Accounting Landmines: Goodwill

When looking at publicly traded companies, one of the accounting landmines in modern valuation is a called goodwill.

You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission. -Warren Buffett

Definition:

Accounting principles require fair value be assigned to a company when it is purchased.  This fair value starts with the assignment of value to identifiable assets.  In today’s modern financial world, often the purchase price of a company exceeds the value of the identifiable assets of the company.   In order to keep balance sheets even, acquiring companies often must hold this excess of value as an asset.

Things to consider when valuing a company that has a lot of goodwill:

Even though such an asset has no apparent tangible value, public companies are required to account for it on the balance sheet.  Accounting principles require that such goodwill be evaluated each year and if the value of the underlying acquisition be charged to earnings if the goodwill has suffered an impairment.  Purchasing a company with a large amount of goodwill on its books is tantamount to purchasing the company’s assets and thin air (my personal opinion).

An example to consider (aka buyer beware ENDP):

Endo Pharmaceuticals (ENDP) recorded $3.5 Billion goodwill and intangible asset impairment charges in the fourth quarter of 2016.  This occurred when the company’s management completed their goodwill and in-process R&D impairment tests.  Using the estimated future cash flows for these areas, management stated that they had to revise their forecasts, Wall Street speak for “we had no idea that something could actually go wrong 12 months ago when we made our estimates.”

This caused the company to take a earnings loss of 14.96/share when the stock price for the company was about 12/share!  The management in their conference call followed this staggering number with diluted earnings per share from continued operations of 1.97.  A discussion of diluted earnings per share could merit its own post.   However, for our purposes here just think that management came to the shareholders and disclosed that in ONE QUARTER they had losses exceeding the value of the company but all is good because diluted earnings are still positive.  This resulted in the share price to drop about 17%.  Goodwill can have a real tangible effect on a company’s value in the marketplace.

As for ENDP’s management, I am reminded of the old 1980 era film with Silvester Stallone named Oscar.  After a day of trying to go straight, “Snaps” Provalone is sitting down with the bankers that are to be his new partners.  His accountant looks through the contract and finds that the contract does not allow him to have a vote on the board.  Snaps ends the session saying something to the effect of, “I’ve dealt with mobsters, bootleggers, and gonzos…but you bankers are scary”.

For another perspective on Goodwill and how it affects a company stock price consider Warren Buffet’s words on it in his 1983 letter to shareholders.  His perspective from that letter would have called ENDP’s assignment of overvalued business purchases to silliness in the goodwill account.  The lack of managerial discipline displayed by the management would be more along the lines of a “no-will” account.

Final thought

I leave you with one final thought, if you consider purchasing a company in excess of its tangible assets.  Lets use a company selling for 100/share and it has 5/share in earnings and 20/share in tangible assets.  Consider amortizing the price of the excess from the earnings over the next forty years using straight line depreciation (5-80/40=3/share).  Is the price still worth the adjusted earnings?

Exploring Spin Offs

Exploring Spin offs

Spin off companies appear to be a place where one can consistently beat the S&P 500.  This post will explore this possible investment closer than previous posts.  If you would like to see my perspective on a spin off that occurred recently you can check out the posts I wrote on the Conduent spin off that occurred earlier this year.  Full disclosure, as of this writing I currently have 100 shares of Conduent and five long term options in Conduent and Xerox set to expire in 2019.

Corporate spin off opportunity from Xerox: Conduent

“Carefully study spin offs” – Charlie Munger

Risks

The risks associated with spin offs are numerous, so before a reader immediately goes out and buys every spin off they can find, some words of caution:

  1. A Deloitte study found that 4 out of 10 spin off companies do not generate a positive return in their first 12 months of trading.
  2. The same study found that the bottom quartile returned -39% over the first year.

You can find the Deloitte study by following this link.

Rewards

The return associated with spin offs is apparent in the Bloomberg Spinoff Index which from 2003 to 2016 returned approximately 15.58% while the S&P500 returned 8.88%!

Reasons Spin offs remain a good place to look for deals

  1. In a world of increasing index investing, many spin offs will be beaten down by institutions selling the shares of the new company outright because it will not be in the index.
  2. Institutions may also find that the recent spin off does not meet their investment expectations (like size or leverage amount) and they will again immediately dump the shares without considering the value of the investment.
  3. Sometimes these smaller companies demonstrate a new, previously undiscovered business opportunity.
  4. Investors often are wary (or haven’t heard) of these companies because many of them are not followed by analysts until after a few months of independence.

Conclusion

With a consistent way to outperform the S&P500, this seems to be a place I want to be in the stock market.  Next week HPE will be spinning off a portion of its business, as a current investor in HPE I will be looking at this spin off with great interest.

Lessons from Warren Buffett’s Annual Letter to Shareholders

Last week, Warren Buffett’s letter to his shareholders was available online.  His letters are always a great read, and they provide insight into his views on investments.  This post will be dedicated to some of the wisdom and humorous quips an investor can glean from his letter.

“Today, I would rather prep for a colonoscopy than issue Berkshire shares.”

Warren Buffet, 2016 letter to shareholders, page 4

Buffett’s reason to not issue shares is a result of past experience.  The examples he cites in the letter include buying Dexter shoe and General Re by issuing Berkshire shares.  Dexter shoe is the most painful decision as Buffett notes that the company’s stock promptly went to zero.  The shares he issued to purchase the company gave the Dexter sellers $6 Billion in Berkshire shares by the end of the year.

The lesson that Warren takes from this experience is to purchase his investments in all cash.  More importantly, for an investor reading his letter it identifies that one of the best investors in the world has a long memory of his mistakes.  The Dexter fiasco happened in 1993 and he is mentioning it in his 2016 letter to shareholders as a lesson learned.

“To recap Berkshire’s own repurchase policy: I am authorized to buy large amounts of Berkshire shares at 120% or less of book value because our Board has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders. By our estimate, a 120%-of-book price is a significant discount to Berkshire’s intrinsic value, a spread that is appropriate because calculations of intrinsic value can’t be precise.”

Letter, pg 7

After a rant against companies that repurchase their shares at an inflated price, Warren identifies Berkshire’s repurchase policy-120% of book value.  His preceding words identified that too many boards today repurchase shares of their stock with no hard numbers on which price is an appropriate price to pay.  This is ridiculous, because price would be the first thing management would consider if looking at an acquisition.

This line of thought provides two lessons that an investor can use-watch your managements and set the appropriate price in hard numbers.  Watch the management of the companies that you purchase and make sure that they are making rational decisions.  They should not be following the crowd to simply buy back shares if the company stock price is inflated.  This would be wasting shareholder funds on a poor endeavor.  Having a hard test for their numbers is a great way to find the value of a company in the market.

“Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.”

“I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.”

Letter, pages 24-25

Warren identifies the best advice he can for investing-use low fee vehicles that match the market.  In my opinion, this is the simplest way to go with investing.  Match the market through a low cost index fund.  If you are not interested in looking at specific positions and digging deep – then purchase an index fund that attempts to match the S&P 500 and call it good.  Correction, if you are over 10 years from needing the money, purchase an index fund that matches the S&P 400 and call it good.  My reason is that the S&P 400 typically outperforms the S&P 500 but it will be more volatile than the S&P 500.  You can read more in the post below.

Investment Plans, Part 3: ETF example

In conclusion, Warren Buffett’s letters are great for anyone aspiring to be a successful investor.  If you would like to read his whole letter in its entirety you can find it here.  I leave you with my personal favorite quote from his letter, it is an adage he used when talking about how Wall Street managers separate their customers from money:

“When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”

-Letter, pg 25