Understanding Hand-Wavy Finance

In this podcast, Motley Fool host Ricky Mulvey and Motley Fool Live programming manager Anand Chokkavelu take a look at the techniques behind "hand-wavy finance," and how companies like to capture your attention.

They discuss:

• How Apple repeatedly "blew away" Wall Street analysts.
• The big bath strategy for reporting bad news.
• What previous hype cycles can teach investors about the latest, shiny new thing.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on July 15, 2023.

Anand Chokkavelu: What he'd do is deliberately lower Wall Street expectations so that Apple could just utterly blow them away each quarter. To do this just repeatedly and it's amazing that he could keep lowering expectations after a blowout quarter. If happiness equals reality minus expectations, Jobs' reality distortion field that helped create some seriously happy investors each and every quarter.

Mary Long: I'm Mary Long, and that's the Motley Fool's, Anand Chokkavelu. Ricky Mulvey caught up with Anand to uncover the techniques of handwavy finance. They discussed how companies draw attention away from bad news. The reasons why businesses like to adjust earnings. One investment, that's the opposite of handwavy.

Ricky Mulvey: Anand before we get into it, what is handwavy finance? This is not an economic definition you can look up.

Anand Chokkavelu: No, not at all. It's squishy as it should be. It's handwavy.

Ricky Mulvey: Yeah, it is squishy. There's something in between. It's not an outright fraud, but it's also not just like buying an index fund. It's somewhere in that like in-between land where you start seeing the handwavy finance. This is, in my opinion, it's, you see it a little bit in earnings calls. A lot of it is when you're seeing investors or CEOs trying to draw attention to a very specific thing in order for someone to not pay attention to another thing.

Anand Chokkavelu: Yeah, it could be. It could be misleading, but it doesn't have to necessarily be. It could be just focusing on the future for our future. But does something that distorts reality a bit.

Ricky Mulvey: I think one example you brought up, it's when you see a little bit of handwavy finance. That's when someone's talking about the shiny new thing.

Anand Chokkavelu: Absolutely, right. We're all talking about like, how many times did they say AI in this? It used to be crypto and used to be whatever, 3D printing, anything like that. It's got that teacher telling a parent your kid is special. It's telling us what we want to hear, you're into AI. Great. Thank you, Coca-Cola or whoever.

Ricky Mulvey: Yep. We're all into AI. I looked into this basically on earnings calls, ESG is out on it and AI is in. FactSet, looked at like looks at mentions of these things. One hundred and fifty six mentions in quarter four of 2021 of ESG that's been cut in half in the first quarter of this year. However, when we're looking at AI mentions that's 2x from last year, about 400 mentions in quarter four of 2022, and then over a 1,000 mentions in the latest quarter of 2023. There's institutional thinking and handwavy finance because one way to spot it is there's usually not a lot of like unique perspectives. You're like I'm seeing this again.

Anand Chokkavelu: I'm actually surprised it's just 1,000.

Ricky Mulvey: Plus 2x.

Anand Chokkavelu: I would buy on more mentions of AI in the next quarter.

Ricky Mulvey: You also brought up, and I think this is interesting to full commitment of handwavy, which is in many cases, we're rebranding our accompany.

Anand Chokkavelu: Right. Anyone can just mention the word a few times on a conference call, but it takes a little more to just totally pivot your company, name it I mean, we all, we all remember the, or at least here about your late '90s tech bubble where you just add a .com and all of a sudden your stock triples. More recently there's a company C3AI, that previously it was C3 IoT. It's also got the AI stock symbol, which is huge.

Ricky Mulvey: Shout out, would that be their investor relations department? That's a pretty good one.

Anand Chokkavelu: I don't know. I mean, I would think it would be Siebel though, the founder, CEO. But maybe it's just some person that the company, whoever thought of it. I guess brilliant in the handwavy space.

Ricky Mulvey: I mean, that's the question. One question is does Medaccount is this now? We're no longer [Meta's] Facebook, we're a full metaverse company. Even though we just dropped a pretty game-changing social media app in the name of Threads. Now I don't have combining two events that happened years apart. However, it does seem like that was a company that makes its money doing something very specific, which is advertising. But don't think of us as that, don't think of as that audit work. We're a metaverse, we're a virtual reality company now.

Anand Chokkavelu: I'll definitely say the vision is the handwavy, although you have to give Zuckerberg credit where you don't want to totally discount them or anything like that. But there is some real stuff where they're spending a lot of money each quarter on it. You can't say it's completely handwavy. But the question for us is, looking back 10, 20 years, we'll know if it was handwavy, if it worked, but then again, it's also taking a risk.

Ricky Mulvey: To me, handwavy is also, you can see it in repositioning. I would say this is the more harmless handwavy type of stuff. You mentioned it with the AI in conference calls. You're seeing that with Kroger, the grocery got a lot of heat for CEO Rodney McMullen brought up AI eight times in the latest fall, and Rodney did not need to do that. [laughs]. If all he said was just data sides and machine-learning because it was basically about their stocking programs for grocery stores. They're like reward systems for shoppers, which they have like data sites, they have pretty good data science teams working on that is they can recommend you Oreos or give you $0.10 off a gallon of gas to encourage you to shop a little bit more. But he didn't say data science as much as he should've. He said artificial intelligence and then the stock drops a little bit and then it creates an image that you don't want to see on that beloved grocery franchise or grocery chain.

Anand Chokkavelu: It is the perfect example of Kroger where we're all like, that brings it home. Again, it's computers. It's just computers have progressed and we just call it different things over time. Whether it's any machine-learning was the AI before AI.

Ricky Mulvey: Yeah.

Anand Chokkavelu: It goes back to using that smartest sounding language you possibly can. I've got a buddy who did the Rubik's Cube now, and he amazes my kids and it's great. He was talking about it and he started, he started saying, algorithm, I'm using an algorithm to do it. He wasn't trying to sound smart is the opposite of the guy. But you're like, yeah, you know what? That sounds like a heck of a lot better than process or step-by-step instructions or I watched a YouTube and just did that. [laughs]. Algorithm that sounds good.

Ricky Mulvey: I like that. I'm going to steal that actually. Why did you do that? I did it because of the algorithm. Like you can question YouTube. You can question your step-by-step instructions, but it's harder to question the algorithm.

Anand Chokkavelu: Even better fits your algorithm. My algorithm, my personal algorithm.

Ricky Mulvey: What other way to spot some handwavy stuff in investing in finance is to look at where the bad news is and how companies addressed that.

Anand Chokkavelu: Right on basically, you want to see it in the headline. But this is the president Lincoln attends our American cousin award. You see it all the time where the best is you just put it in the headline and get it out of the way. The worst is you've got a headline that just says something positive that isn't, anywhere near. I know we're going to talk about some of these. Do you want to talk about your Adidas example on this?

Ricky Mulvey: Let's talk about Adidas because I think this is the best way. First of all, Adidas and I keep going back to it. I think it is one of the most just unhinged earnings calls that that I've ever seen or read. I adore it. CEO comes out and so for contacts right now, Adidas is dealing with essentially a lot of loss of an inventory problem. They had a deal with Ye the wrapper, formerly known as Kanye West. After enough pressure, they had to break ties with him. This was the main profit engine for the company. Now you have multiple problems one, how do you make up for that lost profit? Then also, you have a lot of these just choose sitting in a warehouse. What do you do with them? They've elected to sell them and then donate some portion of the proceeds to charity. But anyway, in the latest earnings call CEO Bjorn Gulden just comes out strong. He says, ''I think it starts actually with the front page where here you see the jerseys that we've made for all the teams that will play in the world cup for women in New Zealand and Australia this summer.''

Don't worry about our inventory problems, we're making some sick [laughs]. Were vacant subsectors, these out here for Adidas after that. But then if you look at the numbers and I'll quickly go through them, €5.3 billion and sales, which is basically flat. Then as we have to look these days, if the missing Yeezy, but we're actually up 7% without that. But then if you look at the gross profit, we've lost about 5%, which is not good. But that's also because of discounts in write-offs of inventory. Below that, we get to the fact that they've missed top-line sales in North America, which according to the CEO, ''It seems dramatic and it is, but it's also what we planned.'' Then it is only after the celebrity collaborations, the music festivals, a small gain in OpEx and e-commerce miss a streetwear line that we get to this point about inventory, which the CEO says, ''Just a quick one on that. As you can see, we have about €6 billion. The Yeezy part of that is €500 million. If you remember back in Quarter 4, it was €400 million. It tells you there was another €100 million that came in. It is what we told you when the contract was broken, we had these things in production that we continued not to what I should say, half the people in the factory lose their jobs. As you can see, the €100 million has been delivered into our inventories and also on the books in Quarter 1.'' I will stop there and I know that was a long one, but that to me that is handwavy at his waviest finest.

Anand Chokkavelu: That is 100 million in inventory. I have problems. That's a big and everyone knew about the Kanye West thing and that's what you're tuning in for. Not jersey promotions [laughs].

Ricky Mulvey: There's also, you brought this up, which is the way that CEOs use comparison baselines. That can often be used for some handwavy finance stuff. Give yourself a small denominator and you can make those increases seem a lot better.

Anand Chokkavelu: Yes. This is the I'm 27% taller than I was in the fifth-grade category. All true. I'm still 5'6. This is Nautilus. The exercise equipment maker that's not Peloton.  Their first meaningful line in their press release for the Q4 was direct segment net sales of 139 million up 16% versus pre-pandemic fiscal 2020. That sounds pretty good.

Ricky Mulvey: That's like 2019 going into early 2020?

Anand Chokkavelu: Yeah. Because their fiscal year ends early in the year. Basically, you're thinking, OK, up 16% versus some period of time ago. Two or three years. But then 339 words later, they talk about their actual net sales in the fourth quarter and how it's down 42.9% versus last year. That's really what happened in that quarter. They're down 43%. But the headline is up 16%.

Ricky Mulvey: Give yourself low expectations and you'll never be disappointed. The one place where it would seem like it would be harder to hide this handwavy stuff audit is the earnings statement. But companies have ways of adjusting that.

Anand Chokkavelu: That's the numbers. The basic thing of earnings is net income. Well, if that doesn't work, companies go to operating income or EBIT, earnings before interest and taxes. Which is actually useful in comparing companies because it ignores debt. Where some companies have debt, so they'll have that interest payments, some won't. You can normalize that. But to be clear, we're still pretending that there are no interest charges or taxes and that thing. But fine, if that's not great enough, EBITDA. Now this is very popular with folks. That's adding back depreciation and amortization to the EBIT number. Now remember you still have capital expenditures which don't show up on that income. That's the equivalent of depreciation. You're ignoring CapEx that you need to do.

Ricky Mulvey: That's the stuff that you need to invest in your factories, your equipment, that thing. As you make those big purchases, you're able to slowly write-off the value of that expenditure.

Anand Chokkavelu: Correct. Now, if that still doesn't work, you can adjust EBITDA. Now you can add back things like stock-based compensation and restructuring or one-time charges. That gets really tricky. Then if that still doesn't work for you, adjusted EBITDA, you can promise adjusted EBITDA profitability at some point in the future. 2025, 2026, we've got a plan.

Ricky Mulvey: Let's go back to the hardcore finance stuff though, which is financial engineering. The ways that companies can use some of the handwavy stuff for and against Wall Street analysts.

Anand Chokkavelu: Absolutely. Let's talk about three of them right now. One is sandbagging. Steve Jobs used to do this for those who used to even vaguely follow Apple back in the day. What he'd do is deliberately lower Wall Street expectations so that Apple could just utterly blow them away each quarter. To do this just repeatedly, and it's amazing that he could keep lowering expectations after a blowout quarter. If happiness equals reality minus expectations, Jobs' reality distortion field helped create some seriously happy investors each and every quarter. That's sandbagging.

Ricky Mulvey: Can we stay on sandbagging for a second?

Anand Chokkavelu: Yeah, please.

Ricky Mulvey: Because that ends up creating a problem for Apple. Because the expectation becomes them blowing out predictions every quarter. This becomes a problem down the road for Apple when it becomes a company of a certain size, and it becomes a little more difficult to just blow out sales goals every quarter. This is in contrast to what Jack Welch did at General Electric, which is, I will meet those expectations to the penny. This is what you can expect and this is what I will deliver versus what Jobs did, which is, I'm going to blow it out every quarter.

Anand Chokkavelu: Both have issues. We'll talk about that in a bit of like, well, how do you get to that exact number each time once you promise it? But I'll say Apple, it's been pretty much flawless in almost every way in the last 15 years, at least as an investor. What happened there was eventually when Tim Cook took over for Steve Jobs, maybe the best transition ever. I mean, unfortunately, Steve Jobs died to make that transition where you don't have him second-guessing what Tim Cook's doing. But they're very different people. Tim Cook was a logistics guy, and he's a lot more deliver what I promise. A few years later, they just pretty much in one quarter just said no, we're not doing that anymore. We're just going to give you a reasonable guidance and we're done. They transitioned well, and they've been fine.

Ricky Mulvey: Let's move on to the next one which is the big bath.

Anand Chokkavelu: I don't hear it used as much anymore. But the big bath theory, to give you the real-life example. I keep crashing my car. But if you crashed your parent's car, it might be a good time to slip in the oh, here's my report card. Versus doing it and then a week later getting dinged for your negative report card too. But for companies, it's oh gosh, this one-time item or this whatever is going to be really bad this quarter. Let's throw all the bad stuff so that future quarters look great by comparison and management can write a comeback story. The COVID stuff is an amazing big bath opportunity, if you time it right.

Ricky Mulvey: Do you think that's something that investors should watch then which is, hey, is this company just throwing all of the bad news in at once so it can just get it out of the way for future quarters or is this a dangerous way to bet on turnarounds?

Anand Chokkavelu: Yeah. I guess it really doesn't change the calculus there. You either believe in management and what they're doing in a turnaround situation or you don't. If you do, then you actually want management to do this. Because it'll take the stock price, if you're buying, take the stock price even lower in the near-term and if you'll recognize that, oh gosh, all this stuff's going to turn around in the next year and they're not going to have these headwinds, they're going to become tailwinds, that's an amazing time to buy a turnaround.

Ricky Mulvey: I think one key I would say flagged the big bath move is going on is anytime a company is cutting its dividend. Because that's essentially the worst news it could deliver to its investors. Maybe see what other news is going on as they deliver that.

Anand Chokkavelu: Yes.

Ricky Mulvey: Then smoothing earnings. This is some more financial engineering that maybe can be a little handwavy.

Anand Chokkavelu: This may be some of the stuff GE would have to pull back in the day. There are lots of accounting games management can play to hit their various incentives as you were talking about with GE. But for example, banks. There's a whole range when you really look at how they account for bad loans. It's pretty wide. Because you have to make a lot of estimations on which loans you're going to default on or which group of loans, and you can be aggressive or you can be conservative on it. Savvy CEO might be extra conservative, which is a term we think of as positive during a particularly good quarter. Now you've made your rainy day wiggle-room to prop up of future bad quarters and you can smooth things along pretty well there. That's just one example.

Ricky Mulvey: And I still don't know if that's a bad or a good thing, which is the ultimate handwavy. This is what we're looking for in handwavy finance on it.

Anand Chokkavelu: That's right.

Ricky Mulvey: I liked this example you also brought up of handwavyness, which is the admission to past mistakes.

Anand Chokkavelu: It's that, our pizza used to suck strategy that we taught from Domino's where they had that commercial where they're like, hey, it used to suck. They're not saying that our current pizza stinks. It's easy to admit those past mistakes, it's very rare to admit a real mistakes in the moment. Everyone used to be an awful dresser in high school. But this particular tracks suits that I'm wearing right now is awesome. It won't be bad in time. But the question is, we talked about this a little earlier, do we actually want these people to tell the truth in real-time? If I'm a hiring manager and I'm hiring someone, I don't want to hear, yeah, I was really spectacularly bad at my last job, which by the way has very similar roles and responsibilities to what I'm interviewing for. I'd be thinking, well, I like the honesty but what else do you not get about human interaction? As a manager, am I always going to be putting out fires? As investors, do you really want the CEO who's just telling the god-awful truth at every moment when they need to be executing against things and having people file behind their vision, and their employees to be doing work that they think is meaningful every day?

Ricky Mulvey: Things are really bad right now.

Anand Chokkavelu: You definitely need to be the optimist as the CEO.

Ricky Mulvey: I don't want this to be completely about handwavy stuff. I think it's worth finishing off maybe by talking about a non-handwavy investment. Non-wavy style of investing. To me, this goes to Vanguard. You can make investing as complex or as handwavy as you want. But you can also just buy the entire stock market for a low-cost index fund and save your money in there automatically. The ticker is VTI, is the Vanguard total stock market index fund. It's one that I've used for some of my savings. And you just get the entire stock market. All of the handwavyness, all of the sales, all of the gains, it's captured into this exchange-traded fund. You don't have to worry about the finer details in some ways.

Anand Chokkavelu: You get Tesla, you get all the handwavy AI companies, you get the ones that do not talk about AI and just execute. You get it all. If there is any antithesis to handwavy, it's Vanguard. If you've ever read a Jack Bogle book, oh my gosh. It's brilliant but it's dry. Because it's just telling you very simple things. He won exercise, buy an index fund, just buy all the companies and invest in the American economy or the world economy and be done with it. 

Mary Long: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy yourselves stocks based solely on what you hear. I'm Mary Long, thanks for listening. We'll see you tomorrow.