Buffett and Munger’s value 2.0, as it has become known, separated itself from value 1.0 by focusing on quality businesses distinct for their durable competitive advantages. In Where The Money Is Adam Seessel tries to answer how the digital age changes this, why value 2.0 investors missed the internet companies, and what value 3.0 investors have to recognize.
The primary difference is that digitalization provides an even more optimistic and expansive view of the global market. Digital businesses can grow way faster than physical businesses because of the internet. In essence, the winner can win in less time than we previously assumed and can achieve scale in just a few years that would have previously taken decades.
The second difference, however, is how we interpret the income statement. Digital businesses, being asset-light cash cows, are able to allocate their cash towards sales and marketing, and R&D. These are lines that grow the top and bottom line quickly. R&D for digital businesses, in many cases, resembles Capex for old-world businesses. The line item often includes the salaries and expenses required to produce and maintain the software itself. While for subscription and other digital businesses, the product is sticky and turnover is often low. The lifetime value of the customer can therefore, be measured and expected to last beyond a single transaction. This means the sales and market expense is effectively creating a “customer relationship asset” that, under accounting rules, gets expensed immediately as the marketing spend occurs. The accounting treatment, in essence, does not represent the actual earning capabilities of the business, meaning the standard valuation metrics, like P/E, don’t work.
The key point here though, is that you must understand the business before you make these Income Statement adjustments. You can’t just remove all the R&D because a lot of experimented software adjustments don’t pay off and should be expensed. And the customer relationship asset depends on low churn and a moat. So it is not a blanket adjustment, it requires skill and judgement and will be different proportions for each business.
For example, in the book Seessel flatly adjusts R&D expense to that of Cambell’s soup, a mature company. But I think we have to ask that, just as R&D is similar to Cap-ex for a physical business, is there a split between maintenance cap-ex and growth cap-ex. Almost certainly yes. The Tech industry is hyper competitive and these businesses require ongoing development to stay competitive. Just as Buffett adjusted cap-ex for the split between growth and maintenance, we need to do the same for Tech R&D.
Connections
Value Investing Requires A Paradigm Shift In The 21st Century
Link Explanation: The linked note explains the overall issue that has faced value 2.0 investors over the last two decades. It asks “how did value investors miss Amazon?”, and this current note answers that question.