With the S&P 500 and Dow Jones Industrials near all-time peaks, some recent Wall Street analysis has stoked the fear there is a massive speculative bubble in the market, one that is about to pop.
This time, it’s Goldman Sachs that has created a monstrosity for bad market signaling and unnecessary headline grabbing. It’s called “The Non-Profitable Technology Index” and it’s often referred to as the “negative earnings” company index.
One particular chart has been paraded around that shows a scary, exponentially rising indexed price of a basket of high-flying tech names. If the chart’s steep rise wasn’t enough to scare the investor, the basis for choosing the stocks certainly would: all of the companies in the basket have negative earnings, according to the Goldman report.
That’s enough to send the financial media into a tailspin about the stock market highs being in an unsustainable bubble. The recent sell-off and volatility in many of those same stocks has helped to sound the alarms for an oncoming bear market as this supposed bubble may be coming to an end.
The major problem is that Goldman’s analysis, like most all of Wall Street research, hinges completely on the published, as-reported, “official” earnings number for each company.
That unfortunately-calculated number is published in every Wall Street research report, then reinforced with every quarterly earnings release and analyst estimate. Too bad it is based on GAAP accounting, or Generally Accepted Accounting Principles. That is the crux of the problem.
What Would Warren Say?
No investor worth their salt would ever rely on an as-reported GAAP earnings number. No investor ought to provide more than a passing glance at Goldman’s new index. The chart in particular doesn’t provide any useful insights as to what it purports.
Under Generally Accepted Accounting Principles, the basis of “profitability”, as-reported net income, simply doesn’t represent what’s really happening in the business.
That last sentence almost perfectly combines and summarizes the exact comments Warren Buffett made in the first ten minutes of his opening remarks at both his 2018 and 2019 Berkshire-Hathaway shareholder meetings. Check it out for yourself in the videos of those events.
Buffet is not alone in openly challenging the reliability of as-reported numbers. At one point or another, many of the greatest investors on the planet have taken similar shots including Charlie Munger, Seth Klarman, Shelby Davis, and the father of value investing himself, Ben Graham. Adding to that list, in the words of the late, great Marty Whitman, “GAAP is not truth or reality.”
Wall Street research ignores the greatest stock pickers in history, in part, because it’s awfully difficult to fix GAAP’s problems. More importantly; however, it’s because fixing GAAP doesn’t support the raison d’etre of the Street.
It’s hard for a banker to stay loyal to a corporate client if said banker is forced to reveal the truth about their clients’ business. GAAP-based numbers provide tremendous wiggle room for bankers to come up with whatever narrative they desire.
In this case, the below chart measures the performance of the aforementioned index. From 2015 to 2020, the index had modest gains. Then, this index showed an exponential spike in 2020 and into 2021, soaring from March 2020 lows.
The price of this particular basket of stocks shows growth of more than 400% from the market bottom to early February. That’s more than 5x greater than the S&P 500 return of 75% during that incredible rebound. Even after the choppiness in recent days, this return dwarfs the tech-heavy Nasdaq composite, which has recovered by over 100%.
Another Dot-Com Bust in the Making?
Many in the financial media have drawn a direct comparison between this chart (and thereby the current stock market) to the dot-com boom and bust of the late 1990s. At that time, so many “new economy” companies lacked earnings.
Back then, the U.S. experienced an incredibly strong bull market, heavily fueled by the rapid growth of technology stocks. With the widespread adoption of the internet, it seemed anything internet-related, or just with a “.com” in its name, could soar in market valuation.
From 1995 to 2000, the Nasdaq rose approximately 500%. During the height of the craze, in 1999, there were 457 IPOs, mostly new technology stocks. A great number of those were banked by my alma mater, CSFB, Credit Suisse First Boston, which at the time was the “800- pound gorilla” of investment banking for technology firms.
Many of those dot-com firms not only lacked profit, they also lacked revenue. Valuations were being surmised and evaluated based on ethereal concepts like “multiples of eyeballs” or sheer employee growth rates. There often was no cash flow data to even consider.
Firms such as Pets.com, Webvan.com, and Flooz.com were raising billions of dollars from exuberant investors desperate to get in on the action. Wall Street’s research reports on those stocks were found to be not only incredibly inaccurate, but also in violation of many kinds of securities laws.
In case after case, sell-side research analysts were found publicly cheering stocks with comments like “back up the truck” to induce the purchasing of initial public offerings. Meanwhile, those exact same analysts were privately telling co-workers, junior analysts, and friends not to touch said IPO with a ten foot pole.
Companies with no revenue, no earnings, and sometimes mountains of debt, skyrocketed in price while, in reality, they did not and could not warrant their hundred million-dollar and billion-dollar valuations.
There were a few notable winners such as Amazon. It actually did have positive earnings… when GAAP distortions were removed using Uniform Accounting numbers. However, most of these firms were shown later to be next to worthless. The stock market collapse was swift and severe and many investors still remember and feel that pain to this day.
Now, the blistering performance of this set of supposedly non-profitable technology firms in the Goldman Sachs index has some investors fearing an imminent repeat of the tech bust twenty years ago. Unfortunately, poorly constructed indexes and sorely lacking research are supporting that fear.
The Economic Reality of Some Supposedly Negative Profit Firms
Today is a different situation as shown by the economic reality of these firms. The high-flying tech companies today not only have revenue and earning potential, many are showing current and strong earning power. Power that GAAP-based, as-reported numbers, and Wall Street fail to reflect – and maybe don’t even comprehend.
Note the following firms that are included in the non-profitable technology index.
GAAP distortions are misleading some research analysts into thinking all the stocks in the index are start-up-esque, money-burning, “.com-like” companies. It suggests that they are all hemorrhaging investor money.
It’s a totally different picture when these companies are viewed using Uniform earnings and other UAFRS-based performance metrics. In other words, what is the real earning power of these firms when the as-reported, GAAP accounting distortions are removed?
There is a stark difference between as-reported earnings and economic reality.
Shopify (SHOP), Spotify (SPOT), Roku (ROKU), Peloton (PTON), Pinterest (PINS), and Teladoc (TDOC) have all been posterchildren of the “non-profitable tech” run. In reality, these firms have positive earnings and earning power trends which GAAP and Goldman fail to capture.
Under Uniform Adjusted Financial Reporting Standards (UAFRS), investors see the reality of a business’s corporate performance. To “get to Uniform,” more than 130 adjustments are made to GAAP-based financial statements.
These adjustments clean up highly distorted GAAP-accounting issues like stock-based compensation, R&D investments, and terribly misguided lease capitalization rules.
A Few of the Profitable “Non-Profitable” Technology Firms
The father of value investing, Professor Ben Graham, spoke of the importance of “earning power” throughout his books, Intelligent Investor and Security Analysis. This concept is seldom, if ever, mentioned in Wall Street research.
Earning power, as represented by return on assets (ROA), provides a far more accurate view of the health or a business. As-reported ROA, as seen in almost every financial database from Bloomberg to Factset to Yahoo Finance, provides a GAAP-based metric, shown in the table below. This is compared against the same metric based on Uniform Accounting.
Once the consistent rules of Uniform Accounting are applied, companies’ true colors are revealed.
Highlighting one example from above, Teladoc Health (TDOC) is a telemedicine and virtual healthcare pioneer. On an as-reported basis, Teladoc Health appears to have no earning power at all, supposedly a highly negative number, over recent years, as shown by the orange bars below.
This early stage company actually did show a negative return on assets in 2017. That is not uncommon for start-ups. The real concern is how fast the firm can shift its profitability upward and enter positive earnings territory.
Uniform Accounting metrics, the blue bars, highlight how the firm has ramped up operational performance incredibly, generating an impressive 26% return on assets in 2019.
Teladoc’s stock has risen from $37.50 to well over $200 per share since 2018. It’s a significant contributor to the rise of the questionably developed Goldman index. The Uniform-based performance metrics show this is entirely justified.
This impressive inflection in profitability, coupled with massive growth in the business, demonstrates that markets are not baselessly investing into a fad. There is fundamental value driving exuberance in Teladoc and many other current tech stocks.
Another point is the trend and trajectory. Firms that are ramping up their investments could appear to have decreasing earnings. A multi-year comparison of earnings is even more telling under Uniform Accounting.
While valuations may still seem extreme for some, these recent stock price movements are not a repeat of the dot-com bubble from 20 years past when bad companies were getting worse.
Certainly, some of the players in the Goldman basket have issues in generating a positive return as of right now. For instance, Uber Technologies (UBER) and Lyft, Inc. (LYFT) seem to have a long runway to traverse before they start demonstrating healthy earning power.
Even then, these companies are a far cry from the non-revenue generating dot-coms of decades past. In the late 1990s, I never bought a toy from etoys.com nor any groceries from Webvan. Yet year over year, I’ve used Uber and Lyft more often than I could possibly count.
The Devil is in the Details
This is a detailed earnings calculation discussion that Goldman and most Wall Street analysts and bankers fail to cover. However, any investor relying on earnings per share or price to earnings has to grasp these issues. Otherwise, that investor ought to just buy a real index, like Vanguard’s VOO for the S&P 500, and stay away from the individual stock game.
One major adjustment made under Uniform Accounting is the treatment of R&D, research and development expenditures. Here, GAAP fundamentally violates its own most basic and foundational “matching principle” which is taught in every college student’s Accounting 101 class.
In the U.S., R&D is treated as a current cost against revenue. In reality, it is an investment in the long-term cash flow generation of a firm. Of course it should be capitalized and expensed over time, just like a machine or any other capital expenditure. That’s the matching principle.
More novice or misguided proponents of GAAP will often pose the question, “What if management is spending R&D on bad or useless innovations? Should it then still be capitalized?”
Yes, of course. Companies make bad investments all the time. At least we as investors can see it characterized as such in the financial statements and then draw our own conclusions as to management’s prowess or lack thereof.
If the investment in research is recorded as an expense, then earnings can go up or down simply because of a change in a company’s investment levels. Imagine if a company reports that EPS has risen, and later the investor finds that the sole reason was management reduced spending in research. It sounds silly, yet, that exact distortion can happen in any given earnings period.
It ought not be the job of accountants to predict and determine the quality of a particular machine, or a plant, or a plot of land, or research spend. In fact, accountants are particularly bad at those tasks because it’s not their job. Accountants ought to stick to accounting – i.e. record-keeping – not valuation. Valuation is the job of the investor.
On the buy-side, and specifically at the top investment management firms in the world, there is widespread use of performance and valuation metrics which adjust for all of the distortions of GAAP. This framework for adjustments is also known as Uniform Adjusted Financial Reporting Standards, Uniform Accounting. (Our reports alone are read by investors at 200 of the top 300 money managers.)
Meanwhile, Uniform Accounting metrics are almost non-existent in research analyst reports and missing from investment bankers’ pitch books.
Wall Street has proven that it is good at neither accounting nor valuation.
Another big issue for the firms included in Goldman’s basket of “non-profitable” companies is stock-based compensation. Right now, imputed stock compensation is interpreted under GAAP to be an operating cash outflow for the firm.
In other words, GAAP-calculated operating cash flow includes a theoretically-calculated non-cash item, concocted by GAAP. It is not now and never will be an operating cash outflow. Companies issue stock in lieu of cash for the very purpose of conserving operating cash. It ought not be reported as the very opposite of what the company is actually doing!
Even worse, the GAAP-approved calculation of said expense is based on the wildly fluctuating results of methods like Black Scholes. The computed, imputed cash compensation, which is not actually cash spent, is based partly on share price volatility and the time until stock award expiration. It goes up and down every quarter.
In my management consulting past, I remember advising a very nice and capable CFO who was ultimately fired for providing a bad estimate of earnings to the Street. Too bad for him, a large part of the miss in reported earnings was not because of unexpected operational missteps. Instead, his team had not correctly forecasted how the imputed stock-based compensation would fluctuate under the Black Scholes calculation model.
High stock volatility and an increasing stock price led to an imputed compensation cost for options which caused earnings to fall below guidance. Of course, this increasing stock price did not increase the cash cost to the company for compensating employees. The increased GAAP-expense had no impact on the cash generating ability of the firm.
The volatility piece of the Black-Scholes model simply skyrocketed far beyond what the CFO could have estimated. Today, as-reported earnings completely distorts one’s understanding of an early stage company’s real “burn rate.” GAAP rules shove non-cash expenses into earnings that could otherwise be better and more sensibly calculated simply as dilution for earnings per share.
Does any accountant or everyday investor really understand the limitations of Black Scholes for calculating the value of stock options, a model which Fischer Black himself later cited as problematic?
On the other hand, the Uniform Accounting alternative, to calculate dilution on earnings for its impact on earnings per share is straightforward. It requires nothing more than an estimate of shares that will be outstanding for which earnings will have to be shared over a greater shareholder base. That method distorts neither cash flows nor earnings from non-cash items.
In combination, these distortions can materially understate or overstate the true profitability of a firm. For these tech companies in particular, GAAP and Goldman have completely missed the mark.
Some of the firms have negative earnings because they are truly unprofitable. Others have very positive earnings and are using those earnings to reinvest into the company… and so they look bad when they actually are not.
Fundamentals Have Not Gone Away
Solid companies have high returns or trajectories headed for high returns. Extraordinary companies have high returns accompanied by high reinvestment rates.
GAAP earnings distorts investment growth, particularly in early stage companies. Wall Street and followers of GAAP accounting can easily misinterpret those firms as bad businesses, as Goldman’s new index does. Many of the companies in this particular index seem to be taking greater shares of their respective industries, and the economy as a whole. Their Uniform metrics show that.
On the other hand, great companies aren’t always great stocks. Valuations fluctuate daily from the ongoing voting machine and sentiment of short-term market trends. On any given day, a company can be trading well over or well below its intrinsic value. The valuations of early stage firms fluctuate widely, as do their prospects for future earning power, so one ought not simply run out and buy them, even if Uniform-based metrics show something better than expected.
The point is, this new Goldman index is another reason to relinquish any faith in Wall Street research and recommendations, if you haven’t already. It tells us nothing about the real valuation levels of the firms or the market as a whole. It’s just a basket of high-flying stocks, of which many companies fully deserve to be.