital (Current Definition)
The traditional WACC is limited to capital provided by investors. It really should be expanded to include non-investor capital sources, as highlighted in blue below.
Cost of Capital Should Include All Liabilities
Two companies could have the same
traditional WACC — only debt and equity from investors — but one could have a
cheaper true cost of capital when those 0% quasi-loans are included.
Non-investor capital sources have
interesting nuances of their own.
Employee and government financing are deferred expenses, so they aren’t true capital inflows. They are, however, quite useful for large corporations with steady cash-flow streams to shield. Berkshire Hathaway’s ballooning deferred tax liability is a prime example here.
Customer and supplier financing are
sources of new capital. In these scenarios, customers pay ahead of time, and
suppliers send inventory to a company before requiring payment. Examples of customer
financing include Kickstarter projects, Tesla’s $14 billion
Model 3 pre-sale, and annual contracts in
SaaS. Some examples of supplier financing are Walmart’s extension
of their payment terms from net 20 to net 90 and small merchants
guaranteeing inventory availability to Groupon’s marketplace.
This broadened WACC can be an alpha
opportunity when a company has an underappreciated capital source and, more
importantly, when that source can meaningfully change a company’s overall cost
The Market Value of Equity
When Luca Pacioli codified
double-entry accounting in 1494, publicly traded
stocks did not exist.
That’s probably why early accounting
standards weren’t built to update the balance sheet based on fair market value.
Why pay attention to quotes in the stock market when there was no stock market
to pay attention to?
To this day, GAAP accounting only
tracks equity book value at historical cost — contributed capital plus retained
earnings after taxes and dividends. If the stock market prices that equity
higher or lower than book value, this new valuation is not incorporated into
the company’s accounting.
The problem is that companies
continue to transact in their own equity after going public. In fact, making it
easier to transact in their own equity is the entire point of going
public. A public company should have less difficulty selling equity to
outside investors, granting equity compensation to employees, and buying back
equity from the market. How can investors track these transactions if they
aren’t fully reported?
The way to fix this is to add a GAAP
line item for the market value of equity.
Adding a Line Item for Equity Market Value
To sidestep the debate between
historical cost and fair value measures, we could add new mark-to-market line
items to the balance sheet. We could also report mark-to-market changes separately
from operating income. This approach would avoid jitters in the income
statement and answer Buffett’s related
criticism of ASC 321.
Investors are already doing this
indirectly. Popular metrics like enterprise value and the Q ratio effectively mark
equity to stock market value. Directly tracking the fair market value of equity
would make clear which companies are savvy dealers in their own equity and
which are masking their underperformance with dilution.
Counting Shared-Based Comp the Right Way
This new line item for equity market
value would also let us properly measure share-based compensation (SBC). As it
stands today, we don’t mark SBC to market.
How Share-Based Compensation Is Currently Practiced
When SBC is first granted, an appraiser comes up with a low equity valuation that gives the employee a favorable tax treatment. We just need to true up the wage expense for the current equity value when the employee exercises their options.
The lack of clarity around marking
equity to market and SBC creates significant potential for alpha. It’s already
challenging to screen for capital allocation — return on shares issued, return
on shares repurchased, and acquisition deal structures. But the most important
capital allocation metric is even more opaque — return on employees hired. Right
now, it can be difficult for investors to see who is earning the highest return
on the teams they’ve built.
The alpha opportunity is to find
entrepreneurs who are world-class capital allocators and underappreciated for
it. Think of the greats: Henry Singleton issuing
highly valued Teledyne equity for M&A and then buying back shares on the
cheap in the 1970s and 1980s. John Malone paying 6x
EBITDA (post-cost synergies) in cash and debt to consolidate small cable
operators into TCI. Mark Leonard adding niche
vertical software products to the Constellation Software portfolio.
Finding just one of these capital
allocators early on would have made an investor’s career. In a decade, we may
look back at the most charismatic team builders in the same light.
The Potential for Network-Based Accounting
The strategies in this series are a sampling of how you can generate alpha from GAAP as it is interpreted today. How you use them depends on your strategy, whether you’re a long investor, a short seller, or an entrepreneur.
Alpha-Generating Accounting Opportunities
How long these alpha opportunities last will depend on how GAAP and fundamental investment strategies evolve over time. Double-entry accounting was developed with pen and paper. Computers could transform the foundation upon which GAAP and investment analysis are built.
Put in plain English, businesses run
on relationships. Double-entry accounting helps us track those relationships,
but GAAP currently has each company report as if it is a separate entity. We
want an easy way to see all of those relationships at once.
You might call this network-based
Contracts are the legal marker of
relationships between business entities. They are the “connective tissue in modern
economics” in the words of Nobel laureate Oliver Hart. With an updated framework,
we could graph networks of contracts between companies.
This approach wasn’t feasible in a pre-computing era, and it’s hardly practical
today with our current data standards. Renovating GAAP for the computing era
would make these relationship models viable.
I think the future of accounting lies
in agent-based modeling. We could treat
companies as individual agents to simulate how they are interacting now and how
they might interact in the future. You’d be able to see each company’s network
of relationships with its customers, employees, suppliers, investors,
competitors, the government, and the public at large. Some of these
relationships are barely mentioned in our current model of GAAP.
Dozens of due diligence questions
would be easier to answer with network-based accounting.
Does a company have long-term or
short-term customer relationships? Have the company’s suppliers started to
provide interest-free financing? Could its investors be suddenly forced to sell
out? And the scary one: Is there some contagious risk that could threaten the
company’s network of key relationships?
The capital markets could be much,
much more efficient if this framework could be properly abstracted into
software. But for now, that’s just a fun conversation to have after work.
Today, I’m more interested in the
alpha that we can generate with the markets as they are currently structured.
And I think that GAAP and the way that investors react to GAAP reports will
create significant opportunities for a long time to come.
Thanks to Tom King, Nadav Manham, Ben
Reinhardt, Kevin Shin, and Slater Stich for their help with these memos.
You can read more from Luke Constable in Lembas Capital’s Library.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: Grandjean, Martin / Wikimedia
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.
Luke Constable is the founder and managing member of Lembas Capital, a public-private investment firm. Lembas looks for companies with charisma – quality businesses with accelerating cash flows and favorable capital flows. Prior to Lembas, Luke worked in special situations, growth, and crossover investing at several hedge funds and a private family office. He received his AB in history from Duke University and his JD from Stanford Law School. He was a champion Civilization IV player and is a member of the California Bar Association. Originally from Philadelphia, Luke now lives in New York, where Lembas is headquartered.