New Constructs' Friday Webinar: Intelligent Capital Allocation 28 April 2023

Welcome everybody. We are happy to be here on Friday, April 28th for another live webinar. Tamara's going to be our MC today. I'll let you take it away from here. Great, great.

Again, welcome. Happy Friday. We're excited that you are spending some time with us in advance of your weekend. We hope to make this as useful as possible. As usual, here's our disclaimers and disclosures. Please do familiarize yourself with this information. We're not an advisory company. We're going to go ahead and start out on society. We got some great questions submitted early, so we wanted to make sure that we hit those. After that, David and Kyle will be going through our latest research. Both on some updates to the long list, and then Kyle will be doing a really brief review of some of the other research that's been put out this week. Then we'll be handing it over to the analyst team, and this week we have Lee and Hunter with us, and they'll be going through a quick update of the first quarter filing season, as well as what's been happening with our new coverage year to date. and some FASB information. So I'm going to go ahead and start by heading out to society. We are soliciting questions for webinars. We got a great set of questions this week that David is going to hit briefly. But I also wanted to point out a really fascinating discussion that I believe Roger pulled together for us a really fascinating analysis on Carrier Global and the acquisition of Weissman.

Roger would love this. And in my comment and reply, I noted that we spend a very significant amount of our new analyst training program on acquisitions, largely because It's pretty fascinating to see how often people overpay and actually how easy it is to break down the implied incremental cash flow required to justify the synergy or the amount paid over the market cap of the company acquired and how few people or companies ever do that. And a lot of that is part of what New Constructs is trying to change in general. Is that we think people will have better behavior and better expectations about what they expect from company management if they get it from other folks too. And so when we do acquisition analysis, and we haven't done it for a while, we will break that— break things down to that level of detail so that it's more likely that folks like Roger, and hopefully maybe even someday Wall Street analysts will say, hey, you're overpaying for that company by $200 million. How do you justify that? And by the way, synergized EBITDA doesn't cut it. Strategic benefits doesn't really cut it. And so great question. And yeah, we'd steer away from that big time, Roger. Synergized EBITDA is, I don't know, that's doublespeak for we just wanted to get a deal done.

That's great. Thank you, David. I know Roger had a couple more questions, one on a company that we just covered quite a bit last week, Suncor. Did you have any comment on this purchase agreement?

Yeah, we think both TotalEnergies and Suncor moving into the Canadian oil sands is a good move. These guys have been good capital allocators, strong returns on capital. Does not affect our thesis on both of these. We think energy is a really smart place to be. These are 2 excellent operators priced for permanent profit decline. I think what was covered last week on Suncor probably says a lot, says a lot of it on this front. And yeah, it does not affect our outlook. Kyle, do you have anything to add there?

Yeah, I would just add that I think the Transfer of assets. It's really just both companies focusing on their strengths, leaning into what they know, and maximizing the ability to do what they do best. And so I think it's a positive on both sides.

And on that front, talking about the replay, Tam, I think we, we missed highlighting the great work that you're doing every Friday after this webinar and posting the replays, the agenda, and the slides. So Everyone just keep in mind that the replay, the slides will be available very soon after this webinar. We finish it up today. If you can't make it in real time, you can do it on your time.

Absolutely. We'll get that up there as quickly as possible today.

And then on the pharmaceuticals industry, Roger, this is a great question and This is where the, the most important aspect I think of investing is about understanding expectations. For example, it's super important to understand the true profitability of a business because even with a great understanding of expectations, if you have no context for the expectations for future cash flows, you have no idea whether or not 20% compounded annual growth in profits with a 50% return on invested capital, you don't know if that's high or low if you don't know where the company's been in the past. Nevertheless, understanding market expectations is essential, is first and foremost, right? And with respect to the pharmaceutical industry, you ask a great question. And I think understanding patent expiration is important. And that's where I would say, look at the expectations or look at the expectations ratings on the stock and then think about how that juxtaposes with the patent expiration. We are not doing detailed work on whether or not they will produce a new drug, whether it's going to get through FDA. That's sort of— from my experience on Wall Street, when we had senior analysts covering the pharmaceutical industry, you either need to be an expert in the science yourself or have a source down there at the FDA or be down there yourself. on the ground trying to figure out what's going on with the FDA for that to— for you to know what's going to happen on the new drug front. Outside of that, we're giving you the best sense of what the fundamentals are telling you. And if the stock price is implying that the profits are going to decline a lot, that's probably because a lot of people believe that when that patent expires, profits will decline. The question is, is that implied profit decline too big or too small?

Thanks, David. And thanks, Roger, for those great questions out on society as well. We're going to jump quickly into the latest research. As we went through the agenda, we have a lot to cover today. So I'll be handing this over to Kyle and David to review Hershey first.

Yes.

So we took Hershey off of the focus list. We closed this long position. Let me get my screen up here to share. We closed this long position because It had done really well and the stock was expensive and we didn't feel great about the expectations implied in the stock price anymore. That we felt they were too high. Been a great business in terms of a stock pick, outperformed by 58% over the holding period. As you can see here, Kyle, go ahead and pull up your screen to show the reverse DCF analysis. that we did to determine that we needed to close this. In particular, if you're looking at the text in that article, that Hershey's got to improve NOPAT margins to all-time highs while also growing revenue at 6% compounded annually, or nearly double the consensus estimate for 10 years. So we don't think it's impossible for Hershey to do that, and they may well, but betting on them doing a lot better than that, betting on them achieving or exceeding the expectations baked into the stock price, we don't think it's such a good deal. And here Kyle is showing this optimistic scenario and exactly how the model produces that $262 value to justify the, the current stock price. Kyle, if you go to the decision page and compare that scenario to our default or, or how that looks. So yeah, click on— there you go. And that's this optimistic scenario. You can see our default's a little bit lower. And default's not going to assume any real margin improvement or, or that they're going to maintain all-time highs. It's going to be an average of the last few years and probably not going to be growing much faster than consensus. So that's why you see a, a lower line in blue and a lower slope. So Higher margin, faster revenue growth is going to be a higher line and a faster slope or a steeper slope. And you can see there in year 12, we get that $262 stock price and the stock is already up $270 or $10 since then. So getting a little bit riskier, get a little bit riskier.

Yeah.

And I would add specifically the assumptions we were looking at with the margins at 21.5% when their previous high was 19.2%. And so it's one of those things where it's not impossible, but again, they would have to get to previously never achieved margins while also growing double consensus or nearly double consensus. And so it's a scenario where risk reward is just not what it once was on this stock.

Awesome. Should we go to The next one?

Discover is a good one.

I'll go ahead and share Discover here. We've talked about Discover a few times, and Italo and Kyle, I think, did some great work focusing first on just the consistency in revenue and profit growth going back to 2015, how we think the business is going to thrive in a rising rate environment. We think the net interest margin will continue to get better over time, which means just more profits. The business has generated a ton of cash flow over the last 5 years. They've returned a lot of value to investors, a high dividend and a strong repurchase share buyback plan. A lot of folks are repurchasing shares, but issuing just as many. And so it's net zero, but Discover has been averaging a 6% annual reduction in shares since 2014. That's enriching investors implicitly. That's an impressive yield. Then a strong competitive position. These guys have a return on capital even higher than our favorite financial company, JP Morgan. That's impressive. And they've got a great reputation for best-in-class customer service. The credit card space is really crowded. In fact, when I was on Wall Street, my first job after the Value Dynamics Framework was covering credit card companies. And so I know these businesses pretty well, and it's a difficult business. It's commoditized, it's competitive, and for Discover to have sort of these meaningfully higher margins at 33%. That's really impressive. And they're competing obviously well, I think, on the, on the things that make credit card companies unique because they're all pretty much accepted everywhere now. There's no advantage there. It's the perks. And they are well recognized for having great perks and a great service offering as well, which It's it's good to know that they're also recognized as one of the top hundred companies to work for. It's difficult to provide good customer service and success if you don't like the company you're working for. I think those things tend to go hand in hand. In in many ways, there's less competition now too, right? Because we had the whole Apple Card experiment with Goldman and Marcus. They're gone, right? So that's going to make things a little bit better. We're not seeing a bunch of silly money being thrown. Thrown at fintech anymore, so they don't have to worry about irrational competition or people using capital as a weapon, which is another way of saying they're funded to lose a lot of money for a long time in a spirit— in the spirit of just gaining market share and hoping at some point the business works. Those business models aren't really getting funding anymore because those business models have turned out not to actually ever work. The only red flag we found really was Charge-offs. They've seen a significant jump in charge-offs, but we've also seen some very strong provisioning. And Discover, compared to all really the traditional credit card companies, has the greatest reserve ratio or reserves relative to loans, except for only Synchrony. And Synchrony is a different business model because they're private. They're white labeling cards. So the Macy's card or any of these other retailers. Synchrony is sort of the private label provider of that, which carries an inherently higher credit risk because they're not able to really screen people out as much. Those credit cards that are white label are typically given out as incentive for people to purchase more. You get a discount if you will sign up for the credit card. And so there's not as much screening to ensure the credit, credit quality of those users. And so Synchrony's got to carry a much higher loan loss allowance. And so that's a different model. But versus all the other credit card carriers, Discover's looking really good going into recession. Tons of reserves, strong provisioning, which would lower your net interest margin, right? So despite this really strong and high level of provisioning to build a higher than usual reserve allowance, they've still had some of the best net interest margins and margins overall in the business. So it's a really well-run business. They're able to put away a lot of money for a rainy day while still maintaining industry-leading margins. That's impressive. And then let's get to the fun part, the reverse DCF, right? Like I said, it's all about expectations, and you don't really know how high or low expectations are always until you look at it in the context of what the company's done in the past. When you have a price-to-economic book value of 0.6, that's always a pretty good sign that expectations are low, right? That implies a permanent 40% decline in profits. What does that look like on a chart? Well, it looks like this where you see a really strong— except for around the financial crisis, right, which hurt everybody— really strong growth in profits where the market price is effectively implying a very strong decline. And our upside price, $149 a share. I don't like to say target price because we don't really have target prices. But you could say that at $149 a share, you're implying effectively no growth in profit from where it was last year, a no-growth scenario, whereas the $102 a share is a significant decline even out over 10 years. And that again, great risk reward. Kyle, why don't you pull up your screen and show us how you put together these reverse DCF models to create that chart?

And Kyle, as, as we do that, I forgot to mention at the beginning of the webinar, please do ask questions as you have them. Don't hesitate to ask questions throughout. No need to save them until the end. We would rather take them on the topics as they come up. And I can also vouch that it's much easier to do customer support and customer success for companies that you love. Thanks, Tam.

So Kyle, walk people through how you put together these 2 scenarios. I think you've got neutral and pessimistic, and that's what's in the report.

The pessimistic would be the current price, right?

And talk people through like how you came up with these numbers and how they compare to what you see in the past so people get a sense of how easy this is to use and How you think about it.

So when we're looking at these, we're looking at, like David said, how they've done in the past, what are consensus expectations for revenue growth moving forward, and where that falls on with that PBV of 0.6. We know there's a big decline in profits baked into the price, and so we can build that in and see what that looks like. And so for our— I'm calling here the pessimistic because the expectation and the current price seem very pessimistic. We looked at revenue growth of 3% in every year out for the next 10 years. Consensus has them at 15.4% in year 1, 3%, 1.6%. So if we average it out, the big jump in year 1, we're not giving them credit for. That's why I call it the pessimistic scenario. And we also looked at NOPAT margins of 17%, which is a significant decline. You can see here, this is the pretax margin and just shortcut, I usually put in my after-tax margin and make the tax rate zero. And just so I don't have to calculate the difference on pre-tax and cash tax rates. But on the pre-tax basis, we're looking at margin of 41%, tax rate 23%. And you can actually jump into the metrics tab over here to see historical after-tax margins as well. In 2022, it was 33%. We're forecasting 17%. So again, a huge decline. You can see in the past they've had significant margin improvement, 25% up to 33% in the past 5 years. And so on this forecast page, we're baking in big decline in profitability and below consensus revenue growth. And we put that together on that pessimistic scenario.

Hey, Kyle, real fast before you go down, will you scroll down to the bottom of the forecast page and show how much the return on invested capital implied by these scenarios is going down?

Yeah.

Right. So one of the benefits on this forecast page people don't always see is that you can see the, the implied performance based on the forecast on this page as well. Kyle's going to show it to you on the DCF, but you can see how the return on invested capital in the neutral and pessimistic scenarios is dropping precipitously from where it has been in the past. Same with the NOPAT margin. You also get to see the change in invested capital, not necessarily a huge drop-off from, from where it's been over the last 5 years, pretty consistent with where it was in '18 and '19. 20, 21, 22, you've seen much faster revenue growth and profit growth, which would require or imply higher returns or higher capital investment. So you're seeing again a good example of how you can on the forecast page quickly see the impact of your forecast.

Once I've built out that scenario, 17% and 3% growth, I can come in here to the DCF review tab. And actually look at the results of that forecast. So I'll come here to the pessimistic dropdown. In this case, we were looking at a 10-year scenario. And we've got our 3% revenue growth, we've got our 17% NOPAT margin, that'll give us the implied NOPAT in year 10, the implied shareholder value there. down at 103. The stock was currently trading 102. So essentially, current price was implying that revenue would grow 3%, margins would fall to 17%, which implies profits, NOPAT, CAGR here, were going to fall 3.5% compounded annually for the next decade. And again, when we look at past projections, even consensus growth moving forward, that's very pessimistic. So we can jump in and say, okay, If that's too pessimistic, let's be a little bit more optimistic. We're not going to say that things are going to be exactly as they were in the past. What would that look like? Obviously, in the current economic environment, things might not be growing as quickly with some of the charge-offs rising. It could be a scenario where slowed growth instead of as fast as growth that they've seen in the past couple of years. So we looked at 6% revenue growth, still below that consensus there in year 1, and 20% margins instead of 17%, which is still a significant decline from that 32% in 2022. And as David noted here, you can see no pet margins, significant rise improvement, or projecting immediate decline and staying low, no improvement in the future years. Keeping everything else the same in those scenarios, as far as changes, net working capital, invested capital overall, we can go to the DCF review tab and pull up our neutral scenario. used the neutral here is not trying to be super optimistic. We don't want to give companies credit for something that maybe they won't achieve. We're still trying to stay conservative here and see if there is any upside in a conservative scenario. We look at that same 10-year, 6% revenue growth rate, 20% NOPAT margin. We come out and see stock price right around $149 a share. And so even in a conservative scenario, where NOPAT only grows 0.9% compounded annually for the next decade. I think they've gone—

pull up the report.

I believe it's 11% over the past decade. 10% over the past decade. So we're projecting if they do 1% compounded annually over the next decade, you're looking at a share price, $149 a share today. And so that's where that really disconnect on current price and what they could be worth in a conservative scenario. And why this stock has good high-quality risk-reward.

Yeah. And one of my favorite comments on the society of all time came from a gentleman who pointed out that our narrative on Tesla was a data and math-based narrative and how refreshing that was. And Discover is the same thing from the other side, right? Tesla, we can show the math on just how absurdly overvalued the business is. And Discover, I think we're making a very strong data-driven, math-driven case transparently, right? As to why the stock is cheap. If it's grown 10% compound annually in the past and we're saying, hey, if it just does 1% in the future, you're talking about some significant upside. And by the way, the current stock price implies a negative 3.5% growth in profits for 10 years. Is that too pessimistic? Probably, right? Great risk reward here. Strong cash flows, strong return on invested capital, rising margins, rising return on capital, but a stock price implying that returns on capital and profits are going to get crushed, right? That's the disconnect that we really like to point out in this, in our research. And we hope that everybody finds it as valuable as we do and as a lot of our customers do in terms of just giving you a really straight, high-integrity perspective on a good long idea. That's going to be really hard, if not impossible, to get from anybody else.

Don't see any questions, so I'm going to jump into the next on the agenda, hit some of the other research we put out this week, and that is also going to be coming out shortly after this call as well. And that is the style ratings. We published the overall Investment style ratings for ETFs and mutual funds. You can find that right on the research tab, and this will give you the breakdown of the styles, the risk-reward of each style as it stands right now. You see large-cap value at the top there being very attractive, small-cap growth unattractive. And actually this afternoon, we're going to be publishing the individual style reports. be able to see the top ETFs, mutual funds in each style, top and bottom, I should say, and see where those fall and some of the best and worst picks in those styles. Also, we published the update to the dividend growth stocks model portfolio. So you can check out the new companies in that. I believe there was 5 or 6. You can check that out and definitely dig into some of the dividend growth stocks. These are companies with strong free cash flow to support not only existing dividend payments but future growth in the dividend payments. So we've got, yeah, 5 new companies there, total of 30 companies in the model portfolio. Definitely check that out. We published that one yesterday, so that is available now for all professional and higher members.

Excellent. Thanks, Kyle and David. Shall we go ahead and move over to the analyst team?

Sounds good to me. So what I wanted to talk about first is that Q1 filing season is upon us. This is the season when most companies file their Q1 reports. Companies with a fiscal year end of 12/31 file their Qs starting this week. Today is the first bigger day we've seen. We expect to get over 2,000 new SEC filings, mostly Q1s, over the next 3 weeks. In addition to it being Q1 filing season for most companies, it's also effectively annual filing season for foreign filers who have longer deadlines to report their annual documents. So we'll be getting a number of 20Fs, 40Fs, and 10-Ks from companies that follow International Financial Reporting Standards, IFRS companies. I think we have maybe 15 of those foreign filers filed today or so that we cover, and we'll be updating our models today, and around 150 quarterly filings today. So I wanted to share my screen and go through a little bit of— What that looks like for users. I think David has shared this kind of analysis in the past, but I wanted to go through it again. If you look back, say, at the last quarterly filing season that we went through, you can see—

Really slowly.

Oh, sorry about that. I had— I blew up the other tab, but not this one. Sorry about that. Yeah. So we again parsed around just shy of 2,000 filings in Q3 filing season. And if you had to do that work yourself or hire an analyst team to be able to do it and you were doing it manually, it would cost you over $1.5 million, $1.7 million worth of value that we're providing here. Our technology allows us to read through these financial statements better than you can as a human. I've done it both ways. I feel like sometimes people think that the technology's not as sophisticated as a human might be, But the reality of it is certainly at scale, using technology makes you better, not worse, makes you faster and better. The technology doesn't get tired, doesn't skip over sections of the filing that are of interest or unique or unusual disclosures.

And the technology is designed to enhance the human's capability. So the idea has always been from the beginning that We want the machines to do what machines do extremely well, and where the machine is not really sure, well, then it relies on a human so that humans can be focused on the more difficult elements in the filing and not be distracted, bored, or waste energy on the simpler parts. And we've been refining this process for 20 years, and that's why we can do what we do so well. And that's why major institutions have written papers proving and advocating for the superiority.

Of our data.

That's right. Yeah. Things like the financial statements don't require any time from analysts. We have a process in place where our technology takes care of parsing that information. And analysts spend their time looking at unusual notes or unusual disclosures. So we're looking for hidden write-downs, hidden non-operating expenses, unusual related party transactions, or anything of interest in the filing. The technology is pretty good at many of those things too. It's especially good at directing analysts to the right section of the filing. So even if the system can't necessarily collect that data point, it can point an analyst to this— that data point and say, this is complicated, how should this be incorporated into the model? Now we've got a team of expert analysts who are going through those filings to deliver that value back to you. Even as an individual, you can only look at a small number of filings. What New Constructs and our technology gets you is the ability to see the results of that kind of analysis for a large number of companies, all done consistently. So we build the same kind of model for a very large number of companies, and that's true whether you're a Gold member or one of our institutional members. So even if you're only looking at a small number of tickers in your portfolio, that, that model is built and comparable with every other model that we've built, and it's built on our deep understanding of what's happening in all those filings. So I think we've already delivered around $250,000 worth of value to clients. You should see a lot more model updates over the next coming weeks. Analysts are excited to do it. I'm sure that all of you love the technology and, and what we can deliver with it, but analysts here at New Constructs love the technology too. Every time it gets better, it makes our jobs easier and So far everyone's been pretty happy about that. No complaints.

We got a question from— a question from Kent Seymour on covering closed-end funds. I know that was something we've looked at in the past. Something about that. I feel like we're— we don't get the holdings or something like that, which makes it impossible for us to cover them.

Yeah, we can cover certain closed-end funds as long as we get the holdings information. I think there are some that we cover. Lots of those closed-end funds hold other funds as their holdings rather than individual securities. And so we don't have the ability at this time to be able to cover ETFs or mutual funds that cover, that hold other funds as components. So that's, that's mainly the problem there. Our fund coverage is driven by our stock coverage, right? So if we cover an ETF, it's because we cover enough of the companies that are held by that ETF or mutual fund. And we are able to aggregate our models to build a model for the fund as a whole. Whenever those holdings are debt funds or commodities or commodities derivatives or any other derivative instruments, we don't cover them. We only cover them if we can cover their components.

We cover around, I think, 7,000 ETFs and mutual funds. 7,000 plus.

We do.

Yeah.

Let me show you. I can pull that up right here. I was going to show this next. The next topic was going to be about coverage. We covered just over 2,700 stocks right now, over 1,000 ETFs and around 6,200 mutual funds. As— yeah.

Are there any funds you want us to look at in particular? Go ahead and send those in to success@ And we'll put it into the queue.

Absolutely. So far this year, we've added over 70 companies to coverage. If you're interested in seeing what our coverage universe is, I think many of you probably have seen this before, but if you're on the ratings page or on the portfolio page, you can always click this coverage button and it opens up this coverage tab and you can search for any securities to see if we cover them here. Like I just showed you, you can look at our stocks, mutual funds, ETFs, our new coverage queue, which is stuff we're working on now.

Show the inactive stocks. The inactive stocks. Interesting, right? There's— it's another 3,000 stocks plus that we covered in the past, but either acquired or went out of business or something like that. And those are important to the integrity of our backtesting. Right. If you were only include companies that are alive when you're looking back in the past, there's obviously going to be a positive bias to the companies that survived. Survivor bias. You don't want to have that. So we keep covering companies that are dead or alive so that when people are evaluating the alpha in our data, they're doing so against the full universe of companies alive at that point in time.

Our last models for Signature Bank and Silicon Valley Bank are still here. Famous recent—

look, you can see the ratings. Yeah. So you can still see it's marked as neutral. It's pretty cheap when it's about to go bankrupt. They're all going to have pretty good valuation at that point, right? Profits are going to zero.

Yep. So we preserve all those things. The other place that users can look— so this is the portfolio page, which I think you're probably all familiar with. Like I just showed, if you click the If you pull this menu down, the very last section has model portfolios for new coverage. So if you click on stocks, you can see a similar list of the companies that we've added to coverage over the last 3 months, right? So you can see a list of everything that we've added. And you can see all of its ratings and all of the metrics that we use. Add them to your portfolio here. The way that we decide which companies to add to coverage is driven by their membership In certain indices, we make sure that we cover the S&P 500 first, followed by the S&P 400, which is a mid-cap index. We cover all of the 500 and all of the 400. Next, we focus on stocks in the S&P 600. There are— let me show you the page for our methodology— the S&P 600, which is the S&P small cap. These 3 indices together are the S&P 1500. We are about 25 tickers shy of covering the S&P 600 at this point, so we will get there soon. And then we aim for companies on the Russell 3000. We also add to coverage IPOs that have more than $10 billion in expected market cap or requests from clients. So those lists of tickers that you send into us, We aim to add those to coverage as long as they're of reasonable size. We say here market caps of at least $1 billion and that they have to file with the SEC. So we have to have access to their filings and they have to be reasonably sized companies.

We had a question about coverage plans, more international stocks or funds, Canada, UK, and that is absolutely a large priority for us. We, we're working on that. That's, that's honestly one of the biggest things we want to do. There are a couple ways for us to do it. We can continue to improve our technology, and we have been doing that. In fact, we've made tons of strides this year in terms of the automated parsing. We could also hire a huge team of people to do it and knock it out that way. We're leaning on the technology. We're hiring some folks, and maybe some more folks are going to help us really meaningfully accelerate that. Our technology is, is amazing as it is, but has a ton of potential, primarily because of the hundreds of thousands of expertly parsed filings that our technology can use to build more and more automation. And machine learning has really developed to a point where we're at a place where we can really take advantage of all of that training data in a way that we haven't yet. So we're really excited to see what we're going to be doing over the next year in terms of adding companies to coverage. When it starts to happen, we expect it to start to happen really fast. We're sort of a scale batch-oriented business. We're not having people out there trying to dig holes with a spoon. When we go after this, it's going to be with a bulldozer, and we're getting the bulldozer ready.

Yeah, the machine learning really relies on accurate and complete data to work well, and you can only generate that data with a disciplined process. New Constructs has been a disciplined organization for its entire existence. And that really gives us a leg up on some of our competitors who might try to do this kind of work. The stats from Silicon Valley say machine learning-oriented startups spend over 90% of their startup capital on data scrubbing and data cleaning. The machine learning itself ends up being very little of what they spend their time doing. We don't have that problem at all. We have an excellent, accurate, and large set of data to, to help train this machine learning system on.

You can't—

Emphasize that enough, right? The accuracy of the data. And that's part of why the papers from Harvard Business School and the Journal of Financial Economics and MIT Sloan and Ernst Young are so important, because they are out there third-party validating the superiority of the data and the training data. And that's what's feeding into our technology. Most of what you see with AI and machine learning It's a black box, and I would urge you to be very wary of anything that's a black box. If you've done the work, you want people to see it and know it. That's why you see in all of our research and all these webinars, we will show you that reverse DCF. We will show you where we get that data from the footnotes. We want you to know how much work we're doing because we know it's right, and that's what our technology is based on. Be careful, folks that aren't willing to provide a, a commensurate level of transparency, because if you got it, there's no reason not to show it.

Yeah, we talked about this a little bit last week, but we have an advantage over many companies doing data collection and finance as well, because we are modelers of that data. We are users of that data. David and Kyle and Italo are using our models on a daily basis to write long research, manage the focus list and our other model portfolios. We build models with the data. We just don't pull it out of the SEC filings and throw it in a database and leave it up to someone else to use. We understand what the data is, what its relationship should look like to other data from the filing, and how it can be used in a model when that stuff makes sense and doesn't make sense. That's a powerful advantage. So if you have coverage requests, let us know. We would love to get them added to our list. And Q1 filing season is immediately upon us. We look forward to updating a large number of models for our customers. So I think now I would like to turn it over to Hunter Anderson, an analyst here at New Constructs, to talk a little bit about our FASB monitoring and tracking process. Thank you, Lee.

As an analyst team, we do quite a bit to sort of maintain the integrity of your models. One of those things is monitoring and following the movements of FASB. So people who aren't familiar, FASB stands for Financial Accounting Standards Board. It is a committee of individuals who are responsible basically setting all of the accounting standards for US GAAP to follow. And to give you an idea of sort of how that process works, somebody will say propose a new accounting rule change. So let's say they want to take operating leases that used to be off balance sheet, they want to put them on balance sheet. It will go through then a rigorous process of debate. Because if you can imagine with these accounting standards, there's a lot of stakeholders and all the stakeholders have sort of different perspectives and prerogatives of what they want. So like the companies themselves that have to produce the 10-Ks and 10-Qs, they have a certain perspective about what accounting standards should be. Investors have a certain perspective, and then data collectors like us also have a certain perspective. And I will say, David, back in the day served on one of those subcommittees for the investor side of that perspective. This is why it's relevant for us, because if certain accounting rules come out and they drastically change how companies go about disclosing certain things, it could impact our model in a negative way if we're not prepared for it. Now, we'll say that the vast majority of these accounting standards are not model affecting as we deem them, but the ones that are, we have to be prepared for so we're not caught empty-handed once these things hit the financial statements. So what Lee's sharing right now is the website, and then we categorize all of these accounting standards based off of when they're effective. So 2019 Qs, that's when all the, you know, accounting standards in that category started. That's when disclosure started. And then we'll also give clients a link to where it is on the FASB website, and then also a description of what the accounting standard is. And so we do this both for our purposes, because we need to track these things to make sure that we're staying ahead of the game. In terms of these accounting standards. We also do it for clients' perspective and benefits here by producing a description of what all these things are. So we wanted to give clients an idea of what this page represented and why it's something that we care deeply about. And I'm happy to answer any questions that we might have, but yeah, I think that's a good summary of what we have going on here.

I think this is a tremendous service. Having served on the Investor Advisory Committee, I mean, the amount and the volume of stuff coming out of FASB every day. And so much of it is noise, agenda setting. What are we thinking about, thinking about to talk about and do work on? And a lot of times the work that they do or the changes they make are entirely inconsequential to investors. And sometimes it can be extremely consequential when they change the operating leases requirements and other changes can be extremely consequential. And so there's, there's a lot of noise and not a lot of signal. And it takes experts to understanding the difference, understand the difference between the two. And so I think this is a really important service, super important, so that you not just can know what's going on with FASB if you're so interested. I would imagine that most of you could care less. You do care that we care so that the models that we're producing will continue to be the best in the world. Right. And they couldn't be if we were not paying attention, close attention to rules coming down the pike. Because what you don't want is for there to be some big accounting rule change and all of a sudden disclosures are different and our models don't adapt to that. And then now the models aren't as, as good as we, we'd want them to be or that you expect them to be. So this is a lot of work. It's expert work. Lee, we should be adding this to the model that shows how much value we're delivering every day because— The amount of time other people— the FTE, the number of full-time employees you need to have around to replace what new constructs does. It's a big number. It's a big number. And it's not just any FTE. It's going to have to be someone who knows enough about accounting to understand what the heck the FASB is saying, because let me tell you, that's not easy. And then also enough about finance to know whether or not those accounting changes are going to matter to your model. And those are 2 very different expertise. Rare to get those together. Hard to acquire. They don't teach it that well, certainly at all in undergrad. And very few business schools teach it. I know because I've been to most business schools and guest lectured on those topics. The professors have said to me in the past, yeah, I want you to come do this for me, David, cuz I hate it. I don't like it. It's no fun for me. And your system does it for 'em. Show 'em that. So it's— this is a big deal. It's a pretty cool section of the website. I'm really proud of the work that Hunter and Sam Moorhead, who leads the charge on this, is doing to keep on top of this. It's extremely valuable.

The FASB puts out notices almost every day. I would say 3 or 4 times a week we get information from FASB. It's almost never clear from the emails whether the thing that they're emailing you about is important or not. You've got to click through and read their agendas. It also takes years for these things to take effect, and they change radically over the course of those years. And Hunter talked a little bit about the stakeholders. Corporations and accounting firms have a big say in what happens here. Corporations are really motivated by compliance costs. It costs them a lot of money to report these things. A fair amount of the stuff coming out of FASB over the last few years has been about lowering the burden, reporting burden, especially on smaller-cap companies. And I completely understand why companies are interested in that, but it makes it harder for people who are trying to analyze the profitability of those companies to get a good read on what's actually happening. I'm really happy that David got to serve on the Investor Advisory Committee at FASB for as long as he did. I think that they try to listen to investors, but I don't know that investors are the ones paying the bills over at FASB. So I think it's a complicated process. The rules are complicated. We always say about disclosures that anything that's possible that can happen will happen. And I think that that's true in accounting in general. So These rules have to be pretty robust to handle all kinds of unusual business cases that maybe don't show up on your initial read on whatever the problem is. And it's also true on FASB's end. FASB puts these rules out and we update our models, and sometimes it takes a year or 2, honestly, for us to understand how companies are going to respond to those changes. They all have an idea about what they're going to do. The reporting in the first year was going to look one way for a bunch of companies, but maybe 5 or 10% of them found an interesting way to report that's cheaper or easier or better for them. And the next year we see 50% of companies switch over to using that. Someone finds a loophole and everyone rushes to fill it. It starts out as this tiny little hole. One year later, it's an expressway.

And part of the reason for that is because the— unfortunately, the folks at FASB don't really see the world that way. I remember when we were writing the rules for bringing operating leases on balance sheet and me and a few colleagues pointed out, other Investor Advisory Committee members pointed out, hey, if you do it this way, you're going to create a loophole. And the response from the board was, yeah, but it's a small loophole. And I was like, wait, wait, wait, you don't understand how this works. Every loophole starts small, but then everybody else jumps into it for no other reason than the fact that if they don't use the loophole, then their earnings look worse than their peers. So they're compelled to, otherwise their earnings look worse, their compensation looks worse, the company looks worse. So it's, it's not, it's not whether they're going to jump into loopholes, just it's, it's, it's when. And, and FASB doesn't honestly, given the complexity of all the accounting, they sort of struggle with like foreseeing the loopholes. And on the operating lease side, that loophole still exists. And that loophole is that companies can make up whatever interest rate they want for discounting their operating lease payments. And higher-risk companies can get away with a higher discount rate, which means their liability they report is lower. Which is an inverse expectation for a low credit quality company. They should have a bigger liability, not a lower liability. Anyway.

And we've seen operating lease disclosures change since they made those rule changes. The initial, the initial push by companies was huge amounts of additional disclosure about operating leases when they went on balance sheet compared to what we saw before. So we saw probably 3 or 4 quarters worth of extra disclosure about operating leases that we had never seen before. And now we see less than we saw before the rule change. We're seeing less breakouts of operating leases on the balance sheet itself. We're seeing less disclosure of future payments in the notes, especially in quarterly filings, seeing less disclosure about anything related to operating leases. So how companies respond in the first wave of filings after an accounting rules change is not a good guide to, to what the impact of that rule change is going to be long term.

And there's really no excuse for it because FASB is floating this out with the companies long in advance. They should provide best practices on disclosure so that we don't have to guess. There's no reason we should be guessing this. There's no reason. There's a, there's a good way and a bad way to do disclosure. And then that's a product that's in our product roadmap future. It's like a grade on the quality of disclosures because some companies do it a whole lot better than others. Typically, the better companies have better disclosures. Microsoft and Apple's disclosures tend to be pretty darn good. They got some really good business models. So again, in the spirit of, hey, if it's really good, you might as well show it, we see that with companies and their disclosures as well. But the operating lease thing was a disaster. It was all over the place. There wasn't a lot of good guidance. And, and I think that reveals a big hole in FASB's delivery, which is, hey, it's not just about changing the accounting rules. You need to have some influence on the quality of the disclosure that results. Otherwise, you're really maybe not doing investors any good. And so that's typically more an SEC problem as far as FASB is concerned, Securities and Exchange Commission. But guess what? Who knows how often the SEC is actually looking at annual reports by law? How often are they required to look at an annual report? The answer is once every 3 years. Once every 3 years.

They're not looking as deeply as we are looking.

No. And, and they're looking manually.

Yeah.

Okay. Yes, I know, because I talked to them about using tools that could do it automatically. Ours. And didn't get the warmest response.

I'll add one quick thing as well. If people are looking for a recent example that was pretty material, you can look at Berkshire Hathaway. I believe it started in 2018. The accounting standard was 2016-01. This requires them now to report all unrealized gains and losses on equity securities, which is like the bulk of Berkshire's business, on the income statement instead of going through OCI. So you see pretty significant changes in the balance sheet and income statement. If you were to look at like our model for Berkshire Hathaway, because we account for that accounting standard, you won't see volatility you'd get from just normal financial reporting. We smooth it out in terms of like reversing it and making sure that our models are comparable.

You're probably better going with the rating, Lee, and looking at the reconciliation page because it'll take a while for this to open. If you go to the reconciliation page, you'll probably be able to look at the net income volatility versus the NOPAT volatility.

There you go, Hunter.

Yeah. So they have to report like all the unrealized gains now. So it goes from very small to very large, but we account for this in our model. But this is a good example.

Yeah. Compare that to the NOPAT row, right? So there's huge amounts of volatility that you manifest in net income. Probably honestly one of the worst decisions FastBeat has made. Nobody thinks this is a good idea. It's part of a movement to try to mark more things to market as a way to let the market sort of help people value businesses. But you don't value businesses on the income statement. You don't really even do it on the balance sheet. Marking things to market is not really that helpful. We care about how much capital's gone into the business, not necessarily how much it's appreciated. That's in the stock price. Anyway, these are discussions that are easier for the finance people, harder for the accounting people. And it's the accounting people making the accounting and disclosure rules. So there's a bit of a mismatch here, and that's part of the value add for new constructs is that we're figuring that out for people. We're doing that translation for you so you get what you need to understand the profitability of the business and you won't see huge swings in reported or unscrubbed profits based on non-economic accounting changes. Like non-economic accounting. The numbers change because an accounting rule changed. There's no change to the business, but an accounting rule changed. That's bad news for people who want to track profitability. We're, we're going to capture that for you and make sure it doesn't happen. I got one, I got one piece of breaking news. Kyle, you go first. I got breaking news, but you go.

Yeah, I was just going to say when this change happened, Buffett actually was in his shareholder letter, said for analytical purposes, our bottom line will be useless. Flat out, bottom line, useless. And so what we're doing is making something actually useful out of that.

And real quick, my breaking news is zombie stock Snap is down almost 20% today. Helpful warning. Not so great. I think on the year it's down— it's only down 3%. It was one of those zombie stocks that took a big run there in January and February. And that's all coming back and then some. And we think that's going to continue to be the case. So snap out of it, as per the name of the report. We got a good reverse DCF on that one too.

We'll see you guys out on Society. I hope you have a lovely weekend. Please be sure to send us your questions over the week. You'll get great answers, not just from us, but from the larger community as well. Got a great community. Thank you for joining us.

Thanks.

Bye, everybody.