I came across this article. Very interesting reading. Some might think it controversial but it is in line with my observations..... Aivars Lode
The Wall Street Hype Machine
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The Investing Con Game by Steve Holzman and David Tedesco
Call us old-fashioned, but in the current investing climate we can’t help but pine for the days when earnings, cash flow, and dividend growth were what determined an attractive investment. Back then, the only public companies without significant earnings that one would consider for investment were those with a potential homerun product, like a bio-technology breakthrough.
Today we live in a world where potential revenue growth is the only thing needed for many newer companies to attract investment and boost their share price. The companies that are being valued at the highest relative valuation are those that are following a growth-at-all-cost strategy. The only metric that matters in the short term is revenue growth. Near-term profitability is irrelevant and long-term profitability is simply assumed. The overwhelming majority of these companies are selling products or services at a structural loss, which is being financed by venture capital, private equity (PE), and public equity investors. Clearly, this phenomenon couldn’t occur without major Wall Street investors, investment banks, lenders and research boutiques first accepting, and then supporting, this change of focus.
A Creeping Level of Absurdity
Investors’ current willingness to fund large and seemingly endless losses in an attempt to drive revenue growth is absolutely staggering. Uber is but one of many examples of this new investment hypothesis. Despite Uber’s insatiable need for cash to fund growth, which has only resulted in deep operating losses to date, investors caught up in the “stars of the moment” are apparently investing in Uber and many other companies on a purely conceptual basis. Investors appear to be completely ignoring both valuation and the lack of any realistic path to profitability. Because of the amazing success of Amazon and a handful of other companies, investors seem to have concluded that revenue growth is the only metric that matters. Business models built solely to generate revenue growth, with little potential for earnings and future dividends, can result in a perverse set of incentives. Products are sold and business agreements are entered into solely to generate revenue under terms not focused on profits. Additionally, share prices can be boosted through questionable related party transactions, a practice that we understand to be endemic.
Many companies no longer attempt to under promise and over deliver the way they once did. Instead, they tell a wonderful story and sell it to unsophisticated investors, as well as professional investors who feel compelled to participate. Consider Tesla’s financial forecasts over the last several years, which do not seem connected to reality. We believe it would be very hard to find knowledgeable observers who feel that these forecasts were motivated by sincere optimism. In our opinion, it was a blatant attempt to push the stock higher. Odds are, this immoral behavior benefits insiders and sophisticated investors at the expense of less informed investors who often can least afford to lose. There are still public market investors who believe we live in a rule-based system where the Securities and Exchange Commission (SEC) has their back. While the SEC has objected to some of the most blatant abuses of Tesla CEO Elon Musk, to date they do not seem capable of containing his manipulation through disinformation, which has recently taken the form of “leaked” emails.
While, in our opinion, less overtly manipulative than Tesla, Uber has also spun a narrative of propitious future success that investors seem to be buying hook, line and sinker. Uber has used massive driver subsidies and pricing designed to generate revenue growth, not profitability, losing billions of dollars in the process. We do not believe demand to be inelastic. If fares rise to the level needed for profitability, we expect demand to fall. While the prospect of disintermediating the global transportation market is intriguing, barriers to entry are not enormous. Also, there remains the question of ownership in the urban public transportation market, and the continued investment required. This all adds to the uncertainty of future profitability. The holy grail of profitability for Uber is fully autonomous taxi systems, but Uber itself has stated that these are approximately 15 years in the future. To put this in perspective, 15 years ago the top show on television was Friends. Given all of this, the price of investing in Uber doesn’t make sense to us.
Investors need to be diligent even when investing in supposedly blue-chip stocks as well. Look at the enormous investor losses over the past three years at General Electric (GE), which once had the highest market valuation of any corporation in the world. During his tenure, former CEO Jeffrey Immelt projected a relentlessly optimistic and fanciful picture of GE’s future, selectively providing mostly positive information. After his 2017 “retirement” (think Nixon), the depth of GE’s deception became known and GE’s stock is now in excess of 80% off its all-time high, erasing more than $400 billion in market value, approximately half of that in the last three years. Due to the opaque nature of GE’s accounting, it is impossible to know the entirety of their deception, but it’s obvious that investors relied on the narrative given rather than a more detailed analysis of the company’s finances and the changing markets in which it operates.
How did we get here? How did we go from a world of under promising and over delivering, more honest accounting, and more realistic expectations to where we are today? Many people will defend the existing state of affairs because they benefit from the status quo. They will cite accounting scandals of yesteryear like Equity Funding, Four Seasons Nursing Centers of America, WorldCom, Enron, HealthSouth, etc. to make the case that financial deceit has always been part of the landscape, which is true. But these examples were the results of blatant fraud. We believe that the manipulation of financials undertaken by companies these days is not illegal (as currently interpreted), but devious and ubiquitous. In our opinion, even sophisticated investors, for the most part, do not appreciate just how endemic this practice is. The supposed referees may be watching the game, but they’re not blowing the whistle as often as they should be.
The Government Doesn’t Have Your Back
Generally Accepted Accounting Principles (GAAP) were established in the wake of the stock market crash of 1929 to address dubious financial reporting by some public companies. The federal government worked with professional accounting groups to standardize financial reporting using consistent terms and practices. GAAP allows for better understanding and more accurate comparison of corporate financial statements. For over forty years GAAP has been supervised by the Financial Accounting Standards Board, which is comprised of members with expertise in investing, accounting, finance, business, accounting education, and research. This oversight, as well as the standardization and thought that has gone into GAAP reporting, protects investors.
Over the past several years the SEC has allowed companies to include in their earnings press releases calculations of earnings that are not in accordance with GAAP. About 90 percent of S&P 500 companies use at least one non-GAAP measure in earnings releases.1 The investing public has been trained to disregard GAAP figures because the financial media, data services and analysts focus overwhelmingly on non-GAAP earnings. Furthermore, companies continue to define earnings in new ways to put an ever more positive spin on financial results. Many public companies go as far as to direct investors’ focus to Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA). While EBITDA can be the right metric to better understand cashflow in some businesses, we believe many of these companies are simply doing this in an attempt to drive higher valuation. We agree with Berkshire Hathaway Vice Chairman Charlie Munger’s assertion that “every time you saw the word EBITDA, you should substitute it with bullshit earnings.”
[1 CPA Practice Advisor, Companies Using Non-GAAP Metrics to Inflate Earnings, August 6, 2018
https://www.cpapracticeadvisor.com/accounting-audit/news/12423724/companies-using-nongaap-metrics-to-inflate-earnings]
Typically, the largest part of the difference between GAAP and non-GAAP numbers is non-cash compensation, namely stock options. A timely example of this was the June 19th Adobe earnings release. Adobe, a leading technology company specializing in publishing software with a $140 billion market capitalization, reported $1.83 earnings per share on a non-GAAP basis, compared to the $1.29 earnings calculated in accordance with GAAP. In the notes accompanying their quarterly earnings release, Adobe indicated that the discrepancy was, in part, due to stock-based and deferred compensation expense. This is not free money. This is financial sleight of hand.
Stock Options Aren’t Free
Most companies, especially fast-growing technology companies, use stock options to attract and retain talented employees. This practice creates an enormous wealth transfer from shareholders to company executives. Focusing on non-GAAP numbers that exclude this transfer not only, in our opinion, results in a misleading picture of what a company is actually earning, it also sets the company up for future problems. If you look at past periods of disappointing stock performance, they often coincide with significant cash compensation increases to offset employees’ disappointment with stock options that didn’t pan out. This erodes margins and depresses stock prices. This was particularly prevalent in the 2001-2004 period. Yet most analysts and leading database services continue to focus on the non-GAAP numbers, which we believe are misrepresentative.
Unicorns for Sale
The private equity market is awash in cash. Much of this is coming from institutional investors under pressure to meet allocation goals and lenders requiring limited covenants. Covenants used to be the canary in the coal mine, alerting investors to developing performance issues. Without them, the first sign of trouble may be defaults. At the same time, acquisition valuations have expanded to heights where most businesses are unwilling to compete with PE funds. As of 2018, the majority of PE-owned investments are being “exited” via a sale to another PE fund, as PE investors just trade assets amongst themselves at ever higher prices. They have left strategic buyers behind, and in doing so have tacitly acknowledged that a healthy operating business seeking to make a profit will find it difficult to invest successfully at today’s valuations. Amazingly, this “little detail” hasn’t given investors pause.
Caveat Emptor
All of this contributes to what we have today, a breakdown of many of the checks and balances that protect investors. After the 1929 stock market crash, the Pecora Commission prompted regulations to be put in place to protect investors. However, the ‘80s, ‘90s and ‘00s were a period of deregulation, self-regulation, and the deterioration of meaningful oversight. This contributed to the 2008 market meltdown and another financial crisis, but this time the response was scattershot. The truly bad players, who enjoyed enormous private gains and had to be rescued by a public bailout, were never truly punished. This helped birth the Tea Party and a justifiably angry public that feels that the game is rigged. To a certain extent the game is rigged.
We’re not saying that none of these so-called “unicorns2” will be successful investments. What we’re saying is, take a step back from the excitement of the moment. We’ve seen similar movies before. In the late ’90s, in excess of $3 trillion was lost investing in questionable dotcom and telecom models. As Gretchen Morgenson wrote in her final New York Times column, “Bull markets cover a multitude of sins, after all. But as the dot-com episode showed, genuine earnings growth — the kind companies can take to the bank — becomes a crucial underpinning when share prices turn down.”3
[2 A privately held startup company valued at over $1 billion, commonly credited to Aileen Lee, founder of Cowboy Ventures.
3 Morgenson, Gretchen “The Reflections of a Truth Seeker,” New York Times, November 11, 2017, Sec. B.]
Our contention is that many of today’s exciting growth companies will never be able to jump the chasm to profitability. Furthermore, we are strongly of the opinion that the smoke-and-mirrors accounting and unrealistic outlooks of these modern-day pretenders results in an asymmetrically high-risk situation for investors, particularly those late to the party. Market behavior isn’t inherently rational and, particularly at extremes, most professionals will admit that they are simply along for the ride. Perhaps investors should take heed of the standard disclaimer a little closer: Past results may not be indicative of future performance. When the bubble bursts, the refrain from the financial professionals is going to be the same as always: “Hey, don’t look at me. I just work here.”
Steven D. Holzman is the Managing Partner of Vantis Investment Advisors L.P. He is a former Managing Partner of Cypress Funds LLC and has been a long-time Senior Advisor to Invemed Associates. Steve holds a B.S. in Accounting from the University of Illinois and was a Certified Public Accountant at Arthur Anderson for approximately five minutes a long time ago. Steve lives in Miami with his wife and daughter, and is also the father of two fantastic older children.
David C. Tedesco is the CEO and Founder of Outlier, a modern conglomerate with businesses in healthcare, technology, aerospace, real estate, entertainment and robotics. Outlier focuses on acquiring the leading businesses in a particular niche and developing them over time, holding them indefinitely. Today, Outlier has a team of over 12,000 across its various businesses and is one of the largest private companies in North America.
David is a polymath who blends deep interests in strategic theory, product design, engineering and finance into a creative, ever-evolving approach to business and investing. He is an active member of the board of directors of many private and public companies and is a regular strategic advisor to numerous private equity firms. He formed his first business at the age of 13 and never looked back. He’s never had or applied for a job, having built, invested in, or acquired every business he has been involved with over the last 25 years.
David codifies everything into theories and is happy to discuss them with you long after you’ve lost interest. He frequently changes them yet is pretty sure they are entirely correct up until he does. He’d rather be correct and lose than wrong and win. Fortunately for him, raising four young daughters allows him to achieve this objective frequently.
David is an alumnus of Harvard Business School. He is an active pilot, pianist, photographer, cyclist, mountaineer and world traveler. He lives in Paradise Valley, Arizona and Sun Valley, Idaho with his wife and daughters.
DISCLAIMER: THE THOUGHTS EXPRESSED HERE ARE STRICTLY OUR OPINIONS. THIS PAPER IS NOT MOTIVATED BY ANY ATTEMPT TO BENEFIT OUR OWN PORTFOLIOS.
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