A less-catchy title for this could be ‘The importance of understanding and accurately valuing assets’, which addresses one of the core challenges faced by investors. This is particularly relevant at this time as many assets have been badly devalued by the impact of the Covid-19 pandemic. I’ll come back to the A380 later.
The assets and capital intensity of a business are important. The market has a clear preference for capital-light companies that are flexible – such as platform technology companies, which are very flexible as other parties supply the assets, such as the screen space to display adverts to consumers, stock, warehouses and delivery vehicles. It is much easier to scale up if someone else supplies the assets!
Following Covid-19, the world looks very different for companies that own excess physical assets like cruise ships, hotels or conference centres. Capital-heavy companies are operationally leveraged, meaning that a downturn in activity affects them disproportionately. Such companies are particularly vulnerable if they are also financially leveraged as the combination of lower revenues, capital intensity and debt can be fatal.
High levels of debt are the real killer as we can accept high capital intensity. For example, we own TSMC and Micron, despite the capital-heavy nature of the semiconductor manufacturing sector – tens of billions invested in plant and equipment, but crucially these businesses have no net debt. For businesses like these that need physical capital to produce products for customers, it is important for us to understand the capital required to generate growth and future returns.
Adjusting asset values
In simple terms, we regard assets as anything that a business needs to operate and grow. One of the central tenets of our global equity investment process is that accounting data are often misleading, which can be unhelpful in applying quantitative analysis to identify investment opportunities. To be meaningful, we adjust accounting data on asset values for inflation, leases and R&D expenditure. We don’t capitalise brands, though we are cognisant of the part they play in returns on capital.
Such adjustments can produce starkly different results. Amazon is a good example: it spent $36bn on R&D in 2019 and the vast majority of this was expensed. However, this investment in R&D is an investment that provides the competitive advantages, so we feel should be adjusted for. GAAP Net Income at Amazon in 2019 was only $11.6bn, so adding back even a portion of the R&D and capitalising it has a massive impact on the financials. This is a complex ‘asset’ to appraise, although it clearly has value that is not reflected in traditional accounting methods.
The pandemic has brought asset values into particular focus. Not only have revenues collapsed in many sectors, either through lockdowns or changes in economic behaviour, but asset values have also cratered. The term ‘stranded assets’ has become popular in the energy sector as investors contemplate the value of undrilled oil reserves in a carbon-neutral world, but we are seeing many other shorter-term examples.
Back to the A380
The plane in question is the sole asset of Doric Nimrod Air One, a specialist aircraft leasing fund, and is currently leased to Emirates, although the lease will soon expire. Valuing the fund is a challenge when its sole asset has a short lease and so many aircraft are currently standing idle, like a global version of the haunting aircraft graveyards in the Arizona desert.
Indeed, some first-generation A380s are already being broken up for their scrap value – apparently, the going rate for an A380 for breakup is $10-15m. This isn’t all scrap as many of the components can be used as spares for other aircraft, but the A380 fleet isn’t big and the market will quickly be swamped if many planes are scrapped.
This example is rather extreme and I should be clear that we don’t buy aircraft leasing funds. Neither are we trying to buy mispriced undervalued assets to make a turn, but rather we want to avoid companies with sizeable ‘stranded’ assets. This may take time to play out while monetary policy is so accommodative and government financial support programmes are in operation, but where there is excess capacity asset price falls will eventually hit share prices.
The key is to understand exactly what a company’s assets are – tangible and intangible – and to try to value them to inform their economic value, rather than simply accepting and relying on accounting data. Asset-light businesses can be particularly attractive as are companies with good ‘moats’ (barriers to entry) around their assets. Against this, we don’t like the combination of cyclicality, capital intensity and financial leverage as this can be an unpleasant cocktail for investors to swallow.
The value of investments and any income from them may go down as well as up and is not guaranteed. The views expressed are the author’s own and do not constitute investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.