Don’t Bury the Past

Welcome back to “The List.”

We’re all about discovering companies that make the most of their capital.

Because companies that do so reliably create wealth for their shareholders.

Now, capital is anything – literally anything – that can increase cash flows.

A warehouse is capital, a delivery truck is capital, and know-how is capital, whether talking about a company’s knowledge base or intellectual property.

Companies invest money to build up their capital base.

Invest to build that base effectively, and cash flows go up.

When a company gets more cash flow from its capital than its competition, you’ve found a management team focused on creating long-term shareholder wealth, not hitting short-term bonus targets.

However, traditional accounting principles systematically undercount capital.

That means corporate executives often end up with more credit than they deserve.

And investors pay the price.

Mind the GAAP

Publicly traded companies publish financial statements according to Generally Accepted Accounting Principles, or GAAP accounting.

Unfortunately, GAAP misses big on counting capital.

So, too, do the “adjusted” financials bandied about on earnings calls.

GAAP does capture investments like equipment, office space, and (sometimes) software needed to run the company. However, it does not treat expenditures like marketing, research and development (R&D), and exploration costs as investments.

Instead of adding these investments to the capital base, these latter items get expensed. And that’s where the problem starts.

Expensing an item is essentially a write-off. A write-off reduces profits during that period, but that expense gets buried in the past, whereas capital has a much longer lifespan.

It’s fine to treat electricity bills, office supplies, and wages as expenses. The benefits don’t extend beyond the period paid.

However, expensing items with long-term payoffs understates capital. 

That means future cash flows are judged based on a lower base of capital, which lowers the bar for management. Future cash flow looks better relative to an understated capital base, so the executive team looks like it’s doing a bang-up job.

But it’s wrong to lower the bar by burying essential capital decisions in the past.

Not A Rose By Any Other Name

Consider the importance of brands.

Marketing campaigns can cost hundreds of millions of dollars to build the brand and revenue over time.

That sounds like an investment to me.

However, GAAP accounting lets management off the hook.

The company writes off those investments by treating advertising expenditures as an expense. Later revenue has a lower hurdle to clear because the capital is understated.

This mistreatment of capital also applies to research and development costs, which build intellectual property. However, GAAP accounting treats those investments as expenses, essentially writing them off as they occur.

The same holds for oil companies.

Drilling for oil builds proven reserves. Those reserves represent an oil company’s capital because reserves should generate income. Drilling costs are how oil companies invest in that capital. But those costs are expensed under GAAP.

When the cash comes in, money spent on exploration and drilling doesn’t appear in the capital. Therefore, the cash flow compared to capital (or return on capital) looks higher than had drilling costs been treated as investments.

Thankfully, there’s a way to correct this capital mistreatment and hold executive teams accountable for their investments.

It All Adds Up

Calculating the right capital and cash flow is not for the faint of heart.

The accounting is insane.

For instance, you unwind those marketing, R&D, and exploration expenses from the income statement and add them to the balance sheet as assets.

You also reverse all the games played with restructuring charges, capital gains and losses, bad debt reserves, and the mother of all accounting playgrounds—retirement plans.

Ultimately, achieving the correct capital base and cash flow requires fifteen adjustments, not to mention that some companies have their particular bag of tricks.

Plus, you must work your way back with these adjustments through years of financials because GAAP misstatements add up over time.

Like I said…insane.

But it’s worth it because once you get a better read on a company’s capital, you’re left with a clear picture of cash flows to judge growth prospects, return on capital, the value of the stock, and all the other metrics that impact a stock price over time.

And that’s what we do here at The Capital List.

Capital matters because it provides the base against which to judge the cash flows a company generates.

You have to get it right, or else you’re wasting time playing guessing games to counter the shell games CEOs play every quarter.

The system I use to get capital right is the same approach I used managing hundreds of millions in trust fund assets back in the day.

Leading mutual fund managers, hedge funds, and advisory firms nationwide also rely on this method.

And now, I’m bringing this system and expertise to independent, self-directed investors like you through The Capital List.

That way, you can focus on companies that make the most of your capital to build wealth.

Think Free. Be Free.

Don Yocham, CFA

Managing Editor of The Capital List