Seeking Alpha Investment Returns: Accounting & Finance Enter the Digital Age

Odyssey Investment Advisory

Frank J. Beil

Jack Bowman

Searching for Alpha Investment Returns: Let the Journey Begin

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There are two inherent problems with investment guidance for equity securities at present, which unfortunately are the economic disciplines of Accounting and Finance. These two economic disciplines have, while still useful if adapted to present circumstances, are for the most part helplessly and hopelessly clinging to outmoded and even harmful fundamental concepts regarding investments and equity valuations. While the Discounted Cash Flow (DCF) Model for equity valuation is still the go to model for investors, the concepts that underly its construction need a major overhaul. Thankfully, Odyssey Investment Advisory is here to provide you with a roadmap that will produce outsized (alpha) returns for equity investors with an investment approach that reconstructs the DCF investment model for publicly held firms so that it is indeed predictive of future cash flow returns for investors.

Accounting earnings (net income) when used as a predictor of value creation (asset price increases and decreases on observable markets) has a predictive value relevance of about 5%. That infers that accounting earnings under US GAAP does not explain 95% of the asset price movements of companies listed on publicly traded exchanges. That is a breathtaking admission of irrelevance of the usefulness of accounting earnings in predicting future cash flows. The problem is threefold:

1.??Net Income that appears on the Income Statement needs to be adjusted to derive Net Operating Profit After Tax (NOPAT)

2.??Stockholders Equity on the Balance Sheet needs to be adjusted to derive Return on Invested Capital (ROIC)

3.??Research and development as well as sales and marketing expenditures on the income statement represent strategic investments that should appear on the balance sheet.

In Finance the two main foundational principles of misleading investors are the efficient market hypothesis (EMH) and diversification. The EMH posits that all available economic information is captured by the market price of the asset, at a particular point in time, and therefore the only investment strategy is capitulation to the fact everyone is smarter than you, so why waste your time trying to beat the market as an active investor. That is absurd, as the market represents the collective wisdom of investors who are psychologically predetermined to “beat” the market. They principally rely on what others are doing and not on a company’s accounting/economic fundamentals when determining which equity securities to “purchase”. Market participants are trying to beat each other, not necessarily choosing equity securities that exhibit a sustainable competitive advantage for the long-term. While investing is primarily about placing “bets” on outcomes, there is a difference between skill and luck in investing. Skill is gathering evidence in forming an investment thesis that is grounded in economic reality and then acting on your evidence-based convictions. Luck is hoping for a favorable outcome without any concrete evidence that you are right. The great conundrum of investing is separating luck from skill. Think of playing poker. Over the intermediate and long-term skill wins out over luck every time. Same as investing success.

Another foundational concept of investing is diversification. Finance students are familiar with the concept of an efficient frontier for investors. That is the rate of return one can expect for a fully diversified portfolio which has been codified as a “riskless” portfolio. There is no such thing. Life itself is risky. Believing in the riskless portfolio is like believing that you can live your life without the risk of an unfavorable outcome. Utter nonsense.

Odyssey Investment Advisory will offer an antidote to the accounting and finance failures described above by offering investment advice based on the evidence of a company’s prospects for earning above market returns by focusing on the accounting/economic variables that matter, namely operating earnings as scaled by invested capital. Our benchmark for alpha returns will be beating a company’s cost of capital rate by 300 basis points. For example, an 8% cost of capital (investment risk) would need to have expected returns of at least 11%. Then the investor can reliably take actions that increase the likelihood of a successful outcome. Then the investor has a build in “safety-net” for earning returns at the investors required rate of return. As mentioned, risk is inevitable in life. All we can do is increase the likelihood of success by doing our due diligence. In investing, that translates to understanding the company’s ability to create value at a reasonable cost. The accounting/finance concept that captures that economic reality is ROIC. Forget the unadjusted accounting metrics of return on assets (ROA) and return of equity (ROE). These metrics need to be translated to NOPAT and Invested Capital (IC).

Company Philosophy

Odyssey Investment Advisory will have a unique corporate ownership structure. Investment returns to the fund will be distributed based on capital contributions to the fund. This translates to fund returns being passed through to owners based on their capital (investment) contribution amount as a % of investment capital in the fund. This novel investment fund feature of fund ownership ensures that investors are indeed owners of the firm. Our mission as a fund is to strive for outsized returns by using our and your skills to select appropriate investments for the fund. Odyssey’s investment philosophy in captured by one of my finance and accounting authors Michael Mauboussin, Chief Investment Strategist at JP Morgan Chase in the following article “Alpha and the Paradox of Skill”.

Investment Philosophy

I have been teaching Financial Statements Analysis at the Carlson School of Management (CSOM), University of Minnesota for over 20 years. In fact, I developed the present course as both an undergraduate and graduate course at CSOM. My objective over the years has been to find a DCF model that truly captured the accounting and finance complexity of companies. Until recently, I was bound by accounting and finance constructs that I didn’t recognize as being inadequate to the task of equity valuation. However, that frustration of knowing something is not fit for purpose has finally been resolved. In 2019, I was alerted to a paper that fundamentally altered my mindset regarding equity valuation. The paper is entitled Core Earnings: New Data and Evidence by Ethan Rouen and Eric So of MIT and Charles C.Y. Wang of the HBS.

The paper was a revelation in determining an intrinsic or fundamental value of a firm by using the DCF model and challenging the market price of the asset. ?The paper also described New Constructs, Inc., an investment research firm that practiced machine learning on a company’s SEC filings in determining the totality of a company’s value creation potential by deriving a company’s Core Earnings. I now had the two things I had been missing regarding my own investment philosophy: the academic rigor of research that is fit for purpose (i.e. useful) and an investment research firm that could deliver on the promise of alpha returns.

The premise of Core Earnings is that components of a firm’s GAAP earnings arising from ancillary (non-core) or transitory shocks are significant in frequency and magnitude. These components have grown over time and are disbursed in various sections of the 10-K. Excluding them from GAAP earnings yields a Core Earnings measure that distinguishes between the recurring and non-recurring components of Net Income and forecasts future performance.

Earnings Distortion is then Net Income (GAAP) – Core Earnings. Companies with positive earnings distortion are overstating their earnings (income) due to non-core or transitory items. In addition, that Core Earnings paper referenced above demonstrates that market participants are slow to embed these earnings distortion components into their forecasts, particularly for amounts disclosed in the firms’ financial statement footnotes. (Which proves the point of not doing their due diligence.) Trading strategies that exploit these factors produce abnormal returns of 8%. The link provided above clearly and unequivocally demonstrates the alpha returns from removing earnings distortions caused by outdated GAAP on an investment portfolio. The reading “New Constructs” Core Earnings Data by Extract Alpha?describes and elucidates the predictive capabilities of Core Earnings when used in building an equity valuation DCF model.

Demonstrating the validity of portfolio construction using and Earnings Distortion Smart Beta Long Strategy is illustrated below. The measure used to construct the smart beta long strategy is:

Core Earnings – Net Income (reported according to GAAP) = Earnings Distortion. In this measure the closer the reported net income is to core earnings the more “truthful” the company is to reporting its economic earnings.

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Earnings Distortion Beta Portfolio*

Portfolio Annualized Return

S&P 500 Annualized Return

Outperformance (Alpha)

18.02%

13.73%

4.29%

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*Using the detailed Earnings Distortion data from 2010 to 2017, we trained a machine learning algorithm to predict the next quarterly return for all S&P500 constituent stocks. We tested its performance from 2018 to 2021, which showcases clear outperformance over S&P500 as well as considerably higher annualized performance compared to the Earnings Distortion Smart Beta strategy.

When the portfolio is constructed of “truth” equities, minimal earnings distortion, the evidence is obvious that core earnings as a measure of corporate performance products alpha returns to investors.

Note that companies that “truthfully” report the operating earnings are practicing good corporate governance. As such, these firms are following the dictates of exemplary corporate citizenship and are appropriate for all corporate portfolios that adhere to best practices in Environmental, Social and Governance (ESG) principles.

Truth Stock Portfolio Russell 3000

Portfolio Annualized Return

Russell 3000 Annualized Return

Outperformance (Alpha)

28.67%

12.56%

16.08%

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Truth Stock Portfolio S&P 500

Portfolio Annualized Return

S&P 500 Annualized Return

Outperformance (Alpha)

17.62%

12.78%

5.14%

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Return on Invested Capital

In a research paper, New Constructs and Deloitte, demonstrate the superiority of ROIC as the metric that is the most useful in correlating enterprise value and stock market returns. The corresponding R-squared correlation of 71%, ROIC as scaled by enterprise value, is astonishing in explaining a firm’s equity valuation. Compare that to an accounting earnings coefficient that explains the changes in asset prices for publicly traded companies of 5%. As they say, we may be on to something here.

ROIC as a measure of company financial performance is intuitively informative to investors because it scales returns, in the form of NOPAT based on the investment expenditures, in the form of invested capital made to produce operating earnings. This measure then captures economic value creation by correlating efforts (invested capital) with accomplishments (operating earnings).

Investors then after calculating the firm’s cost of capital, have insight into the value creation capability of the firm, by using the formula ROIC – Cost of Capital. If the resulting amount is positive, then the firm is creating wealth, if the number is negative the firm is destroying wealth. Because we are determining investment opportunities in equity securities, we suggest that the cost of equity should be used in computing potential wealth creation instead of the more commonly used weighted average cost of capital (WACC). We are seeking returns to investors and not returns to the firm so cost of equity is the preferred approach.

NOPAT

The calculation of NOPAT is a two-fold process. First, we start with the firms income statement (for access to any publicly traded company my preferred source is www.sec.gov, company filings). We are interested in the company’s operating income so we need to make the following adjustments to the company’s GAAP reported income. These adjustments are derived from the Core Earnings guidance that is found in Core Earnings: New Data and Evidence article cited above.

1.??Remove interest income and expense components from the income statement. Interest components are financial items not operating items.

2.??Remove clearly stated, i.e. on the face of the income statement, transitory and/or non-recurring items.

3.??Adjust income tax expense to reflect taxes on operating income. Remove impacts of taxes on interest expense and the consequent tax shields created by debt financing. Those are financial, not operating items. In addition, use the effective tax rate for operating income which is the amount of income taxes payable after adjustments for debt financing items. The effective tax rate is the amount of income taxes payable and not income tax expense. We are eliminating the onerous calculations for deferred tax assets and liabilities.

4.??Make other adjustments as necessary which may include the following: The items below are the adjustments made by New Constructs to derive Core Earnings. Since these adjustments are idiosyncratic for each firm when constructing the DCF model for valuation we list them here as an indicator of the level of accounting analysis that needs to by done to arrive at Core Earnings. Further newsletters will illustrate these adjustments for each company recommended.

a.???Remove asset write-downs hidden in operating expenses

b.??Remove non-operating expenses hidden in operating earnings

c.??Remove non-operating income hidden in operating earnings

d.??Add back change in reserves

e.??Remove income and loss from discontinued operations (except for REITs)

f.???Add back implied interest for the present value of operating leases

g.??Adjust for non-operating tax expenses

h.??Historical adjustments: Add back goodwill amortization prior to 2002 and include employee stock option expense prior to 2006

i.????Remove reported non-operating items

In the subsequent months, we will be posting further newsletters (briefings) that address specific investment candidates and other thought provoking (hopefully) articles that demonstrate our investment philosophy.

Frank & Jack

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