The writer is a professor of accounting and finance at New York University Stern School of Business
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.”
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? In the US, during the booming decade prior to Covid, almost 50 per cent of public companies reported annual losses. Among high tech and science-based (pharma, biotech) enterprises the loss frequency was a staggering 70 per cent.
European companies display a similar trend, though the frequency of loss is a bit lower: 35-40 per cent. Booming economies, while roughly half of public companies are in the red? Welcome to the bizarre world of accounting.
The loss frequency in both the US and Europe started accelerating in the 1980s. This is not a coincidence. The 1980s were characterised by a surge in corporate intangible investments in areas such as research and development, information technology and brands.
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 characterised practically all industries, as managers realised that innovation was the key to competition, long-term.
In the US, 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, such as salary and interest payment, and investment, such as buildings and equipment, was clear. Expenses are payments for past services and therefore charged against revenues in the earnings (income) calculation. Investments generated 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 $9.4bn 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. Obviously, many of the presumed “losers” are in fact successful growth drivers, but most investors, fixated on reported earnings, don’t realise this.
To identify the fictional, accounting-driven losers, I carried out a study “All Losses Aren’t Alike” with Feng Gu and Chenqi Zhu on all loss-reporting US companies in the past 25 years. We added back to their earnings (losses) the intangible investments they expensed minus amortisation.
Thus, we undid accountants’ folly by capitalising and amortising the R&D, IT and brand enhancement. The result: a full 40 per cent 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 were starkly different in terms of great importance to investors:
Thus, “accounting losers”, by and large, are very successful enterprises. The icing on the cake is that investment in the stocks of “accounting losers” is very lucrative. 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.