Mauboussin – Underestimating The Red Queen

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In their  latest episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle discuss Mauboussin – Underestimating The Red Queen. Here’s an excerpt from the episode:

Jake: This white paper that Mauboussin has out, it’s called “Underestimating the Red Queen.” We actually have discussed already what a lot of this paper is based on. This is the theoretical physicist, Geoffrey West’s work, which his book, Scale that we talked about actually, Season 2, Episode 49, which was December 17th of 2020.

Tobias: Remembered that well.

Jake: We’re front running Mauboussin research. Just kidding. It talks about Kleiber’s law. What that was if you remember from our segment was that, basically along the x-axis there’s a log scale of an animal’s body mass. It’s like one, 10, 100, 1,000. Then on the y-axis, there’s a log scale that is the animal’s metabolic rate. That’s energy used per unit of time. There’s this nice upward sloping line along this logarithmic scale, it’s about three quarters rise over run.

We can plot out how much does an animal weigh versus what’s their metabolic rate, and we see this nice line. What’s underlying that explanation is really how nature dissipates energy throughout a network. It explains the rate of blood flow, the number of heartbeats, longevity and growth. This is what the most important thing is. In the context of this white paper, and I don’t know if you guys have ever really stopped before to ask yourself like, “Why do we stop growing at some point?” There’re some living things that grow continually until they die, like, Peloton.

Tobias: [laughs]

Jake: Too soon. But there’s a reason for this. Nature is figured this out. It’s allocated to the growth of new cells as well as the maintenance and repair of the old cells. When you’re born, most of your energy gets directed towards that growth. But eventually, after you’d become a certain size, all your energy has to go towards maintenance and you stop growing.

This similar phenomenon exists for businesses. In a corporate context, financial capital serves as what like nature’s energy is, so there’s an analogy there. Growth stops at the point that maintenance needs are consumed by the available incoming energy or capital effectively. Understanding the growth of the company means that we have to understand the difference between growth CapEx and maintenance CapEx. This is something we’ve talked about on the show before, but this paper dives into it a little bit deeper.

It’s possible that a lot of the growth that you’re looking at is maybe not quite as shiny as you think it is because it’s possible that they’re spending more on maintenance than you imagine. This is where the Red Queen effect comes in. If you remember in Alice in Wonderland, the Red Queen says it like, “You have to run twice as fast to just stay where you are.” This is a little bit of Buffett’s talked about standing on your tippy toes at a parade.

There’s lots of different analogies. Matt Ridley, who’s my favorite author has this book called The Red Queen. It’s basically, how that relates to biology. There’re these arms races that happen in biology, especially around immune systems, which is interesting to go back and reread given our last two years of experience with COVID and all that.

Tobias: Oh, we just got demonetized, probably not.

Jake: Ah, shit.

Tobias: You’re allowed to criticize it now.

Jake: Oh, okay.

Tobias: It’ll be okay.

Jake: It’s all good. There are two complications that impact this conversation. One is inflation and the other is technological obsolescence. So, the first one, inflation, when prices are rising, the CapEx exceeds depreciation even in a stable business because the new CapEx that’s being funded is at an inflated rate, and when you’re depreciating it that’s based on older historical costs. An opposite in the case of deflation, Moore’s Law type of situations, the CapEx gets cheaper over time, and depreciation then is overstating the maintenance CapEx. Sometimes, the first movers actually don’t have much of an advantage compared to the followers because their costs can be higher than if the costs are falling.

Technological Obsolescence

Jake: The other one is this idea of technological obsolescence. What’s happened there is that, it’s increasing the chances that you’re overestimating the useful life of an asset. A write down is really this sudden recognition of the loss of the usefulness of this asset. Of course, there’s another kind of bifurcation here that makes it complicated and that’s tangible versus intangible. If you remember some of our conversations, like, for tangible assets, depreciation tends to understate maintenance CapEx.

This might be because the tangible part of the economy is almost like this mature, fully grown adult as compared to a younger growing company where they– Because it’s newer, more of the capex is likely going towards growth as opposed to maintenance. I can’t help but wonder about David Einhorn’s observation, maybe last year when he was talking about how a lot of basic industries have been starved of capital recently, especially in the last decade. I think he’s referring to energy largely.

Anyway, this younger part of the economy is more based on the tangibles, so, more energy is going towards growth maybe than maintenance. Mauboussin found through research that, “firms with higher intangibles have faster growth rates, but they also have higher standard deviations.” When something breaks, it’s a really long way down to find that next thing of value. You can’t reuse computer code for very much. Think about Blackberry or something like, what’s the next use of it? It’s like, “God, it’s miles below what we were valuing it before.”

This actually goes back to our– Remember, we’ve talked about Eugen von Böhm-Bawerk about his subjective value and the different bags of grain that he was going to decide, like, what to use them for. As you remove grain, you don’t just satisfy your needs that much less. You cut off whatever the least useful thing was for you and then that’s the next where the price is set as to the value of something. So, it’s all just like at the margin.

When you compare to, let’s say the tangible economy where physical machinery has scrap value or real estate that they have could be used for something else. There’s another layer down where obsolescence isn’t quite as far of a cliff compared to intangible world. The rest of this white paper, Mauboussin is walking through a bunch of examples, and it’s probably better to read it than to hear me talk about the specifics because there’re numbers and it starts to get confusing.

But one thing that was interesting was, there’s this accounting professor named Peddireddy. He did a study where he looked at companies from 1974 to 2016, and he looked at all these different industries, and in general, he found that maintenance CapEx exceeded depreciation and amortization by about 20%. Of course, there’s a lot of variation between industries and therefore there’s probably even more variation between companies within industries.

But in general, 20% overstating, that could be material. To give you a little idea of some of the numbers of this, in 2020, Amazon, Google, and Microsoft, all changed the useful life that they were using for their servers from three years to four years. All of a sudden, earnings got boosted by about $2 billion each from just a simple accounting change for all three of those companies. In the case of Amazon, I think about a 10% increase to earnings, just non-economic changes. It’s just purely, we’re going to say that that these servers that are running are good for four years now instead of three years.

Bill: Amazon, Google, and Microsoft?

Jake: Yeah.

Bill: You mean the three big cloud providers?

Jake: Yeah, exactly.

Bill: So, maybe they’re actually worth more for longer than people anticipated because the cloud’s a really big thing?

Jake: I don’t know if that’s the takeaway, but there might be.

Bill: Okay. Just throwing out an alternative reality.

Maintenance CapEx v Growth CapEx

Jake: Okay. It could be. What’s actually ironic about all this is actually the energy companies, none of the companies report their maintenance CapEx versus growth CapEx. It’s quite possible they don’t know the answer to that. I bet most CFOs don’t really know the answer to what dollar should be considered growth CapEx versus maintenance.

But ironically, energy companies do this because the way that just the dynamics are that because they start with a certain amount of reserves and they know that they exist with some certainty, and that they’re accessible by today’s technology, they go and tap those reserves, they therefore know how much like they need to buy or go and find to replace those reserves, so, they can see actually what maintenance CapEx is based on production level. So, ironically, energy’s already been doing this and it would probably be helpful for investors if more companies tried to give us some of those numbers rather than us trying to back into them. But anyway, great white paper, stand on the cutting edge of research as Mauboussin does and I would check it out if I were you.

Tobias: How do you divide the CapEx up into maintenance CapEx and growth CapEx?

Jake: How do I personally?

Tobias: Yeah. What’s the simple rule of thumb for doing it? Or, there is none.

Jake: I think it’s so industry specific that it’s really hard to give a simple rule of thumb. I think there’s a lot of art to this, and maybe almost to the point where it’s theoretically correct, but operationally almost impossible to execute in a way that you wouldn’t– Incredible amount of chance of tricking yourself probably in this, because it’s so hard to determine.

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