Is a big writedown lurking in your portfolio? Keep an eye on goodwill

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It is fair to assume that few investors lose sleep over the accounting treatment of goodwill on the balance sheet of companies in their portfolio. That may be about to change for several reasons.

The CFA Institute recently published a report that suggested investors should get up to speed on the issue for two reasons: Goodwill is a surprisingly large item on the balance sheet of many companies in developed economies, and the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are both revisiting current procedures.

Not mentioned by the CFA Institute is a third reason for zeroing in on goodwill: Investors are scrutinizing growth stocks with more intensity and those that disappoint are marked down severely. Goodwill is not confined to growth stocks, of course, but companies that grow rapidly through acquisition tend to have greater exposure to goodwill and other intangible assets than old economy manufacturers. Understanding the accounting is critical for an investor valuing a serial acquisitor.

First, a reminder of why goodwill appears on the balance sheet initially. The figure represents that portion of the purchase price in excess of the value of the assets of the target company after they have been adjusted to fair market value. Why would the acquiring company pay a premium over the value of assets that have just been marked to market? Perhaps they feel that they are better operators and can extract more profits from the same assets, or maybe there are synergies where one sales force can now offer a wider suite of products. Other intangibles that also may appear on the balance sheet after an acquisition are patents, customer lists and service contracts for which a specific value can be attributed.

With this as background, how big an item is goodwill on the balance sheets of companies these days? According to the CFA Institute study, as of 2019, goodwill represented 9.3 per cent of total assets of the S&P 500 companies and a more dramatic 42.2 per cent of shareholder equity. For Canada, the numbers were 3.6 per cent of assets and 26 per cent of equity. In the unlikely event that all goodwill were written off at a stroke, then 23 per cent of S&P 500 and 11 per cent of Canadian companies would have negative equity.

Which brings us to the accounting issue. The treatment of goodwill has been under regular debate for decades. In 1970, the preferred methodology was to amortize the sum over not more than 40 years, but in 2001 the FASB switched from amortization to retaining the full amount on the balance sheet, subject to a periodic review. If the calculated fair value of the net assets fell below the carrying amount of the goodwill, then some or all of it would be written off. The IASB adopted a similar standard for international reporting.

Even if you are not an accountant, you can imagine that this periodic review was difficult, time-consuming and open to subjective assessment by management, so it was a source of regular complaint. As a result, both the FASB and the IASB have reopened the debate. According to the CFA Institute, the FASB favours a return to amortizing goodwill, while the IASB prefers to retain the existing policy of leaving the entire amount in place unless there is impairment, but with better disclosure.

As individual investors, we are not a party to this debate, so there is no point taking sides, but we should be alert to those companies in our portfolios with a large exposure to goodwill under either scenario. Goodwill and other intangibles have a tendency to disappear overnight as investors in Nortel Networks will recall. At year end of 2000, Nortel’s intangibles were US$19-billion. One year later, they were US$3.1-billion and shareholder equity cratered from US$29-billion to US$4.8-billion.

None of this is to suggest that there is no value to intangibles. With developed economies increasingly moving toward the service sector, many companies derive a large part of their market value from intangibles such as brand names, customer loyalty, patents, etc. For years, investors have recognized that the assets of advertising agencies and asset managers ride up and down the elevators every day (before work from home became the norm), so even value investors look beyond the bricks and mortar when analyzing a company.

There is general agreement that intangibles have value. The issue is, did a company that has grown through serial acquisition overpay for some of these takeovers so that the goodwill is currently overstated? Paradoxically, companies that have not grown can also be prone to writedowns of goodwill as new management faces the reality of past mistakes. In my own portfolio, I note that Laurentian Bank of Canada LB-T wrote down the entire goodwill associated with its personal banking division last fiscal year although there was allegedly zero impairment the previous year. No doubt the arrival of a new chief executive sparked a review of the assumptions.

Using the CFA Institute study as a rule of thumb, we can say that if goodwill and other intangibles represent more than 25 per cent of the equity of a company in your portfolio, you might want to dig a little deeper. For example:

• When the company was making acquisitions, was it paying a multiple of sales or earnings far in excess of industry norms at the time?
• Or, have all multiples in the industry shrunk so that what seemed reasonable back then now looks extravagant?
• Has a new management team arrived with a mandate to clean out the excesses of the past?
• Have revenues and margins improved in recent years, or are the promised synergies still not yet in evidence?

Answers to these questions may alert you to the possibility of a writedown of goodwill or other intangibles in one of your holdings. Often, the market has known for some time that the intangible value has evaporated, but it is always better to be ahead of the crowd.

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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