Nobody Goes There Anymore, It's Too Crowded

– David Wanis, January 2021

Company fundamentals are like the Yogi Berra restaurant from the above quote. They are almost roundly ignored, because everyone knows that everyone knows they are already accounted for in the share price. Apparently, no one reads annual reports anymore because they are too readily available to be of any value.

Even consensus estimates, business models, total addressable markets and management team track records are becoming irrelevant in the meta-game of finding unpriced investment returns. How do we know when markets have gone too far? Will it become obvious in hindsight that while everyone pivoted to short interest – not as a sign that a company may be in trouble, no that is too obvious, rather as a sign that a short squeeze can be engineered – that the answers were perhaps hidden in plain sight on the pages of the annual report?

Our investment process puts emphasis on looking at and understanding what is reported and disclosed before wandering into the arena of considering what may be. Recently we have found the restaurant-of-facts to be as useful as ever, and we think the ease at which we can get a booking tells us fewer people are going there. OK I have stretched a metaphor too far, but the observation is that we are finding interesting and we would think significant information that is not widely discussed nor seemingly discounted into stock prices.

Without giving away names (we wouldn’t want to take away the thrill of the hunt!) three areas that are cropping up repeatedly in small caps of late are;

  1. Intangible Capitalisation and Amortisation policies: This is the big one. This is the long-term implication of the world moving from tangible to intangible sources of value. Unlike the agreed consensus on what is expensed and capitalised in a traditional asset heavy business, and the useful life of those assets finding their way to the balance sheet, in the new world there is a large amount of discretion on how expenses are treated and how they are then amortised through the P&L if they are capitalised. Even auditors when flagging concerns are deferring to management judgement on policies of both capitalisation and amortisation. Most of these costs are for peoples’ wages. The decision to allocate part of the wage bill to an asset that creates future value over time has wide discretion. Moving costs into the future (and through a generous assumption on the life of the asset created, far into the future) allows management to present a more favourable picture today to a market that remains obsessed with reported (or management adjusted) P&Ls. Our concern of course is that there is accrual creep going on across the market where the quality of earnings for many companies deteriorates and a gap between the reported economics of a business and the true economics widens. Management are changing the rules as time goes on (extending the life of an intangible asset from five years to ten years for example) and almost always in the direction of better earnings today.
  2. Cash Collection: There appears nothing structural changing in the cash collection cycle of companies, however there are always several companies reporting invoiced revenue they struggle to collect. Sometimes it is related to the nature of the business to have long collection days, but often it is an indication that something is amiss in the business.
    This number can be distorted by financial engineering through receivables securitisation (as we noted in 2019, there are ways of fudging most of the accounts if management are motivated enough), but even a third-party financier would eventually balk at lending against invoices that are unlikely to ever be collected.
  3. Payables Financing: After the last few golden years of payables financing, we are seeing some signs that where possible (equity capital raising was the method de jour in 2020) companies are keen to wind down these programs. Maybe as they became more obvious to investors, the cash flow free kick was reversed in analyst models and uncomfortable questions started to be asked about their economic as opposed to optical purpose. Or perhaps the ability to squeeze small suppliers, who were facing their own existential threat from COVID-19, was no longer possible. We hope we are seeing a reversal rather than a temporary pause in their use.

As we observe companies reporting – both this month and in coming years – we are watching results of companies whose decisions around their accounts have flagged that reality may be diverging from the ever more convoluted versions of the future being constructed by the market.

January was almost so eventful a month, there feels like nothing more to say. A riot that turned into a domestic incursion into the US capital. Record number of COVID-19 deaths globally. A new U.S president. Hedge funds under attack by dis-enfranchised and well co-ordinated day traders. It serves as a useful reminder that every day the market offers a distraction from the patient and disciplined implementation of an investment philosophy. Sometimes sticking to the plan is both the easiest and the hardest thing to do. Generating long term returns has a lot to do with doing what works in the long term – particularly when it is not working in the short term.

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