Fellow Partners,
Based on your feedback I am going to experiment with changing from monthly to weekly updates from the start of 2021. These will cover similar ground as the monthly updates but will be 2-4 minute reads vs. the 8-12 minute reads typical of the monthly updates.
As always I continue to value your candid, direct feedback.
Here is the December 2020 update.
Summary
Putting oil back in the ground
The importance of intangible assets
Value hiding in plain sight
Compounding trust over long periods of time
Putting oil back in the ground
We bought 5% of the Walt Disney Company in 1966. It cost us $4 million dollars. $80 million bucks was the valuation of the whole thing. 300 and some acres in Anaheim. The Pirates ride had just been put in. It cost $17 million bucks. The whole company was selling for $80 million. Mary Poppins had just come out. Mary Poppins made about $30 million that year, and seven years later you’re going to show it to kids the same age. It’s like having an oil well where all the oil seeps back in...
In 1966 they had 220 pictures of one sort or another. They wrote them all down to zero – there were no residual values placed on the value of any Disney picture up through the 60s. So [you got all of this] for $80 million bucks, and you got Walt Disney to work for you. It was incredible.
You didn’t have to be a genius to know that the Walt Disney company was worth more than $80 million. $17 million for the Pirates ride. It’s unbelievable. But there it was. And the reason was, in 1966 people said, “Well, Mary Poppins is terrific this year, but they’re not going to have another Mary Poppins next year, so the earnings will be down.” I don’t care if the earnings are down like that. You know you’ve still got Mary Poppins to throw out in seven more years... I mean there’s no better system than to have something where, essentially, you get a new crop every seven years and you get to charge more each time...
I went out to see Walt Disney (he’d never heard of me; I was 35 years old). We sat down and he told me the whole plan for the company – he couldn’t have been a nicer guy. It was a joke. If he’d privately gone to some huge venture capitalist, or some major American corporation, if he’d been a private company, and said “I want you to buy into this...” they would have bought in based on a valuation of $300 or $400 million dollars. The very fact that it was just sitting there in the market every day convinced [people that $80 million was an appropriate valuation]. Essentially, they ignored it because it was so familiar. But that happens periodically on Wall Street.”
Warren Buffett
In September 2020 Nintendo released a number of products and games to celebrate the 35th anniversary of the 1985 launch of the original Nintendo console. This included a package of the first three 3D Mario games:
I bought it to re-experience the fun I first had playing Mario 64 when it was released in 1996, and to share the experience with my son:
I happily forked over $60 to buy the game when it was released. Five million other people did as well. That’s a fast $300 million in revenue — much of it profit due to digital distribution (no middle men) and the fact that Nintendo didn’t have to build anything new. They’re just re-selling what they already own. And they can do this again and again and again. (Case-in-point: this is the third time I’ve bought Mario 64 — first in 1996, again in 2012, and now in 2020).
What a business.
Thanks to my friend Ryan O’Connor at Crossroads Capital for first bringing this gem to my attention. His deep dive on Nintendo is a great read for those interested in the company.
Intangibles matter
The Nintendo story is a great example of the value and importance of intangible assets, which account for over a third of all American business investment (see table below for examples). For accounting purposes these investments are often treated as an expense, though when they are the product or means of production — such as the Super Mario game catalog and brand — they are clearly an asset.
Business investment in intangible assets has grown faster than investment in tangible assets (e.g. buildings and equipment) since the late 1970’s. Today $1.4 is invested in intangible assets for every $1 invested in tangible assets — a complete reversal of investment ratios in a mere four decades.
Yet seeing this trend in company financial statements is a challenge. Take Microsoft: in fiscal 2020 reported capital spending was $15 billion. Yet this figure is likely closer to $35 billion if portions of R&D, Sales & Marketing, and General & Administrative expenses are re-allocated as investment in intangible assets, not business expenses.
This makes intuitive sense. Microsoft reports revenue split by their main product lines: Windows, Office, and Azure (cloud services) — all of which are software products in nature. These products are the products of the firm. But they are not represented in Microsoft’s financial statements in any format that comes close to approximating their true value to the firm.
In service-led economies the value of a business is increasingly in intangibles — assets you cannot touch, see or count easily. It might be software; think of Google’s search algorithm or Microsoft’s Windows operating system. It might be a consumer brand like Coca-Cola. It might be a drug patent or a publishing copyright. A lot of intangible wealth is even more nebulous than that. Complex supply chains or a set of distribution channels, neither of which is easily explicable, are intangible assets. So are the skills of a company’s workforce. In some cases the most valuable asset of all is a company’s culture: a set of routines, priorities and commitments that have been internalized by the workforce. It can’t always be written down. You cannot easily enter a number for it into a spreadsheet. But it can be of huge value all the same.
Why does this matter?
Intangible assets have unique characteristics which are hugely advantageous to the firms that possess them — most importantly the fact that intangible assets can be used by lots of people at the same time (they are “non-rival” goods). Microsoft only needs one primary code base for Office and Nintendo only needs one game catalog for the Mario brand — regardless of how many people use these products. This allows for infinite scalability from a relatively fixed cost base which can be highly profitable in the short-run and produce increasing returns to scale in the long-run. This economic attribute is also a major reason some enormous firms keep getting bigger.
Hiding in plain sight
Why is it difficult to see an accurate representation of intangible assets in company financial statements?
Intangibles’ treatment in company accounts is a bit of a mess. By their nature, they have unclear boundaries. They make accountants queasy. The more leeway a company has to turn day-to-day costs into capital assets, the more scope there is to fiddle with reported earnings. And not every dollar of R&D or advertising spending can be ascribed to a patent or a brand. This is why, with a few exceptions, such spending is treated in company accounts as a running cost, like rent or electricity.
For one, estimating their value is itself difficult, though the deeper challenge is posed by the strain we have put on accounting rules. We ask corporate accounting to serve many masters: tax authorities (profit), business operators (company performance), creditors (debt repayment), and business owners (long-term cash flows).
There are too many complexities in business to serve all these stakeholders well with a single set of accounting rules. This combined with the relatively rapid growth of investment in intangible assets (software is eating the world…) has created opacity in the means by which businesses with substantial intangible assets create value.
A more detailed accounting discussion would be helpful here, but I’ll save that for another day. Suffice it to say a substantial remedy to seeing the value of intangible assets comes from one of my favorite adages:
It is better to be approximately right than precisely wrong.
Warren Buffett
In valuing intangible assets the ability to make reasonable estimations of value trumps the attempt to nail them down to a precise figure. This will frustrate those who try to use spreadsheets for everything (I’m sure a few of you are chuckling at me right now), but is a critical skill in a world where enormous — and rapidly growing — business value is derived from asset-light businesses with outstanding intangible assets.
Closing items
The best conversation I listened to recently had (almost) nothing to do with investing. Former 76ers General Manager Sam Hinkie made a rare appearance on ESPN. (Sam’s resignation letter is a master class in application of liberal arts thinking). I highly recommend listening to it at some point over the holidays (link here). It is worth the time.
In the interview he discusses The Process (again, worth investigating), but the primary concept he returns to over and over is the idea of “compounding trust with people over long periods of time”. This struck me as a fantastic way to describe what this partnership is about.
We hold a set principles, we focus on quality, and we invest accordingly. The core of our behavior comes down to compounding trust with each other as we compound capital over long periods of time.
Thank you for the continued opportunity to compound trust with you. I wish everyone a wonderful holiday season and look forward to serving you in the year ahead.
All the best,
John
Founder and Managing Partner