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
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):
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.
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.
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.
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.
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:
Cash Flow from Operations
Cash Flow from Investing
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:
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.
Taxes – yep, Uncle Sam, likes cash too.
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.
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.
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.
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.
2021
2022
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.
Prepaid Expenses – same concept as above but with expenses. The company pays upfront, but ratably recognizes the expenses over some longer period.
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.
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.
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.
This article is predicated on using the accrual based accounting method.
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.
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.
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.
One of the most leveraged companies in one of the most impacted industries, managed to limp along and delay the inevitable for almost a full quarter. The Hertz filing is likely just the tip of iceberg…
I wrote previously that the velocity of change is much more difficult for companies to handle than the magnitude. Hertz had to deal with both. The travel industry has been one of the most impacted (velocity & magnitude) sectors during the COVID pandemic and response.
Hertz’s fleet of 700,000 vehicles, which are mostly rented from airports, has largely been idled due to the slow down in travel caused by the pandemic. Complicating the matter is the value of these assets are falling as vehicle sales slow and used car prices fall.
Hertz also has $21 billion in long term debt.
All of these factors combined into this bankruptcy filing came with lightning speed – relative to filings – adding Hertz to the short list of companies in the “no coupon club.”
Bankruptcy filings are going to be a lagging indicator. And there’s going to be more to come.
My vantage point for the COVID pandemic and response has been somewhat unique – sitting here in Lower Deer Valley Utah since mid-March. I am fortunate to fall into a line of work that transitioned to work from home seamlessly. However, that’s not the case for many, especially around here. No tourists, no work.
The same concept applies to many parts of the economy. No shoppers, no store sales. No diners, no restaurant sales. No vacations, no travelers. No sporting events, no ticket sales, etc.
The likely outcome appears to be a fairly broad, deep, and lengthy economic recession (80% probability). But that expectation looks to be in the minority using the S&P 500 as a proxy of the consensus view.
Source: MarketWatch
There seems to be a disconnect between the reality on the ground and expectations. I think there are few things going on:
Velocity of the pandemic & response
Lag in economic data & company reporting
Demographics of those impacted by initial shutdowns
No single source of issues
Hope for a rapid return to normalcy
Velocity: I wrote earlier about the absolute stunning velocity of the global shutdown due to the COVID pandemic. It’s almost incomprehensible. It’s like nothing anyone alive today has ever experienced.
Lag: Given the speed of the fallout and the fact that impacts to U.S. companies did not truly start until mid-March, barely any of the financial impact is being reported in Q1 financial reporting. Q2 results will be telling. Those won’t be available until July; still two months away. Same issue with most economic data; it’s a lagging indicator and barely incorporating the impacts yet.
These next two charts are not helpful – folks have barely had time to miss one mortgage payment and it’s not in the data yet.
Demographics: The initial stay at home orders have had a disproportionate impact on certain cohorts. Many white collar workers (like me) simply picked up our laptops and started working from home. No fear of lost income. No major life setbacks – other than Mrs. SFTE zoom-bombing my meetings. Not the case for many lower wage, retail and service jobs.
Guess which of these cohorts is more invested in the market? Hint: The groups not being impacted (yet). So be careful about using their views to assess the current state.
Source: During the Great Financial Crisis, the source of the issues was concentrated in the financial system. I’m not sure if the breadth makes the current situation better or worse over the longterm, but it does make it harder to understand.
Headlines like this are more tangible than hand-made cardboard signs in windows of thousands of small businesses.
“A single death is a tragedy; a million deaths is a statistic.” ― Joseph Stalin
Return to Normalcy: There’s also quite a bit of hope for a rapid return to normalcy. I’m all for hope, but let me quash that notion. I would love to get back to normal, but that doesn’t exist anymore. This is like 9/11 in terms of resetting normal. I will never touch an ATM or gas pump handle with the same innocence again. There is no f-ing way I am getting on an airplane any time soon. “Any environment that is enclosed, with poor air circulation and high density of people, spells trouble.”
Mrs. SFTE would fight you tooth and nail if you tried to take her into a restaurant. Those dentist appointments for mid-Summer, cancelled. Check with me in six months (and no, I will not have two cleanings back to back so no pent up demand here). Summer sports camps, ha. Summer vacation plans, cancelled. This is all lost income to someone, somewhere.
Yes, we’re a bit weird, but I bet not that weird. If you haven’t noticed, this virus can kill you. I’m 101% against being killed. My guess is so are most people. That is why the data shows trends like this:
So if people did not wait for stay at home orders to alter their behavior, how much will changing those orders affect their behavior? Not enough to make the recession go away.
Here is some economic data we do have:
The Initial Claims graph just broke the y-axis:
Lots of jobs have been lost (stunning velocity):
Unemployment rate is currently worse than at the peak of the Great Financial Crisis:
Approximately 70% of the economy is based on consumer spending, so no good news in this chart:
The handicap to the magnitude and duration of the recession is the amount of fiscal and monetary intervention being deployed. This also falls into the incomprehensible and unprecedented category.
Federal Reserve interest rate cuts – from 1.50%-1.75% to 0.00%-0.25%. I still cannot explain negative interest rates to my mother.
However, by and large, these measures do not seem to be creating jobs, simply offsetting the financial impact of the shut downs. At the end of the day though, it is jobs that matter. Jobs will drive spending, and spending drives over two thirds of the U.S. economy.
“A better measure for how real people experience the business cycle: the ebb and flow of jobs creation. Losing your job is a recession; finding employment represents recovery. Looking at the business cycle through this lens paints a more complicated picture.
Perception on Main Street is always important for recoveries, and that will be true in the extreme this time. Given the sharp, dramatic jobs losses, which will probably get worse, sentiment in the broad population will be highly relevant for charting the path of the post-recession trend. On that front, jobs will arguably be the most relevant stat.
With that in mind, consider how private employment has fared on a rolling one-year basis in the past. As the next chart below reminds, the labor market often contracts through a recession and for a number of months after the downturn officially ends, based on NBER dates. In some cases, a positive one-year gain in private employment doesn’t arrive until several years after the recession’s official end.” Source: CapitalSpectator.com
Based on history, jobs do not recovery quickly from recessions:
And the jobs picture is likely to continue to deteriorate. My sense is that there are also a lot of tough decisions going on in corporate boardrooms all across the nation. You don’t know what Q2 is going to look like for most companies, but by now the current reality is fairly clear for most managers.
This chart is through March:
My investors are encouraging all their portfolio companies to renegotiate leases, defer 401k payments, stretch payments to vendor, and renegotiate contracts. There is someone on the other side of each of those decisions who is going to be missing some income.
Somewhat obscured by the COVID pandemic is an oil crisis and simmering trade war, each with their own economic fallout. The oil crisis is threatening a major source of high paying jobs in many parts of the U.S. The opposite was true during the Great Financial Crisis, when the budding shale boom was counteracting that recession.
So, as you assess the likelihood of a deep and prolonged recession, keep in mind that the velocity and disproportionate initial impact is creating distortions in the data and news cycle.
