By Hunter Hopcroft, Managing Director of Portfolio Solutions for Armada ETF Advisors, an ETF issuer focused on quantitative REIT research and asset management.
In the news and in academic papers, you will often hear about “users of financial statements.” Who, exactly, is meant by users of financial statements is left to the reader. If you use the evolution of Generally Accepted Accounting Principles (GAAP) as a guide, the answer would appear to be short-term equity speculators. While that creates structural and idiosyncratic issues, it also creates an opportunity for investors who take an unconventional approach to security analysis.
Under what Marty Whitman, founder of Third Avenue Management, called “the disclosure explosion,” GAAP transitioned from providing objective benchmarks to the much harder, arguably impossible task of capturing “truth” or “economic reality.”
While earlier guidelines (pre-1970) focused on full disclosure, leaving interpretation to investors, later developments sought to prescribe what should be disclosed and how. Whitman believed the decisions that had to be made under the expanded GAAP regulations were better left to analysts, creditors, and competent investors than to financial statement preparers.
As Whitman observed, GAAP had become more like The Internal Revenue Code, with rigid, complex rules. The key difference is that the tax code aims to arrive at a singular number: the tax liability, while GAAP is only meant to serve as a periodic benchmark of company performance and overall health. The desire to establish an absolute framework has forced every company to report on a going-concern basis, meaning that cash flow and accounting earnings took primacy over the balance sheet and the building of corporate wealth.
The distinction is not abstract. A company that is strictly a going concern relies on income statement flows — revenue and the resulting profits for its valuation and survival. However, in focusing myopically on the income statement, GAAP deemphasizes the company’s asset base, creditworthiness, and access to capital markets. Whitman from the July 2004 Third Avenue Value Fund investor letter:
“In fact, corporate and securities holders’ wealth is created in four separate, but interrelated, ways. To emphasize any one, or two, of the four to the exclusion of the others is to misunderstand corporate finance. And the present trend of GAAP is to overemphasize two factors – cash flow from operations and reported earnings – with a consequent de-emphasis of other factors that are at least equally important.”
The four factors involved in corporate wealth creation are as follows:
- Free cash flow from operations available for the common stock. This seems a relative rarity in the corporate world.
- Earnings where earnings are defined as creating wealth while consuming cash. This is what most prosperous businesses seem to do. Earnings may be of limited, or no, value unless also combined with access to capital markets to finance cash shortfalls.
- Asset redeployment and liability financing and refinancing. These activities include mergers and acquisitions, contests for control, diversification, the purchase and sale of businesses, the reorganization of troubled companies, liquidations, and spin-offs.
- Access to capital markets on a super attractive basis. Probably more wealth has been created through this venue than any other, ranging from the ability of real estate entities to finance on a long-term, fixed, low-interest rate, non-recourse basis to venture capitalists selling common stock into an IPO bubble
Today, GAAP focuses on 1 and 2, while 3 and 4 have been neglected or rendered unreliable by the rigidity of presentation requirements. Why? In Whitman’s prescient telling, the change followed a general market evolution. More assets began being managed in line with what he called Modern Capital Theory (MCT), now broadly known as the Efficient Market Hypothesis (EMH).
Modern Markets
In such a market, asset prices are assumed to be “correct” until new information impacts them. As a result, reported earnings are “deemed to be far more important than what can be learned from studying and interpreting all of the other GAAP numbers available for a corporate analysis.”
Whitman would hardly believe the intellectual and computing power now dedicated to positioning assets before and after companies’ quarterly EPS releases (saying nothing of the explosion of alternative data trying to gain an edge on those figures). Moreover, a growing share of assets are managed passively, leaving it to a smaller cohort of fast-money investors to set prices when new information is released.
“In the current regulatory scheme, there seems to be much too much emphasis on controlling disclosure to meet the perceived needs of short-run traders. There is no question that capital markets are most efficient where the trading markets are free, fair, and orderly. However, fulfilling the stated information needs of short-run speculators really does not contribute to the maintenance of free, fair, and orderly.” - October 2006 Third Avenue Value Fund Letter
These trends have continued unabated since Whitman retired in 2012. In January of this year, Todd Baker, writing for FT Alphaville, flagged SoFi Technologies' SOFI 0.00%↑ choice of using fair value treatment for its loan book. While completely allowable under GAAP, the choice sets SoFi apart from its competitors. Most lenders use the more conservative amortized cost method with a provision for expected losses (CECL reserve). In fact, only six banks use fair value accounting, and SoFi’s assets represent 97% of the assets reported in this fashion.
The company can recognize day-one revenue gains by booking loans at a premium to their unpaid balance. This choice also positively impacts SoFi’s regulator capital ratios. Baker,
“The goal of fair-value accounting is to estimate a value that represents the price of the asset in an arm’s length transaction. But inherently, fair-value accounting involves assumptions and estimates by management which materially affect earnings and capital levels — if those estimates are “aggressive” or wrong, they could materially overstate both.”
The inputs to those estimates are unobservable, yet the outputs are blessed by an auditor. In the goal of having financials reflect “reality,” the expansion of GAAP, in this case, harms the face-value user of reported financials. Those users include not just retail investors, but also factor-based strategies that use standardized ratios for portfolio construction, regulators, and creditors.
Implications for Real Asset Investors
There is a key analytical distinction between evaluating companies that are primarily going-concern-type enterprises and those that are investment-type companies. GCs and ITCs in Whitman’s parlance. While a GC is very much an income statement business that “consume cash to create earnings,” ITCs engage in balance sheet activities that include “asset conversions” like sales, refinances and M&A transactions that grow corporate wealth largely independently of accounting earnings. Real asset companies like REITs are much closer to ITCs than GCs.
Whitman provides interesting examples of how GAAP classifications can contradict this economic reality. He discusses Kmart, which carried $3.4 billion of merchandise inventory as a current asset. While this classification makes sense from an investment vehicle perspective (as the inventory would be converted to cash within a year), from a going concern viewpoint, this inventory is more akin to a fixed asset - something that must be maintained for the business to continue operating.
Similarly, he points to Forest City Enterprises, which carried $5.2 billion of real estate as a fixed asset. Whitman argues that many of these assets could be considered current from an investment vehicle perspective, as they could be readily sold or refinanced without interrupting operations. Of course, in the end, Kmart liquidated its inventory while Forest City was acquired by Brookfield.
For ITCs, access to capital markets is the most important driver of business performance. Whitman,
“Access to capital markets seems to be quite capricious. Loss of such capital market access by companies which needed continuous access was the precipitant for a large number of the biggest insolvencies in U.S. History: Drexel Burnham, Enron, Bear Stearns, Washington Mutual and Lehman Brothers” - October 2015 Third Avenue Value Fund Letter
Add Silicon Valley Bank & First Republic to the list now. To what degree did GAAP conceal or delay the discovery of the risk these companies carried?
As GAAP has left the ITC investor behind, they have come to rely on various non-GAAP metrics to provide objective benchmarks. REIT investors must assess the assumptions and adjustments inherent in Funds from Operations, NOI, and leasing disclosures. These metrics are used primarily to divine the fair market value of assets but are more crucial in determining credit quality. Can the company continue to pursue asset conversion activities like turning cash into new cash-flowing assets? Will they be able to refinance their liabilities in an accretive way?
Conventional security analysis does not offer much of a guide to answer these questions. Further, sell-side research, in responding to the needs of their largest clients, tends to focus on marginal beats and misses to these non-GAAP benchmarks. The long-term real asset investor benefits greatly from mispricings created in the wake of short-term-driven disclosure and the resulting trading. Whitman,
“For us, markets are taken as given, something investors take advantage of because they understand a business.”
For real asset investors, understanding the business is less about discounting cash flows (although that plays a part) and more about understanding how a company’s assets and liabilities may evolve over the coming quarters and years to support greater shareholder wealth creation. Whitman,
“GAAP, first andforemost, ought to be geared toward meeting the needs and desires of creditors rather than the needs and desires of short-run stock market speculators, who are vitally interested in day-to-day stock market price fluctuations.”
It behooves all real asset investors to take this credit approach and view GAAP as limited, perhaps even flawed, especially in its current form. The users of financial statements should err towards a “modified convention of conservatism,” which tends to understate profitability and asset values. The “analyst’s job is to adjust those understated, objective GAAP figures to the analyst’s version of economic reality.” That’s hard, but if there is an art to investing, it is in having a differentiated view of reality that comes closer to the truth than the market.
Original Article
About the Author:
Hunter Hopcroft is the Managing Director of Portfolio Solutions for Armada ETF Advisors, an ETF issuer focused on quantitative REIT research and asset management.
Prior to joining Armada, Hunter was the Alternative and Real Assets Portfolio Manager for an RIA based in Richmond, Virginia. In that role, he directed allocations to private equity, hedge funds, REITs, and Structured Products. Previously, he was a capital markets advisor for a consulting firm focused on large-scale timber acquisitions.
Hunter has advised on capital formation for both emerging real estate sponsors as well as institutional groups and serves on the investment committee of a private equity real estate fund.
