Category Archives: Finance

Resulting

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A quick thought here.

Recently, there have been a number of articles comparing the performance of those investors who left a portion of their portfolio in “safer” assets coming out of the Great Financial Crisis (GFC) versus those who took a more aggressive posture and were mostly or all in equities.  I will pick on this one:

Go To Extremes

I get it.  If you look at asset performance over the last ten years or so, the returns of U.S. equities look fantastic.  Holding anything but U.S. equities has been dilutive to portfolio performance.

Be careful though just focusing on the results of the last decade and making the leap that holding mostly U.S. equities was a good decision. Or that should be your strategy going forward.  That would be called “resulting”.

Resulting” is a poker term that refers to our habit of judging a decision based solely on the outcome it produced. – Thinking In Bets by Annie Duke

A good outcome is not necessarily the result of a good decision.  And vice versa.

Questions To Ask About Your Stock Options

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This is not financial advice.  Talk to a financial advisor if you need financial advice.

Congratulations!  That job offer you just received included a stock options award.  Welcome to the big time!  Or something…

The question everyone wants to know is what could those stock options be worth.  But it seems like a lot of employees are afraid to ask.   Don’t be afraid.  

I am going to assume that you understand the basics of options.  If not, there are plenty of articles covering option mechanics.  Here is one from Morningstar. There are plenty of others.

If the options are for stock in a publicly traded company, then this is probably a relatively easy question to answer.  They are probably worth $0 when issued – as the strike price will correspond to the current stock price and most of the other relevant information will be publicly available.  

However, if we are talking about a privately held company, then you need to collect some data to ascertain if those options are your path to a life of luxury or just a little extra kicker.  I am a firm believer in finding ways to accumulate wealth that has leverage, and owning part of business is certainly a good way to do this.  But, if we’re talking private companies, then generally it will take some sort of liquidation event (i.e. a sale of the company) to trigger any payout, so all that is baked into my comments below.

Fully Diluted Share Count

First, to evaluate how much those options might be worth someday, you need to understand how many shares are outstanding.  In other words, how much of the company do your options represent?  So, I personally would phrase this question as:  What is the fully diluted share count?

This matters because if a company is worth $150 million and there are 50 million shares, then every share is worth $3 dollars.  Your options would be worth:  Option Count x ($3 – Your Strike Price).

You need the total share count to help you estimate how much a share could be worth at different valuation numbers, for example.

Who Gets Their Money Before Shareholders

Second, you also need to know if anyone is going to get paid out before the shareholders.  There can be a number of mouths to feed before shareholders see any proceeds including the following:

  1. Bankers, Lawyers & Any Transaction Fees
  2. Working Capital Adjustments
  3. Debt
  4. Preferred Shares

For simple math, you can probably ignore the expenses related to bankers, lawyers, and other transaction fees.  This is not to say they are going to be small.  But we are doing horseshoes and hand grenades math here.

Same with the working capital adjustment.  This is a purchase price adjustment due to estimating how much money is going to be left in the business by the sellers vs. how much actually gets left behind.  Since the negotiations typically take place several months before the close, an estimate is used and then trued up based on actuals.  But for our purposes let’s ignore it.

Debt.  This is not to be ignored.  If you sell the aforementioned business for $150 million but there is $50 million of debt, then only $100 million is left over for shareholders.  This, as a shareholder, you care deeply about.

Preferred Shares.  This could be a topic of an entire post, but for simplicity, you should understand that there can be different “classes” of shares and each class may have different provisions.  The provisions you care most about is the preference in the proceeds waterfall.  Let’s say in the aforemention business with 50 million shares, that 25 million are Participating Preferreds that get paid out at $2 a share.  And then participate ratably with the other 25 million Common Shares.  So, take your $150 million purchase price and subtract off $50 million of debt.  Then take the remaining $100 million and pay the Participating Preferred their $2 per share ($50 million), leaving $50 million.   Then all shares, both Participating Preferreds and Common Shares, get the rest, so each share is worth $1.

So, as a Common Shareholder, you also care deeply about Preferreds.

Valuation

This one is a bit subjective, but you should have some decent data points.  The strike price on your options should be a reasonable approximation of how much the company thinks the shares are worth today.  Under IRS guidelines, you should not be issuing shares under fair market value.  Now for private companies, that can be highly subjective, but at least you have a starting point. And the fair market value should take into consideration any of the considerations above.  You can take the strike and the total share count and work backwards to get a total equity value and if necessary, add back any debt, to get a total company value.   

Some companies, depending on their culture, may consider some of those data points to be confidential or at least highly sensitive.  If that is the case, then I think it would be an extremely fair request to ask if they could put together a schedule that showed the potential share price at various valuation levels.  They could bake in all the items above, without having to disclose them specifically.  

I am always a little surprised by how many employees do not ask these questions.  But , hopefully that helps you evaluate any stock option awards that you have been offered.  

I Am A Closet Active Investor

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I am a closet active investor.

This statement is partly predicated on the fact that most investing decisions, including purchasing index ETFs, contain an element of active decision making.  Unless you are 100% invested in the entire market, even the index ETF selection process involves the selection of asset classes, which is by definition, an active choice.  

As Rick Ferri, perhaps the most notable expert in the world when it comes to indexing says, “there’s no such thing as passive investing. It’s true. Passive investing in its purest form doesn’t exist. Only lesser degrees of active management exist.”  – The Myth of Passive Investing

In fact, some research suggests asset class selection is potentially the most significant driver of returns.

“More than 90% of the variability in returns for institutional portfolios had to do with the asset allocation decision.” – Four Investing Lessons From David Swensen

Also, I believe that a lot of the research on “passive investing” vs. “active investing” is based on periods of history where the aggregate level of “passive investing” was much lower than it is today.  So it will be interesting to see how those relationships hold up as the amount of “passive investing” increases to a much higher percentage in the research dataset or if that relationship changes and additional opportunities for more active selection decisions present themselves.  Further, we have had a fairly long stretch of broad gains across almost all asset classes, which seems like the perfect environment for less active decisions.  It is possible the environment will change in the future.  I may write more on all that later.

Based on my investing philosophy, I have a portion of my portfolio that is invested mostly in the equity of individual names.  The starting point is based on some of the tenets laid out in Joel Greenblatt’s book, The Little Book That Beats the Market

I have been doing this for over a decade.  And I have created a little bit longer checklist as I have attempted to enhance my investing decision making process.

So, for your enjoyment, here is my investing checklist:

This is not investment advice.  Use at your own risk.  If you do use this checklist, you will likely be publicly shamed based on your under-performance, generating excessive fees and taxes, lack of non-income producing assets in your portfolio, and knowing what EBITDA means. Other legal disclaimers.  Blah, blah, blah.  

Risk Adjusted Returns

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In today’s low rate world, where growth is becoming harder to come by, focusing on risk adjusted returns is more important than ever.

“A risk-adjusted return is a calculation of the profit or potential profit from an investment that takes into account the degree of risk that must be accepted in order to achieve it. The risk is measured in comparison to that of a virtually risk-free investment—usually U.S. Treasuries.” – Investopedia

Dividend stocks might yield 3-4%. Which feels better than the 1-2% you can earn in treasuries. And way better than the 0.5 – 1% you can earn in money markets or CDs (if that is even possible).

What are you trading for the extra return.

Risk.

Is that a good trade right now? Don’t know. Been thinking about it a lot though.

“The answer is that there is no, and can be no safe, dependable way to make a high return in a low-return world,” Marks said. “It’s too good to be true.” – Howard Marks

Photo by AbsolutVision on Unsplash

EBITDA Is Not A Good Proxy For Cash Flow

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Do not say “EBITDA is a good proxy for cash flow”1

I worked as a cash flow lender for quite awhile and never heard a colleague at our institution ever say anything to that effect.  In the business world, I do hear the folks make the simplification.  It’s a shortcut that can get you in trouble.

I am a firm believer that you can tell a lot about a person’s knowledge of financial statements by understanding where they focus their attention.  More on this later.  

However, I find that managers, business unit leaders, and maybe even C level executives tend to spend a lot of time on the income statement, and not much else.  And when focusing on the income statement (a.k.a., P&L, profit & loss), most attention is paid to revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization).  Also, business folks like to adjust EBITDA by removing non-operating items or other one-time, non-recurring items.

Again, I am not going to opine on how I utilize financial statements right now or where I spend the majority of my time.  But the other statements are there for a reason.  The balance sheet and statement of cash flows provide information not available on the income statement.

But let’s address why you should not make the statement that “EBITDA is a good proxy for cash flow.”

EBITDA is a good proxy for operating income.  It focuses the readers of the financial statements on what generally accepted accounting principles (GAAP) say the accounting profit (or loss) of the business is for the period.  It does this by ignoring certain items (i.e., push them below the line):

  1. Interest – interest is typically paid on debt.  Debt is a financial engineering / capital structure decision for most businesses, not an operational one.  Also, some companies have debt and others don’t.  Setting aside interest payments helps look at the operations of the business regardless of capital structure.
  2. Taxes – a note of caution here, read your debt covenants carefully, as this is generally read as income taxes.  In my opinion, taxes such as commercial activity taxes and other “taxes and fees” are very much a part of operations and most lenders agree.  However, taxes on income can be heavily influenced by interest payments, depreciation, amortization, and other deductions.  So, setting income taxes aside let’s you focus on the operations of the business, without those distortions.
  3. Depreciation – this one is a bit more murky in my mind.  However, depreciation on capital spending is generally considered not part of operations.  And it is highly dependent on the type of business and accounting policies in place.  
  4. Amortization –  this one can be extremely murky as well.  Commonly, intangible assets and goodwill, such as those created during an acquisition, lead to amortization.  Also, capitalizing certain software development costs can also create amortization.  And with the introduction of ASC 606, capitalizing certain contract costs (i.e., commissions) will create amortization.  I personally have some difficulty calling some of these non-operational – especially software companies that capitalize software development costs or really any commission expense based on selling contracts (please show me something more operational than selling your products).  But typically all amortization is excluded from EBITDA.
  5. Non-Operational Adjustments – oh, what a slippery slope this one can be.  But many “non-recurring” items are excluded or “added back” when calculating EBITDA, creating “adjusted EBITDA”.

But EBITDA may not approximate cash flow for quite a few reasons.  It’s also a little unclear what people mean when they say “cash flow”.  The cash flow statement has three major sections: 

  1. Cash Flow from Operations
  2. Cash Flow from Investing
  3. Cash Flow from Financing

But setting that aside, the cash flow statement is explaining why the amount of cash changed and by how much.  So let’s stick with that spirit and ask is EBITDA a good proxy for “the changes in cash” in a business.

Like all things, it depends on the business a bit, but let’s look at a few elements excluded from EBITDA that can help explain why EBITDA does not serve as a good proxy for cash flow:

  1. Interest – debt investors generally like to be paid in cash.  Bummer, I know.  So, depending on how much cash interest is being paid, this one can cause EBITDA and cash flow to diverge pretty substantially.
  2. Taxes – yep, Uncle Sam, likes cash too.
  3. Depreciation – generally non-cash, but the thing that causes depreciation, capital spending, typically involves cash.  Capital spending does not show up on the income statement.
  4. Amortization – many of these items are non-cash, although some are cash events.  Software developers, regardless of whether you are electing to capitalize their salary expense, typically like to be paid in cash.  And, so do sales people.  Especially sales people.
  5. Non-Operational Adjustments – yep, many of these are cash events, regardless of whether or not you consider them operational.  Shove enough cash events “below the line” and you will create some large variances.

What else could cause EBITDA and cash flow to diverge?  Here are a few big ones.

  1. Subscriptions – many subscriptions are billed in advance.  So the company receives all the cash upfront, and then ratably recognizes revenue over the term of the agreement.  Depending on the term and how it spans reporting periods, this can create some really large variances between EBITDA and cash flow.  For example, let’s say a company signs a one year subscription agreement for $100,000 with a customer on July 1, 2021 through June 30, 2022.  According to the terms of the agreement, the customer will pay upfront.  
20212022
Revenue / EBITDA$50,000$50,000
Cash Flow$100,000$0
Variance$50,000-$50,000

Side note: You can see why in a growing subscription business, cash flow would be overstated vs. a business in more of a steady state stage.  Also, you can see where a declining subscription business could encounter some cash flow issues not apparent by only looking at the income statement.

  1. Prepaid Expenses – same concept as above but with expenses.  The company pays upfront, but ratably recognizes the expenses over some longer period.
  2. Accruals – this whole article is predicated on using the accrual based accounting method.  So, let’s say you accrue year end incentives but pay those out some time after year end.  Depending on how large those are (they are high six figures in most my businesses), that will cause EBITDA and cash flow to look different.
  3. Distributions – this one is a bit grey based on the definition of cash flow, but if a business is making distributions to owners / shareholder (i.e, dividends), these are not going to show up anywhere on the income statement.  Those types of activities show up in the Cash Flow from Financing section and are generally not considered operational.  However, it does mean you could have a business where EBITDA is significantly higher than cash flow depending on the size of the payments.
  4. Financing Events – either selling securities or redeeming them won’t show up anywhere on the income statement.  Similar to distributions, these events are not considered operational.  But they certainly impact cash flow.

I guess you could amend the original statement to say “operating cash flow”, but I would argue, this just makes you less wrong.

So, I would encourage you never to say “ EBITDA is a good proxy for cash flow.”  Instead, avoid the shortcut altogether, and get to know the statement of cash flows.

  1. This article is predicated on using the accrual based accounting method.  

Diversification

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There’s been volumes written on the topic of diversification.  The pros, the cons.  What diversification really means?  How many positions one needs to hold to be diversified?  

Here are some good quotes. I doubt I could add anything useful if I tried. However, I mostly agree with the below statement.

“Being truly diversified means that there almost always will be a part of your portfolio that is sucking wind. (Big note: if every piece of your portfolio is working really well, it means one of two things: you’re incredibly lucky or you are not actually diversified. I would assume the latter.)” – De Thomas Wealth Management

Here’s what the holdings look like in my account where I attempt to deploy a broad, diversified, ETF strategy.

Not too much pain here…

I assure you this is a broad mix of ETFs representing equities, fixed income, real estate across U.S., international, emerging markets, etc.  Most would call this a well diversified portfolio.

The fact that almost every fund is pegged up against its 52 week high makes me more than nervous.  The issue is not that these aren’t funds holding diversified assets.  The issue is almost every asset is moving up together and correlations among asset classes are increasing. 

“He notes that the correlation between the yield on the Barclays Global Aggregate Bond index and global stocks currently sits at 0.24—a correlation of 1 means two assets move in lockstep—and has been fairly steady since the market stabilized after the coronavirus meltdown. If the correlation turns negative, which would mean that stocks and bonds move in opposite directions, it could be bad news for equities. “ – Barrons

When did stocks and bonds start moving in the same direction? It used to be, they didn’t.

So how do you diversify when correlations are increasing? 

Well, if most asset classes are going up, then you probably don’t care about diversification as much or the fact that correlations are increasing. Higher correlations mean assets are moving in the same direction. If that direction is up, then I guess higher correlations are good.

However, you will probably start to care about diversification and correlations more if the wheels start coming off. I’ve found this chart helpful in thinking through that problem historically.

Although as the chart says, past performance is not an indication of future performance.

Gaming It

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Looks like Q discovered the stock market.  Some recent comments on Reddit related to GameStop (GME):

“HOLD!”

“WE LIKE THE STOCK”

“DIAMOND HANDS!”

“IF HE’S NOT SELLING, IM NOT SELLING!”

In business school, we had this class that was called Management Game.  We formed management teams for simulated companies.  Each week we made a series of decisions, which were input into a computer simulation.  There were board meetings.  And best of all, there was even a stock market.

Every “player” was given some “game money” to trade.  So, we got to trade with make believe money.  Sort of like the real stock market today.

I remember, I cornered the market in my company’s stock and drove the price way up.  Which was great, as long as I kept buying.  And then I stopped buying….

Turns out I was the only buyer.

It was a good lesson in markets.  The current price is only a reflection of the current marginal buyer and seller.  That’s it.  Don’t read any more into it.

Barely Enough Time to Miss One Payment

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As the impact of the COVID pandemic unfolded, the speed at which the fiscal and monetary responses were rolled out seemed almost too fast.  My thought was that people barely had time to miss one mortgage payment.

Well, the data is in for April and it seems like lots of people did just that.  

“At 6.45%, the national delinquency rate nearly doubled (+3.06%) from March, the largest single-month increase ever recorded, and nearly three times the previous single-month record set back in late 2008.1” 

Data is only available through April.  May will be interesting.

  1. Black Knight’s First Look at April 2020 Mortgage Data  (https://www.blackknightinc.com/black-knights-first-look-at-april-2020-mortgage-data/)
  2. Calculated Risk Blog (https://www.calculatedriskblog.com/2020/05/black-knight-national-mortgage.html)