17
Dec
2017

Seasonal thoughts on Goodwill

Tis the season of goodwill.  As it happens I am reading a book on Goodwill – not the goodwill of everyday usage, but accounting and economic Goodwill.  Capitalism without Capital by Jonathan Haskel  ,‎ Stian Westlake  

I have found Goodwill fascinating ever since I read Buffett’s 1983 essay on Goodwill and balance sheet accounting.  It’s a little bit of a departure from my attempts to do text analysis of Chief Executives outlook statements, but there is a deep connection which I will get to.  Maybe it’s not interesting for everyone… I got talking to my next door neighbour about intangible assets, and she literally started yawning and fell asleep.  Even Buffett admits that you can lead a full and rewarding life without thinking about intangible assets. But thinking about intangibles can help solve puzzles like:

Why houses in major cities is so much more expensive than less well connected minor towns. 

The recent trend where a few ultra rich superstars (the 0.1%) are going very well – meanwhile others almost as talented/lucky don’t own a private jet.

Why some investments increase in value 10x, 100x or even 1000x – but most don’t.

Goodwill : a definition

When one business buys another, accounting principles require that the value paid must be recorded on the balance sheet of acquiring company.  Almost always the acquirer pays a premium to the accounting value.  If Carlsberg buys a small craft beer brewery, its acquiring mash tuns, fermenting tanks, maybe some kegs, a brewery and everything that’s inside.  But rather than just buying the equipment, acquiring a brewing company is also be buying the intangible assets (supplier relationships, brand, distribution etc).  That’s why companies normally pay a premium to tangible assets.  This premium would be recorded as “Goodwill” on the balance sheet of Carlsberg, or whoever is buying.  Importantly – goodwill recorded is just a function of the price paid, it says nothing about whether the acquirer overpaid or got a good deal.  There have been tens of billions of dollars written off when a company finally admits that it might have overpaid, it happens across lots of different sectors. (Hewlett Packard buying Autonomy, Royal Bank and ABN Amro, Time Warner after buying AOL).  Goodwill is one type of intangible asset, but brand, software, patents, training systems, even a film franchise like StarWars etc are all forms of intangible assets.

 

 

 

 

 

 

 

 

The book’s thesis is that in developed economies like the US, UK and Europe tangible assets (physical stuff that you can touch like factories and equipment) are becoming less important.  Instead intangible assets are becoming more important.  The authors admit that computers and the Internet are important drivers of this shift, but actually the change predates both the Internet and the rise of the PC.  Interconnections of knowledge have been growing for a long time, and it’s the interconnectedness that technology enables, even if it’s the telephone and television rather than the internet and PC.

Superstars v the rest

One implication of the rise in intangibles is a skewed distribution of returns.  A few hugely successful companies like Facebook, Apple, Amazon, Netflix, Google – and the majority of companies struggling.  We might call this “superstars” and “the rest”.  The reason is that intangible assets are much easier to scale.  Facebook scales, whereas a yoga studio does not. Even if you are the best yoga teacher in the world, and you spend all your waking hours teaching yoga, you’re still probably not going to earn enough money to afford a private jet, or even a house in London.

But it isn’t just technology companies like Google or Facebook, if you develop a successful brand of fizzy water (whether it is Coca Cola or Fever Tree) you can scale the brand more easily than physical assets like a bottling plant that will need to add more trucks, bigger production lines or even build new bottling plants altogether.  A company like Uber has achieved huge scale with relatively little investment in tangible assets (eg cars or even hiring drivers as employees), which means that revenue per employee rises massively.  As does revenue per unit of capital.  The intangible nature of these companies means they operate as a “winner takes all” platform.

But it’s hard to predict who the winners will be.  Hollywood Economics: most films struggle to make money, but a few (Titanic, StarWars etc) enjoy disproportionately large success. 

“In a world where there are a few leaders and many laggards, the net effect of this could be lower aggregate rates of investment, combined with high returns on those investments that do get made.”  Perhaps there is a way of identifying the winners? That’s where my project comes in. 

Rather than focus on historic numbers, perhaps there is a way of analysing the qualitative information in text of financial reports to reduce uncertainty, point to who has a winning platform.

Investing in intangible assets

Some of my best investments (Burford  litigation as an asset) and worst (Quarto, who publish mindfulness colouring books) have been about identifying value in the intangible assets.  When looking at my successes, one thing that jumps out to the naked is eye is that Burford and Games Workshop Annual Report  (fantasy miniature figures) make interesting reading – the management are clearly trying to explain their business and the choices and trade-offs they are making to investors/readers.  The same is true of WPP the branding and marketing company, which until recently has been a fantastic performer. 

Atlas Shrugged

Whereas a Bob Diamond company like Atlas Mara – the strategy and the language used to describe it, makes little sense to me (see below):

  • combining our global institutional knowledge with our extensive local insights and experience;
  • harnessing our access to capital, liquidity and funding to both support growth and enhance the competitiveness of our existing operations;
  • leveraging technology to provide innovative and differentiated product offerings and excellent customer service; and
  • continuing to attract and retain top talent – people who share our passion for Africa and our mission to effect change.

It just sounds like something an American investment banker would come up with because he thinks it sounds good. Or maybe he didn’t even write the strategy, just left it to the Investor Relations guy (who’s probably as useless).   Even if management achieve their vision, is Atlas Mara going to destroy the competition in the way that a technology platform does?  Are there really network effects in cross border banking anywhere?  The history of banking suggests when banks expand across borders things often go wrong.  HSBC has spent the last few years selling off much of its banking network in far flung countries.  Atlas Mara’s own share price history also suggest reasons for scepticism, the shares have fallen from around $12 to just over $2.5 – If I can train my computer to detect “waffle” and poorly thought out strategy, then that should improve my (and maybe others) investment process.

There is a second reason that I think it’s an interesting project.  The “superstar” intangible economy means not just corporations like Amazon and Google do disproportionately well.  Also some individuals do too. 

Intangible-intensive firms need better staff to create synergy with their other intangible assets: better managers, better movie stars, better sports heroes.  And these “superstars” do disproportionately well.  It’s not just intelligence, it’s people with imagination to see potential where others can not.  If you spent hours playing with a early computer in the 1970s, that was actually rather valuable time spent.  If you spent hours practicing morse code that probably wasn’t.

An aside on accounting value of Paul Pogba

Paul Pogba began his Premier League Football career at Manchester United in 2011.  But quickly Pogba decided to leave for Juventus, probably feeling he wasn’t getting enough first team football.  In 2016 Manchester United then bought him back, paying over €100m for him. If Pogba had stayed at Manchester United all the time, he probably wouldn’t have been recorded as an asset on the club’s balance sheet at anything like that value.  But as they had established a market price for the player, he counts as an on balance sheet asset.  

Most companies record their acquired intangible assets on their balance sheet, but don’t try too hard to accurately record the value of internally generated intangible assets.  For instance Facebook doesn’t record the most of the value of its own social network on balance sheet.  But the major acquisitions that Facebook (Instagram, WhatsApp) will remain valuable for a long time given they have billions of Monthly Active Users. That cost / intangible asset / investment (take your pick) of $18bn will sit on Facebook balance sheet for some time.  But a football team’s intangible assets are players who get old, and can’t run around so fast.  So Manchester Utd deduct the costs of buying players (who are intangible assets) over the period of their employment contract, which is typically just a few years.  2017 intangible costs were $124m in the profit & loss account (ie writing down the value of the price paid for players, which is a non cash cost) around half the value of paying the players salaries $263m (which is a cash cost).

But the company actually spent $193m buying players that year, versus $52m of proceeds from selling players.  The difference between the cash cost and the p&l ends up on the balance sheet, which is $718m versus equity of $477m.  If you wrote off the value of the players, Manchester Utd’s equity would have negative value, at least that what the accounting conventions suggest.  In one sense that’s correct – Manchester Utd without superstar players probably isn’t worth very much.  In another sense, it’s not: the value is the brand, the footballing history, the huge fan base in Asia.

Source: Manchester Utd 2017 Annual Report

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The growing importance of intangible assets mean that there are increasing differences in rewards in the same industry, perhaps a surprising source of income inequality. Premier League football players earn a lot of money.  But it’s skewed, the very best players like Pogba are worth multiples more than the players in teams at the bottom of the league like Swansea City.

Although Premier League football is an outlier in terms of financial rewards, the same point applies more generally to businesses.

Network effects

“Being well networked, knowing about important developments in one’s field, and having the standing to bring together collaborations, ask for favours, and coordinate partnerships becomes more important in a business” according to the book on intangibles.

This explains one of the puzzles of urbanization: the willingness of people to pay a very high price to live next door to other people who are also prepared to pay a very high price for their property.  Or indeed why hedge funds want to be in Mayfair.  It’s worth it because the value of the interactions is high for people who work with intangible assets. And living and working in expensive locations increases your perceived value in they eyes of your peers, customers and competitors. People whose jobs are bid co-ordinators, public relations, product managers, lawyers, business development, designers, developers, marketers, head-hunters and so forth. If you trained as an engineer and work in a factory you probably think these are “bullshit professions”

But Berlin’s much delayed new airport is a good example of what happens when you have lots of engineers but lack the intangible expertise like good governance.  The result is billions of Euros wasted and 10 year delay as costs spiraled out of control.      https://www.hertie-school.org/en/debate/opinion/detail/content/large-public-infrastructure-projects-early-planning-mistakes-often-catalyse-inexorable-cost-spirals/

That’s why companies really value employees who combine decent technical skills with the soft skills – much of which is about building relationships in and outside their own company.  Viewed in this light, the link between the so-called creative class and cities is not surprising, according to the book.

The price of everything

At least with premiership football players we know that there is a lot of analysis that goes into estimating their worth.  Goals, shots on target, assists, completed passes, tackles made etc.  There really is a wealth of information that means teams can identify valuable players like Pogba.

The value of nothing

Chief Executives are a different story.  The correlation between high CEO compensation and company performance seems weak. What is the equivalent of goals, shots on target, assists, completed passes, tackles made for a Chief Executive?  Why have Chief Executives done so well out of the intangible economy?

The most convincing explanation is that some people are good at exploiting the uncertainty over their worth.  There’s lots of pseudo-science in remuneration committees justifying complicated performance related bonuses and Long Term Incentive Plans – but the truth is more mundane.  Bob Diamond, greatest “talent” was not running a bank.  Instead his greatest talent was creating the perception that he was fantastic at running a bank, and his skill at creating this perception was incredibly well rewarded.

What if I and others start using machine learning and Natural Language Process to identify management who are genuinely adding value?  That is better tools for appraising and valuing intangible assets, would also mean better tools for valuing management’s contribution to success.  And what if I can also identify management who are overpaid and full of hot air? It probably won’t reduce inequality.  In the intangible economy there will always be superstars. But it will mean that the “gift” of inequality is more fairly distributed to the genuinely deserving. 

Merry Christmas.

 

Photo by Mike Arney on Unsplash

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