September 24, 2019
Tomorrow, Professor Joel Litman is unveiling his “Investment Truth Detector” system for figuring out the true earnings of a stock. (Sign up here to reserve your seat if you haven’t already.)
We were so impressed by Professor Litman and his “Truth Detector” that we sent feature editor Alice Lloyd to find out how he came to tell folks what Wall Street won’t – and why some of the biggest money managers in the world currently use his research.
The advantage of knowing what other investors don’t can be extraordinary…
One widely available stock has gained more than 1,000% since Joel’s system identified an opportunity in it… Another has doubled.
It’s incredible. And it’s simple: Just type in the stock ticker of any company you might own… and immediately see its true earnings number – plus where it’s likely going next.
We urge you… If you own any individual stocks, sign up for Joel’s event right here.
Today and tomorrow, we’ll be sharing Alice’s feature in two parts. We hope you find it as fascinating as we do.
What Wall Street Won’t Tell You
By Alice Lloyd, Feature Writer
Meet Joel Litman. He strikes an imposing, even otherworldly, presence… particularly if he’s recently flown in from his firm’s office in Manila. There, he commands a corps of number-crunchers, expertly trained in tracking down the Platonic ideal of pure valuation.
I’m accustomed to seeing finance gurus in Dockers and Patagonia vests. So I was surprised to hear that Litman always wears a three-piece suit. When we met on a late-summer day in Baltimore, he’s paired said suit with wingtips, a pared-down paisley tie, and a Patek Philippe watch. The uniform rarely varies, he tells me, even when he’s on-site in the South Pacific.
It’s there, his home for half the year, where he oversees his staff of about 100 eagle-eyed accountants. Their work – correcting financial statements line by line to account for the 130 worst flaws and inaccuracies built into the standard rules by which accountants measure value – is as technically tedious as it sounds.
But what it all amounts to is more thrilling: a sort of hard-won secret knowledge that comes from not just knowing the rules of accounting… but knowing better.
Knowing, in other words, what’s wrong with the rules that dictate how companies are valued.
Because as Litman says, there’s plenty wrong. And knowing how it’s wrong is valuable.
Litman and his team give their clients a perspective on the market that ordinary analysts either don’t know or conceal from all but a select group of investors. And the locus of this labor – as far as humanly possible from Wall Street – makes me feel like I’ve wandered into a Joseph Conrad novel.
For one thing, you’d be hard-pressed to get an American investment banker to build a painstakingly detailed database like the one his staff has developed over the last decade. Why not? “Because it’s boring!” Litman says. “It’s profitable, especially in the long term, but it’s not fun.”
What Litman has built since his firm, Valens Research, got its start in 2009 was made possible by hard work, yes. But also by the fact that the rules of accounting misrepresent actual values – more so than most investors realize.
Frequent weekday readers of the Financial Times may already know this. (I’m an infrequent weekend reader myself.) The standard system of rules that accountants use is often wrong. Litman’s ever-growing database corrects 130 of the most egregiously misleading errors baked into the rules system.
Some, like the rule that dictates how accountants evaluate research and development costs, are philosophically flawed: Are research and development costs an investment in future profit, or a loss? Often it’s the former, but not according to the accounting rules.
Others, like the rule that dictates how accountants report pension costs, were altered for short-term political expediency: “The pension accounting rule was developed by Congress in the 1990s to save the market from the appearance of loss in a high-stakes year for recession recovery,” Litman explains when I ask for the third or fourth time how on earth it all got so very, so convolutedly bad. “The rule was written to hide what would have looked like one bad year but could have been explained away. And it set in place a quarter-century of confusion.”
When you think about it, it almost makes sense: Accountants are a put-upon people. They do the math. They follow the rules. Even when they know the rules are wrong, they still follow the rules. I mean, they’re accountants
But what if one day, an accountant took a look around at his rule-following colleagues, stood up from his desk piled with financial statements that the rules of his trade had left him no choice but to mangle – and said, “Enough is enough!”
Well, that’s basically what Litman did.
After most of a decade on Wall Street, he’d developed an even greater distaste for the way capital markets are reported. He published a case study in the Harvard Business Review, “Give My Regrets to Wall Street,” about a company weighing whether to go public or stay private. Its assessment of the downsides of leaping into the wild (and, Litman emphasizes, meaningless) world of public valuations was uncomfortably honest. Two years later, he left to start Valens Research.
He recruited Rob Spivey, an old protégé from his days on Wall Street, and opened a small office in Cambridge, Massachusetts, which is still their stateside home base. Even as a 19-year-old intern at Credit Suisse, Spivey stood out to Litman. His grasp of Wall Street’s biases was surprisingly sophisticated: Reporting real values to the public would never be a true priority at an investment bank whose primary loyalty is to its clients’ earnings. “When it comes to reporting values, the question for Wall Street is always going to be, ‘At what point do you become biased toward your clients?‘” Spivey says, when I asked why he chose working with Litman over the Wall Street life favored by some of his business school classmates. When I asked whether he ever regrets it, he said life with Litman is more exciting: “You know you’ve got a little bit of an edge – and you know you’ve earned it.”
The calls they’re most proud of at Valens are contrarian analyses they were able to make with confidence because they knew what was wrong with the rules. And because they’d done the tedious math. Facebook (FB), for instance, is a favorite…
When Facebook went public in 2012, the conventional outlook was, “As reported, it looked like a terrible company,” Litman recalls. “But the reported values were wrong: They were pouring money into research and development, and paying employees with stock options” – both of which misleadingly undermined Facebook’s reported value at the time, because of the peculiarities of the accounting rules. And, just as Valens predicted, Facebook rebounded.
Their call on Planet Fitness, too: “A ton of people said the stock was a short,” Litman grins. “They said, ‘I don’t know what these Valens guys are saying, this doesn’t make any sense.'”
And they were right, it didn’t make sense. Planet Fitness looked like an absurdly bad call because its strip-mall storefronts are leased. The accounting rule for valuing leases – a rule which, Litman explains, was so flagrantly misleading that its reform finally took effect this year – and the rule for deferred tax liability, which remains in place, grossly exaggerated their losses. Based on Litman’s read of the reported financials, he found, “Their expansion would actually cost a lot less than people thought. And the earnings that they generated ended up being a lot more than people thought.” The stock went up several hundred percent. And best of all for Valens and its clients and friends, everyone else had been looking the other way. It was an unloved company – its growth invisible absent an excruciatingly close read – and a radical idea.
Making the case for these calls sounds almost farcical the way Litman recounts it. He’s a kind of anti-Cassandra, saying, “It’s actually a great company: You’ve just got to look at Note 19 on page 78, then you’ve got to look at Note 25 on page 140 – and if you’re not looking at that detailed level, you’re not going to see the true numbers”…
Tomorrow, we’ll share the second half of Alice’s feature, so keep an eye on your inbox. Until then, here are the stories we’re reading…
News reports often give the impression that human beings have wrecked the earth, the middle class is disappearing, and the world is getting more dangerous… But our instincts are wrong. We needn’t be so scared…
In the past the Saudis have always been able to step up to the plate and meet what’s missing… This is a different situation because the country with the greatest spare capacity is the one hampered.
It’s a simple idea. When you’re the highest bidder, you almost always overpay… Unless you know something that everyone else is missing.
And let us know what you’re reading at [email protected].
Assistant Editor, American Consequences
With P.J. O’Rourke and the Editorial Staff
September 24, 2019