The Investment Thread

So, to revisit the Tech P/E stuff, I've gotten a lot further in this book, and I want to hit a highlight idea of it. (Where the Money is - Adam Seessel)

It was a realization that the way value investors look at Tech is misguided, because capital expenditures (thus return on investment) are very different for most tech companies (it also lead him to discover other good non-tech companies).

The way he puts it all together is the BMP checklist. B = Business, M = Management, P = price.

Business Quality - Does the company have a low market share? In a large and growing market? Sustainable competitive advantage?
Management quality - Does management think and act like owners? (vs custodians) Do the executives understand what drives business value?

Price - can you arrive at a reasonable earnings yield, over 5%?

The price part is what gets manipulated, because of how standard GAAP accounting skews towards tangible assets/Capital, vs R&D, which is pretty much all Tech spends on. I'm not an expert at this, so I'm going to paraphrase a bit from the book, but he does a much better job explaining his logic, and borrows Buffett's, being "approximately right, is better than precisely wrong"

R&D for a tech company, like Intuit, is like new factories and inventory is to more mature "Industrial age" companies. The difference is accounting practices force Tech companies to expense R&D immediately, but Cap Ex on a new factory can be expensed over multiple years. So, general accounting rules biases Tech companies to having depressed Earnings, thus higher P/E multiples. i.e. Campbells Soup can spend the same amount as Intuit, but based on spending on Cap Ex, vs R&D, Cambells Soup can show higher earnings, with similar Sales totals. Do we really think Campbells Soup is a higher margin business than Intuit?

That's one of many examples used in the book, and Seessel gets into how he estimates a better way to look at the 'earnings'. He calls it Earnings Power. And he uses the idea of Return on Capital, and how these Tech companies (the good ones) focus on future growth and future profits, not just current ones. Amazon has always been very transparent about that. They famously re-print Bezos' 1997 letter outlining their plan.

https://www.sec.gov/Archives/edgar/data/1018724/000119312513151836/d511111dex991.htm

So, as more Tech companies dominate the S&P 500, the P/E ratio will increase, artificially, because of how standard accounting rules deal with them. However, it's not always a value bubble. It's a data distortion. At the same time, prices CAN get out of whack. But you can't use the standard P/E to explain it.