New OSAM paper on book value and ROE

There’s a fascinating new paper on earnings, book value, ROE, P/E, and other metrics written by the anonymous scribe formerly behind Philosophical Economics. It’s very long but worth reading to the end, and the appendices and footnotes are really cool too. You can find it here: https://osam.com/Commentary/the-earnings-mirage

Have you been through it yet? I downloaded it but so far only had time to skim.

My first impression is that this is just another version of an old 1970s fad; inflation adjusted accounting. Commentators back then thought it was a big deal but the Steet pretty much slept through it, and then, inflation came down and the field vanished. Seemed to me the author was trying to adjust each contribution to retained earnings for CPI from that time forward and at the end, add it all up to come up with higher BV calculations which would lower ROE, etc. and wind up with the click festival that’s inevitable any time anyone announces that corporate earnings are overstated.

What else is in there?

Thanks for the heads-up on this. I always learned from Philosophical Econ’s posts.

He also had him on his recent podcast where they touch on a lot of these topics

More to the point, has anybody looked at testing these concepts?

Well, your first impression isn’t wrong, but there’s a lot of other fascinating stuff, including a good discussion of how and why depreciation is almost always understated, which leads to overstating earnings.

I’ll try to get through it over the Brexit v1.0 holiday weekend.But you just raised another red flag; another writer, the gazillion and 12th but who is counting, who has issues with depreciation and may or may not understand the dominance of imprecision in pretty much everything and talks himself into the standard click-bait conclusion: earnings are overstated.

I suppose I’m jumping quickly on this to illustrate an approach to reading articles, studies, papers, etc. EVERYBODY approaches what they do from some sort of biased starting point (including moi). Given universally understood problems with replicability, it’s important to read everything with a critical eye and to do that, it’s helpful to understand the author’s biases and determine how they influence the process and conclusions.

(For the record, if anybody is unsure what my biases are, just ask, though I think I’m usually pretty upfront about them.)

OK. I actually started reading but gave up. I’m not going to blow my holiday weekend diving into this guy’s obsession with proving he’s the only smart person on the planet. This stuff reminds me of an old law school professor who often answered the brilliant points we raised in class by saying “That sounds good if you say it fast enough.” I gave OSAM my clicks to get the paper. They should be happy.

Apparently, nobody told this guy that investors are quite capable of thinking in terms of real return and don’t need all his machinations. Also, it appears nobody told this guy that while the media presumes inflation is the CPI, the market understands full well that this index, like all others, is limited and that we need to think in terms of a constellation of measures. He also doesn’t seem to realize the statement that depreciation is based on historical cost, while technically true, is extremely simplistic and of limited use outside the classroom.

There is no singular historical cost upon which depreciation is based. We’re dealing with a compilation of many initial costs for many assets owned by a corporation each one which is continually updated based on retirements and dispositions on the one hand and additions and improvements on the other with the latter taking place each year at then-prevailing prices. So its more like an actively traded stock portfolio the overall cost basis of which is continually being averaged up and down.

Investors also understand that depicting genuine economic values is hard,very, very hard. The accounting profession gets this and that’s why we have, in essence, two completely different income statements (the second one is what we know of as the cash flow statement) which, taken together with the balance sheet, tell us a bunch of different aspects of the overall story. Nobody can KNOW the true intrinsic economic value of any business; all we can ever do is circle around it with different sorts of clues, just as I suggest we do with the inputs to ideal stock valuation frameworks.

What’s most important about financial statements is not so much the raw numbers but that they reflect reasonable and transparent protocols (and on the whole, the accounting profession does a pretty good job here) and that we have as much consistency as is feasible (less than 100% given the different kinds of businesses out there few of which are pure plays in widget manufacture) across the publicly-owned universe. That, plus a reasonably fair non-manipulated market (again, not 100% but probably better than at any time in history) is what it takes to give investors all they need; opportunities to make reasonable approximations and assumptions and, to paraphrase Damodaran, try to be a bit less wrong then everybody else.

I suppose I shouldn’t have expected more from an anonymous author who adopted, as a pseudonym, the name of a trader who, despite some famous successes, also had total wipeouts and was quite familiar with the bankruptcy process and ultimately died in poverty.

Disagree, find a lot of value in the paper: Not because his conclusions are right, but because of his thinking in Terms of how Balance Sheets and cash flow Sheets do not reflect reality (they never will!).
This leads to stuff like why does book to value does not work that well anymore (Easy, bc Software is not activated on the right side of the Balance sheet) and why value or Quality Faktors like FCF / totalassets give better results.
I agree not with his conclusions, but he lays out the right thinking in Terms of “which line items are better then others bc. they are less bound
to Accounting politics”.

Regards
Andreas

Isn’t it in today’s R&D intensive world that current profits are under reported as R&D is mostly expensed instead of capitalized. This I guess is mostly done for tax purposes. Thus, both depreciation and profits are underreported.

These and other reasons, such as individual-company risk, is why I gave up on a fundamentally based individual stock selection and am 100% focused on ETFs. No idiosyncratic company surprises, ample diversification in a couple of positions, and exposure based on a composite of macro factors work fantastically well!

terve_sijoittaja → Yep, I work as a CEO in a small IT-Service Firm: We invested 40 Million the last 5 Years in new Software products and have
not activated them, e.g. the “Investment” went straigh to Costs into the Profit and loss Statement and they do not apear on the left side of the balance sheet. We do now 10 Million per year SaaS turnover on those Investments, break even next year, then they will generate About 3-5 Million free cash flow.

Lots of firms do the same bc they want to be protected from Takeovers and from shareholders that want Juice or they want or they simply want
nice, returning SaaS free cash flow that can be reinvested to strengthen competative Advantage and to be able to print smoth earnings
year after year… :wink:

so what is the take in analysing SaaS firms? Analyse their SaaS Products and how the SaaS products will perform in the future… (only posible discreationary not with P123…)

Same with IP (Disney is a nice case on this!)

“so what is the take in analysing SaaS firms?”

Check out “the Rule of 40”. AND growth rate trumps all if the company satisfies the Rule of 40.

fwiw, here’s a post from Andreessen Horowitz on the topic.