Dr. Michael Burry has become something of an investing hero since his involvement in the subprime mortgage crisis. He began his investing career many years before the subprime crisis and started blogging about his investment ideas around the turn of the century.
These initial investment theses' give some excellent insight into his investment process, which later led him to achieve market-beating returns at his hedge fund Scion Capital. Scion Capital ultimately recorded returns of 489.34% (net of fees and expenses) between its Nov. 1, 2000 inception and June 2008.
Stay away from tech
Like all investors who have earned their stripes during periods of great market exuberance or depression, Burry learned a significant amount from investing during the peak of the dot-com boom.
One of the most interesting lessons that he discusses in his investing blogs is that of stock options awarded to internet company employees instead of wages. These options have the initial impact of lowering a company's expenses but can be highly misleading for investors as the adjusted figures did not give an accurate representation of the underlying business fundamentals.
Even though accounting standards have changed since the early 2000s, tech companies still use such quirks of accounting to improve their books. In a journal dated March 28, 2001, Burry detailed why he believes all investors should be skeptical of this approach.
Here's the excerpt from the blog post:
“I'm going to outline a problem that a lot of tech companies face – and that makes their stocks in general overvalued. Unlike nearly every other industry, tech companies compensate their employees in a manner that hides much of the expense of the compensation from the income statement. Of course, I'm talking about options.
“With the most prevalent type of option – called 'nonqualified stock options' – the difference between the price of the stock and the price of the options when exercised accrued to the employee as income must be taxed because it is considered compensation. Not according to generally accepted accounting principles (GAAP) but according to the IRS. So the IRS gives companies a break and allows them, for tax purposes, to deduct this options expense that employees receive as income. The net result is an income tax benefit to the company of roughly 35% of the sum total difference between the exercise price of the company's nonqualified options during a given year and the market price of the stock at the time of exercise.
“Since GAAP does not recognize this and the income statement – for whatever reason, I'm not sure – cash flow statements record this 'net income tax benefit from employee stock compensation' in operating cash flow as a positive adjustment to net income. After all, the company included neither the cost of the options nor the income tax benefit on the income statement. Hence, the correction to cash flow.
“Great, right? So net income is understated, right? Wrong. When evaluating U.S. companies, investors also assume that if the IRS can tag something, then it is a real profit. And if they allow one to deduct something, then it is a real cost. For instance, goodwill amortization cannot be deducted for taxes, but that's of a topic for another day.
“For many tech companies, options compensation is a big issue. In a rising market, the net income tax benefit can be quite large – but it only reflects 35% of the actual cost of paying employees with options. How does it cost the company? Because the company must either issue new stock or buy back stock for issuance to employees in order for the employees to obtain this stock at a discount. The cost is borne by shareholders. The per-share numbers worsen while the absolute numbers improve (after all, issuing stock at any price is a positive event for cash flow if not shareholders).
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“This is why I call a lot of technology companies private companies in the public domain – existing for themselves, not for their shareholder owners. Of course, it is a shell game. A prolonged depressed stock price – for whatever reason, including a bear market – would cause a lot of options to become worthless and would likely require the company to either start paying more in salary or worse, to start the pricing options at lower prices.”
Both Twitter (TWTR, Financial) and LinkedIn (LNKD, Financial) are (were) extremely guilty of this practice. According to the New York Times, in 2014, LinkedIn paid employees $319 million in stock, or 14% of revenue; in 2015, that rose to $510 million, or 17% of revenue.
Including these costs, operating margins for fiscal 2017 would have been around 0%, up from the 25% predicted. Twitter’s financials meanwhile look horrible if stock compensation figures are included. Last year the company awarded employees stock compensation worth $615.2 million, which was not included in the cost of sales which came to $2.9 billion. Including these costs would have more than doubled Twitter’s net loss for the year of $456.9 million.
Disclosure:Ă‚ The author owns no stock mentioned.
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