A colleague opens his MBA finance class by asking the students: “Who would invest in a company which reported 10 consecutive years of losses?” Some of the students wonder whether they are in the right class, and no hands...
A colleague opens his MBA finance class by asking the students: “Who would invest in a company which reported 10 consecutive years of losses?” Some of the students wonder whether they are in the right class, and no hands are raised. The instructor continues: “Too bad, if you had invested in such a company, say Amazon or Tesla, you would have been a billionaire by now.”
As you will shortly see, the instructor’s case isn’t an aberration. In fact, investing in losing companies, as long as you know which ones to choose, is very lucrative.
But first, how frequent are corporate losses? Figure 1 shows the frequency of loss reporting in the U.S. and the EU+UK. In the U.S., during the booming decade prior to Covid, almost 50% of public companies reported annual losses (middle curve), and among high tech and science-based (pharma, biotech) enterprises the loss frequency was a staggering 70% (top curve). European companies (bottom curve) display a similar trend, though the frequency of loss is a bit lower: 35-40%. Booming economies, while roughly half of public companies are in the red? Welcome to the bizarre world of accounting.
Figure 1 shows that the loss frequency in both the U.S. and Europe starts accelerating in the 1980s. This isn’t a coincidence. The 1980s were characterized by a surge in corporate intangible investments: R&D, information technology, brands, etc. Whole industries, essentially intangible (without heavy physical assets) emerged in the 1980s and accelerated thereafter: software, biotech, internet services providers, to name a few. Moreover, enhanced investment in intangibles?the main drivers of innovation and growth?characterized practically all industries, as managers realized that innovation is the key to competition, long-term. In the U.S., the aggregate investment in intangibles surpassed in the mid-1990s the investment in tangible, or physical assets, and the gap is constantly growing. Enter accounting.
Up to the 1980s, the accounting distinction between an expense, like salary and interest payment, and investment, like buildings and equipment, was clear: expenses are payments for past services and therefore charged against revenues in the earnings (income) calculation, whereas investments generate future benefits and are therefore reported among assets on the balance sheet. This distinction was blurred since the 1980s.
Intangibles are clearly investments, expected to generate future benefits, but accountants treat them as regular expenses reducing earnings. Pfizer’s $9.4 billion R&D in 2020 is recorded the same as salaries and salesperson commissions (the international accounting standards allow the treatment as an asset of a part of R&D—a small step in the right direction). The absurd result: the more innovative the enterprise, the higher its accounting losses. This accounting treatment of intangibles explains much of the sharp rise of corporate losses exhibited in Figure 1. Obviously, many of the presumed “losers” are in fact successful growth drivers, but most investors, fixated on reported earnings, don’t realize this.
To identify the fictional, accounting-driven losers, I (with coauthors Feng Gu and Chenqi Zhu) focused on all loss-reporting U.S. companies in the past 25 years, and added back to their earnings (losses) the intangible investments they expensed minus amortization. We thus undid accountants’ folly by capitalizing and amortizing the R&D, IT, and brand enhancement (the technical procedures of capitalizing intangibles are fully explained in our study “All Losses Aren’t Alike,” in https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3847359). The result: A full 40% of loss reporters would have been profitable without the expensing of intangibles. We term those companies “accounting losers,” in contrast with “real losers.”
We then examined carefully the two groups of companies and found that they are starkly different in terms of great importance to investors:
“Accounting losers,” investing heavily in new products and services, file for many more patents, and are granted substantially more valuable (blockbuster) patents than “real losers.” Surprisingly, “accounting losers” generate even more valuable patents than profitable companies. Employees of “accounting losers” are more productive and turnover less than those of “real losers”. Consequently, “accounting losers” reverse much more quickly their losses to reported profits than “real losers.”Thus, “accounting losers”, by and large, are very successful enterprises, a fact masked from investors by anachronistic accounting rules which portray these companies as perennial losers. The icing on the cake, presented in Figure 2, is that investment in the stocks of “accounting losers” is very lucrative: The figure compares the growth rate of investments made in 1995 in profitable companies, “accounting losers,” and “real losers.” The investments are rearranged every year according to the earnings reports of companies. Amazingly, investing in “accounting losers” dominates, on average, even investing in profitable companies. The reason: investors, by and large, treat “accounting losers” as “real losers,” only to be surprised by subsequent performance. Outdated accounting rules obviously fail investors.
Note: This article was first published in the Financial Times here on June 3, 2021.