Thread by @CCM_Brett

On yesterday's @chitchatmoney I talked about this @mjmauboussin essay on the role of intangible investments:

morganstanley.com/im/publication…

Here are some further thoughts on the topic⬇️

Quick aside: if you want to hear the author talk about the essay at length (and definitely do a better job of explaining it than I ever could), listen to his appearance on Invest Like the Best

open.spotify.com/episode/1dGqfl…

1. As most of us know, a lot of factors go into what future Free cash flow (FCF) for a company will look like.

Most of these factors are out of our control though

2. The one thing an investor can control is their ability to understand a company's prospects for creating value

Mauboussin use Wal-Mart and NPV of a store as an example

3. The future value of a company is determined by its return on invested capital (ROIC)

The steady-state is when return on investment equals the cost of capital, which means ROIC is 0

4. It is key for investors to understand the magnitude and ROIC.

However, what is tripping up a lot of analysis is the change from tangible to intangible investments and how things are expensed vs. capitalized using GAAP

5. In other words, a lot of investment is being hidden on the operating expenses line

6. Here is a nice chart showing the rise of intangible investments over time

7. One example is the way R&D is treated under GAAP accounting. The financial accounting board said it should be expensed instead of capitalized

This treatment of R&D is one of the reasons Maobaussin argues investors are understating capex spending

8. The majority of investment spending is going to be hidden in opex. So, companies with high gross margins will tend to be the ones with some investment in the income statement (not always the case, though)

9. One thing to make clear is that switching costs from the income statement to cash flow does not effect FCF, but the expected ROIC a company will have

10. Investors need to decide what gets classified as intangible investment and how long to amortize these investments on the cash flow statement

11. Using as an example, the paper goes through how to reclassify expenses as intangible investments.

The key is that FCF doesn't change, but ROIC does.

12. The next part of the paper goes through something I've never heard before, which is that OCF - capex does not equal FCF.

You learn something new every day

13. One of the keys in the paper: SBC should move to the "from financing activities" portion of the CF statement. Failing to do so overstates FCF

14. Always add payments on leases to capital expenditures so you don't improperly inflate FCF

The paper uses as an example

15. Intangible investments can be riskier because they have more of a "sunk cost" compared to a tangible investment

The big picture takeaways:

- Build your own income statement, but do it using principles that make sense
- Intangible investments overstate ROIC when they are expensed instead of capitalized