source: Koyfin

The chart compares the total return since November 11, 2009 of three exchange-traded funds:

• SPDR Gold Shares , a trust which owns physical gold bullion;

• VanEck Gold Miners ETF , which tracks an index covering global gold miners. The three largest miners (Newmont, Agnico Eagle and Barrick Gold) account for nearly one-third of assets and nearly two-thirds go to the top 10. GDX thus provides exposure to the largest miners, the so-called “majors”.

• VanEck Junior Gold Miners ETF , which tracks a different index focusing on smaller gold miners. GDXJ was launched in November 2009, which is why our chart begins there.

The reason the chart is incredible is because it tells a relatively simple story: the absolute failure of an entire industry over nearly fifteen years.

Getting Leverage To Gold

Assume that in November 2009, an investor was bullish on gold. He would have good reason: the world was still in the midst of a global financial crisis, U.S. wars in Iraq and Afghanistan were ablaze, and uncertainty seemed to reign. All of these factors (financial insecurity, geopolitical strife, a distrust of banks) are among reasons for buying gold.

And so our investor has several options. The simplest is to own gold directly. That could be through physical ownership or through physical ETFs like GLD. If our investor believes gold will go up, it seems wise to own the underlying commodity.

But one issue with gold is that it doesn’t go up that much. Adjusted for inflation, gold has risen less than 300% in a century, real returns of about 1.34% annualized:

source: Macrotrends

Of course, if caught at the right moment (into and out of the end of the gold standard in 1971, or after a decades-long bear market) gold can soar.

But part of the appeal of gold is as “a store of value” which doesn’t necessarily augur the huge potential returns that are possible in equities. For many investors who see gold as a hedge against trouble and not necessarily an investment that should provide huge returns, this is not a problem. But our investor would like to be more aggressive. He wants leverage to the gold price, a trade in which his returns outpace those of the underlying commodity.

Looking To Miners

In theory, gold miners can provide that leverage. Imagine a simplistic model of a miner that can produce 100,000 ounces of gold a year. Its all-in cost to produce and deliver an ounce is $1,500. Its corporate costs are $30 million annually.

At the current spot price of $2,300 (we’re using a round number to keep the math simple), our miner should earn revenue of $230 million per year1. All-in costs are $150 million, creating gross profit per ounce of $800 for an $80 million total. Less $30 million in opex, our miner earns pre-tax profit of $50 million.

If we move the gold price, we start to see the leverage in the mining model. Cut gold by 20%, to $1,840 per ounce, and our miner’s profits are essentially gone: gross profit drops to $34 million, and pre-tax profit to just $4 million. That’s a 92% reduction in profit off a 20% move in the underlying.

Of course, if the price of gold increases 20%, profits soar. At $2,760 per ounce, gross profit per ounce spikes from $800 to $1,260. Pre-tax profit nearly doubles to $96 million ($126 million in gross profit less the same $30 million in opex).

In both scenarios, the underlying stock doesn’t necessarily fall or rise 90%-plus. Investors will base their valuation of the stock on the entirety of future cash flows, which no doubt will include further volatility in the gold price as well as responses by market participants to that volatility.

Notably, the higher price will turn some gold projects from uneconomic to economic; a distant low-grade mine that has an estimated all-in cost of $2,000 per ounce is too risky at a spot of $2,300, but perhaps worth the gamble at $2,800. In addition, private citizens might decide to scrap gold jewelry at a higher price. Both responses increase the supply of gold, and thus (in theory) should reduce the price2.

But, even given those effects, the price of a gold miner should be more volatile than the underlying. So if our investor believes the price of gold will rise, he should be looking to gold miners for bigger returns if his thesis is correct.

Gold Miners Have Failed

This of course is the same kind of operating leverage that we discussed back in December, in explaining the seemingly nosebleed valuations still assigned to growing tech stocks.

But in practice, neither majors nor juniors have provided that operating leverage. Amid nearly 15 years of rising gold prices, both GDX and GDXJ have provided negative total returns. That’s an abject failure to provide the one thing miners are supposed to provide: leverage to the underlying.

What’s relatively stunning about the period is how consistent the failure has been. Over the past twelve months, miners have eked out some outperformance, but not much (GLD +22%, GDX +25%, GDXJ +29%). Across 3-, 5-, and 10-year periods, the ETFs have all provided lower total returns than physical gold.

The same consistency holds across the miners themselves. The three biggest miners, who should have the scale and diversification to manage through varying external environments, haven’t come close to outperforming:

source: Koyfin

On a 10-year basis, Agnico and Newmont have outperformed, but as with the ETFs, there’s been no sign of operating leverage. Perhaps most damning, over 20 years, a position split between Newmont and Barrick would be negative3, even with gold quintupling over that time frame.

So why haven’t gold miners delivered on their potential? There are numerous factors. Mismanagement is one: Barrick’s chairman, John Thornton, has been criticized for years for excessive compensation, and given the performance of Barrick stock no doubt should be.

Gold mining also suffers from geopolitical turmoil and tax-hungry governments. For instance, many miners had to sell Russian assets in 2022. In 2019, Acacia Mining, a Barrick subsidiary, was hit with a $190 billion tax bill (that’s ‘billion’ with a ‘b’) from the government of Tanzania (the firm later settled for $300 million).

Know What You’re Owning

Gold mining is not an easy business. But that’s precisely the point. We have decades of evidence that miners as a whole are not capable of driving the operating leverage their business model should generate in theory.

That perhaps doesn’t mean that every gold miner should be avoided. Streaming play Royal Gold , which buys future rights to produced gold, has been a winner. Alamos Gold , created through a 2015 merger, has outperformed. Juniors have been acquired at premiums that created value for their investors.

But the history of the sector (at the very least) has to create some caution toward entering the space at all. Gold miners need much more scrutiny than just an understanding of reserves and production. Management, capital allocation, and geopolitical risk are all massive factors.

There is a broader lesson here as well, however, which is the importance of not just getting an investing thesis right, but executing correctly on that thesis. We talked last time about Stanley Druckenmiller’s simple thesis on the growth of generative artificial intelligence, which led him to make a hugely profitable bet on Nvidia . But an investor could have credibly played genAI growth through other stocks that have underperformed: Augmedix , which is using genAI for medical transcription, soared in the second half of 2023 on hopes it could capitalize on the trend, only to plunge 83% this year.

In the bubbly environment of late 2020 and 2021, many investors made incorrect bets on trends, whether electric vehicle growth or the rise of so-called ‘fintechs’ that could revolutionize the banking industry. More than a few compounded those mistakes by owning the tenth-most promising EV manufacturer or a psuedo-fintech with no real differentiation. Missing on the trend meant sharply negative returns, but missing on the execution often led to a loss near or at 100%.

Of course, in this environment, there’s another group of miners that have gained prominence. Bitcoin miners even have their own ETF, the fantasticly-tickered Valkyrie Bitcoin Miners ETF .4 Since its launch in February 2022, we see a similar, if not quite as dire story:

source: Koyfin

Bitcoin has risen 29% since WGMI launched and the ETF is -12%. As with Newmont and Barrick, majors Marathon Digital and Riot Platforms are lagging badly. Once again, the seemingly simple way to get leverage in theory isn’t quite so simple in practice.

As of this writing, Vince Martin has no positions in any securities mentioned.

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Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

In the Internet age, we are bombarded with a fire hose of information. More content is published each day — across news and opinion sites, social media platforms, Substack, and other outlets — than an individual could consume in her lifetime.

And so we filter. Surely somewhere on the Internet is a fascinating article on, say, life in 15th-century China. Very few of us will ever read it — because very few of us will ever look to find it. Most of us self-select specific writers, specific social media accounts, and specific topics, not just because they cover topics of interest, but because by self-selecting, the experience is superior. Communities sprout, inside jokes are created, and there’s a built-up knowledge base to better appreciate — or better critique — new insights. The choice is between knowing a little about many topics, or more about a few. Most of us choose the latter course.

There are obvious parallels in equity investing. There are about 5,700 companies listed on the New York Stock Exchange and the NASDAQ, and another 3,000-plus exchange-traded funds. Globally, there are roughly 55,000 public companies. Assuming an investor worked more than full-time — 50 hours a week for 50 weeks a year — she could spend 24 minutes on each of the U.S. stocks. Expand her reach globally, and the average drops to about two minutes. And if we assume that a proper deep dive takes about ten hours (a round and arbitrary figure but one that doesn’t seem that far off), each year she can cover 250 companies: less than 5% of the U.S. total and less than one-half of one percent of the global universe.

For investors, as with consumers, there simply isn’t enough time. We can know very little about many stocks, or a lot about a few. Most investors choose the latter. But how, and why, we choose makes a difference.

Finding An Edge — Or Finding An Interest?

A self-directed investor can begin to filter in one of two ways: where she believes she has an edge on the market, or where she simply is the most interested.

These two directions are not by any means mutually exclusive. To some degree, an investor has to go in both directions. For newer or younger investors with a smaller portfolio, the purely financial calculation is probably to simply buy index funds. Imagine a $100,000 equity portfolio (not necessarily a small portfolio by any means) where an investor believes she can create two points of excess returns (or alpha) above the market. That’s $2,000 a year.

To be sure, that $2,000 compounds, and the portfolio should grow larger over time; perhaps the excess returns too can grow as our hypothetical investor improves. Still, two points of alpha on a consistent, annual basis is a difficult target. Most investors capable of beating the market in that manner can probably find other, more certain, sources of income.

So there needs to be some kind of enjoyment in the process. Simply believing that there are untapped opportunities in, say, small- and micro-cap biotech stocks does little good if an investor has no interest in the sector. The research required to find the opportunities in the group is going to feel like work. And it’s difficult to put in that amount of work for such a nebulous, long-term target.

Still, there is a primary direction to choose — and there isn’t necessarily a correct answer. Investing behind one’s interests likely makes it more certain that the work will get done correctly: it’s easy to understand a business fully if that process is enjoyable. And the rise of Reddit and X in the last decade, has made investing in many stocks, a more shared and more enjoyable experience1.

That said, investors still set out with the focus on profits first. Historically, the conventional wisdom for these individual investors was to focus on the micro- to mid-cap space (generally considered $10 billion and under, with some investors targeting only the low end of the range), because those were the stocks in which the individual investor actually might have an edge.

There are hundreds of millions of dollars a year spent on simply understanding the totality of the Microsoft business and forecasting the company’s earnings. The idea that a hobbyist can compete on its face might seem fanciful. Meanwhile, in micro-caps and small-caps in particular, many major funds (and successful investors) would never even consider taking a position, because a) the position wouldn’t be large enough to move the needle and/or b) the act of building the position itself would move the stock price higher2. In micro- and small-caps, then, individual investors can compete and in some cases they actually have an edge over their institutional counterparts.

What’s Your Edge?

Whatever an investor’s strategy, it is helpful to have at least some idea of what the edge might be.

One possibility is simply to be smarter than everyone else. Not necessarily more intelligent or more researched, but more attuned to the psychology of the market. It sounds close to delusional, and for most of us it probably is. But the likes of George Soros and Stanley Druckenmiller3 have created billion-dollar fortunes without adhering to an obvious, consistent strategy, and that same sense likely applies to Warren Buffett and his partner Charlie Munger as well.

Soros has proposed a general “theory of reflexivity”, anchored in his philosophical studies as a young man. But he also famously said that “when I see a bubble forming, I rush to buy, adding fuel to the fire”, and claimed that backaches let him know when there was something wrong with his portfolio. His most famous bet, against the British pound in 1992, earned him $1 billion and didn’t rest on esoteric knowledge of trade flows; rather, he correctly bet he could outlast the Bank of England.

Druckenmiller made a mint on NVDA (he recently cut his position) on a simple thesis: his young partner told him to buy the stock, and then after the release of ChatGPT, he saw the stock as a winner and dramatically expanded his position. It’s not impossible to imagine a (very happy) patron in a bar buying drinks and telling the same story with the same returns (albeit on a percentage, not a dollar basis).

Source: Koyfin

Buffett and Munger, meanwhile, are known for decades-long investments in the likes of Coca-Cola and Wells Fargo , but both men have engaged in a variety of strategies over time. As the leaders of Berkshire Hathaway, the most consistent part of their investment process has been simplicity: not overreacting, not chasing, and keeping errors to the bare minimum.

There are other avenues to take. Sector concentration can help: if an investor is only going to cover 10% of the market, perhaps that 10% should be mostly in U.S. tech, or global software. There are learnings from each individual stock that provide a broader knowledge base across the group as a whole. Commodities — whether actual commodity trading, or a focus on oil and gas names — benefit investors who enjoy broader geopolitical analysis.

Buy What You Know

And then there is the advice from another well-known investor, Peter Lynch. This advice is worth covering, because it’s often shortened to “buy what you know” and therefore horribly misunderstood.

Lynch’s advice, a key part of his One Up on Wall Street, originally published in 1989, is better explained as “buy what you know better”. The advice is not to think, “hey, there’s a Starbucks on every corner, everybody knows Starbucks, I should buy the stock.” Rather, the point is that individual investors have areas of expertise that can be applied to the market. That may be from primary employment: a software developer might know which companies are hiring aggressively, or putting out a substandard product, or at risk from a rising startup.

It can be as a consumer, seeing a growing business (for instance, Starbucks in the 1990s, or the experience at Cava suggesting it indeed is the “next Chipotle ”) or a broader trend (perhaps energy drinks, and the rise of Monster Beverage , in the 2000s). But the key idea is that an investor should invest on the basis of something that the market doesn’t know — or at least doesn’t fully appreciate.

Perhaps the greatest individual investor ever seems to have adopted that strategy — and a few others as well. Herbert Wertheim, a retired South Florida optometrist, built a multi-billion-dollar portfolio off earnings from a business he founded, invested in some of the best-compounding stocks of all time. Wertheim, with a background in engineering, focused not on financials but on patents, which as a 2019 profile in Forbes noted led him to IBM , 3M , and Intel . Those stocks have all hit tough times in recent years, but spent decades outperforming the market and creating a good chunk of Wertheim’s fortune. Meanwhile, he incredibly bought both Microsoft and Apple in their initial public offerings, and as of 2019 still owned those shares.

It’s unlikely any of us will reach those heights. But the story of Wertheim, and others like him, is of investors who find their niches, and find what they do well. The wonderful thing about having 55,000 stocks worldwide is that there’s no shortage of places to look.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

There is a more interesting question, however: is Gill committing market manipulation?

(Disclaimer: The author has no legal training and nothing in this post should be relied on as legal advice.)

What Is Market Manipulation?

U.S. Supreme Court justice Potter Stewart famously said of pornography that “I know it when I see it.” There’s a similar sense with market manipulation, a crime whose definition remains somewhat uncertain, despite a 1950 law specifically prohibiting the manipulation of security prices.

The SEC, on its investor protection website, provides a colloquial definition:

Market manipulation is when someone artificially affects the supply or demand for a security (for example, causing stock prices to rise or to fall dramatically)

The key word there is “artificially”. The Commodity and Futures Trading Commission, which, as its name suggests, regulates commodities and futures, offers a four-part test for market manipulation. The last two parts are “that artificial prices existed” and “that the accused caused the artificial prices”.

Already, the crime of market manipulation seems a bit fuzzy. The SEC and CFTC don’t necessarily agree on the exact definition, and even the CFTC’s test came from case law, rather than direct guidance from Congress. But the sense from both regulators is that market manipulation comes when traders try to influence the price rather than the value of the instrument.

This is why an activist short report from Hindenburg Research is not market manipulation (despite many protestations to the contrary). When Hindenburg took aim at Icahn Enterprises last May, its detailed report was an attempt to influence the value of IEP stock. The firm made a detailed argument that the stock was overvalued; its goal was to make other investors agree, which in turn would lower the price of IEP, providing a profit on the trade.

The purpose was not to simply shock the market and make investors dump stock as quickly as possible. That likely would be considered illegal: case law to this point suggests that while short selling is completely above board, it becomes manipulative when “combined with some sort of misinformation transmitted to the market.”

Notably, at least per the CFTC test, that “misinformation” has to be purposeful. If Hindenburg had, for instance, badly miscalculated Icahn Enterprises’ net asset value, that likely would not be considered market manipulation. If the firm had, however, forged documents claiming that IEP didn’t actually own the businesses it claimed to, that almost certainly would be judged manipulation (and fraud as well).

The “artificial price” definition does provide a broad sense of what regulators do see as illegal. Standard “pump and dumps” certainly qualify. In those activities, traders often disseminate false information with the aim to drive the stock up before (the ‘pump’) and then sell as close to the top as possible (the ‘dump’)1.

Here, it’s quite obvious that the traders are trying to manipulate the price, not the value. In contrast, a coordinated, factual, effort to highlight the value in a stock — say, through a company’s investor relations program, or an activist campaign — isn’t manipulative. The goal of those investors (as with Hindenburg) is to make the price of the stock reflect their perceived value, not to make the price go up through false information.

Fake takeover offers occur from time to time2: those are classic, obvious market manipulation. So are fake news articles reporting a takeover bid, like the one that briefly spiked Twitter stock in 2015. “Spoofing”, in which traders enter bids they have no intention of exercising in order to influence prices, was specifically banned in the Dodd-Frank Act of 2010 (enacted in response to the financial crisis).

These market manipulation violations all make sense: they are, as Justice Stewart might have put it, quite easy to see.

But the line between what is and what isn’t manipulation does get fuzzy, as two recent examples show. One is GameStop. The other is a trial underway as we speak.

Archegos: $200 Million To $36 Billion To Zero

In 2013, Bill Hwang established Archegos Capital, a family office designed to manage the wealth he’d created during a past career as a hedge fund manager. As Bloomberg detailed in 2021, Hwang was incredibly successful. In 2016, according to a source, a single trade on Netflix made a profit of nearly $1 billion. By the next year, another source estimates Hwang’s portfolio had risen ~20x, to about $4 billion.

But at some point in 2020, Hwang began to press his bets. He ran his portfolio reportedly at about 5x leverage, and began to concentrate in a few stocks. According to a 2022 indictment, Archegos owned:

• over 70% of outstanding shares in GSX Techedu (now known as Gaotu Techedu );

• over 60% of Discovery Communications Class A and over 30% of Class C (that company is now Warner Bros. Discovery );

• over 50% of iQiyi and ViacomCBS (renamed Paramount Global );

• over 45% of Tencent $TCEHY.

No one knew Archegos owned these kinds of stakes. Hwang used swaps with nearly every major investment bank to essentially hide his economic ownership3. The multiple agreements also meant that each bank didn’t know how leveraged the fund was. In fact, Archegos had $163.5 billion in gross market exposure, on the back of just $36 billion in assets. That’s leverage of more than 4 to 1.

On its own, that kind of leverage isn’t unusual for family offices and hedge funds. But banks usually are only willing to lend at that kind of leverage for funds running a hedged long/short strategy. Archegos, instead, was plowing ever-greater capital into a small number of stocks. Its buying alone was driving those stocks higher:

source: Koyfin

In March of 2021, ViacomCBS announced a convertible debt offering, clearly designed to take advantage of the soaring stock price created by Archegos’ steady buying. The offering tanked the stock, and that started a domino effect that wiped out the fund within days. All told, investment banks lost about $10 billion in the collapse, with about $5.5 billion coming from Credit Suisse. CS would eventually be acquired by UBS with the Archegos losses a contributing factor. Hwang was indicted in 2022, and charged with running a “massive market manipulation scheme”.

Did Bill Hwang Manipulate The Market?

Where market manipulation gets a bit fuzzy is in the fact that almost every investing strategy (to some extent) moves the market. Hwang’s concentrated, leveraged portfolio in early 2021 is an extreme example of a simple fact: buying (or selling) a security moves the price of that security. Even a single retail investor, buying a relatively small position, can make a stock price change.

There are cases where intent isn’t quite clear. In 2018, the CFTC lost a market manipulation case surrounding interest rate swaps; the defendant successfully argued that his firm, DRW, was trying to take advantage of a mispricing. The judge agreed that, even when DRW was submitting over 2,500 bids in an effort to move the price of its swaps higher, the resulting price was not artificial. DRW thought it had an edge, and kept trying to communicate that information to the market.

In the case of Archegos, there’s a clear question that Bloomberg columnist Matt Levine asked in 2022:

Bill Hwang is not some dope; he is a long-time hedge fund manager with a Tiger Management pedigree… Bill Hwang presumably did not want to lose all his money. What was his exit plan? How did he think the story would end?

Even the judge in the case has wondered:

“What did he want? What did he want to achieve? Being a big shot, I suppose that’s possible, but it doesn’t seem to me that was his aim,” the judge, Alvin Hellerstein, said at a hearing [in 2023]. “I can’t figure out his aim.”

Indeed, this is part of the defense strategy in the trial, with Hwang’s lawyers calling the case the “most aggressive open market manipulation case” ever. Reuters noted the prosecution’s “unusual manipulation theory”, and quoted an attorney who noted “the defense will argue those buys were bona fide”. Inded, they did: the opening statement said that Hwang had “the courage of his convictions”, and believed deeply in the companies in which he invested.

Even with multiple Archegos executives testifying against Hwang — and one openly admitting to market manipulation in court — it’s hard not to have some sympathy for that argument. Higher stock prices didn’t lead to higher fees; Hwang was investing his own cash4. The stocks may have been ‘pumped’ by his buying, but it wasn’t as if Archegos was disseminating false information or even any information. Many major players on Wall Street had never heard of Archegos until it collapsed5.

The prosecution’s argument is that Hwang wanted to be a “legend on Wall Street”, which itself highlights the point that there isn’t a clear financial aspect to the alleged crime. There was no simple way for Hwang to cash out without destroying his portfolio. Indeed, it took a single convertible offering for the entire house of cards to collapse. It seems like at least part of Hwang’s motivation was true belief. As a well-known investor in a retail chain might have put it, he liked the stocks.

Market Manipulation In GameStop

In 2021, as GameStop was peaking, Levine noted noted that an illegal pump and dump in theory could be executed by a small group without lying, perhaps through an “expensive newsletter”, and still be considered market manipulation. And so the obvious question is whether a large group of traders, operating through a subreddit, could be guilty of the same.

Levine didn’t really the answer the question (and given the tenor at the time, we can’t blame him). We’d guess that if you asked a junior SEC lawyer to build a case for market manipulation against, say, the most popular and strident Reddit posters, she could probably do it quite easily. We’d also guess that if you asked a senior SEC lawyer to actually prosecute that case, she would decline, likely with an expletive or two.

But there is a logical argument that GME bulls are committing market manipulation. The first two parts of the CFTC’s four part test (which wouldn’t necessarily apply, but as far as we can tell provides the broader framework established in case law even in SEC cases) are perhaps more interesting:

• that the accused had the ability to influence market prices;

• that [the accused] specifically intended to do so.

Really, the question is about the first part: do Redditors have the ability to influence market prices? Clearly, they intend to do so. And we’d argue, even after yet another stock offering from GameStop today, that the GME stock price is artificial. The fourth part — “that the accused caused the artificial prices” too seems to hold, if you believe the first part is satisfied.

To be sure, this is mostly a fun, theoretical example. The idea that GMEBull237 on Reddit would be dragged into court for market manipulation remains far-fetched. But there is an irony pointed out by multiple observers: it seems pretty clear that the GameStop bulls screaming the loudest about market manipulation (by short sellers) are the ones who are coming the closest to actually manipulating the market.

Is Keith Gill In The Clear?

One month ago, Keith Gill, posted a picture on X of a man leaning forward in a chair to play a video game. In two trading days, GME nearly tripled. Three weeks later, he posted a screenshot of his position in the stock, a portfolio then valued at roughly $180 million. A livestream followed, during which GME tanked 40% as Gill apparently didn’t give his fans quite what they were hoping for. Along the way, Gill has posted an endless series of memes on Twitter, each with tens of thousands of likes and many thousands more in views.

It is truly incredible that any of this matters, that memes from a former middle manager at an insurance company in Massachusetts has led to a month with average daily volume just over 100 million shares (in the range of $2.5 billion per day) and allowed GameStop to now raise over $3 billion in cash.

But is it illegal? It’s close enough that Morgan Stanley unit E*Trade reportedly considered kicking Gill off its platform. Yet, as the Wall Street Journal noted last week, it’s difficult to see Gill’s conduct crossing the line:

Gill’s recent actions don’t fall into that framework. None of his posts have been explicit endorsements of investing in GameStop or claims about the company’s financial prospects. It is unclear whether Gill has sold his shares, or whether he is still amassing a giant GameStop stake.

That was written before the livestream. In it, Gill was quite obviously being careful. He completely legally talked his book, discussing his optimism toward the company’s turnaround. And it’s hard to believe Gill amassed a position worth $180 million without getting some excellent legal advice6.

At the same time, this isn’t really good. It’s not what a market regulator wants to happen. It’s not really what market participants want to happen. Investors and companies generally want to create sustainable long-term value, not ephemeral short-term peaks.

Frenzied trading, and raising cash directly from retail investors at likely inflated prices, is not the sign of a healthy market. Levine famously wrote on February 1, 2021 that “if we are still here in a month I will absolutely freak out [emphasis in original].” He’s poked fun at his own quote multiple times since, but we indeed “are still here” more than three years later.

And to some degree, we are still “here” because of Gill. He had the ability to create a higher price in GME, and did so. The key distinction is whether this higher price is an artificial price. Gill would argue (and in his livestream did argue) otherwise. But of course he pretty much has to say that in public. An admission that the price is artificial might well be considered an admission of guilt.

But what’s fascinating about the confluence of Gill’s return and Hwang’s trial is that the two investors have so much in common. One might well ask of Gill the same question that judges and writers have asked of Hwang: what’s the endgame? For Gill, is the prestige of being the ultimate Redditor/ meme investor the true goal? He easily could have walked away — quietly — with a nine-figure fortune. He instead has opened himself to exposure, and made a huge bet (with short-term call options on a highly volatile stock) that does have some risk of collapsing. It’s still a long way to June 21, when Gill’s options expire.

Is the aim for Gill — like prosecutors argue of Hwang — more power and prestige?

source: X.com/RoaringKitty

It’s a truly stunning symmetry. We have two men, Hwang and Gill, who have clearly manipulated the market — if not in the legal sense, then clearly in the practical sense. And yet, for both, we still don’t know if what they did was legal, or how their stories will end.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

source: Reddit

The account seemingly belongs to Keith Gill, a former middle manager at an insurance company who became an apparent multi-millionaire thanks to the epic 2020-2021 run in GameStop. The same evening, Gill’s Twitter account posted the reverse card from the game Uno.

On Monday morning, GME opened up 74%. Shares have faded from those highs, but the stock has still moved, with two-day gains of 14.5%. That’s enough for Gill’s position — as represented in the Reddit post — to gain about $48 million in value1.

The unusual nature of Gill’s posts provides a window into a long-running debate over what kind of trading is legal and what’s not. The implications are useful for investors to understand and they highlight other important concepts — including the possibility of following insiders into (or out of) trades.

GameStop five-year chart; source: Koyfin.com

Is Keith Gill Committing Insider Trading?

Gill’s trade does look questionable from a number of angles, not least from the perspective of regulators. Indeed, the Massachusetts Secretary of State has confirmed an investigation into the trades. A leak from Morgan Stanley unit E*Trade suggests the broker is considering dropping Gill as a client owing to concerns about manipulation.

What does seem certain is that Gill is not committing insider trading. Despite that, the trade and his standing with GameStop actually provides an interesting structure through which to view cases where insider trading laws do apply.

(Disclaimer: The author has no legal training and nothing in this post should be relied on as legal advice.)

It’s worth noting first that Gill is not an insider: he’s not an officer or director of GameStop, nor is he a 10% shareholder. Even if the June options were exercised, which is the most likely outcome if they stay above their $20 strike price, he would still own less than 7% of the company.

Exercising an option means putting into effect the right to buy or sell the underlying security. After all, that is what an option is: it’s the right to buy or sell a stock at a specified price on or before the expiration date. To do this, you simply tell your broker that you wish to exercise the option. The reason Gill would likely exercise just ahead of expiration is that he probably has more liquidity in selling the stock acquired over time than in trying to sell 120,000 (!) call options within two weeks. Volume at that strike on Tuesday was less than 6,000; it simply will be hard to find that many buyers, even given the frenzied trade in GME options.

It’s possible (though unlikely) that Gill is part of a group that could, in theory, breach the 10% threshold. There’s been some speculation that Gill must be backed by someone, given that the Reddit screenshot shows an investment of $175 million, and that exercising the calls would require an incremental $240 million.

But even if Gill were an insider, his trade likely wouldn’t violate U.S. regulations. Insiders cannot trade on material non-public information (MNPI), but U.S. insider trading laws also require that an insider have a fiduciary duty to the company itself.

It’s possible, perhaps, to argue that Gill had material non-public information when he made the trade, knowing that his plans would stoke a social media fire that would send the stock higher. The catch in terms of the law is that Gill has no responsibility to or agreement with GameStop itself not to trade on that information. As the excellent Bloomberg columnist Matt Levine (himself a former securities lawyer) argued recently:

Insider trading, I like to say, is not about fairness: It’s about theft. In the US, most of the time, it is illegal to trade on inside information about a company not because that’s unfair to everyone else who doesn’t have the information, but because you have some duty to somebody else not to misuse their information.

Notably, the rules are different elsewhere. In Europe, as law firm Quinn Emanuel Urquhart & Sullivan has put it, insider trading regulation “is fundamentally underpinned by a notion of information parity and fairness across all market participants. [emphasis in original]”.

But in the U.S., the responsibility to the organization matters. It’s why Gill can trade on his information. It’s why Berkshire Hathaway can disclose its purchases after making them, even though the very fact the company is buying a stock likely makes it rise. (For instance, last month Chubb jumped 7% when Berkshire disclosed it had amassed a $6.7 billion investment over the preceding months.)

Of course, that applies to short sellers as well: the likes of Hindenburg Research can short a stock before they attack it publicly. Again, they have no responsibility to the company to protect non-public material information, such as the fact that a company’s trucks were rolled down a hill instead of propelled by an engine.

The Patchwork Of Insider Trading Law

What’s notable about the U.S. regime is that there isn’t actually a specific law against insider trading. At the federal level, the crime is prosecuted under Rule 10b-5 of the Securities and Exchange Act of 1934. But Rule 10b-5 covers securities fraud more broadly. What has come to be defined as insider trading has developed not from Congressional dictates, but largely from individual cases.

Those cases can be quite fascinating (Levine is constantly referencing the more interesting ones). Just in April, an executive at Medivation was convicted in a relatively novel case covering so-called “shadow trading”. The executive discovered that his company was about to be acquired by Pfizer and bought call options on shares of another biotech, Incyte . He rightly assumed that the Medivation announcement would spike INCY stock; the trade made about $120,000. The SEC won the trial at jury, even while the agency acknowledged that there was no precedent for shadow trading to be considered a crime.

Other cases often revolve around whether a ‘tip’ from an insider is illegal. For decades, courts have wobbled over whether a “personal benefit” — in the most blatant example, a cash payment or profit-sharing agreement between the source of the information and the trader — is required for an insider trading conviction. What has been established is that the duty of an insider to protect information ‘travels’, so to speak, to close confidants. In February, a Houston man pleaded guilty to insider trading after overhearing his wife discuss a pending merger as she worked from home.

So while the broad sense of illegal insider trading has been established, there are continuing cases that define the boundaries of the crime: who is or is not an acceptable ‘tippee’; what actually constitutes MNPI; whether the so-called “mosaic theory”, in which a trader combines MNPI with more standard, acceptable research, should apply.

Overall, the importance of duty to the corporation remains paramount — and that focus has some logic. It’s good for the equity market if MNPI surfaces. It makes prices more accurate, which in turn helps direct capital formation across the economy. The debate, as seen in the differences between the American and European perspectives, might be how that information becomes public, and who profits in the process.

A Focus On Disclosure

Of course, insiders do trade in their own company’s stock and not all insider trading is illegal. In fact, most of it follows very basic rules. In the U.S. regime, insider trading regulation focuses on disclosure.

Any insider who buys or sells shares must disclose the trade in a Form 4, which must be filed within two business days. In addition, investors who accumulate a stake over 5% have to disclose that stake within five business days (that period was shortened last year from the previous ten business days). There are also periods in which insiders can’t buy, specifically when they are in possession on MNPI (think, for instance, the day before a quarterly earnings release, when executives know the results but the market does not).

Notably, those disclosures come after the trade is made — and those disclosures alone can move the stock. When Tesla CEO Elon Musk purchased shares of Twitter in 2022, the disclosure of his ownership — a disclosure which almost certainly was too late, violating regulations in the process — sent Twitter shares up 27% in three days.

As with other cases — think Berkshire or Hindenburg — this does seem potentially unfair, since Musk was able to buy Twitter at ~$37 with the knowledge that his purchases likely would move the stock higher2. But, again, insider trading regulation in the U.S. is not about fairness.

Some investors do put a great deal of emphasis on what is disclosed, particularly around insider buying. The old saw is that insiders can sell for many reasons: portfolio diversification, estate planning, or to raise cash for major purchases3. But insiders only buy for one reason: because they believe the stock is cheap.

Academic research suggests that, as a whole, insider trades are a reliable signal in both directions. Obviously, that does not mean every trade is a helpful signal — executives have their own biases and motivations which can influence decisions — but insider buying is an important vote of confidence in the stock. That appears particularly true during so-called “cluster buying”, in which multiple executives purchase stock at the same time.

And so there is an inherent logic to how legal insider trading is structured in the U.S. Insiders are rewarded: they generally get to buy at a price that doesn’t reflect all of the information they have. That in turn means, on average, those insiders receive immediate returns when that information does become public — even if that information is simply the disclosure of ownership by Berkshire, the building of a stake by an activist, or multiple, aggressive, buys by executives.

But it does appear that disclosure is quick enough that non-privileged investors can still profit off the signals provided. Even when understood after the fact, insider moves still matter.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

Joseph P. Kennedy, the father of John F. Kennedy, was said to have made his fortune by selling short ahead of the Crash of 1929. It’s not clear whether that, or his alleged bootlegging, was supposed to be more damning. Even in 2017, at a time when U.S. stocks were doing quite well, then then-head of the New York Stock Exchange said that “it feels kind of icky and un-American, betting against a company.”

But it’s almost certain that at no point in market history have short sellers received as much scrutiny, and indeed as much attention, as they have over the past few years. The incredible rise in GameStop stock in early 2021 created a narrative of rich versus poor, big versus small, and in some eyes good versus evil.

With GME roaring again, it’s worth understanding why short selling exists at all, whether the current narrative is accurate — and indeed whether it’s an appropriate strategy for individual investors to use. Unsurprisingly, a more sober look at short selling suggests its current perception is far too negative.

Source: Koyfin, GME rides again

The Mechanics of Short Selling

As most investors know, short selling is a bet that a stock price will go down. A trader borrows shares of the stock and then sells those shares. If the stock goes down, she can buy back the shares — ‘covering’ the short — for less cash than she received in the short sale, creating a profit. If the stock goes up, she buys it back at a higher price, and thus a loss.

Behind that simple trade is an entire industry that exists to match lenders (including index funds and brokerages) with borrowers. In most cases, the process seems relatively simple — but in actuality it’s quite complex. In February, Bloomberg columnist Matt Levine detailed the difficulty of simply settling an trade between institutions, and similar challenges can arise for short sales. The result is what is known as a “failure to deliver”, in which the short seller does not actually locate the stock she has agreed to sell.

But in most cases, particularly in stocks with low short interest (and thus healthy inventory from potential lenders like brokerages), the process works smoothly. The short seller pays a fee to borrow the shares — but notably also receives most of the interest created by the cash collateral that secures the share. And so in an environment with normalized interest rates, short sellers actually receive positive net interest on short sales with a low cost of borrowing.

Of course, the practice is also exceptionally risky. The 2021 gains in GME essentially blew up hedge fund Melvin Capital. In theory, short sales have the potential for unlimited losses, and many investors will argue that returns conversely are capped at 100%1. More broadly, short sellers need stocks to decline, and over time the average stock goes up. Selling short is a risky trade that, in general, seems to fight against the tide.

Why Short Selling Exists

Back in October, we highlighted the role of activist short sellers in the equity market. As we wrote then, the high-minded purpose of the stock market is to provide signals — to companies, to individuals, to entrepreneurs — that help the economy accurately allocate capital for the benefit of society as a whole. But without short sellers, there is no incentive for negative information to make its way into the market.

In theory, that means bigger bubbles and less accurate equity prices. In this telling, short sellers provide an important service, creating something of a brake on “irrational exuberance” in the market.

Of course, as noted above, many investors disagree with that characterization. But setting aside flowery justifications, there is a key reason why short selling does exist, and should exist: hedging.

Indeed, the ‘hedge’ in ‘hedge fund’ comes from the ability of those funds (unlike mutual funds) to sell stock short. That lowers the correlation of hedge fund returns to the market, which in turn mitigates short-term risks for hedge fund investors. For some of those investors, like pension funds or college endowments, short-term risks are material: the need to distribute capital in any environment means an inability to simply ‘wait out’ a broad market downturn.

There are more narrow applications of hedging as well. Merger arbitrageurs often short as part of their strategy to bet on (or against) deals closing. Their existence allows ordinary investors to sell on a deal announcement, with merger arbs taking on the risk (and taking a small fee, in the form of positive returns, in the process).

Convertible bond issuance would be nearly impossible without hedging. Buyers of those bonds, which are convertible into a pre-set number of shares2, can short sell to hedge their exposure to movements in the stock price. This allows more speculative companies to issue convertible debt that contains exceptionally low cash interest. During 2020 and 2021, zero-coupon convertibles (ie, no cash interest) became common. This allowed those companies to fund their growth in a much more attractive manner3.

Indeed, one repeat issuer of convertibles (albeit not zero-coupon convertibles) has been Tesla . More than a few investors have pointed out the irony that Tesla chief executive officer, Elon Musk, has repeatedly criticized short selling while his company funded itself using an instrument where short selling is essentially required.

The Rise Of The “Short Squeeze”

What’s different about the current perception of short selling is that it’s come at a time when markets are rallying, not fading. The practice occasionally has been banned in the U.S. and in other global markets, but nearly always when stocks are falling. For instance, the short selling of financial stocks was restricted in September 2008.

In those scenarios, restrictions on short selling seem more logical (even if the wisdom of those restrictions remains up for debate). Short sellers can cause a short-term decline in the share price of the targets, particularly if a number of trades are put on at the same time. More structurally, they do increase the number of shares that are actually in the market, since there are two investors with a long position for each share sold short. The original buyer has long exposure to the stock, and so does the investor who bought those borrowed shares from the short seller4.

In a plunging market, when regulators are under pressure to do anything, and investors are looking for scapegoats, banning short selling seems a quick way to relieve downward momentum in the market and satisfy frustrated investors.

But as we write this, the S&P 500 has gained 83% in the last five years, and sits less than 1% off its all-time high. And yet criticism of short sellers as dishonest, manipulative, and even villainous persists. This historically would be an environment where bears were pitied rather than scorned.

Clearly, a differentiating factor this time is the rise of Internet commentary and social media. The latter trend has been blamed for many ills, of course, including political polarization. Arguably a similar dynamic has played out in investing-focused media.

Certainly, the discussion of “short squeezes” has risen exponentially over the past decade or so. A Google search for the term on Seeking Alpha or InvestorPlace in 2014 shows exceptionally few articles focused on the topic. Over the past year, however, both sites have published dozens of such pieces:

source: Google

Yet there’s no evidence that “short squeezes” occur more often — or even really exist at all, at least in the sense that they’re commonly understood.

If a heavily-shorted stock rises after a solid earnings report, that’s not necessarily a “squeeze”. Instead, it’s simply the flip side of the valuation compression driven by the pressure caused by initial short trades.

In other words, if short selling causes price declines as the trades are entered, by definition it must cause price increases as the trades are exited. Short sellers will buy back shares to mitigate risk, which adds to the fuel from investors buying the stock on fundamentals (and also decreases the amount of shares available). That is categorically not the same thing as a short squeeze, in which short covering cascades in a vicious cycle: ABC goes to $20, so shorts buy back, which sends the stock to $22, which means more shorts have to cover, and so on.

The first dynamic, in which short covering helps the stock price if the results of the business outperform, absolutely can and should be part of a bull thesis on a heavily-shorted stock. The second, however, is a trading strategy, to the extent it exists at all. Just because a stock goes up doesn’t mean there was a squeeze: even the U.S. Securities and Exchange Commission, examining industry data, could not definitely conclude that the January 2021 rally in GME was a short squeeze or a gamma squeeze5. If there was a short squeeze, it was pretty much over by the time the stock became national news; the shorts at that point were relatively new to the trade:

source: U.S. Securities and Exchange Commission

Conspiracy Theories And High Short Interest

So what has driven the sharp increase in discussion of short squeezes? We’d argue the answer is simple: it’s a compelling topic for publishers. Short squeezes create the tantalizing possibility of huge, immediate gains. And, particularly in the social media environment, they create a “heroes versus villains” dynamic that is much more fun, to put it simply, than dry discussions of fundamentals. As is so often the case with social media, that dynamic seems to have gotten out of hand.

It’s impossible to discuss this topic without at least addressing the narrative around short selling in some corners of the market. Some forms allege massive manipulation by multiple market participants, with activities ranging from “naked shorting” to the dissemination of false information to the creation of ‘fake’ or ‘synthetic’ shares of stock.

It would take another entire series of articles to dispute many of those claims. We discussed many in a piece a little over a year ago, as Bed Bath & Beyond headed into bankruptcy. So committed were BBBY shareholders that they bought shares from the company despite its obviously dire prospects; those hundreds of millions of dollars in capital simply went to modestly improve the recovery of creditors.

But the broad argument is simple: anyone who has spent any time around the financial industry would instantly know that there’s no possibility of collusion. If any hedge fund was creating a massive undervaluation in a security, or just leaving itself vulnerable to a painful squeeze, any fund that could would take the other side of the trade in an instant6.

For the most part, all of this discussion is a distraction. High short interest does have value as an indicator — but only as part of a bull case. It’s worth noting in the sense of risk: educated traders clearly are betting against the stock, and at the least an investor needs to (emphasis on “needs to”) understand why that it is. And, again, high short interest can increase near- to mid-term returns thanks to covering, as seen in the likes of GME and Carvana.

Focusing on short interest to the exclusion of other factors, however, is generally a recipe for disaster. Investors can certainly get lucky in meme stocks and high short interest plays, as has been the case this week. But no one could have foreseen the catalyst: the return of Keith Gill, a.k.a RoaringKitty, which has sparked a massive rally in meme stocks.

The enormous irony which so many meme traders miss is that Gill’s original case had little to do with a short squeeze, and certainly did not center on a MOASS (Mother Of All Short Squeezes). Instead, as Gill detailed in testimony to Congress, he believed that GameStop was an attractive turnaround play.

RoaringKitty didn’t believe the shorts were evil; he believed they were wrong. He was making a fundamental case — and that is really the only way to make reliable judgements over the long term.

As of this writing, Vince Martin has no positions in any securities mentioned, though he does kind of wish he was long GME.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

One of the themes we’ve hit on multiple times in this series is the idea that accounting is as much an art as a science, as we discussed in our comparison of earnings and cash flow. Similar to earnings, book value is not necessarily a perfect representation of what it tries to represent: the actual value of a company’s assets, less its liabilities.

The catch, however, is that valuing a company’s assets is exceptionally difficult. Indeed, the stock market itself is an argument over the ‘true’ value of a company’s assets (net of debt, of course). And the structure created by accounting practices is poorly suited for the heavily intangible assets owned by so many modern companies.

So, for many stocks, book value is basically a useless metric. But what makes book value interesting is that, for some stocks, it’s exceptionally important.

What Is Book Value?

On a balance sheet, shareholders’ equity, or book value, is calculated in two ways. First, the company nets out its liabilities against its assets. But shareholders’ equity also needs to equal the sum of additional paid-in capital (representing sales and issuance of stock above par value), accumulated other comprehensive income or loss (from items such as equity investments), and retained earnings (the sum of profits in the company’s existence). We can see the line items in a recent quarterly filing from Meta Platforms , formerly known as Facebook:

source: Meta Platforms 10-Q, first quarter 2024

The second calculation usually is of little interest to investors. Retained earnings can occasionally be interesting in showing a company’s history. For instance, Plug Power , founded back in 1997, has an accumulated deficit (the mirror image of retained earnings) of nearly $4.5 billion. Its market cap is just $1.6 billion; those two figures give an idea of just how much capital Plug Power has spent in its 27-year history.

Its the first calculation — assets versus liabilities — that has some relevance to an investment case. But, as Meta shows, book value has some significant limitations.

Meta And The Problem With Book Value

For the most part, a company’s liabilities aren’t subject to significant accounting effects. There are some required calculations around line items like contingent consideration (potential payouts to the former owners of acquired businesses) or long-term tax liabilities, but those calculations have reasonable constraints. Generally speaking, both the company and the investors know what total liabilities are to a reasonable degree of certainty (debt, for instance, has a fixed principal amount).

But for assets, it gets a little trickier, because with modern companies, something is missing:

source: Meta Platforms 10-Q, first quarter 2024

Meta Platforms has book value of $149 billion. Current accounting rules suggest that is the value of the company’s equity. However, the actual market in which META stock trades applies an extremely different valuation: Meta has a market capitalization of $1.1 trillion, more than seven times its book value.

Many of Meta’s assets are common and easy to value: cash, marketable securities, and accounts receivable are all known figures. Property and equipment gets a little more dicey. Meta buys servers and depreciates them on a four- to five-year lifespan; buildings are depreciated over 25 to 30 years. Here, we already see a bit of an issue to which we will return later: buildings aren’t necessarily depreciating assets.

But the broad point still holds: many of the assets in the property and equipment line item degrade over time, and that expense is imperfectly calculated through the depreciation of those assets, almost always on a straight-line basis. In other words, ~20% of the server cost is charged as depreciation each year, an expense accounted for in the profit and loss statement.

Goodwill is a somewhat nebulous figure. It is an intangible asset that represents the premium paid in acquisitions; the purchase price, less the net “fair value” of the assets, is booked as goodwill. But, like other intangible assets, goodwill can’t be increased — it can only be decreased through an impairment.

Famously, Meta (then Facebook) paid $1 billion for Instagram in 2012. The company booked just $433 million in goodwill related to the acquisition. Again, the figure can’t go up, even though Instagram now is a key part of a business worth over $1 trillion.

What is even more problematic is that there is no line item for Meta’s own intangible assets. The servers that power Facebook are represented; the money due from advertisers is on the balance sheet. But the Facebook brand, its network, its user base, its power are, by accounting standards, not considered assets.

This seems bizarre. But those accounting standards mean that book value is essentially useless when dealing with companies whose businesses run on intangible, rather than tangible assets. In the modern world, this means software companies, fabless semiconductor developers, social media companies, and even retailers.

Indeed, META is not an outlier. The six most valuable companies on U.S. exchanges all have market capitalizations that are at least seven times their book value. The price-to-book for Nvidia is more than 50x; Apple 36x; Microsoft nearly 12x. Those multiples are not only high, but given the treatment of the intangible assets which power those hugely profitable businesses, those multiples are simply meaningless.

When Book Value Matters

And yet:

To recap Berkshire’s own repurchase policy: I am authorized to buy large amounts of Berkshire shares at 120% or less of book value because our Board has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders.

Perhaps the greatest investor ever, Warren Buffett, happily used book value as a metric for repurchasing his own company’s shares, as detailed in the quote above from the company’s 2016 shareholder letter1.

Given the limitations of book value, that policy seems surprising. But the reason Berkshire based its repurchases on book value is because, at the time, many of the company’s assets were properly valued. Berkshire’s book value of $620 billion included goodwill and other intangible assets (booked via acquisitions) of about $100 billion. A good chunk of the assets, however, were cash and equity investments (representing Berkshire’s massive portfolio) which were fairly valued by accounting rules.

Berkshire’s policy highlights the kind of business for which book value can be useful: one in which accounting rules require that assets be valued at, or close, to their fair market value. One obvious sector where book value matters is financials (which, to some extent, Berkshire belonged in 2016). Major banks are often valued in part on price-to-book — and that makes some sense. The assets of a bank, in particular, are relatively fixed, as seen in the JPMorgan Chase balance sheet:

source: JPMorgan Chase 10-K, 2023

Of course, the same is true of liabilities:

source: JPMorgan Chase 10-K, 2023

And so an investor can use book value — and particularly tangible book value, which excludes intangible assets and goodwill — as a reasonable guide to what the bank’s actual net assets are.

Using P/B In Financials And Other Sectors

To be sure, this isn’t perfect: as we learned during the regional banking crisis last year, following the failure of Silicon Valley Bank, some assets aren’t necessarily marked to market. And there are accounting maneuvers banks can use to impact their book value (such as classifying securities as “hold to maturity”).

Still, from a rough standpoint price to book represents the market’s view on the strength of the underlying financial franchise. A good bank should get a premium on its book value, since the bank presumably can drive consistent, solid returns on its equity and assets. A more questionable bank, not so much. And so P/B winds up being, at worst, a reasonable proxy for the market’s view of various financial franchises, particularly major banks:

source: Koyfin

In this vein, P/B can be used in terms of relative valuation, even as a broad starting point for thinking through an investment. Clearly, the market places a premium on JPM, while Citigroup remains a turnaround story (as it’s been for years). As for European banks UBS , Barclays , and particularly Deutsche Bank , investors clearly have concerns:

source: Koyfin

So a qualitative bull case for these banks can absolutely be based on relative P/B or P/TBV multiples. If Deutsche Bank can get its act together, and see its business valued even at the net value of its assets, the stock (in theory) can rise at least 150% as P/TBV moves toward 1x2.

Similarly, the multiple scandals at Wells Fargo have led investors to apply a discount relative to JPM and Bank of America . But the discount could narrow if the bank satisfies regulators and returns to normal (hopefully ethical) operations.

To be sure, banking stocks require significant, and often idiosyncratic, analysis. But book value and tangible book value can be part of that analysis, and the same is true for similar sectors where assets are both important and properly measured by accounting rules. That includes other financial industries like insurance or brokerages3, and homebuilders.

When accounting rules create a reasonable picture of a company’s actual net asset value, then price to book does have some value. And the gap between market cap and book value and/or tangible book value becomes a reflection of investors’ view of the actual operating business.

The Limitations Of Book Value

Put another way, the gap between market cap and book value, when book value is reasonably accurate, is the market’s valuation of what accounting rules can’t and don’t measure.

But, again, sometimes book value isn’t accurate. In 2018, Berkshire Hathaway abandoned its decades-long focus on book value. Buffett wrote that “the annual change in Berkshire’s book value…is a metric that has lost the relevance it once had.” A key problem was the company’s shift toward acquiring businesses in full instead of equity investments.

As Buffett noted, “accounting rules require our collection of operating companies [emphasis in original] to be included in book value at an amount far below their current value, a mismark that has grown in recent years.” Berkshire’s balance sheet could reflect the success of its investments, which were marked to market, but it could not and can not reflect the success of its acquisitions.

That distinction highlights the limitations of book value. It also gets to a somewhat odd truism: the better the business, the less book value matters. The best businesses have attributes — the wisdom of magnificent investors, a massive technological edge, network effects of dominant social media platforms — that accounting rules can’t measure. But, of course, it’s precisely those attributes that create world-changing companies. Book value can to some extent value a company’s assets, but it can’t really capture what those companies are able to do with them.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

In fact, there’s a classic principal/agent problem in the structure of a corporation. Managers and workers are the agents running the business on behalf of the principals, the equity investors who actually own the business. And those equity investors want their companies to take risks.

Certainly, that should mean intelligent risks. Shareholders won’t cheer if a CEO uses corporate cash to, say, build a search engine or create a new division from scratch that serves an entirely different industry. But to some degree, equity investors want some risk. That’s why they own equity, and not lower-risk debt, in the first place.

But for executives who are paid purely in cash, there isn’t a direct incentive to take risk. To some degree, the incentives point the other way. “Good enough” becomes more than good enough. A CEO’s best bet is to not rock the boat, and importantly not to take risk. Risk increases the potential for downside, which increases the possibility of getting fired and losing the cushy cash salary. Yet the upside potential added by risk creates little direct financial gain for the executive.

In this model, a CEO’s financial incentives are actually much closer to that of a bondholder, rather than a stockholder. She simply wants the company to be stable, so she can keep getting paid. Any upside in equity value is someone else’s concern.

For employees, the use of equity-based compensation is more straightforward. It gives those employees a stake in the business and, presumably, extra motivation. For early-stage startups, stock-based comp is perhaps the only way to attract high-value talent. Cash-only compensation eats up too much capital or leaves the company hiring only those employees unwanted by larger firms.

This is the theory, anyway. In practice, there are real concerns — and real questions.

The Rise Of Stock-Based Compensation

Over the past couple of decades, the use of stock-based compensation has risen dramatically, as detailed in this excellent paper from Morgan Stanley:

source: Morgan Stanley, “Stock-Based Compensation: Unpacking the Issues”

To be sure, this trend doesn’t solely reflect changing preferences by corporate boards of directors (who ultimately make the decisions regarding stock-based compensation). As Morgan Stanley notes, companies in the Russell 3000 today are younger (owing to the tech boom of the past three decades). Younger companies are more likely to use stock-based comp:

source: Morgan Stanley, “Stock-Based Compensation: Unpacking the Issues”

But it’s worth noting that the rise in stock-based compensation has had a more significant impact than the above two charts might suggest. A 2021 paper calculated that the average operating margin for the Russell 3000 as a whole is in the range of 11%. Notably, that figure is based on forward-looking estimates from analysts. Given that they aim to track the adjusted numbers provided by most companies, those estimates usually exclude stock-based compensation.

As a result, some investors argue that a material proportion — more than 10% — of the operating profits of U.S. public companies are not real. They exist only because the companies are paying more and more of their executives and employees in more and more stock. Yet, skeptics claim, investors and analysts are choosing to ignore that fact.

What Does Stock-Based Compensation Cost?

Companies are required to disclose the amount of their annual stock-based compensation. This creates some difficulty, because it’s not clear what exactly that amount should be.

There are all sorts of differing awards. Restricted stock — simply a grant of shares in the company — can vest over time: an employee gets 100,000 shares of stock, and each year 25,000 of those shares become unrestricted (and thus can be sold). Performance stock, as the name suggests, vests based on performance, and boards can and do choose from all sorts of metrics: total shareholder return, operating margins, even the results of a key business unit1.

Stock options, meanwhile, provide the ability to buy shares at the exercise price — but they, too, take myriad forms. Many vest over time; some have an exercise price linked to market conditions (for instance, the stock outperforming peers). The exercise price can be equal to, above, or below the current market price, for varying reasons.

All of these various compensation instruments receive differing accounting treatments in an effort to create a best approximation of their actual cost at the time. For instance, restricted stock is usually calculated at the cost of the total award at the grant date (ie, 1,000 shares at $50 is an expense of $50,000), with the cost then recognized over the vesting period. Stock options are accounted for using the Black-Scholes method2.

But one of the problems in terms of forward-looking guidance from companies is that a key input for many of these calculations is the stock price itself. In other words, a company knows that it will issue restricted stock and/or options over the course of the year, but it doesn’t actually know what that issuance will cost.

And so companies that use stock-based compensation in size often will guide to adjusted figures. This is not, as skeptics claim, because the company is trying to ‘trick’ investors (or at least, that’s not the sole reason). It’s because the actual accounting expense of stock-based compensation can be volatile, and likely will be more volatile based on the underlying stock price. Of course, the heaviest issuers of stock-based compensation are younger and smaller companies — precisely the kind of companies that usually have the most volatility in their stock prices.

The reliance on the stock price in calculating expense in and of itself is a tell that the accounting for stock-based compensation, like other forms of accounting, is not gospel. There are assumptions baked in, and factors that mean the line for both stock-based compensation in the earnings and cash flow statements may not be telling the entire story.

The Musk Awards

The two major awards granted to Tesla CEO Elon Musk give a sense of how these packages can work, how complex they can be, and what the SBC line item might actually mean.

In 2012, Tesla gave Musk his first package. It seemed huge at the time. Musk received options to buy 5% of Tesla at the stock price at the time the package was awarded ($31.17 per share, or $2.08 adjusted for subsequent stock splits). But for all of those options to vest, Tesla had to reach ten operational milestones, and had to hit ten successive levels of market capitalization. At the highest end, Musk’s package would be worth roughly $2 billion — but it would require Tesla’s market cap to rise by more than 13x3 and for the business to take the following steps:

source: Tesla proxy statement, 2013

As it turned out, Tesla kept hitting its goals. And so the company booked ever-high stock-based compensation to Musk, both to account for the vesting of options granted in 2012, as well as the higher probability that future tranches would vest as well. The growth of the business (and the workforce) increased SBC as well, but reading through 10-K filings from the time, the Musk package alone was a major contributor to a sharp increase in stock-based compensation expense:

source: Koyfin

In 2018, the board decided Musk needed another package. This one was far bigger: it granted Musk options to buy 12% of the company at the stock price in place at the time of the award. And with Tesla much more mature, the operational milestones were replaced by revenue and EBITDA targets.

Musk got 1% of the company (with the exercise price again equal to the stock price at the time) for every $50 billion in added market capitalization, as long as the added market value was met by improvements in the business.

source: Tesla proxy statement, February 2018

Once again, all the targets were met; Musk wound up receiving options to buy more than 300 million shares at an exercise price just above $23 (both figures adjusted for subsequent stock splits). As recently as late December, that package was worth $72 billion. It’s still worth about $40 billion, even with TSLA down 37% so far this year. Unsurprisingly, that massive package led to a further increase in SBC expense:

source: Koyfin

What Musk’s Package Tells Us

Investors who are skeptical of stock-based compensation will often argue that it is “a very real expense” too often excluded from reported financials. They’re absolutely right that the expense is real.

We can see that in the Tesla packages, which totaled, at the peak TSLA stock price, something like $80 billion in value for Elon Musk. The latter award was invalidated by a Delaware judge in January: she called the grant “unfathomable”.

But Tesla shareholders protested, perhaps rightly, that it wasn’t as if Musk took the money for nothing. At the time of the first equity grant, in 2012, Tesla had a market capitalization just over $3 billion. Four of the ten operational milestones in the first package relate to the production of prototypes. Today, Tesla is worth ~$500 billion, and (for now) remains the unquestioned leader in electric vehicles.

The investors who owned Tesla at the ~$3 billion valuation in 2012 wanted risk. Elon Musk took those risks: as he himself has admitted on multiple occasions, the company nearly went bankrupt, and the launch of the Model 3 in particular was not a preordained success.

Whether Musk’s role in Tesla’s development merits a package worth $56 billion, or $56 million, is up for debate. The inequality created by these types of awards — and broader CEO compensation, which has soared to 350x the salary of the average worker from just 21x — drives political arguments as well.

But, again, Musk’s wealth was only created because Tesla stock went up. Had the company gone bankrupt, the actual stock-based compensation expense would have been zero. That would have been small comfort to shareholders, admittedly. But Tesla shareholders ended up doing exceptionally well, even if they paid Musk dearly for the company’s success.

So, What Does SBC Really Cost?

The split in outcomes (generational wealth for Musk, portfolio-changing returns4 for shareholders) gets to one of the core questions about stock-based compensation: what does it actually cost shareholders?

Again, we get an accounting figure which is a decent approximation of the expense. An investor can think of that figure as an estimate of what the cash compensation would be for the equity being distributed at the time.

But the practical impact isn’t necessarily reflected. Musk’s award is an outlier, certainly: most stock-based compensation is more broadly distributed across employees and issued at levels much more likely (or, in the case of time-vested restricted stock, almost guaranteed) to be reached. As an outlier, though, it provides an interesting case study for how SBC should be viewed.

What Musk’s award truly highlights is that stock-based compensation costs more as the stock goes up. If a company in 2024 pays an employee $100,000 in cash and 10,000 restricted options that vest in twelve months at an exercise price of $10, and the stock doubles to $20, in some sense that employee’s compensation for the year was $200,000.

If the stock gets halved, however, there was compensation booked for that option grant, but it didn’t really cost shareholders anything; the employee won’t exercise, and her practical compensation for the year was actually just the $100,000 in cash received. Similarly, the practical expense of restricted stock is lower if the stock went down, since the company issued shares that, at least according to the market, are worth less.

It’s worth noting that, in extreme cases, GAAP5 accounting for share-based compensation can significantly understate the actual cost. From 2018 to 2021, per filings, Tesla booked $2.2 billion in SBC related to the 2018 Musk award. In 2021 alone, Musk exercised options with an intrinsic value of more than $23 billion.

This creates a somewhat odd dynamic. After all, shareholders (or at least active shareholders) own a company for the upside. Yet — and the Musk award is an amplified example of this — in a company with high stock-based comp, the more upside there is, the more of the upside goes to employees and executives. In this sense, SBC is almost a bit of a downside hedge. Using less cash to pay employees now lessens the need for capital raises and/or the risk of bankruptcy down the line6.

Stock-Based Compensation and Valuation

One of the common themes of this series has been that basic accounting structures are usually good enough. But it’s important to understand the underpinnings of those structures, because sometimes they’re not.

SBC is a good example. For the most part, investors can use the accounting figure to get a sense of how profitable the business actually is. Fundamentally, it does seem like an issue if adjusted operating income is barely above — or less than — the booked amount of share-based compensation.

But sometimes that figure can be misleading — or, at the very least, investors can get to a more accurate estimate of the impact of SBC by going in a different direction. That direction usually involves estimating future dilution based on SBC, and thus accounting for equity issuance in terms of shares outstanding instead of the accounting figure for the expense.

Here, too, Tesla provides a good example. After the release of Tesla’s fourth quarter 2021 report in late January 2022, an investor could have looked at Adjusted EBITDA of $11.6 billion for the year, added back $2.1 billion in stock-based compensation expense, and used $9.5 billion as the ‘true’ EBITDA figure.

Or she could read the 10-K (p. 84), see the $910 million of expense related to the Musk award, and simply add his options to the share count to account for the fact that all of the options would vest. She could then use the remaining ~$1.2 billion to roughly estimate dilution going forward (book expense/market cap is a reasonable proxy, though the K usually gives enough detail to get more specific), and build that rise in share count into her model.

Certainly, the former approach seems easier. And, again, in nearly all cases, it’s good enough. But it’s worth understanding both methods because there are examples where current-year stock based compensation is inflated. One somewhat common instance is when founders get a grant of stock before the IPO: that grant is expensed as share-based compensation over time, though it’s more accurate to simply account for those shares before their expense is booked7. When doing a truly deep dive, it’s not a terrible idea to use both methods — or at least keep an eye out in the 10-K for disclosures that might suggest that the booked method of share-based compensation is understating, or overstating, the case.

Is Stock-Based Compensation Being Ignored?

We noted earlier that SBC has its share of skeptics who believe the market is simply making an error in accepting adjusted figures (nearly all of which exclude stock-based compensation) at face value. It’s not hard to have a little bit of sympathy for their claims.

After all, particularly before the 2022 sell-off in tech, many investors, and sell-side analysts, discussed stocks in terms of adjusted earnings multiples which ignore significant dilution. So did management teams — and not just at young, fast-growing companies:

source: Salesforce Q4 FY22 (ending January) earnings release; highlighting by author

For fiscal 2023, Salesforce in March 2022 was guiding for $32 billion in revenue, and still was more than doubling its adjusted operating margin by excluding stock-based compensation. Investors were happily paying more than 40x that adjusted figure — and ~80x adding back stock-based comp — for the stock. Many of those investors pointed to 20% margins as proof of how impressive the underlying business was.

Admittedly, in terms of market cap, the dilution wasn’t quite as significant: Salesforce was worth about $200 billion at the time, so stock-based comp (based on the booked expense, which seems reasonably in line) only created annual dilution of under 2%. Still, that’s a significant headwind to annual shareholder returns.

However, investors worried about stock-based comp were largely shouting into the void. It was precisely these companies — young, fast-growing, tech-focused, using the most SBC — who had the best returns. CRM was one of those names:

source: Koyfin. chart from 3/2/10 to 3/2/22

But as Morgan Stanley noted in the report linked to earlier, a study found that, when controlling for growth and age, high issuers of stock-based compensation in fact underperformed on a risk-adjusted basis. The firm cited another review of sell-side estimates which suggested some analysts (hopefully not those from MS) ignored the impact of dilution in their cash flow models, which unsurprisingly led to more (and perhaps) overly optimistic price targets.

In the two years since tech tanked (and then recovered), stock-based compensationhas become a much bigger point of contention. This is somewhat ironic since the spike in interest rates is credited with starting that sell-off, yet higher rates actually decrease the value of stock options and restricted shares8. Salesforce, like many other companies, has focused on lowering SBC along with other expenses, though equity issuance still clearly has a huge effect on its adjusted numbers:

source: Salesforce Q4 FY24 earnings release (highlighting by author)

In the sense of the broad market, stock-based comp ‘alarmists’, for lack of a better term, have been mostly wrong. They’ve missed out on opportunities. Even CRM stock has roared back, briefly touching a new all-time high last month (with expense control a key reason why).

But skeptics are right that SBC is a real expense. It matters. Dilution impacts shareholder returns, as evidenced by the fact that tech companies like Salesforce are using corporate cash to buy back shares simply to offset the dilution from equity issuance. Obviously, that’s cash that could go to dividends, acquisitions, or buybacks that actually reduce the share count, instead of keeping it flat.

And they may be proven even more correct in the coming years. One of the important questions about stock-based compensation that will be answered amid tighter corporate spending and, perhaps, the next recession is whether the incentives of SBC actually work.

There’s absolutely a possibility in which, particularly in tech, stock-based comp proves to be a “heads I win, tails you lose” proposition for employees relative to shareholders. If the stock goes up, employees and executives profit, and potentially handsomely so. If it goes down, however, the company then has to provide more option awards and/or equity grants to give employees roughly the same value at the new, lower share price.

In that scenario, SBC is not just a real expense, but one that is perhaps bigger than investors, and accountants, have contemplated. That might be enough for the skeptics to finally be vindicated.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

Even for those who subscribe to this theory, there are some obvious issues. It makes sense to discount future cash flows, certainly: in all but the most unusual environments, a dollar in 2034 is worth much less than a dollar in 2024. But by how much should we discount those future cash flows — and why? Expectations around inflation and interest rates are of course factors. If an investor can get 5% interest from the U.S. government for one year, almost by definition a dollar 12 months from now has to be worth less than 95 cents today.

But this same theory argues that investors also need to account for risk: a higher-risk investment should have a higher discount rate. Of course, that simply gets us back to the starting point: how high a discount rate? And why?

Is Tesla a risky investment? Bears would argue that of course it is: any auto manufacturer is risky. Bulls would retort that of course it isn’t: it’s a diversified business with multiple high-margin revenue streams led by a charismatic, historically successful CEO.

Of course, all this ignores the much bigger problem. How, exactly, is an investor supposed to know what future cash flows look like? Indeed, the biggest critique of discounted cash flow models (often referred to as ‘DCFs’) is that they are subject to the “garbage in, garbage out” problem.

Garbage In, Garbage Out

A DCF is useless if the inputs to the model — the projected future cash flows — are wrong. In fact, it can be worse than useless. By creating a present value for the business (which in turn is used to value the stock), the model creates a false sense of accuracy. And it doesn’t take much for inputs to create vastly different outcomes.

Imagine a business with free cash flow per share of $2.00, which is projected to grow 5% annually, where the discount rate is 8%. A rough DCF model (which assumes 2% growth in perpetuity after 10 years) values each share at $42.84.

Lower near-term growth to 3%, however, and raise the discount rate to 10%, and valuation drops all the way to $27.39, even keeping the same long-term growth rate of 2%.

In the chart below, the colored area represents the actual free cash flow per share being generated over time, discounted back at the respective discount rates. As we can see, being wrong up front means an investor is still wrong decades later, even on a present value basis:

source: author

Still, the theory behind discounted cash flow provides a useful framework for understanding what active equity investing is actually supposed to be: finding businesses that are going to generate more cash flow than the market currently projects. Those projections are built into the stock price (though, as seen multiple times over the past four years, the connection between future cash flows and the actual stock price in the market can become strained). The fun and difficulty in stock-picking is trying to assess where the market is (hopefully) wrong.

There’s one more interesting question to consider however: why, exactly, are we discussing cash flow and not earnings?

Why Cash Flow Is ‘Better’ Than Earnings

After all, it’s earnings that get the focus from investors and, notably, the financial media. The period that begins a few weeks after the end of each calendar quarter is called “earnings season”, not “cash flow season”. In theory (at least this theory), cash flows drive stock valuations. In practice, it’s earnings that seem to drive stock prices.

The semi-accurate answer to the question is that cash flow is real, and earnings are not. A dollar in cash can be reinvested in the business or distributed to shareholders via share buybacks and/or dividend payments.

In contrast, earnings are essentially an accounting fiction. $100 million in cash flow is $100 million going into the corporate bank account. $100 million in earnings is a number on a ledger.

One way to understand this is to work down the P&L from EBITDA, (earnings before interest, taxes, depreciation, and amortization). Above the EBITDA line, there are differences between earnings and free cash flow: stock-based compensation, for instance, is deducted from GAAP earnings (though SBC is excluded from adjusted figures reported by most companies these days). But, roughly speaking, EBITDA is a good starting point for both earnings and free cash flow.

After that, however, the metrics notably diverge. To get to free cash flow from EBITDA, the business deducts:

• cash interest payments;

• cash paid for taxes; and

• capital expenditures, or actual cash paid for physical assets

These are all obviously real, concrete expenses. In contrast, to get to earnings from EBITDA, the business deducts:

• interest expense under accounting rules, which may include non-cash expenses like the amortization of debt issuance costs;

• the book tax rate, which may differ notably from the actual cash paid (for instance, if the company runs a loss that creates a deferred tax asset);

• depreciation, another non-cash expense which accounts for the reduction in value of existing physical assets;

• and amortization of previous spending, most notably of intangible assets acquired in an acquisition.

And in those deductions, businesses have a perhaps surprising amount of flexibility. For instance, major tech companies last year chose to extend the useful life of previously purchased servers. This had the effect of lowering annual depreciation expense, since the same initial cost was spread over more years. By one estimate, the shift added some $10 billion to their total reported earnings.

Indeed, bearish takes and even outright short sales can be based on a consistent gap between earnings and free cash flow. That gap suggests that the company is using accounting techniques to make earnings look better, because there are no such techniques for improving free cash flow (other than outright fabrication of the statement itself). Companies like IBM and General Electric have been targeted for aggressive accounting, particularly around adjusted numbers. And the ability for companies to manipulate earnings has led to scandals in the past, with the early 2000s trio of Enron, Tyco, and Worldcom the most prominent.

Those scandals have been minimized substantially by the Sarbanes-Oxley Act of 2002, which assigned personal responsibility for accurate accounting to top corporate officers. Still, there are legal ways in which companies can make not just adjusted earnings, but GAAP (Generally Accepted Accounting Principles) earnings, more favorable. That aside, many aspects of earnings are based on actual judgments by corporate officers, whose biases are clear.

There is no bias in the cash flow statement. Again, it represents the dollars going into (or out of) the corporate accounts. In that context, it would seem like cash flow is the far more important metric.

Why Earnings Exist

But cash flow has a big problem. It’s lumpy:

source: Koyfin

Above is a five-year chart of quarterly free cash flow from Facebook owner Meta Platforms $META. The chart is hardly unusual.

Free cash flow can swing wildly for many reasons. Changes in working capital ( current assets and liabilities like inventory, accounts payable and receivable, and accrued expenses) are a key part of free cash flow:

source: Meta 10-Q, Q3 2023

And those aspects of working capital move for reasons that have little to do with the underlying performance of the business. A significant payment might come in on October 1 instead of September 30, which boosts fourth quarter cash flow at the expense of the previous period. Inventories for retailers can fluctuate dramatically over the course of the year, building in the third quarter and then bottom in the first quarter, after the busy holiday period. For some businesses, the timing of bonus payments to employees is significant, and certainly enough to make free cash flow in that quarter much weaker.

Even taking the longer view, variability between years can be significant. Sotera Health $SHC is an interesting example. The parent of sterilization provider Sterigenics settled a huge lawsuit in 2022, which hit earnings but the payment wasn’t made until 2023. And below the operating cash flow line, capital expenditures have doubled, due to expansions at existing facilities and the construction of new ones.

source: Sterigenics 10-K

So Sotera’s free cash flow has plunged into the red, to a burn of $362 million in 2023 against an inflow of $179 million two years earlier. But that decline doesn’t necessarily reflect a similar change in the actual operations of the business.

The point of earnings is to construct a scenario in which immaterial working capital effects basically don’t matter, while the impact of larger corporate decisions (like capex or acquisitions) are spread out over a longer period. Indeed, this is exactly how depreciation works: the elevated capital expenditures in 2023 (which Sotera expects will continue this year before a drop-off in 2025) don’t lead to a sharp drop in reported earnings. Instead, depreciation rises over time, with the ‘hit’, as it were, from the capital expenditures extending across the useful life of these new facilities.

Why We Focus On Earnings

The broader point is that earnings may be ‘fake’ relative to cash flow, but in some sense they are actually more ‘true’. The accounting regime around earnings creates a construct in which the ongoing, consistent operations of the business are actually measured.

Certainly, earnings are not perfect. There are judgments and errors (it’s possible, for instance, that servers won’t last as long as tech companies now believe, which will require accelerated depreciation in future years if the value of those servers is written off to zero). There is outright manipulation, even of the petty kind: a 2018 study found significant evidence that quarterly earnings per share numbers are rounded up to the nearest penny rather than down.

But it’s useful to imagine a world where free cash flow was the headline metric, instead of earnings. It would be bedlam. Businesses would make huge efforts and incur high expense to pull in cash just before the end of the quarter or year end. Analyst estimates would often be off by hundreds of millions of dollars, solely because of the timing of a capital project or the receipt of a sizeable check.

In contrast, earnings provide a smoother picture, one that generally speaking is (roughly) accurate based on the efforts of everyone involved. And the point of that smoother picture is not just to tell investors what has happened, but what will happen. It provides the ability to see trends, to understand changes in the business, and to better forecast the future. It is, after all, the future that matters for investors.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

The simple definition of debt is that it is a borrowed asset (usually cash) that has to be paid back. In the corporate world, there are liabilities that share the latter half of that description, even if those liabilities aren’t necessarily created by borrowing cash.

For the most part, these liabilities aren’t all that material to valuation. But there are exceptions to that rule, and it’s useful to understand what some of these terms actually mean when seen on a balance sheet.

An Overview Of Non-Debt Liabilities

There are monies that a company will have to pay in the future, even if they are not necessarily debt. Defined-benefit pension plans can run at a deficit (ie, plan assets are less than liabilities), meaning the company is likely going to have to fund its plan at some point.

Contingent consideration represents payments for acquisitions that already have occurred, payments that are based on the acquired business hitting targets negotiated at the time of the acquisition. Companies that once were owned by private equity often have tax receivable agreements, or TRAs, which require the now-public company to reimburse its former owners for tax savings.

One notable difference between these liabilities and debt, however, is that non-debt liabilities aren’t necessarily fixed. These liabilities do have to appear in financial reports, as seen here in the balance sheet statement from ZoomInfo Technologies :

source: ZI 10-Q, October 2023 (with author highlighting)

Quite often, these liabilities aren’t fixed, but instead estimated by management. ZoomInfo owes 85% of future tax savings to its former owners — but, obviously, it’s far from certain exactly what those total savings will be. If ZoomInfo’s business falls off a cliff and the company never makes another dollar in profit, the actual TRA liability will be zero. Conversely, if the company generates profits above what management currently expects, ZoomInfo will send far more in TRA payments than it estimates.

And so these non-debt liabilities have to be considered differently than debt, which almost always represents a fixed amount owed with a scheduled maturity. TRA payments can last, in theory, for decades. So too can a pension liability. The line on the balance sheet is a useful estimate — but it’s only an estimate.

What Is Contingent Consideration?

Contingent consideration is money owed to the former owner of a business after an acquisition. The liability usually comes from what are known as “earnouts”, in which the former owners receive additional compensation if the acquired business meets targets under its new ownership.

For instance, a business might sell for $50 million in upfront cash, with another $10 million awarded if that business generates, say, $25 million in revenue in the second year after the acquisition closes. The agreements can be more complicated, with multi-year targets (ie, $25 million in year 2, and $40 million in year 3, with each year sporting its own potential award) or metrics beyond revenue (such as profits, market share, or even the number of customers acquired).

(It is possible in the micro- and small-cap universes to have deferred consideration for an acquisition, where the former owners are owed cash after the deadline closes no matter how the deal performs, but usually it’s too risky to make an acquisition without the ability to immediately fund it.)

When the acquisition closes, the acquirer has to book a liability for contingent consideration. After all, at that point it owes the sellers something of value: essentially, an option on performance of the acquired business. And so the management team of the acquirer will run an estimate for the likelihood the target will be hit, usually using a Monte Carlo simulation, and book a liability accordingly. If the earnout is $10 million and the simulation suggests a 25% chance it will be reached, the liability for contingent consideration should be booked at $2.5 million.

The Value Of Earnouts

Contingent consideration is rarely material to valuation on its own. Even in acquisitions with that feature, the majority of the cost is in the fixed upfront payment: if sellers wanted to maintain the upside optionality in the business, they wouldn’t be sellers in the first place. And of course the total cost of an acquisition (or multiple acquisitions) is usually a small portion of a company’s market capitalization.

But contingent consideration can give valuable insight by providing a ‘true’ account of the performance of acquisitions. The reason is that the calculations underpinning contingent consideration liabilities need to be updated each quarter. The change in liability, then, reflects the most recent assumptions from management about the prospects of the acquired business and the odds that it will hit its earnout targets.

And management has to be completely honest about those assumptions. It’s probably not securities fraud if a chief executive officer says on an earnings call that an acquired business is “performing well”1. “Performing well” can mean almost anything. But it almost certainly is securities fraud2 if a chief financial officer intentionally overstates an earnout liability to create the perception that the acquisition is going according to plan.

So if a booked liability for contingent consideration goes up, that (perhaps counterintuitively) is good news. Yes, there’s a greater likelihood the company will have to compensate the sellers of the acquired business, but that cost is relatively small. The more important news is that the acquired business is performing well enough that the odds of hitting an earnout have increased. And each quarter, the company will detail in SEC filings how much contingent consideration has changed:

source: i3 Verticals 10-K, fiscal 2023

Last year, we recommended i3 Verticals , a hugely acquisitive software company (i3 now has made 49 acquisitions since its founding). And one of the points we made at the time was that rising contingent consideration charges suggested its acquisition strategy was working well.

For i3, the estimate changes seem to be material. Contingent consideration was booked at just $22.8 million at the end of FY22, so the outlook for the acquisitions subject to earnouts has improved noticeably. We can also see in the cash flow statement that in FY22 and FY23, i3 paid more than $37 million in contingent consideration beyond its original estimates:

source: i3 Verticals 10-K, fiscal 2023 click to enlarge

Again, both the original and updated estimates almost certainly were done in good faith. And while there isn’t really a formula to say how important post-acquisition performance is to the stock, common sense says it matters. i3, even up 10% since our recommendation, has a market cap of barely $500 million.

The fact that contingent consideration was revised upward markedly in FY23, and that the company has paid out significantly more in earnouts than it originally estimated, is firm evidence that the acquisition strategy continues to perform well. For a company that makes multiple acquisitions every year, that’s obviously an important piece of information to understand.

Defined-Benefit Pensions

Defined-benefit pension liabilities are rare to see these days at public companies, which have generally tried to push 401(k) plans for worker retirement instead. But we have highlighted Unisys , whose pension liability is carried at a value greater than the company’s market capitalization. Micro-cap newspaper operator DallasNews isn’t quite as extreme a case, but its pension liability is more than 80% of its market capitalization.

Calculating a pension liability is truly an estimate, because so many factors are at play. Actual payments into the fund over time will depend on interest rates (which affect yields for the pension’s bonds), returns in the equity market, and the lifespan of the plan’s participants. One important point to remember is that higher interest rates are actually good news for a pension, since they provide the ability to re-invest maturing bonds at much higher rates. Unisys has estimated that a 100 basis point increase in interest rates lowers its liability by $170 million, an enormous figure given that its market cap is about $340 million at the moment.

Again, it’s rare for pension liabilities to be nearly this material, and in cases like Unisys or DallasNews the issue is discussed quite often on conference calls or even mentioned in investor presentations. For most modern companies, defined benefit plans don’t exist. For older companies, funding isn’t always an issue. IBM , for instance, said at the end of 2023 its pension was underfunded by $4 billion, but that’s barely 2% of its $175 billion market capitalization.

In the corner cases where pensions matter, using the company estimate as a measure of the liability is probably the simplest method. The data isn’t offered to calculate an independent estimate (we aren’t told specific investments, for instance, or have a sense of the population covered by the pension). And, again, in those cases, management will be aware that investors see the pension as material, and will provide commentary and data on the status of the pension and plans to fix it.

In those scenarios, a pension can be treated much like debt, albeit debt that doesn’t necessarily have a fixed maturity date or a fixed amount. The 10-K should detail mandatory annual contributions, which can be considered somewhat akin to interest. Certainly, they come out of corporate free cash flow. It is possible for earnings to be positive, and free cash flow to be negative, because the pension contribution comes out of the latter but is not included in the former. But, again, in the overwhelming majority of cases, a defined-benefit pension either doesn’t exist or doesn’t really affect the investment case.

Tax Receivable Agreements

For reasons we don’t necessarily need to go into here, a structure known as an “Up-C” can create a deferred tax asset for a company going public3. Unsurprisingly, private equity owners taking their businesses public aren’t keen on leaving the value of that asset for public market shareholders. And so, those companies will execute what is known as a “tax receivable agreement”, in which the former owners are compensated with 85% of the savings created.

The liability can be substantial. In the example above from ZoomInfo, the total TRA liability nears $3 billion. The company currently is worth about $6 billion.

But it’s important to remember that, again, the TRA is just an estimate. More importantly, unlike a pension, a TRA liability doesn’t really need to be “paid back”: money is only owed if the company is making profit that creates tax expense, and even then the company can keep 15% of the savings.

And so a TRA liability really shouldn’t be treated as something akin to debt. That liability is offset by the deferred tax asset created by the Up-C structure (ZoomInfo’s deferred tax asset is currently booked at $3.7 billion). Put another way, a portion of profits are going out the door no matter what: either they are going to federal and state governments or they are going to the former owners. It’s mostly an accounting vagary that requires the latter payments to be booked as a liability, and not the former.

The simplest way to actually account for the TRA is to just value the business on a fully-taxed basis, which most companies will actually do in their adjusted results anyhow. It’s possible, perhaps, to see the TRA (as with earnouts) as a sign of management confidence in the long-term health of the business, but in this case the signal seems much, much weaker.

Most notably, the savings from deferred tax assets can be decades out, and there are many other factors that can affect the liability. For instance, ZoomInfo’s TRA liability came down in 2022 and 2023 in part because the company didn’t make a 2023 payment, but also because a change in Massachusetts state law created lower tax rates (and thus lower taxes on which to generate savings that would then passed along to the former owners).

But ZoomInfo does highlight one very important aspect of a TRA. There is a situation in which a TRA acts like debt: when the business is sold. As the company wrote in the most recent 10-K:

source: ZoomInfo 10-K, 2023

If ZoomInfo were to sell itself, it has to reimburse its former owners for the TRA liability. That liability isn’t necessarily a deal-breaker: ZoomInfo writes elsewhere in the 10-K that the TRA payment would be based on the current booked liability, calculated based on a discount rate. Still, that expense might easily be $1 billion or more, a material impediment toward a takeover offer at, say, $9 billion.

In an environment where private equity firms seem happy to own profitable tech firms, ZoomInfo is probably off the market, at least for now. That’s information that obviously is enormously important for investors — but it’s information only understood with an understanding of how something that isn’t debt can, in this case, act quite a bit like debt.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

We closed our last piece by highlighting Bausch Health, which by one metric looks like perhaps the cheapest in the entire market.

Based on consensus estimates, BHC trades at 2.44x fiscal 2024 earnings per share. And that’s with the company growing EPS 13.7% in 2023 and another 12%-plus expected in 2024.

Given double-digit growth, a sub-2.5x multiple seems ludicrous. Indeed, an investor could argue — and we’ve heard versions of this claim in the past — that Bausch is a no-lose proposition. After all, in less than three years, the company is going to post earnings that will likely be greater than its current market capitalization.

Of course, the equity market doesn’t just leave no-lose propositions lying around. And even a casual look at BHC trading volumes suggest this isn’t a stock the market is ignoring.

So the question is why BHC looks so cheap — and if, indeed, it is so cheap. A big part of the answer comes down to the balance sheet, which makes Bausch a perfect model for a step-by-step primer on understanding debt as a part of equity research.

source: Bausch Health 10-K, p. F-41

A Look At Bausch Health

In 2010, a pair of drugmakers, Biovail and Valeant Pharmaceuticals International, merged in a $3.2 billion deal. The deal technically merged Valeant into Biovail, a Canadian concern which marketed antidepressant Wellbutrin and other drugs. But the combined company retained the name of Valeant, which had developed antiviral ribavarin and, via acquisitions, built out a fast-growing business in dermatology.

The ‘new’ Valeant was led by the chief executive officer of the ‘old’ Valeant, Michael Pearson. Pearson had executed 15 acquisitions in three years when the merger was announced; his strategy remained the same in his new role. If anything, it ramped up. In 2011, the company made eight acquisitions of companies or product rights with total upfront payments of $2.7 billion; many of the agreements had milestone payments and/or royalties on future sales as well. The following year, nine deals totaled more than $3.5 billion.

In 2013, Valeant paid $8.6 billion for Bausch + Lomb (it would spin off a portion of its ownership in 2022). The next year, it tried and failed to buy Allergan1. Undeterred, Valeant spent $15 billion on gastrointestinal drugmaker Salix in 2015.

The strategy was incredibly successful — until it wasn’t:

source: Koyfin. Chart from 1/1/10 to 1/1/17

It was short sellers who helped catalyze the plunge in Valeant stock. Andrew Left of Citron Research, following work done by independent journalists, accused the company of “Enron-like accounting” in its use of a specialty pharmacy.

Regulators caught on, with some help from Valeant itself: reportedly, the U.S. Securities and Exchange Commission started its investigation of Valeant after the company asked the SEC to investigate its critics. The same acquisition strategy that had driven Valeant stock up added to the pressure, particularly after Pearson admitted the company had been too aggressive in raising prices of acquired drugs.

By 2016, Pearson was gone. In 2018, the company changed its now-toxic name to Bausch Health. But an important legacy was left: a massive amount of debt on the balance sheet, used to pay for the acquisitions under Pearson’s watch.

Why Is BHC So Cheap?

In the stock market, when something seems so ridiculously cheap, there’s usually a good reason why. At 2.5x earnings with double-digit growth, BHC certainly qualifies as “ridiculously cheap”.

And so an investor’s first question with a stock like this is: why does such an opportunity seem to exist? In other words: what’s the catch?

With Bausch, there are two. The first is that it is a pharmaceutical company, and those can’t be valued like any other businesses. Early-stage pharmaceutical stocks are valued based on the potential of their drugs in development. More mature companies face what is known as a “patent cliff”. As the patents for key drugs expire, generic competitors flood in, and revenues can, as the name suggests, fall off a cliff. And so the company must successfully — and continually — launch new products to keep overall revenue stable, let alone growing.

For a generalist investor, trying to model the puts and takes of a diversified drug portfolio is essentially impossible. There are constant legal challenges to existing patents (Bausch is dealing with a legal dispute over Xifaxan, which drove ~20% of sales last year), pharmacological questions about the potential success of new drugs and competitive products, marketing and market size considerations, and many more complications.

But one of the points we’ve made in this series generally is that common sense can go a long way. The fact that BHC is trading at less than three times earnings pretty much by definition means the market sees those earnings as heading into a period of decline. That decline doesn’t necessarily begin in 2024 — neither management nor Wall Street believes as much — but the market is telling us it will begin soon.

The other factor here is debt. As we noted in our piece on financial leverage last year, debt lowers the price-to-earnings multiple of a stock. And Bausch has a lot of debt, as even a cursory look shows:

source: Bausch Health 10-K (author highlighting)

Again, common sense is helpful here. Bausch has a market capitalization of $3.5 billion. It has debt of $22.4 billion (and just under $1 billion in cash).

To some degree, then, we’ve already answered the key question. Why is Bausch so cheap? It’s a hugely leveraged (net debt is six times its market capitalization) pharmaceutical business with serious risk of a decline in profits. In that context, the 2.4x P/E multiple isn’t a sign of a market gone mad. Instead, it actually seems somewhat logical.

Bankruptcy Odds

The question, of course, is how logical. Common sense says BHC is a risky play. But in turn that also suggests it’s a potentially lucrative play as well. To oversimplify the story here, BHC trades at 7.6x EV/EBITDA, with net debt at about 6.6x EV/EBITDA. Expand that multiple one turn to 8.6x, and the stock roughly doubles. That’s, again, an oversimplified, on-paper model focusing on one metric, but it gets to the idea that there is potential for BHC to post huge gains if the worst-case scenario is avoided.

And as we noted last time, one way to judge the likelihood of that worst-case scenario is to look to the credit markets. That is the job of a debt investor: to accurately price the odds of the worst-case scenario. Those investors are pricing in pretty high odds of disaster here:

source: Finra (author highlighting)

What’s notable is the fact that near-dated maturities have high yields. One of the bonds not shown, a 6.125% issue that matures in February of 2027, has a yield to maturity of 24%.

We know, via common sense, that those yields suggest the bond market is pricing in a material chance of a restructuring. How material is up for debate. Calculating bankruptcy odds via a bond price would look something like this:

risk-free return = [bankruptcy odds]*[returns in a restructuring] + [1-(bankruptcy odds)]*[returns if the debt is repaid]

In other words, it’s an expected value calculation, with two possibilities: bankruptcy before maturity and no bankruptcy before maturity.

We know the return if there is no bankruptcy. The catch is that we don’t know the return in a restructuring. Does Bausch start skipping interest payments later this year, or in 2026? Is there any recovery value for these bonds?

We do know from the 10-K (p. 66) that in 2022 Bausch exchanged about $5.6 billion in unsecured debt for new secured debt with a face value of roughly $3.1 billion. And that unsecured debt had interest rates ranging from 9% up to 14% — the latter a rate that still implies a pretty high chance of bankruptcy. And those bonds are in front of the unsecured issues in any bankruptcy scenario.

Recovery value for these bonds may well be zero, or close. Based on that assumption, we can get an estimate of bankruptcy odds priced in by the bond market (we’ll put the math in a footnote2): at least 40% by 2027.

The Claim On Cash Flow

It bears repeating: investors don’t have to run this math every time. If a press release cites a 1.8x leverage ratio, and a decently-growing stock trades at, say, 23 times earnings, the exact details of the balance sheet are probably relatively immaterial. It’s always worth checking, but simply reading the 10-K (particularly with experience) will almost always surface any potential issues.

Even for a name like Bausch, investors don’t necessarily have to do this kind of math at all. Algebra isn’t required to prove the core point: when yields start getting to the mid-teens, the odds of a bankruptcy start becoming significant. And a bankruptcy almost always means shareholders get wiped out3.

There’s another important structural point to consider. Simply dodging a bankruptcy in 2027 doesn’t mean BHC is a buy. The stock may rise between now and then as it’s de-risked. But from a fundamental perspective, that alone doesn’t get the job done.

In theory, a stock price should be equal to the sum of its discounted cash flows in the future (i.e., a dollar in cash flow generated in 2033 is worth much less than one today). In essence, investing is about trying to find situations where that cumulative total is much higher than the current stock price suggests.

But for heavily indebted companies like Bausch, it’s bondholders that have claim on the cash flow first and foremost. As the 10-K notes, under the terms of the credit facility and senior bonds, Bausch can’t distribute any cash flow to shareholders.

It’s not quite right to say that Bausch has to repay all of its debt before its stock is worth anything at all. But it’s somewhat close. The next billions of dollars in Bausch’s free cash flow are going to bondholders. Only if there’s enough left over will stockholders see a dime. And so the argument that BHC is a steal because it can earn its market capitalization in less than three years falls completely flat: it might earn that cash, but shareholders won’t get that cash.

Admittedly, few companies are in a financial position quite like this. But many are restricted from paying dividends or doing share repurchases until the debt is repaid or at least reduced to a more manageable level.

The Bausch + Lomb Spin-Off

We’ll close with an admission. In the interest of using BHC as a primer for understanding debt mechanics, we left out a key and quite interesting part of the story.

As noted above, Bausch Health spun out part of its stake in Bausch + Lomb in 2022. It still owns 88% of that business; it long has planned to distribute that ownership to shareholders in the second step of the spin off.

Bausch + Lomb has a market cap of $5.6 billion. The Bausch Health stake is thus worth, at least on paper, about $4.9 billion. And so if Bausch Health could fully spin off that stake to BHC shareholders, that alone would represent 40% upside to the current BHC stock price.

Unfortunately, those efforts have been paused. Incredibly, the issue is a lawsuit not from Bausch Health bondholders, but from its former shareholders, who hold a multi-billion dollar judgment against the company for its past activities. And so this aspect of BHC stock, like the headline valuation, provides more evidence for perhaps the most important investing lesson: if something looks too good to be true, it probably is.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

Debt Matters

Company filings show how much debt a company has outstanding at the end of a reporting period. For instance, at the end of its fiscal second quarter, Procter & Gamble had $33.7 billion in total debt:

source: P&G 10-Q

This figure is important. As we’ve discussed before, it’s used to help calculate enterprise value which essentially is the valuation of the entire business. And the ratio of gross debt (debt net of cash) to EBITDA can provide a snapshot of a company’s leverage and financial stability.

In many cases, the total amount of debt is all an investor really needs to know. Often, the specific details of a company’s borrowings aren’t that important and generally speaking, the more stable the business, the less the details matter. P&G, for example, is a blue-chip issuer. The company is not going bankrupt. Its interest expense impacts cash flow; its debt net of cash affects valuation. The precise maturity and even interest rates of its particular bonds, however, are immaterial.

In fact, even in an almost unprecedented environment in terms of interest rates, the actual interest rate on specific bonds isn’t terribly important for a mature issuer. Debt issued during the low-rate environment of the 2010s that matures this decade will have to be refinanced at higher rates — but that impact is relatively minimal for most companies.

For instance, AT&T is the world’s most indebted company, but with nearly $24 billion in bonds maturing between 2024 and 2026, the impact to interest expense from refinancing is maybe $1 billion, and likely less. That matters, certainly, but the figure represents about 5% of guided 2024 free cash flow. AT&T’s aggressive efforts to pay down debt will offset some of that increased expense as well.

However, for small or higher-risk companies, bond prices carry enormously important information. They can highlight whether a company is exposed to refinancing risk — and whether a company is exposed to bankruptcy risk.

Where Do You Find Bond Prices?

We’ll start with a primer on actually finding bond prices. In the U.S., transactions of the corporate bond in the secondary market (ie, between financial industry participants rather than with the company itself) are reported to FINRA, the Financial Industry Regulatory Authority. Helpfully, FINRA makes that data available to the public.

Last year, FINRA redesigned the website, and the new version unfortunately is far less intuitive than the old one. The top field on the home page suggests a TRACE1 or CUSIP2, but neither is easy to find unless an investor already knows which specific bond she is looking for. Instead, the way to go is to the “Browse Bonds” list below:

source: Finra

After clicking through a page, an investor will find a search engine:

source: Finra

The highlighted column is the “maturity date”. In other words, when the bond comes due. Three of the four bonds in the screenshot already have matured. The list is sortable, however, so clicking on “maturity date” will put the longest-maturing bonds first (Apple has one bond that does not mature until 2062). Investors can then click on the symbol column to see information for the specific bond:

source: Finra

Helpfully, the down arrows on the right open up detailed, investor-friendly, explanations of the various attributes. Below that is a price to yield chart (remember that price and yield move in inverse directions; price here is in red):

source: Finra

With this easily accessible data, investors can have a better understanding of how a company’s specific bonds are trading.

Spread In The Secondary Market

As we wrote in our last piece, floating-rate debt trades (almost always) at a spread to rates that are risk-free or close. The standard benchmark has become SOFR, the Secured Overnight Financing Rate, which measures the interest rate for borrowing cash overnight with U.S. Treasury bonds as collateral.

In the secondary markets, fixed-rate debt also trades at a spread. We know the risk-free rate for a given period: it’s usually defined in the yield in U.S. Treasuries over that period. And we know the YTM (yield to maturity), which represents not just the coupon (the interest rate paid based on the par value of the debt) but the difference between the par value and the current price, pro-rated for the time to maturity.

YTM assumes that interest payments are reinvested (a simple Google search will show many effective calculators) but to provide an oversimplified example, imagine a $1,000 face value bond trading at 923 with zero interest that matures in a year. The investor pays $920; after one year, she receives $1,000. Her YTM is ~8.7% (total return is $80 on a $920 investment).

As a result, YTM figures provide an excellent proxy for what borrowing costs would be if the company issued or refinanced debt. YTM is the yield that credit market participants accept for owning debt in the secondary market. Almost always, the interest a company would have to pay in the primary market (ie, through issuing debt itself) is going to be roughly the same.

That assumes, of course, that the debt is the same. In a restructuring, secured or first-lien debt will have a higher-priority claim on the company’s assets. And so unsecured debt will, particularly in a distressed situation, have a much higher yield than secured issues. If the company can’t issue more secured debt (usually because all assets are already pledged as collateral for outstanding first-lien borrowing), it’s the outstanding unsecured issues that provide a better proxy for the company’s ability to issue new debt.

Meanwhile, secondary debt markets are based on the participants’ understanding of YTM relative to the risk-free rate. No one would accept, say, a 3% YTM on a 10-year bond from even the best company, when they get a 4.3% yield in a U.S. Treasury bond that matures at the same time. And so the spread between the yield of an existing bond, and the yield of Treasury bonds with the same maturity provides an important indicator of the financial health of the business.

source: Daily Treasury yield curve, U.S. Treasury

The Spread To Risk-Free

For instance, an Apple 1.65% corporate bond maturing in February 2031 last traded at a price of 82.74, for a yield to maturity of 4.57%. A U.S. Treasury bond (used as a ‘risk-free’ proxy) traded at a yield of 4.16%. The spread of 41 basis points (or 0.41%) is obviously quite small. So investors are pricing in a vanishingly small possibility of Apple going bankrupt between now and 2031.

Sensor manufacturer Sensata Technologies also has a bond maturing in February 2031. That bond last traded at a yield of 6.10%, a spread of 194 basis points. That suggests the credit markets see some risk that Sensata could get into trouble — but not a huge risk. Sensata is not Apple — but what company is?

But there is also Bausch Health , the former Valeant Pharmaceuticals that went on a debt-fueled acquisition spree in the 2010s. Its 5.25% bonds that mature in February 2031 have a yield to maturity of 21.74% — a spread of 1,758 basis points. That, obviously, is huge. The high yield is in part because those bonds are unsecured: if Bausch were to declare bankruptcy between now and 2031, owners of these particular bonds might well be wiped out.

The difference between these three bonds doesn’t necessarily mean that any of the three companies is a better equity investment. But what the credit markets offer is an exceptionally useful measure of downside risk.

Indeed, there is a school of thought that when it comes to risk, bond prices provide more valuable information than equity prices. There’s a logic to that (one to which I personally subscribe): debt investors by definition are focused on risk, because the upside is almost always capped.

An investor who owns Bausch bonds doesn’t get more money if the company’s profits surprisingly triple. She gets a nice yield if the bonds are paid off; she likely loses money if Bausch goes bankrupt between now and 2031. Depending on the nature of the bond and the value of the business, she could lose only a portion as she gets equity ownership in a Chapter 11 bankruptcy. Or she could be wiped out if the assets are worth so much less than the debt that only secured bondholders get a portion of their money back.

So all our credit investor really cares about is the odds of Bausch repaying that debt, along with the potential recovery in a bankruptcy. All she cares about is risk. As a result, yields in the secondary credit market reflect the combined calculation of experienced, professional bond investors of the risk inherent in a company’s debt.

Quite obviously, that is hugely valuable information for equity investors. Because in nearly all cases, if bond investors lose money, equity investors lose all of their money when they are wiped out in a restructuring4.

What The Spread Tells Us About Bausch

So we know how to find bond prices and yields, and we can understand the spread of that yield to the risk-free rate implied by U.S. Treasuries. But, at the risk of being anticlimactic, that doesn’t always mean that the information is useful.

Again, for most companies the actual price of the bonds isn’t that important. Whether the spread of a specific Apple bond to the risk-free rate is 41 basis points or 61 basis points has really no bearing on the equity.

For Sensata, the bond price does provide a bit of comfort that credit investors, at least, see the business as reasonably consistent and well-protected. That’s particularly true because the company has a decent amount of debt: nearly $3 billion net of cash, more than half its market cap and a little over 3x 2023 Adjusted EBITDA. In that context, a spread under 200 basis points is rather slim, since high-yield bonds (also referred to as ‘junk’ bonds) usually offer a much higher spread:

source: CurrentMarketValuation.com

Where bond prices get more useful is with a company like Bausch. Right now, Bausch stock trades for 2.23x the consensus estimate for 2024 adjusted earnings per share. To be clear, we didn’t miss a decimal point: Bausch’s forward P/E is 2.23x. And that’s with the Street estimating that EPS will increase about 12% this year, on top of 10%-plus growth in 2023.

The combination of a stunning low P/E multiple along with EPS growth would seem to suggest that BHC stock is an absolute steal — one of the best buys in the entire market. But the credit markets are telling us otherwise. The 20%+ yield to maturity in the 2031 issue means that there is a significant probability of bankruptcy in the next couple of years.

How significant? It’s difficult to precisely calculate. But in our next installment, we’ll use that highly indebted company as a model for understanding the interplay between debt and equity, and how to use data from the credit market to inform decisions in the stock market.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

• Discuss the different types of debt available to companies.

• How the choice of debt can impact equity value.

• Why it’s important to understand not just how much debt a business has, but also, what type of debt it is.

This will be the first of a multi-part series and you may also wish to read our piece looking at the risks and rewards of financial leverage for equity investors.

The Different Kinds Of Corporate Bonds

Corporate debt can vary in multiple ways:

• who the lender(s) is/are;

• what the interest rate is and how it is calculated;

• what assets are secured by the debt;

• when and how much money is borrowed; and when and under what terms that money is repaid.

The dizzying array of options exists because different companies have different needs as they mature (and like so much else in finance, because a wider offering of products usually means higher fees for the investment banks pitching those products).

Source: AT&T cover page from 10-Q listing most of the company's exchange-listed bonds

Public corporations can raise debt from multiple sources. Corporate bonds are sold to investors via an investment bank (or a consortium of investment banks), known as the underwriter. In the U.S., some bonds fall under Rule 144a of the Securities and Exchange Commission, meaning they can only be sold to qualified institutional buyers. Others can be owned by retail investors via most brokerages.

In most cases1, corporate bonds have a fixed maturity date — the date at which the borrowed funds must be repaid — though some bonds can be ‘called’ by the issuer ahead of time. Pretty much every bond has to be repaid upon an acquisition or other “change in control”, often at a premium. Bonds can be secured by all or some of a company’s assets, or be unsecured.

They include covenants, which restrict the company from certain activities. Some covenants can be somewhat harsh: they might, for instance, preclude the company from issuing any additional debt at all. Others are more boilerplate, preventing the company from moving assets to other subsidiaries, or spinning off or selling part of the business without triggering bond redemption.

Bonds generally have a fixed interest rate, or ‘coupon’. (There are a few bonds with a floating interest rate tied to specific benchmarks, but those are rare). Interest is usually paid every six months. And when the bonds mature, the company repays funds to the current bondholders, which quite often are not the same investors who bought the bonds when they were issued.

Some corporate bonds are convertible bonds. Convertible bonds can be repaid either in equity or in stock. In rare circumstances, it’s up to the company to choose; if the company elects to repay in stock, they almost always have to issue those shares at a discount to the price at the time2. The standard structure, however, is that bondholders are paid in stock if the stock trades above a certain conversion price.

That conversion price is usually higher than the stock price at the time of issuance: a company might issue a $1,000 bond convertible for 50 shares while its stock trades at $12. If the stock clears the $20 conversion price3, the bondholder can convert into shares; if not, she is repaid $1,000 at maturity.

This sounds like an awful deal for the company, which is either repaying debt or issuing equity at a discount. But the benefit to the borrower is a lower interest rate4. In 2021, in particular, amid a hot equity market and rock-bottom interest rates, many companies were able to issue zero-coupon convertibles. More than a few got excellent deals. Snap has a zero-coupon convertible due in 2027 with a conversion price above $89; the stock currently trades at just $16.

Most corporate bonds are issued in increments of $1,000. But so-called “baby bonds” are offered in smaller increments (often $25), in large part because they are actually designed to be owned by individual investors (and traded on exchanges). Baby bonds are often issued by companies looking to raise smaller amounts of capital. Generally, telecom companies, financials, and BDCs (business development companies, which invest in the debt and/or equity of other companies) are the most common baby bond issuers, though here too there are exceptions.

Bank Debt and Private Credit

But companies can also borrow directly from banks or, nowadays, alternative lenders that supply what is known as “private credit”5. Those borrowings take different forms. A term loan mimics a bond: the company borrows a set amount of money, and must repay it at the maturity date. But term loans are much more likely than bonds to have floating interest rates, usually defined by a “spread” to the Secured Overnight Funding Rate, or SOFR6.

In contrast, a line of credit or a revolving credit facility (also known as a revolver) allows a company to borrow up to a specified limit — but unlike a term loan, the funds can be drawn (and, usually, repaid) at the company’s discretion. There are obvious parallels in consumer debt: a term loan is akin to a personal loan, while a revolver is like a credit card. In the former arrangement, a preset amount of money is borrowed up front; in the latter, the borrower has discretion to borrow, up to a preset limit. (Both companies and consumers can access lines of credit, of course, and real estate investment trusts do take out mortgages against their properties.)

Unlike bonds, these borrowings are owed to either a single institution or, sometimes, a syndicate of institutions. These loans can be traded, but not on public markets and certainly not to individual investors. Covenants can be much more restrictive; some term loans include restrictions on EBITDA7 performance. If the company fails to meet those targets, the lender can force a default and eventually take control of the company, zeroing out shareholders in the process.

And usually bonds have a longer maturity schedule: in 1993, both Disney and Coca-Cola issued 100-year bonds. Maturities of seven years or longer are more common for bonds. Shorter-dated borrowing is usually bank debt of some kind. A specific company’s borrowings and their terms are detailed in 10-K filings with the SEC. Exhibits to the 10-K often include the actual credit agreements themselves.

Why Companies Choose Different Debt (Or Debt At All)

For any corporate borrowing, then, there are a myriad of considerations. How long should be the maturity be? How much money should be borrowed relative to either the market capitalization and/or to EBITDA and free cash flow? What interest rate is acceptable? Is a convertible issue preferable?

Some of these decisions are made for the company. For instance, smaller companies usually can’t issue traditional corporate bonds, since they’re simply not big enough. A $10 million bond issue doesn’t work for the issuer, which will see a big chunk of the proceeds lost to expenses. It doesn’t work for buyers, either: those buyers want the ability to sell the bonds if necessary, but such a tiny issue will have very thin liquidity8. And so direct lending, either via a bank or an alternative credit provider, is often the only option. Conversely, a massive company can have a revolver or even a bank loan, but those offerings won’t be large enough to fund all of their needs. No bank will be willing to take on that amount of company-specific risk.

Generally speaking, within the menu of choices there are some rules. Obviously, the lower the interest rate, the better — and even that rate is a tell. If U.S. Treasury bonds that mature in seven years yield 4%, and a company can issue seven-year debt at 5%, that is a sign that the credit markets view the company as rather stable. (We’ll discuss the importance of interest rates in much more detail in the second part of this series.)

The longer the maturity, the better. This, too, is a tell: if bond investors are willing to lend to a company for decades, it by definition means those investors believe the company will exist decades from now. That aside, longer-dated maturities are usually more attractive because they can create a no-lose proposition for the issuer. If interest rates go up, the company has locked in cheaper financing than it would have otherwise received. If they go down, the company can sometimes refinance (if the bond is callable).

For similar reasons, fixed-rate issuance is preferable. It also gives management clarity as to expenses in the future. This can be accomplished in floating-rate debt, however, by hedging interest rates through a so-called interest rate swap. In a swap, an issuer gets paid if rates go up (and pays if they go down), meaning that higher or lower expense on floating debt is mostly offset by profit or loss on the hedge.

But beyond those broad rules, the choice of debt by a company can provide valuable information. A revolver, for instance, can be set up simply for optionality: in case an attractive acquisition pops up, or if management sees a plunging share price as an opportunity for stock buybacks. There is a fee for unused capacity, but it’s usually quite small (less than 1%), and so an entrance into a revolving credit facility is not necessarily a sign that a company has big plans.

A term loan, however, is different. Again, term loan funds are delivered in full immediately — and interest begins accruing immediately. Companies have to disclose the use of proceeds for the loan, and usually provide detail to investors, but sometimes the boilerplate of “general corporate purposes” is used. In that scenario, investors have to suss out the actual motivation. Is the company looking to make a big acquisition or add a new plant? To alter its capital structure by increasing debt and buying back equity? Or is it worried about a potential cyclical downturn?9

Similarly, the choice to issue a convertible, and on what terms, provides information. In some cases, the convertible route is simply a matter of financial engineering to get a lower effective rate10. But a convertible bond, particularly without a hedge, shows a management team willing to essentially trade equity upside for interest savings, which in turn suggests some caution from that team toward the stock price.

Debt Is Complicated

This all sounds incredibly complicated — and perhaps needlessly complicated. Consumers make do with just a handful of credit products; surely companies can do the same.

But the complication exists because, for corporations, debt has many different purposes. It can be used to fund new factories, or to fund acquisitions. It can simply add a bit of leverage for equity holders. If a company can borrow at 5% to repurchase shares in a business whose value increases 10% annually, the remaining shareholders quite obviously benefit.

Borrowing capacity on a revolver or line of credit can be used to act quickly if opportunities arise — or, in some cases, to assure existing investors that the company’s financial situation is secure. If, for instance, the economy turns south and orders dry up, the company can simply draw funds from its revolver while it waits for the external environment to improve.

The good news for equity investors is that the complicated details themselves aren’t that important. It’s credit investors who need to understand the vagaries of first- and second-lien debt, or the recovery value in a bankruptcy implied by a current yield on a corporate bond. For equity investors, debt analysis often boils down to common sense.

For instance, if a company is issuing debt at 11% in the current environment, that is clearly a sign that the credit markets see some risk. If it’s issuing a convertible at a low premium, that suggests either management that is pessimistic toward the stock price or a market that is unwilling to offer better terms. If a company is in danger of tripping EBITDA covenants, that dramatically increases risk, whether of an eventual restructuring or a hasty effort to sell an asset with little negotiating power. The maturity of a low-interest bond, assuming the company doesn’t have cash on hand to pay off the debt in full, likely means a necessary refinancing at a higher rate (and thus higher interest expense and lower profit).

The choice of lender certainly matters. Last week, we highlighted iRobot , whose stock has plunged after its proposed takeover by Amazon . One of the obvious risks in iRobot is its debt: not just the amount of debt, but the fact that it is owed to PE giant Carlyle Group .

As we wrote then, Carlyle is a more dangerous lender than, say, a major bank. Its experience in actually running companies makes it much more likely to take a hard line with iRobot and potentially wind up with the business at the cost of simply writing off the loan. A major bank would not run the business, but instead be forced to sell it (here, too, with little negotiating power). Incentives thus lean toward giving the company more time. IRBT is literally a worse equity investment because of who it borrowed from11.

With experience, these issues become easier to spot and easier to understand. But the broad point is that equity investors need to understand more than just how much debt a company has. They need to understand what kind of debt a company has, too. In many cases, it honestly won’t matter. But, as we’ll discuss in future articles, when it does matter, it really matters.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

Unsurprisingly, DPZ stock tanked. And while the financial crisis played a role, the comparison to competitor Papa John’s suggested that Domino’s itself was to blame as well:

source: Koyfin; total return chart from Domino’s initial public offering in 2004 to the end of 2009

And so on January 5, 2010, chief executive officer David Brandon announced he would step down in March1, to be replaced by Patrick Doyle. What followed was arguably the best turnaround in recent history:

source: Koyfin

There have been a few good ones2. Some investors will choose Apple after co-founder Steve Jobs returned to the company in 19963. But Apple’s problems in the mid-1990s weren’t driven solely by poor execution. The later rise of the company was driven by new products starting with the release of the iPod in 2001. Similarly, Microsoft has been a massive winner since the arrival of CEO Satya Nadella, but that company benefited from the shift to the cloud and the massive installed base that was created under Bill Gates and Steve Ballmer.

Solar inverter manufacturer Enphase Energy incredibly rose more than 100-fold in a matter of years after T.J. Rodgers, the founder of Cypress Semiconductor, joined the board of directors in early 2017. Better operations under Rodgers’s guidance helped, but so did the “green rush” into solar energy.

Where Domino’s stands out is in being such a pure turnaround. An improving macroeconomic picture helped the company, certainly. So did the rise of apps which allowed the company to quickly grow its digital sales. But for the most part, this is a story in which an already well-known stock provided total returns of more than 6,000% in less than 15 years simply through operational improvements.

What Domino’s Did

When Doyle left Domino’s in 2018, it was to much acclaim as the leader of “a remarkable transformation” and “one of the best restaurant CEOs of our time”. But, interestingly, it was under Brandon that Domino’s turnaround actually began.

In 2009, Domino’s changed its pizza recipe. To market the new product, it launched a series of commercials, and a four-minute documentary, that admitted the old product simply wasn’t any good. Doyle himself starred in the documentary, which featured reviews on Twitter and elsewhere complaining, among other things, that the pizza “tastes like cardboard”. In the 4-minute film, Domino’s employees respond to those complaints, and at the end visit a critic with a piping-hot version of the new product.

Doyle added technology development and marketing changes. The chain was one of the first to allow for a saved “easy order” feature on its app. A move to a single point-of-sale program across the entire franchise system allowed for a more advanced digital offering. Per the most recent 10-K, digital sales are about two-thirds of the worldwide total.

This is the archetype of a turnaround case. New (and better) management, a smart strategy, and on-point execution combine to allow the business to finally fulfill its potential. And the Domino’s story highlights what makes the turnaround narrative so tempting: it doesn’t really look that hard.

The rise in DPZ stock has given Doyle a sterling reputation: Burger King owner Restaurant Brands International added more than $2 billion in market cap in two days when it named Doyle chairman in November 2022. The irony is that the turnaround began under Brandon, and DPZ had began to rally before Doyle took over. (The stock rose more than 70% in 2009.) Perhaps more importantly, Doyle himself was at Domino’s when the company’s pizza by its own admission “sucked”. Between 2004 and March 2010, Doyle was vice president and then president of the U.S. operations.

No doubt Doyle deserves credit for taking such a drastic step, and it’s certainly possible that it took Doyle (who had previously worked overseas for the company) to convince higher-ups of the wisdom of his strategy. That said, the strategy wasn’t even all that innovative. Privately-held Hardee’s had done the same thing in the early 2000s, launching a line of much-improved burgers and a self-flagellating marketing campaign. Most ads included the tagline: “It's how the last place you'd go for a burger will become the first.”4

So, basically, Domino’s promoted from within and copied someone else’s playbook. Since the end of 2008, total returns in its stock are more than 100,000%. Surely, other companies can do roughly the same thing.

Turnarounds Keep Not Turning

Yet that is not the case. The list of failed turnarounds is far, far longer than the list of successful ones. Rodgers took his Enphase playbook to both battery developer Enovix , which continues to struggle in its bid to get to volume production, and solar panel installer Complete Solaria , whose very survival is in question. QSR stock has only modestly performed the S&P 500 since Doyle’s hiring, though it has outperformed McDonald’s and Wendy’s .

The relatively low rate of success for turnaround cases perhaps isn’t that surprising, because there are stumbling blocks for both investors and the executives on whom they are betting. The biggest problem in identifying a potential turnaround is identifying whether the downturn in the business is actually a result of execution to begin with.

One obvious example of this problem was in specialty retail during the 2010s. In retrospect, declining sales and profit margins at most retailers during the period were driven by shrinking traffic to traditional shopping malls and the rise of e-commerce. But at the time, both retail CEOs and their shareholders believed that execution was a bigger problem. Better designs, better marketing, lower gas prices, the end of tariffs on Chinese goods were just a few of the potential changes that would offset secular trends and return profits back to prior levels. For many companies in the space, save for the unprecedented explosion in demand during 2020-2021, those profits never got there, or even close.

For executives, the incentives all line up toward creating a narrative of a potential turnaround. Certainly, their egos will benefit: CEOs rarely, if ever, get to top spot without supreme self-confidence. It’s thus nearly impossible for a leader, and particularly the new leader often charged with a turnaround, to admit that there are structural impediments to profit improvement — impediments that he or she simply cannot fix.

A turnaround narrative also gives a new CEO space. This is why the first report under new leadership is so often known as a “kitchen sink quarter”. The company squeezes every piece of bad news it might have — goodwill impairments, layoffs, weak guidance — into a single release. That gives the new CEO time to execute strategic changes, because the implicit message becomes “the last CEO was a dope, it’s going to take some time to clean up this huge mess I was left.”

There’s also the not-insignificant fact that companies themselves are complicated organizations, with conflicting incentives, entrenched leaders at varying levels, bureaucracy, and always-changing competitive threats.

It’s not a coincidence that some of the most disappointing supposed turnarounds this century have been companies that were leaders last century: General Electric , IBM , Kraft Heinz . Larry Culp looked like one of the greatest CEOs of all time when he was at Danaher , to the point that during his tenure Danaher produced other great CEOs. Despite no shortage of activity, he’s appeared relatively pedestrian at GE.

What To Do About The Uncertainty Of Turnarounds

The core issue with turnarounds is that no one really knows, certainly at first. A CEO who has been with a company for six weeks or six months is still learning the lay of the land. Investors may not be able to decipher whether the core problem is execution, or competition, or secular changes in the customer base. In nearly all cases, each of those factors is playing a role, but the relative proportion will always be unclear.

And of course, those factors are hardly independent. Domino’s could have rolled out its turnaround strategy in 2012, instead of 2009. And by that point it’s possible the company’s reputation would have been damaged to the point that a turnaround became impossible, and/or the company’s best managers had departed for more successful chains.

All told, it’s much easier to forecast a business that is performing well than it is one performing poorly. Domino’s could have made a ‘better’ pizza that wasn’t as good, blown its one chance at restoring its reputation, and spent another decade as a perpetually disappointing turnaround. Meanwhile, in 2016, Microsoft’s adjusted earnings per share hadn’t moved for four years5. Many investors at the time thought it would be the “next IBM”, doomed to see its empire carved up by smaller, younger, more nimble rivals.

To be sure, the incredible returns in DPZ, and solid returns in other turnarounds, show the strategy shouldn’t be dismissed out of hand. But the history of turnaround cases does provide some lessons for investors.

The first is simple: be skeptical. Nearly all struggling companies are going to offer some version of a turnaround plan, whether under existing management or new leadership. They will work on paper, because, again, they always work on paper. In practice, they’re likely to fail, and there is an argument that, owing to rapid technological change, they’re now more likely to fail.

The second is that turnaround strategies need to be specific in both the problems being diagnosed and the solutions being offered. Domino’s is a perfect example: our pizza is not good enough, we’re going to fix it, we’re going to tell people that we fixed it. In contrast, most 2010s retailers offered vague assertions of ‘better’ merchandise or improved marketing. Fading old-line giants like IBM and Kraft Heinz have made acquisitions and shed businesses to ostensibly improve reported revenue and profit growth. But beyond financial engineering have often failed to deliver coherent, measurable plans to create better businesses.

The third is again highlighted by Domino’s: there’s no rush. The new pizza and the new ad campaign in fact was a relatively quick hit. In the first quarter of 2010, domestic same-store sales increased 14%. And on the earnings call, Doyle talked up multiple metrics in terms of existing and recaptured customers that further supported the idea that the turnaround had a solid foundation. (Amazingly, DPZ stock actually declined 13% in trading that day.)

At that point, Domino’s had tripled since the end of 2008, so investors had missed out on some gains by not perfectly timing the bottom. But there was still plenty more upside ahead: DPZ provided total returns of 3,615% since the Q1 2010 release.

Of course, not every turnaround will prove to be one of the best stocks of an entire decade. And that’s exactly the point: most are going to whiff. But in many cases, the turnaround opportunity still implies three-digit upside. If, for instance, a stock is down 60% from its high, a return to past earnings and past valuation suggests returns of 150%.

The size of those returns is part of what makes turnaround cases so tempting, and why investors are willing to take on the risk that the turnaround doesn’t work. The history of successes like Domino’s and Enphase, and the long list of failures, shows that it’s probably wise to minimize that risk. After all, the rewards can still be more than attractive enough.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

source: Koyfin

Given those staggering returns, if an investor had recommended AAPL 23-plus years ago, he would certainly have some bragging rights. Over at Value Investors Club, an investor with the handle ‘paul62’ did just that. (VIC is a subscription platform, but articles older than six months can be viewed with a free membership.) At least in terms of returns, it is perhaps the best stock recommendation ever published online — and it’s a recommendation that provides interesting lessons about investing.

An Obvious Buy

In retrospect, AAPL in December 2000 looks like a no-brainer. Shares looked incredibly cheap looking backwards. Shares traded at less than 7x the company’s earnings for fiscal year 2000 (which ended September 30).

Even that didn’t tell the whole story: Apple also had just over $4 billion in cash and short-term investments, and just $300 million in debt. There was another $786 million in long-term investments in both debt and equity. As paul62 noted, those investments included stakes in Earthlink, Akamai Technologies , Samsung, and ARM Holdings .

All told, net of debt Apple had about $4.5 billion in cash and investments. Incredibly, at the time, its market capitalization was just over $5.2 billion. Apple’s enterprise value was barely over $700 million, yet in fiscal 2000 it had earned $786 million in net profit. Adjusted for its liquid assets, then, Apple stock traded for less than one times earnings.

To be sure, the fundamentals weren’t quite that good. The $786 million in net profit did include a non-cash gain on sale from the company’s investment in ARM. But, after taxes, that gain represented just over one-third of reported net profit. On an operating basis, AAPL was well under 2x net earnings.

And it traded at that level not necessarily because of anything wrong with the business, but because of something very wrong with the market. The dot-com bubble1 peaked in March of 2000; by the end of the year the NASDAQ 100 had halved. (Quite famously, that index would not make new highs until 2014.) The crash affected Apple as a stock, and in the short term hurt Apple as a business. As paul62 noted, sharply slowing demand for computers (in part because many startups had so quickly gone bust) led to an inventory glut which the company would need to work through.

In Apple’s fourth quarter earnings release from October 2000, then chief executive officer Steve Jobs forecast a “second disappointing financial quarter” in Q1 FY01, due to elevated inventories at Apple’s direct customers. Even so, Apple still guided for revenue to be down only modestly for the full year, with expected earnings per share of $1.10-$1.25. At the low end, that still translated to roughly $400 million in net income — leaving AAPL still trading at less than 2x earnings.

Why Was AAPL So Cheap?

The obvious question looking backwards is: did investors lose their minds? Clearly, Apple in 2000 was not what Apple is today, but it was still a wonderful business. Again, the company generated over half a billion dollars in operating income in a single year.

But if you look more closely, there are some potential factors that could have given investors pause. The issue for Apple was not just the dot-com bubble. Ahead of the fiscal Q4 release in October, Apple gave a profit warning in which it said educational sales had disappointed, as had sales of the new Power Mac G4 Cube.

Both aspects of the guidance were concerning. The education market in theory should have been immune to the pressures in the corporate world. More importantly, education long had been Apple’s strength, but in 1999 Dell passed Apple in terms of market share. Apple’s outlook for fiscal 2001 suggested market share losses might well be accelerating, particularly with the rise of other PC makers like Gateway and Compaq.

As for the Cube, Apple had launched the product only a couple of months earlier, at which point Jobs called it “simply the coolest computer ever”. A miss with that key product suggested several quarters of disappointing growth before the next major launch. Plus the possibility that Jobs’ ability to assess ‘cool’ wasn’t quite what investors thought it was. It was that September pre-announcement that really crushed AAPL stock, not necessarily the dot-com bust:

source: Koyfin

The long-term AAPL chart suggests that all worked out just fine. But in fact, it didn’t. The G4 Cube, which Apple pitched as an “entirely new class of computer”, was a cubic computer housed in acrylic glass:

source: Wikipedia

It was also, as current CEO Tim Cook termed it in 2017, a “spectacular failure”. The high-end model cost $2,299 (over $4,000 in 2024 dollars), yet without a clear end market the product didn’t sell. The Cube was discontinued after just one year. As for the updated guidance for fiscal 2001? Apple didn’t even come close. Actual sales were $5.36 billion, against the initial outlook of $7.5 billion to $8 billion. Apple didn’t generate $400 million in net income. It posted a net loss for the year (even with more help from investment sales).

A Lack Of Trust

In other words, from a short-term standpoint the market kind of had it right. And it’s important to put that perspective in the context of Apple’s longer-term story as of late 2000.

Bear in mind that Jobs had left Apple in 1985, returning 12 years later to the day. In the months before he came back, Apple was in serious financial trouble. It was, in fact, Microsoft that saved Apple2, with a $150 million preferred stock investment made weeks before Jobs came back.

From that point on, Apple’s financial results inflected positively. But, of course, it was impossible to know exactly why that had happened. Was it Jobs’s brilliance? Or the fact that the personal computer market was exploding, and a rising tide was lifting even the leaky Apple boat?

Some investors believed the latter. There are only four comments on the VIC piece, but they all get to various aspects of the bearish take on AAPL at the time. One provides its own lesson. The commenter writes that I would be a “buyer below 14”, which is an all-time case of being penny wise and pound foolish. At that valuation, a few percentage points in price simply didn’t warrant the risk of missing the opportunity. But even that bull writes that Apple “had better tech than some other companies [it] just marketed [its] products wrong.”

Another commenter snarkily gives Apple “credit for being able to be profitable long after their products have become irrelevant”. Further giving a sense of where Apple’s reputation actually was at the time, a third writes that “[I] would be more comfortable with an industry/sector leader such as Dell or Compaq [emphasis ours].“

In retrospect, however, the best is this one:

What troubles me is that when you ask the company about their plans for the large cash balance, the straightforward answer is that they plan to spend it on new initiatives.

One of those new initiatives was the iPod, launched in October 2001, a product that changed not just Apple’s fortunes, but (we’d argue) was the first step in the company’s transformation of global culture.

Lucky Or Good?

Given the comments, and even the somewhat muted nature of the recommendation itself — which focuses much more on the downside protection of the cash rather than the strength of the business — the recommendation of AAPL at a split-adjusted $0.259 per share seems to argue for contrarian investing. The market went one way; paul62 went the other, and wound up with positive returns.

But another way to look at is that AAPL in 2000 is simply a one-off, a massively lucky break. There was no way for paul62, or anyone else, to possibly forecast what Apple would become. At the time, no one knew that Apple would release the iPod, and when they did, this forum post from MacRumors shows massive (and, once again, hilarious in retrospect) disappointment from ardent Apple fans:

source: MacRumors

Certainly no one could have foreseen the iPhone. Research in Motion (now BlackBerry $BB) had gone public in 1997, and released its first device the following year, but that device was not actually a phone. As late as 2002, RIM’s stock was below $2. (It would peak at $147 in 2008.) Palm and other makers of PDAs (personal digital assistants) had seen their share prices plunge from March 2000 as well. The category at the time seemed something of a fad.

Meanwhile, in late 2000 the case for buying a busted tech stock near its cash balance (or below its cash balance) was in fact a great way to get into trouble, rather than to make profits. The market was littered with companies who had raised capital during the bubble but didn’t have profits, or any kind of real business model. No shortage of investors had bought those companies on the way down in August and October, seeing them as too cheap, only for those stocks to keep falling. Apple was certainly much better than nearly all of those companies, a good number of which eventually went bust, but, again, it had its own concerns and a hardly unblemished track record.

What Can We Learn From AAPL?

AAPL at a pre-split $14 looks in retrospect like an easy buy, but for many reasons it was not so at the time. But with the benefit of hindsight, there are some lessons the stock can impart.

The first echoes a theme we keep coming back to in this space: investing is hard. Concerns about Apple in 2000 were legitimate. The Mac business generated nearly $30 billion in sales during FY23. But there was absolutely a world in which Mac’s market share dwindled, and then created a vicious circle: software developers would devote their energies to PCs, making Macs less attractive by comparison, leading to more developer pressure, and so on.

Another lesson here is important: there are no perfect stories. It’s tempting to assume at first glance that AAPL was cheap in late 2000 because investors were panicked by the dot-com bust. Indeed, this leads to a common piece of investing advice: that good investors with a long-term focus just need to wait for the market to do something dumb (for lack of a better word) and capitalize.

But the market simply doesn’t do things that are that dumb that often. Again, there were legitimate company-specific concerns. AAPL had risks. Indeed, AAPL was a risk. All equity investments are. The market, then and now, rarely leaves profitable, growing companies with massive end markets trading for peanuts — even during one of the biggest sell-offs in modern history.

All that said, even ignoring the benefit of the hindsight, the risk/reward in AAPL in late 2000 was attractive, and there are lessons in that fact as well. The downside protection highlighted by paul62 was real, and important. The argument that Apple might blow its cash on “new initiatives”, as one commenter replied, ignored just how much cash the company had. It’s not just that cash and investments accounted for nearly 90% of the market cap, but that Jobs and his team couldn’t blow $4 billion even if they tried. In that context, AAPL was different than some busted IPO from 1999 — or, for that matter, 2024.

There’s also management. Steve Jobs in 2000 wasn’t the mythologized figure he became, but at the very least among Apple users he was immensely popular. Even before the iPod, let alone the iPhone, Jobs was an executive worth betting on. That, too, created a distinction from other cash-rich stocks with ugly charts. A good balance sheet is not enough; there needs to be a potential upside catalyst, and Jobs was one of those catalysts for AAPL.

That in turn gets to the lesson imparted by where AAPL headed over the next 23-plus years. By the end of 2001, the stock had gained 50%-plus from the lows. But even after that rally, the same bull case largely applied. Even with ugly FY01 financials, Apple with more than 60% of its market cap in liquid assets still would have been an excellent buy.

Apple stock closed 2002 slightly below where it was recommended here. But it then became clear that the iPod was a winner, and that iTunes would print cash, and that the Macintosh line had stabilized. By the end of 2004, AAPL had more than quadrupled from the lows — yet it still had more than one-quarter of its market cap in cash and investments and clearly had enormous growth opportunities from its new efforts.

By then, AAPL had a different bull case, and that case would go through various permutations over the next two decades. No doubt over that time some investors looked at the multi-year chart and thought the run was over, and sold their shares. Others believed that the opportunity for enormous upside had passed.

Quite obviously, it hadn’t. Since the end of 2004, AAPL still provided total returns of 16,000%. And that perhaps is the most important, and optimistic, lesson here: investors don’t have to bottom-tick the chart. The call by paul62 is about as good as it gets — but investors still had years left to make an awful lot of money.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

The simplicity of yield in banking accounts is, for the most part, an exceptionally good thing. The ability of depositors to move money with the click of a mouse did cause some problems during the regional banking crisis in March, as depositors fled banks with perceived risk. But from the perspective of those depositors, and the economy as a whole, it’s useful that individual customers (or indeed, small businesses) don’t need to evaluate the credit profile of their banks. Money goes in the bank, and that same money, plus a little bit extra, comes out on demand. Every single time.

But this simple structure creates problems as depositors move into investments that are more complex and less certain. Those investments do not act like bank accounts — and many investors get in trouble for assuming otherwise.

Dividend Yield Is Different Yield

Some stocks offer dividends, cash payouts that in the U.S. usually are paid quarterly at a consistent level that is meant to rise over time2. Those dividends thus look an awful lot like interest payments.

As a result, some investors take the framework of a savings account and apply it to equities: the amount invested is like the principal placed into an account, and the dividend yield — the annual amount of the dividend paid, divided by the current stock price — is just like interest.

So an investor might look at an online savings account from, say, SoFi , and see a yield of 4.60%. And then, seemingly reasonably, she might look at AT&T and see a dividend yield of 6.73%. AT&T’s yield is higher, and thus in this framework AT&T stock seems preferable as an investment meant to generate income.

Indeed, it’s common to see precisely this argument being made on social media or in the comment sections of investment websites. But shifting the framework of bank accounts to equity investments is wrong — and wrong twice.

The problem is that in a bank account, the principal is guaranteed. The interest rate is variable (it’s sensitive to broader interest rates as determined by the Federal Reserve), but some level of interest is guaranteed. In stocks, neither is the case.

A dividend is not interest. It’s not a contractual agreement, but rather paid solely at the option of a company’s board of directors. Ideally, that dividend rises over time. The likes of Procter & Gamble and Johnson & Johnson are so-called “Dividend Kings”, having not just paid, but increased, their dividends for 50 consecutive years or more. But there is no guarantee that any income investment (or any investment at all) is going to be as successful as those two giants have been.

Companies can cut or even eliminate their dividend at their discretion. Coming into this year, HanesBrands had paid a dividend for nearly a decade; the company eliminated its payout in February. In May, Big Lots , stopped its program, which had begun in 2014. Cuts are more common: VF Corporation came into this year as a Dividend King, and has since cut its dividend twice.

Stock Is Not Principal

The bigger issue, however, is that, unlike in a bank account, in an equity investment the principal is not guaranteed. The worst-case scenario for a bank account is that the interest rate drops back to near-zero and the accountholder is left with her initial deposit plus some interest. The worst-case scenario for the owner of a dividend stock is that the dividend is canceled and the stock goes to zero.

What is particularly dangerous about chasing high dividend stocks is that there’s a brutal “double whammy” effect: the dividend is cut because the business is performing poorly, which means the value of the initial investment plunges as well. As we noted last month, VFC is down 83% from its highs. BIG hit a 32-year low this year, and is off 90% from its 2021 peak.

Our first piece in this series, on Walgreens Boots Alliance , too highlighted the danger of chasing yield. Enviva , which we covered in June, had just eliminated its dividend; the stock plunged 67% in a single session and has fallen another 85% since.

Source: Koyfin.

Even if the stock doesn’t necessarily collapse, there is an opportunity cost. Since the start of 2013, Hanesbrands has paid just shy of $8 in dividends, but the stock has lost $6.25 in value. Overall, even taking the dividends as cash (rather than reinvesting them as HBI fell from 2015 highs), investors over the nearly eleven years would have made about 16% total. Those who chose a simple index fund, the S&P 500 Total Return , generated returns of nearly 300%. Even in a zero-interest-rate environment, a traditional savings account or CD (certificate of deposit) would have done better.

AT&T stock is another classic example. That stock is one of the most popular among income investors because not only has it almost always offered a high yield, but it ‘seems’ safe. Wireless providers don’t have a ton of macroeconomic exposure (it takes financial disaster to cancel one’s wireless plan) and the AT&T brand is one of the most well-known in America.

As a result, investors have been chasing yield in T for years and have been punished with startling underperformance:

source: Koyfin; 10-year chart of total returns in T and SPY

Yield Is Not Additive

But perhaps the most basic misunderstanding of dividend yield is that a dividend is not additive in the way that an interest payment is. An interest payment is added to the principal. A dividend payment, however, comes out of the earnings of the business, and thus comes out of the value of the business. If a company distributes cash worth 1% of its market capitalization, all else equal the next day the market capitalization should be 1% lower.

And so investors don’t come out ahead. Essentially, 1% of their investment was transferred from ownership in the business to cash. That’s a hugely important point to make: a dividend payment is simply the transfer of control of a small part of a company’s cash to its shareholders. One day, the dividend payment is in the corporate bank account. The next3, it is in the bank account of the company’s shareholders.

Special dividends provide a clearer way to highlight the mechanics. Imagine a stock that trades for $15, and the company has $5 per share in cash. The company then declares a $4 per share special dividend.

The valuation of the company plus that cash hasn’t changed4. And so after the special dividend payout, the stock should drop to about $11 (though other factors may affect trading somewhat). On the ex-dividend date5, shareholders owned a business, roughly speaking, worth $10 per share and with corporate cash of $5 per share. On Thursday, shareholders own a business worth $10 per share, corporate cash of $1 per share, and have an additional $4 per share in cash in their accounts. The math essentially gets to $15 per share on both days.

Why Dividends Are Overrated

Essentially what this means is that all the coverage given to dividend stocks, all the paid services, and the fact that dividend yields are considered one of the most important financial metrics are, in a sense, much ado about nothing.

But, again it’s more nuanced because it’s important to understand why some companies pay dividends and others don’t. While individual cases vary, the broad distinction is that dividend payers don’t have an appropriate use for all of the capital they are generating. Those companies can reinvest current earnings into management’s eighth-best idea to increase future profits, or give a portion of those earnings to shareholders who can invest it in their best idea (which sometimes is simply more shares of the company’s stock).

Basically, companies start paying dividends when they don’t have any better ideas6. But companies with significant growth ahead do have better ideas, and potentially high-return opportunities to allocate current earnings (acquisitions, increased short-term spending to drive long-term revenue, new businesses, etc.).

This in turn colors the idea that dividend stocks intrinsically are better, an argument some investors make. Those investors would argue that while dividend cuts do occur, that doesn’t mean dividends should be ignored altogether. They’d also point out that dividend stocks historically have outperformed the market.

But the outperformance of dividend stocks at least in part is based on confusing correlation for causation. Dividend stocks outperform not necessarily because it’s better to pay a dividend, but because the kinds of stocks that pay dividends likely offer a better profile. They are more mature, usually profitable, and often more defensive (in other words, less susceptible to macro cycles that can wipe out an investment).

There’s also huge survivorship bias at play: companies that maintain their dividends almost by definition are good companies, and thus substantially more likely to be good investments.

To be clear, this is not to say that dividends are bad, or that dividend stocks should be avoided. Rather, it’s to highlight a hugely important point: dividend stocks are just stocks. The fact that they pay a dividend in nearly all cases actually has a nearly-immaterial impact on any detailed calculation of fair value.

Watch Out For High Yield

In fact, high yield usually is a signal of danger, not opportunity. Over the long-term, high-yield stocks have shown some evidence of outperformance: the highest-yielding members of the Dow Jones Industrial Average, for instance, did better over a quarter century from 1987 to 2012.

But an investor should understand why a stock — or any investment — has a high yield. The working presumption should always be that the market is pricing in higher risk. It expects profits to decline and/or the dividend to be cut. In the bond market, where interest rates are almost always fixed against the par value of the bond, yield rises as price declines. Outside of dramatic changes in interest rates (like that seen over the last 21 months), that higher yield almost always means higher risk.

At the very least, a stock cannot be bought just for its yield. The reasoning there is simple, and part of a theme we’ve emphasized throughout this series: successful investing is hard. The idea that one single, widely available metric means a stock is a buy ignores that immutable fact. But the nature of yield elsewhere in finance makes it easy to fall into that trap. As we noted in May, even professionals make simple errors when it comes to dividends and buybacks.

Admittedly, it might seem contradictory to argue that a high dividend yield is nearly meaningless as a reason to buy a stock, but worth noting as a reason not to buy a stock. But the reason a high yield can be a red flag is not intrinsic to the size of the dividend payment, but rather due to the correlation between a dividend and earnings.

Dividends come out of profits, and when a yield goes up it’s almost always because the earnings multiple (and usually the stock price) is going down. And when the earnings multiple is going down, that in turn is a sign that the market is pricing in lower expectations for future profit growth. And it’s that profit growth that really matters, not a single metric that discloses how much of that profit shareholders are getting at the moment.

If you enjoyed this article you can helps us by sharing it or clicking the ❤ button.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

In 2019, Uber went public. The company’s initial public offering was priced at $45 per share, which valued the company at $82 billion. Even that figure was a disappointment; the $45 price was at the low end of the range, and the year before two investment banks had pitched the company on a valuation of $120 billion.

That valuation seemed insane. The $120 billion figure was higher than the market capitalization of established giants like 3M , 21st Century Fox (most of which would soon be acquired by Disney for $71 billion), and Nvidia . And indeed, Uber stock fell on its first day, and in four and a half years on the public market UBER has been a poor investment by the standards of large-cap tech peers:

source: Koyfin

But this performance is hardly what the stock’s most ardent skeptics would have predicted at the time of the IPO. To those skeptics, UBER was the sign of a tech market that had lost its mind, one in which valuation was meaningless. And a quick look at the company’s fundamentals seemed to confirm that argument.

In 2018, Uber did generate $11.27 billion in revenue. But it had $14.3 billion in expenses, not including $648 million in interest expense. Surely, a company posting a loss well past $3 billion wasn’t worth $8 billion, let alone $80 billion. Yet Uber has now reached that $120 billion valuation — and this week was selected to join the prestigious Standard & Poor’s 500 index.

Unprofitable Tech Stocks Keep Winning

UBER was far from the only high-growth, high-valuation name that aroused the ire of fundamentally-minded investors. Amazon.com faced questions about its valuation for most of the 2010s. SaaS (software-as-a-service) names like Salesforce.com , Adobe , and Workday looked expensive and kept getting more expensive. Less mature software plays seemed even worse: many were valued not on profits, but on revenue, because they had no profits of which to speak.

And yet, overall, those stocks have sharply outperformed, even with investors last year showing more caution toward high valuations. The Invesco QQQ Trust Series 1 , which tracks the tech-heavy, large-cap, NASDAQ 100 index, has been a far better investment than the S&P 500, which includes more old-line businesses, more dividend payers, and more value stocks:

source: Koyfin

Similarly, the Russell 1000 Growth Index has handily outperformed the Russell 1000 Value Index:

source: Koyfin

And, again, to many investors this simply did not make sense. The willingness of investors to pay 15x or 20x sales for high-growth businesses often was dismissed as a consequence of zero interest rates. With no ability to get returns from savings accounts or debt instruments, by this theory investors were forced to chase returns in the equity market at essentially any valuation.

This theory seemed validated last year when the Federal Reserve increased interest rates, and many high-flying growth stocks fell sharply. (UBER, for instance, plunged 41%.) But in 2023, growth is once again outperforming. That in turn suggests there’s another factor at play, and that investor willingness to pay up for growth has a logic to it beyond just low interest rates. And there is some logic: investors prize operating leverage.

What Is Operating Leverage?

Operating leverage is the rate at which increases in revenue turn into increases in profits. As with financial leverage, which we covered last week, operating leverage amplifies revenue growth. The higher a business’s operating leverage, the higher profits go as revenue rises.

There are businesses with low operating leverage. Relatively speaking, traditional retail businesses usually qualify. An accounting firm is another example: adding more business requires adding more accountants, and so profits generally increase at a rate similar to revenue.

Generally speaking, operating leverage is greatest with businesses with high fixed costs and low variable costs. A classic high operating leverage industry is airlines. To fly a 747 from New York to Los Angeles costs much the same whether the plane is empty or full; the only variable cost is fuel (which goes up owing to the extra weight of additional passengers). And so if a flight is breakeven at, say, 75 passengers, the airline loses substantial money if it sells 60 tickets — but at 90 tickets, the operating profit of the flight is not much lower than the revenue generated through the incremental 15 tickets.

As with financial leverage, operating leverage is mostly a good thing — but with a cost. The high operating leverage of an airline is why investors continue to buy shares of existing airlines and keep trying to start new ones: they can be absurdly profitable when well-run, and can grow earnings in an absolute hurry when times are good. Analysts expect United Airlines to generate adjusted EPS of $9.76 this year, near quadruple the $2.52 print from the year before.

But the combination of operating leverage and macroeconomic risk is why airlines keep going bankrupt. Famously, Southwest Airlines is the only major American carrier to have never declared bankruptcy. In the U.S., airlines only survived the coronavirus pandemic thanks to tens of billions of dollars in government aid. United’s adjusted EPS even in 2021 was a loss of nearly $14 per share, two years after it earned more than $12.

What Operating Leverage Means For Growth Stocks

Ideally, then, what investors would love to own is a business that has high operating leverage but lacks the downside risk of high fixed costs and/or cyclical exposure. And that is exactly what so many tech stocks of the last 20 years have offered.

Take Uber, for instance. One big reason for the company’s massive losses in 2018 was heavy promotional spending that was designed to capture customers for the long haul1. That spending had an inherent logic because a platform business like Uber has exceptionally high operating leverage: its profits soar as revenue grows.

The specific, numeric term for operating leverage is “incremental margins”: the percentage of an additional dollar in revenue that turns into operating income. For Uber, or other platform/marketplace businesses like Etsy , incremental margins are exceptionally high. Just as it costs United very little to fly an extra passenger across the country, it costs Uber little to book an extra rideshare. Incremental margins are now 9% of bookings, meaning Uber gets an extra $9 in EBITDA for every $100 in customer spend — and that’s with driver and customer incentives and other factors.

But in terms of incremental leverage, even better than Uber is the SaaS business. Once a software platform has been developed, the cost of adding an extra user is minimal. It’s a bit of energy, a bit of storage spending, perhaps sales commissions and other factors. And because SaaS demand has grown and continues to grow, for the best SaaS companies the downside risk of high operating leverage — which only arrives when revenue declines — doesn’t really exist. No matter what interest rates are, it’s not hard to see why investors are willing to pay huge premiums to own that kind of business.

How Operating Leverage Makes The Fundamentals Work

The irony of the fundamental protestations against growth stock valuations is that it’s operating leverage that actually makes the fundamentals work. The same companies that looked foolishly overvalued just a few years ago now have grown into those past valuations.

Uber itself is an example. In 2018, the company posted an Adjusted EBITDA loss of $1.85 billion, more than 16% of revenue. This year, analysts expect positive Adjusted EBITDA of roughly $4 billion, nearly 11% of sales. That’s a 27 percentage point improvement in five years. And while that doesn’t mean Uber can expand margins by another 27 percentage points over the next five years, it’s clear that profits can continue to grow at a rate far higher than revenue.

The software sector has shown similar operating leverage, particularly with investors now demanding a focus on profitability over a focus on growing revenue. Salesforce is a perfect example: its operating margins expanded 850 basis points (8.5 percentage points) year-over-year in the third quarter. So impressive was the performance that the company’s own founder called it “pretty incredible” on the third quarter earnings call. Between fiscal 2021 (ending January) and fiscal 2024, Salesforce’s revenue should increase about 63%. Its operating income will jump roughly 180%, with margins soaring to 30% from 17%.

The ‘new’ Uber, perhaps is Snowflake . The data software developer trades at nearly 24x trailing twelve-month revenue; on a GAAP (Generally Accepted Accounting Principles) basis, the company has lost nearly $900 million over the past four quarters. It has a valuation of $62 billion.

But there is a path for Snowflake to grow into that valuation, as operating leverage and high incremental margins drive quick profit growth. In 2021, Snowflake’s Adjusted EBITDA was modestly negative; by 2025, analysts expect margins above 15%. Adjusted net profit should more than triple this year, and with revenue still growing at more than 30% annually there’s plenty of room for that to continue. Even with a recent rally and such a nosebleed valuation, analysts still believe SNOW should gain more than 15% over the next twelve months.

Why Operating Leverage Makes Revenue Growth So Important

This is not to say that UBER, CRM, SNOW, and other growth stocks are still buys at the current price simply because of operating leverage. Operating leverage explains why investors are willing to pay up for those names — but, for two reasons, it doesn’t mean investors are necessarily right to do so.

The first reason is that, no matter what operating leverage a business has, the valuation still needs to make some sense. With operating leverage, a stock can grow into a high valuation, but it can’t grow into any valuation. That was a lesson investors forgot during 2021. In particular: each of these names still trades below their peak from that year:

source: Koyfin

But the more important point is that high operating leverage makes revenue growth absolutely paramount. A 10x or 15x revenue multiple can make fundamental sense if a business can consistently increase revenue and thus drive almost exponential profit growth. If that growth shows any sign of weakness, however, the entire story changes dramatically. Profits don’t compound at the rate investors expect; over a multi-year period, that has a material impact on the stock’s valuation.

This is why SaaS stocks, in particular, can plunge on relatively tiny changes in revenue expectations. Last month, BILL Holdings , which provides SaaS software for back-office financial operations, lowered its full-year revenue guidance by $80 million. The stock plunged 25% the next day; BILL’s market cap declined by more than $2 billion.

Operating leverage can keep valuations elevated — but operating leverage only exists if revenue is growing. When skeptics complain that growth investors care solely about revenue, they’re not entirely wrong — they’re just missing why that revenue growth is so important.

If you enjoyed this article you can helps us by sharing it or clicking the ❤ button.

As of this writing, Vince Martin has no positions in any securities mentioned.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

On November 30, 2006, the last day of fiscal year 2006, according to its annual report Lehman Brothers had total assets of $503.5 billion. The global investment bank also had $484.4 billion in liabilities, leaving stockholders’ equity (also known as book value) of $19.2 billion.

In other words, Lehman was levered about 26 to 1. The gross value of the assets ($503.5 billion) had a value roughly 26 times the net value of the assets ($503.5 billion less the $484.4 billion it owed) on its balance sheet. That multiple had soared over the previous five years. At the end of fiscal 2001, Lehman was less than eight times levered.

For a while, that increasing leverage was actually good news for Lehman Brothers and its shareholders. After an eight-month recession in 2001, Lehman had moved aggressively not just into mortgage-backed securities, but into originating the mortgages themselves. As housing prices soared during what only in retrospect was so clearly a bubble, so did Lehman’s assets and profits.

At the end of fiscal 2001 (ending November), Lehman had $64.7 billion in assets and book value of $8.4 billion. That year, the firm generated $1.16 billion in net income. Five years later, the asset base had increased eightfold and book value by about 130%. Net profits more than tripled.

Unsurprisingly, Lehman’s stock price responded to that growth. From 2002 to February 2007, shares roughly quadrupled. Less than two years later, in September 2008, Lehman filed for what is still the largest corporate bankruptcy in history. In less than a decade, the investment bank had shown both the promise and perils of leverage.

How Balance Sheet Leverage Works

To be sure, Lehman is an unusual example — and such a high-profile example that global banking regulators in the post-crisis period have made sure no financial institution can repeat Lehman’s experience. (Of course, Lehman was far from the only culprit.) Banks in general use leverage far more aggressively than do other kinds of companies. The very nature of fractional reserve banking requires leverage, though it does add risk to the system. That risk again came to the forefront earlier this year, when Silicon Valley Bank collapsed.

But most public companies outside the financial sector also use balance sheet leverage. As with banks, for these companies leverage increases risks and rewards, if not quite to the same level. To understand those risks and rewards, an overly simplistic example is useful.

Imagine three businesses. Each business is worth $1 billion, but:

• Company A has $300 million in debt (we’ll call it “medium leverage”);

• Company B has $600 million in debt (“high leverage”);

• Company C has no debt (“no leverage”).

For each business, we can split the $1 billion valuation into debt and equity. Company C has $1 billion in equity; despite the same valuation, Company B has just $400 million. For publicly traded companies, the $1 billion figure is known as enterprise value, the sum of its debt and equity; the total value of the equity is its market capitalization, which can also be calculated by multiplying the share price by the number of shares outstanding.

The medium-leverage Company A has a market cap of $700 million and debt of $300 million; Company B has a market cap of just $400 million and debt of $600 million; and Company C, since it has no debt has both a market cap and enterprise value of $1 billion. So what happens if we increase the overall valuation of each business by 10%, to $1.1 billion? The value of the equity increases at a quite different pace:

• Company A (medium leverage): market cap climbs 14%, from $700 million to $800 million

• Company B (high leverage): market cap climbs 25%, from $400 million to $500 million

• Company C (no leverage): market cap climbs 10%, from $1 billion to $1.1 billion

The greater the balance sheet leverage, the higher the returns on the exact same increase in the valuation of the business. But, of course, the converse is true: if you cut the valuation of the business by 10%, the higher-leverage businesses underperform. In fact, at least on paper, if you reduce the valuation of each business by 40%, equity in the high-leverage business is completely wiped out.

In practice, this is not completely true1, but, again, this is a simplistic model. The broad point still holds: balance sheet debt amplifies both upside and downside. This is why that debt is referred to as leverage: it acts in much the same way as does a physical lever:

source: author

This is precisely why regulators have reacted to the financial crisis by removing the ability of systemic financial institutions from becoming so highly leveraged. When Lehman was levered 26 to 1, it took a roughly 4% decrease in its asset base to wipe out its entire book value. But even lower leverage can be dangerous.

At the end of 2022, Silicon Valley Bank was about 13x levered, with total assets of $212 billion and net assets of just $16 billion. A relatively modest reduction in the value of the total asset base would wipe out those net assets, and leave the bank insolvent. That reduction — at least in the terms of the market value of the government bonds SVB held, if not the value at which they were carried on the balance sheet — came when the Federal Reserve quickly raised short-term interest rates, lowering the prices of long-term government bonds owned by the bank.

Investors began to realize that, when considering the market value of the company’s assets, the bank was technically insolvent. Customers soon followed the same logic, and after a classic “bank run” SVB collapsed2. Though the story was different from that of Lehman, the stock chart looked much the same. In early March 2023, SIVB stock had more than quadrupled over the previous decade; within weeks, the stock was zeroed.

source: Koyfin

The Impact of Debt On The Earnings Statement

Of course, debt isn’t free. Given those higher interest rates from the Federal Reserve, debt in fact is much more expensive than it was just a couple of years ago.

The interest paid on debt creates its own form of leverage. Corporate debt often has a fixed interest rate that does not change until the debt matures. Recent history aside, even interest on variable-rate debt3 generally leaves annual interest expense relatively stable.

The stability of interest expense contrasts with the potential variability (and hopefully growth) in the underlying business. And in this way, debt provides leverage on the profit and loss (or P&L) statement as well.

Let’s return to our three hypothetical companies. We’ll assume each business is generating operating income — also known as earnings before interest and taxes, or EBIT — of $100 million, can borrow money at 8%, and pays a 25% tax rate. The enterprise value to EBIT (EV/EBIT) multiple for each business is 10x, but because of interest expense, each company’s cash flows prove to be much different.

For Company A, its $300 million in debt creates $24 million in annual interest expense. With $100 million in EBIT, that leaves $76 million in pre-tax income, and $57 million in net (or after-tax) profit at the aforementioned 25% tax rate4.

Company B, with the highest debt level of $600 million, of course has the highest interest expense. At $48 million, it’s nearly half of operating income. Taxes take out another $13 million, leaving net profit of $39 million.

Company C, with no debt, simply is paying a 25% tax rate on its EBIT, leaving net profit of $75 million — nearly double that of Company B.

From this perspective, corporate debt seems, well, kind of dumb. Because of its debt, Company B’s net profit is barely half that of Company C — despite having an operating business that is (in this simplistic model) exactly the same.

But Company B’s equity holders actually are getting benefits in exchange for the lower free cash flow. The lower free cash flow is matched by a lower equity value. In fact, looking solely at net profit, the highest-leverage business, Company B, trades at a little over 10x net earnings ($400 million market cap, $39 million net profit); the zero-debt Company C trades at more than 13x ($1 billion market cap, $75 million).

As noted earlier, the leverage on the balance sheet magnifies upside from a valuation perspective if the business outperforms (as those equity holders believe it will; otherwise they wouldn’t own the equity in the first place). But there is also leverage in the P&L in which interest drives faster growth.

Assume each business grows its EBIT by 10%. The no-debt Company C grows net earnings 10%. Medium-debt Company A sees net profit rise to $64.5 million ($110 million in EBIT, $24 million in interest, $21.5 million in taxes), or growth of 13%. And heavily-leveraged Company B gets a huge jump: $7.5 million on a $39 million base, or an increase of more than 19%.

In other words, Company B does have a smaller equity value. But it also has a lower multiple relative to net earnings and faster bottom-line growth. To be sure, those lower multiples occur because the company is riskier: if operating profit starts to decline, the company’s net earnings will plunge at a faster rate. For shareholders who are bullish on the underlying business, however, that is obviously a risk worth taking.

Deleveraging: Where Debt Gets Really Interesting

If, overall, leverage increases returns and stocks on the whole go up, it would stand to reason that higher leverage overall would be a good thing. That’s not necessarily the case, however. Too much leverage can lead to a restructuring in a worst-case scenario — but it can also wreak havoc on an operating business even without a bankruptcy filing.

Employees can get nervous about the health of the business. Competitors can and will try and poach customers, arguing that they shouldn’t take the risk of a supplier going out of business. Management may be tempted to cut costs in a bid to cover interest expense, particularly during a recession. That’s precisely when cuts are most likely to lead to negative long-term consequences, such as the inability to retain talent or a failure to invest in opportunities that will drive growth when the external environment improves.

And there are businesses out there that have too much debt, even in the eyes of their own executives. Acquisitions can fail to provide the expected return — or simply require a debt load that the company plans to pay down with the additional cash flow from the purchased business. The sharp change in interest rates of late means that, for some companies, debt that was issued last decade, and maturing in the near future, will come with sharply higher interest rates as it is refinanced. And so for these companies, debt reduction, known as deleveraging, becomes a priority.

Deleveraging can be a significantly positive catalyst for a stock. That’s perhaps counterintuitive given the argument made above: that leverage can increase equity value and earnings growth. But, again, for companies for whom leverage has become not a modest amplifier of underlying growth, but a risk to that growth, reducing leverage can have significantly positive effects.

Let’s return to Company B, which had debt of $600 million, a market cap of $400 million, operating income of $100 million, and net earnings of $39 million. Management decides that the debt has become too unwieldy in a higher interest rate environment, and chooses to focus its efforts on reducing that debt.

In year 1, the company takes that $39 million in earnings5 and pays down debt. After 12 months, assuming the business has the same valuation and earnings power, the enterprise value should still be $1 billion. But now debt is just $561 million, and the equity ‘slice’, as it’s known, thus has expanded to $439 million. Simply by paying down debt, the value of Company B’s equity has risen by nearly 10% in a year.

Of course, there’s a virtuous circle effect as well. In Year 2, Company B’s has lower debt, and thus lower interest expense: 8% on $561 million is less than $45 million, again the previous $48 million. Earnings now increase by a little over $2 million after-tax; another $41 million in debt is repaid, adding 9% more in equity value simply by shrinking the debt portion of enterprise value.

This perhaps doesn’t sound like much. But this model is all occurring in a vacuum. If Company B can grow its operating income even modestly, thanks to leverage that will drive a strong increase in net income, which in turn means more debt reduction, which reduces interest expense, which means even higher net profit and free cash flow. And so the virtuous circle turns.

Any discussion of leverage, however, has to include the caveat that the virtuous circle can turn into a vicious cycle in an instant — and not just for financial institutions. Once interest is eating up a substantial portion of operating income — for Company B, nearly half in our simple model — the margin for error becomes exceedingly thin.

Any decrease in operating income means net income starts to decline at a rapid rate. Lower net income means that debt reduction is slower than hoped — or doesn’t happen at all. Equity investors get nervous, creditors get nervous, and suddenly the company is in a fight to access needed capital.

Leverage can turn sour exceptionally quickly. And it’s why investors are rightly cautious about overleveraged businesses. In theory, leverage can work wonderfully. Reality is often much trickier.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

It seems not only weird, but counterproductive. After all, the most common investing wisdom from the likes of Warren Buffett and other great investors is to buy and hold great businesses for the long term. And it hardly seems like a great idea for the businesses themselves to run their operations with a focus on single quarters as opposed to multiple years.

Indeed, in Europe, a six-month reporting period is much more common (though large and/or U.S.-listed companies still provide quarterly updates). And in the U.S., well-known industry participants have on occasion suggested the domestic market copy the structure on the Continent.

In 2018, then-President Donald Trump asked the U.S. Securities and Exchange Commission to evaluate semi-annual reporting. That same year, Tesla chief executive officer Elon Musk floated the idea of taking his company private. In an email to employees, Musk spoke directly to the idea that quarterly reporting leads to a focus on short-term thinking:

Being public also subjects us to the quarterly earnings cycle that puts enormous pressure on Tesla to make decisions that may be right for a given quarter, but not necessarily right for the long-term.

Before and since, academics and corporate executives — and even a few investors — have made similar arguments. Yet quarterly earnings remain.

We believe that’s a good thing. But our personal opinions aside, investors have to deal with the world as it is, not as they think it should be. And understanding why earnings matter, why they move stocks and even why (and how) they can lead to overreactions is a key part of understanding the investing world.

What “Consensus” Means

Particularly during ‘earnings season’ — which runs, roughly speaking, 15 to 35 days following the end of a calendar quarter1 — the focus of the financial media seems to focus intently on whether a company “beats” or “misses” with its earnings report.

It’s worth taking a step back to understand exactly what a “beat” or a “miss” means. Sell-side analysts2 — ranging from giants like Goldman Sachs and JPMorgan Chase to smaller outfits of which many individual investors are unaware — publish their estimates of revenue and earnings per share3 in the quarter. The average of those estimates is referred to as the consensus estimate. When the company reports earnings, its actual revenue and earnings per share are compared to the respective consensus estimates. If actual results are better than estimates, the company “beat” consensus; if they’re worse, the company “missed”. And if the company goes one-for-two (for example, beating revenue and missing on EPS), earnings are referred to as “mixed”.

That description alone gets to one of the core complaints about quarterly earnings: who, exactly, put analysts in charge? It’s not uncommon to hear investors gripe that if a company “misses” earnings, it wasn’t the company that missed; rather, it was Wall Street that got it wrong.

It’s a somewhat fair complaint — but it also misses the point. Consensus estimates are a guidepost, but investors absolutely make up their own minds. Indeed, before a report, institutional investors in particular may have a so-called “whisper number”, a more up-to-date forecast. But that aside, one thing to absolutely keep in mind is that just because a company beats earnings, that does not mean the stock goes up.

This is a fact that often causes confusion for inexperienced investors. There is a sense in which if a company “beats”, the stock should go up, and if it “misses” the stock should go down. That sense, on its face, has some logic behind it: if the company is performing better than Wall Street expects, then the stock should go up after earnings.

BILL Plunges

But that’s not how it works — for a few reasons. Again, investors make up their own minds. More importantly, however, is that stock prices react most directly to what is going to happen in the future, not what has happened in the past. Backwards-looking results are useful in trying to forecast future results, but on their own have exceptionally little value. If, for instance, a company’s earnings are 10 cents better than expected, but the long-term outlook remains unchanged4, the stock price should be 10 cents higher. No more, no less.

In that context, the absolute worst-case scenario for a stock is if the company beats estimates for the prior quarter, but provides its own outlook that misses estimates for the next quarter, or even worse the full year. The good news is looking backwards; the bad news is looking forwards. Again, the market (wisely) places much more emphasis on the latter.

In this earnings season, we have a perfect example of this phenomenon. On Thursday, after the market closed, bill payment provider Bill Holdings reported earnings for the third quarter. Relative to consensus expectations, Bill.com had a solid quarter: adjusted EPS of 54 cents was 4 cents better than the Street anticipated, and revenue growth was about two percentage points higher than sell-side analysts expected.

The next day, BILL stock plunged 25%. The problem was that the company cut its full-year guidance. Following the fiscal fourth quarter release in mid-August, the midpoint of guidance suggested revenue of $1.30 billion, and adjusted EPS of $1.895. After Q1, the full-year outlook dropped to $1.23 billion, with EPS falling to $1.815.

Source: Koyfin

Those moves don’t sound like much, admittedly. But bear in mind that the cut came after a fiscal Q1 which was better than not only analysts, but the company itself, forecast. Both revenue and earnings per share for fiscal Q1 were better than even the high end of the company’s guidance range5.

If you do the math, then, the market’s expectations for the last three quarters of fiscal 2024 plunged dramatically. By the company’s reckoning following the Q4 release, revenue from Q2 through Q4 of fiscal 2024 was supposed to be right at $1 billion. Following the quarter, implied guidance was $920 million. Adjusted EPS was forecast — again, by the company itself — at $1.40 over the last three quarters of the fiscal year. After Q1, the same math suggested implied EPS guidance of $1.2656.

Now, an investor could argue that a roughly 10% decline in expected earnings over the next three quarters doesn’t support a 25% decline in the stock price. But in fact, that kind of reaction is completely logical. What Bill Holdings itself is saying is that its profit growth over the next nine months is going to be lower than it expected. That matters — enormously. Setting aside the debate over whether management believes performance over the next three quarters is just a ‘speed bump’ (and investors should not take management 100% at its word), from a purely mathematical perspective that outlook should have a significant impact on the value of the stock.

After all, what matters for a stock is not what earnings are right now, but what earnings will be in the future. Indeed, for every stock, its valuation is essentially an argument over what its earnings will be in the future. And if Bill Holdings itself thinks its near-term earnings will be lower, that in turn means that its long-term profits, too, will be lower. In other words, if investors expected Bill could increase earnings 10% a year off the fiscal 2024 base, then the fact that this year’s base is lower has effects that last long into the future. Unless management can convince the market that the next few quarters are simply an anomaly — and Bill management clearly didn’t — then a 25% decline off a 10% ‘miss’ in earnings over just three quarters makes perfect sense.

It’s Not Just The Numbers

After the market closed on Wednesday, Confluent , a provider of data analysis software, released earnings for the third quarter. Q3 looked fine, and perhaps even impressive. The company posted a surprise adjusted profit of 2 cents per share against the consensus estimate for a 1 cent per share loss. Revenue of $200 million was $5 million better than the average Wall Street estimate — and in the context of a single quarter, a 2.5% beat is not something to sneeze at.

The next day, Confluent stock plunged 42%. But, in this case, the overall numbers seemed reasonably solid. The company’s outlook for fourth quarter revenue missed only by a couple million dollars. Purely in terms of the math, nothing suggested such a sharp plunge, which took roughly $3.5 billion off the company’s market capitalization.

Source: Koyfin

In terms of the basic math, the plunge in BILL perhaps makes some sense. A shortfall relative to near-term expectations leads to an exaggerated long-term impact. But Confluent’s outlook for the entire year was pretty much in line with Wall Street expectations. And yet the stock was still crushed.

The issue here, however, is one that isn’t apparent just using basic math. On the earnings conference call, Confluent management admitted that two major customers were bringing their software workloads back ‘on-premise’ (in other words, onto local servers) instead of running them through the cloud offerings provided by Confluent.

Admittedly, it seems close to insane that investors would react so violently to such a data point. And CLFT’s plunge in turn would seem to be a buying opportunity. Some investors certainly saw it that way: the stock did gain 9% the session after the 42% plunge.

But, taking a step back from the numbers, the market’s caution does make at least some sense. If Confluent’s biggest customers are pulling data in-house, surely that’s a negative sign for the rest of the business. And if the value proposition here is not so compelling as to preclude such a change, then perhaps the pre-earnings valuation was simply wrong, because the underlying business here is not as attractive as investors believed. If that’s the case, then a 25% reduction on the stock price isn’t an overreaction; rather, it’s an appropriate reaction.

The Market Isn’t That Dumb

The broad point here is that when a stock moves in a way that doesn’t purely match the “beat”/”miss” direction implied by analyst consensus, it doesn’t mean that investors are acting foolishly. Nor does it mean that sell-side analysts themselves “got it wrong”.

Rather, like everything else in investing, quarterly earnings are complex. There are no simple rules. An earnings “beat’ doesn’t mean the stock has to rise; a “miss’ doesn’t by definition, imply a plunge (even if that is the most likely outcome).

What matters is the new information that quarterly earnings provide. Quite often, that information simply doesn’t mean much. A good business grows its revenue and profits at a rate roughly in the range that investors expect, and in turn the stock price makes a relatively small move.

But on occasion, that new information is meaningful — in both directions. Disappointing results can mean the business isn’t growing as quickly as investors hoped. Surprisingly strong results, however, can mean the business is performing much better than investors had realized. And in those instances, earnings per share that are only a penny or two better than analysts projected can drive 10% or even 20% increases in the stock price.

A good example here is 3-D printing play Proto Labs . The company’s third quarter report doesn’t look that impressive: revenue only rose 7.4% year-over-year. But profit margins increased nicely, with adjusted EPS jumping over 25%. And in a market that is worried the industry is headed for a decline, that report was more than enough to send the stock up over 30% the day after earnings were released.

It bears repeating: the stock market is an argument over future results. It’s precisely because that argument is fought over unknowable answers that investing is so fascinating, so dangerous, and so messy. What quarterly earnings provide is one more data point in that argument. Quite often, that data point largely confirms what investors already believed. But, on occasion, it changes those beliefs. And it’s on precisely those occasions that stocks make huge moves — in both directions.

As of this writing, Vince Martin is short TSLA.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

EBITDA, or earnings before interest, taxes, depreciation and amortization, has become one of the most widely-used metrics in the investment community — and one of the most controversial.

EBITDA is controversial to some investors because it excludes very real costs. Interest expense represents cash out the door. The same is usually true for taxes1. Depreciation and amortization are both non-cash expenses, but each represents the multi-year accounting treatment of assets paid for in cash.

Making matters worse, modern companies now use an “Adjusted EBITDA” metric, which backs out even more expense. Most notably, nearly all companies that report Adjusted EBITDA exclude stock-based compensation to employees. That compensation is not necessarily a cash expense, but it’s certainly a real expense. The additional shares paid to employees who exercise their stock options mean existing shareholders are diluted: the size of their ownership stake in the company declines2.

As a result, some investors derisively refer to Adjusted EBITDA as “earnings before everything”. Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, famously said, “I think that every time you see the word EBITDA, you should substitute the words ‘bullsh— earnings’”.

The criticisms of EBITDA are valid — in some cases. EBITDA, by definition, does make profits look better. Companies can and do take liberty with the metric. Certainly, valuing a stock — or many stocks — on EBITDA alone can get investors into trouble.

But at the same time, there is value to understanding, and to using, EBITDA — and even Adjusted EBITDA. Neither metric is perfect, but neither should be dismissed out of hand, either.

EBITDA Arrives

According to multiple sources, EBITDA was first used by John Malone in the late 1970s. Malone, a billionaire who still heads the Liberty Global complex, at the time was rolling up a series of small cable television systems across the U.S. He would eventually sell the group to AT&T in 1999 for a deal worth, in total, a whopping $48 billion (about $90 billion in 2023 dollars).

To this day, Malone is exceptionally adept at avoiding corporate income tax, a key reason why Liberty’s companies have enormously complicated corporate structures. One way to minimize income tax is to minimize reported earnings under existing accounting frameworks.

And so, at a time when investors focused intently on earnings per share, Malone developed EBITDA to provide a framework for the market to better understand his businesses. The attractiveness of EBITDA to Malone, perhaps counterintuitively, was that it could allow investors to get a better understanding not of net earnings, but of cash flow.

Again, the ‘D’ (depreciation) and ‘A’ (amortization) are non-cash figures. But from EBITDA, investors can get to a reasonable estimate of free cash flow by subtracting cash interest expense3, cash taxes, and capital expenditures. The latter figure, essentially, is the cash flow statement version of depreciation: capital expenditures are the actual cash spent in a given year, while depreciation is the accounting-based, non-cash, cost of the asset spread out over a given period4.

Certainly, Malone was trying to make his business look better by using EBITDA. But it’s worth noting that, in this original example, he was also providing more accurate information to investors. In the case of a business that was growing quickly, booking upfront losses to acquire customers, and using debt to fund acquisitions, net earnings per share simply wasn’t that useful a metric.

And indeed Malone was right. Shareholders in his cable company, Tele-Communications Inc., made massive profits. In this case, the use of EBITDA wasn’t an attempt to create the perception of value that wasn’t there. Rather, Malone was trying to help investors understand the value that was there.

Where EBITDA Is Useful

To be sure, not every business is going to be what Tele-Communications was in the 1970s: fast-growing, acquisitive, and a bit messy. But, broadly speaking, there are industries and profiles in which EBITDA is much more likely to be useful.

In our earlier piece on price-to-earnings multiples, we noted that real estate investment trusts (REITs) almost always use a metric known as funds from operations (FFO). FFO is generally seen as more accurate because REITs have exceptionally high depreciation expense, as the cost of constructing, say, an office building is depreciated over 39 years. But, in fact, that depreciation expense isn’t actually ‘real’ at all: assuming proper maintenance spending, the building is not worth zero after 39 years. Usually, it’s worth more than it was nearly four decades earlier.

A similar dynamic plays out in the resorts and casinos sector. Casinos are inordinately expensive to build: the Wynn Resorts location outside Boston, for instance, cost $2.6 billion. But once that money is spent, the depreciation expense going forward isn’t really of interest to investors. And so for a casino operator, what really matters is not net income — which is depressed by that depreciation expense — but cash flow. And EBITDA provides a better example of understanding what cash flow looks like: again, investors can deduct cash interest expense, the capital expenditures required to keep the property updated, and whatever cash income taxes are required. Indeed, casino executives and Wall Street analysts covering the industry will tend to use EBITDA almost exclusively.

Not coincidentally, casinos are also usually heavily leveraged companies, with substantial amounts of borrowings. And for indebted companies, EBITDA is useful in two ways.

First, EBITDA is commonly used in judging a company’s credit. Because the metric excludes non-cash expense and interest costs, it basically includes every dollar the business generates that could, in theory, go toward interest repayments. Indebted companies will usually report a leverage ratio, which is the total amount of debt (or debt net of cash on the balance sheet, in the case of a net leverage ratio) divided by EBITDA over the past four quarters.

Leverage ratios provide a quick look at the health of a company’s balance sheet. Very broadly speaking, a net leverage ratio over six times is exceptionally dangerous, and 3x-5x can be dicey for the wrong business or one in the wrong industry.

Similarly, EBITDA can provide a framework for understanding the valuation the market is assigning to the entire business, not just the equity. Analysts will usually use enterprise value to EBITDA multiples; enterprise value (market capitalization plus net debt) is the proper numerator because it represents the value of the entire business.

Two companies can have similar price to earnings multiples, but different EV to EBITDA multiples because of dissimilar balance sheets. For instance, building products companies Masco and Gibraltar Industries both trade at about 13x this year’s forecasted net earnings per share. But Masco has nearly $2.5 billion in net debt on its balance sheet; Gibraltar basically has zero borrowings.

And so, on an EV/EBITDA basis, MAS trades at about 10.1x, and ROCK 9.1x. What that tells us is that the market is valuing Masco’s business more dearly, even if it is valuing the two companies’ equity essentially identically.

Adjusted EBITDA Takes Hold

While Malone’s original use of EBITDA might have had some value, EBITDA admittedly has proliferated massively in the nearly five decades since. The metric became more popular in the late 1990s, when amid the ‘dot-com bubble’ more unprofitable companies went public.

Importantly, it wasn’t just a ‘dot-com bubble’; the concurrent telecom bubble was even larger. Perhaps ironically, many companies were looking to take Malone’s strategy in cable and apply it to communications assets. One of those companies, Global Crossing, in the third quarter of 2020 reported a net loss of $602 million, but positive Recurring Adjusted EBITDA of $355 million. Unlike TCI, however, Global Crossing’s use of EBITDA was not highlighting hidden value: the company filed for bankruptcy just 15 months later.

As tech stocks recovered, and as they led the market in the 2010s, the use of EBITDA, and in particular Adjusted EBITDA, spread. The sheer number of unprofitable companies, and particularly unprofitable companies with huge valuations, was a key factor. For companies with negative net income, EBITDA provided a metric that could be positive, or close. And for those companies, stock-based compensation tended to be much higher than in mature industries. The variance in the accounting for SBC made adjusted figures smoother and (in theory) easier to understand5.

By 2017, even Buffett himself was criticizing adjusted numbers, and implicitly Adjusted EBITDA:

Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.

Many investors felt the same. Again, stock-based compensation is a real expense, and for many tech companies a very real expense. In the first three quarters of 2023, stock-based compensation at Snap has been over 30% of revenue. The company reported $2.4 million in Adjusted EBITDA over that period — a figure that excludes a stunning $991 million in stock-based compensation.

Snap is a somewhat extreme example, but most big tech companies are excluding SBC from their Adjusted EBITDA figures. And that fact gets to the idea that the expansion of EBITDA usage, and of ‘adjusted’ figures more broadly, has become a tool for companies to inflate their performance, rather than to give investors a more accurate picture of the business.

WeWork Takes It Too Far

That idea was strengthened in 2019, when WeWork tried to go public. At the time, the office sublessor was still flying high, with investments from Softbank valuing the business at $47 billion. As part of the initial public offering process, WeWork filed a Form S-1 with the U.S. Securities and Exchange Commission, and included a novel term: “Community Adjusted EBITDA”.

Unsurprisingly, by the Community Adjusted EBITDA standard, WeWork’s business was performing quite well. In 2017, it had posted Community Adjusted EBITDA of $233 million on revenue of $866 million. CAE had increased 143% year-over-year.

The problem was that Community Adjusted EBITDA almost literally was “earnings before everything”. The metric excluded interest, taxes, depreciation and amortization, but also:

• revenue from sponsorships and ticket sales to WeWork-branded events;

• expenses from running ancillary businesses (including a coding academy);

• sales and marketing expense (!);

• growth and new market development spending, which incredibly consisted of things like developing WeWork designs;

• pre-opening expenses; and

• general and administrative expenses — in other words, corporate overhead.

If you squint, you can see WeWork’s point as an evolution of Malone’s. What WeWork was trying to communicate with the figure was, essentially, the spread between what it charged tenants and what it paid landlords in existing developments. But even in that context, the exclusion of overhead, in particular, was laughable, and the Community Adjusted EBITDA metric spawned no shortage of jokes.

There was a serious side to the metric as well, however. Between CAE and a claim in the initial prospectus that WeWork’s mission was to “elevate the world’s consciousness”, the initial public offering process itself punctured the aura surrounding WeWork and its founder Adam Neumann. The IPO failed, Neumann was removed, and WeWork wound up going public via a merger with a special purpose acquisition company in October 2021. In its second quarter 2023 earnings report in August, the company warned that it was possibly headed for bankruptcy.

Source: Koyfin

Keep It Flexible

The irony of the WeWork IPO, however, is that the company’s use of Community Adjusted EBITDA actually disproved some of the claims made by critics of EBITDA and/or adjusted profit figures. The market’s response was so intense that a long-awaited IPO of one of the world’s most valuable companies was canceled. That response alone shows that “bullsh— earnings” can only go so far, and that investors indeed did, and do, understand what adjusted figures really mean.

That in turn gets to a key point for new investors: to remain flexible. There are no hard and fast rules in investing. Yes, Adjusted EBITDA figures make the business look better — but they also provide more information. Even the nature of that information can be useful. Is the disclosure of EBITDA figures even useful, or is it being released (as Buffett alludes to above) simply to provide a bigger figure than net income? Is management working to make the business look as good as possible — or removing figures (such as a non-cash gain on sale of an asset) that would actually make performance look better?

There is no single investing metric that tells the entire story. A net earnings figure is useful in most situations — but constrained by accounting rules and decisions, and not necessarily applicable to every business during every reporting period. EBITDA does make a business look better, but it’s also valuable when performance doesn’t reach the standard of positive net income and/or non-cash figures are impacting the bottom line.

Simply put, there are reasons why EBITDA has become such a common metric. One of those reasons is that, often, it makes executives looks good. But that reason alone isn’t enough. As WeWork’s Community Adjusted EBITDA shows, if investors didn’t believe there was some value in the metric, it wouldn’t exist at all.

As of this writing, Vince Martin is long shares of Gibraltar Industries.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.

The following quotes all come from Twitter, in the wake of the May 2nd short report on Icahn Enterprises , written by Hindenburg Research. They highlight many of the criticisms of so-called activist short sellers:

Hindenberg research is a nefariously planted "company" by Wallstreet to bash companies and manipulate markets. This is getting published because of $bbby court case.

Ninja technique to make money. First short the stock (evident from the sell off since last 2 weeks) and then drop the report. Then get out on fomo. May be Hindenburg is the face of Financial criminals […] Taking the short position and dropping the report to create the fomo is market manipulation.

How these guys can legally make money off this this is beyond me. Yet the SEC goes after a few retail investors that buy low and sell high. What in the world is the difference here?

It comes down to this - without the report, it’s still trading at $50…Hindenburg is printing money on the short side at the expense of IEP shareholders thanks to a summarized article with a bunch of already public info. A hit piece. Should be ILLEGAL

It should be said that Hindenburg is now almost certainly the most well-known (and likely the most successful) activist short seller. The firm’s 2020 report on Nikola revealed significant, long-running deception from the company, deception that eventually led to the imprisonment of Nikola founder Trevor Milton.

Most famously, the company rolled one of its trucks down a hill, while failing to mention that the truck actually wasn’t being propelled:

source: Twitter via Hindenburg Research

Despite the fact that Hindenburg got one right, to many investors, activist shorts don’t seem fair. A blast of negativity comes out of nowhere, with no warning. The stock often moves before shareholders even have time to read the whole report. And those reports almost without exception are incredibly biased. Even if true, they include only the worst information about the business, leaving out many of the company’s positive attributes.

It’s not just investors who are concerned. In late 2021, Bloomberg reported that the U.S. Justice Department had launched a criminal investigation into short seller activities. Commentary from a DOJ official in May suggests results of the probe might arrive any day now. Back in 2017, the then-head of the New York Stock Exchange, referred to short selling more broadly as “kind of icky and un-American”.

But we see it quite differently. Short sellers in general, and activist shorts in particular, serve an important function in the market. And even investors who disagree should respect activist shorts and listen to what they say. As we’ll see, those shorts are often right — and can provide value to all investors even when they’re not.

The Nobility Of The Equity Market

In its highest form, the purpose of the public equity market is to properly allocate capital. Stock prices provide signals to the entire economy that, in theory, should govern investment flows.

Those signals go to the executives of publicly traded-companies: their own stock price might suggest comfort, or dismay, with the direction of their business. Witness, for instance, the market’s recent uncoordinated decision to dozens of companies that “growth at any cost” investment was no longer wise. But the signals also reach competitors, private companies, suppliers, and nearly every other economic participant — including, importantly, the entrepreneurs that provide the next generation of publicly-traded businesses which will serve thousands or even millions of customers.

In this admittedly idealized model, equity investors are rewarded for providing new information to the market1, which makes prices more accurate and, in this telling, capital allocation more efficient2. Because of those accurate prices, the free market functions more efficiently.

Certainly, not everyone agrees with this theory. In practice, there are scams and pumps and dumps and manias and errors. But even in this idealized story, there is a potential problem: how is negative information to be incentivized?

The Role Of The Short Seller

One obvious incentive is that active investors can sell owned equity, avoiding losses faced by fellow shareholders and thus improving their overall returns. For instance, an investor who learned about the rise of GLP-1 agonists early could have exited, say, Hershey, and escaped a larger drawdown.

But the current structure of the equity market provides another incentive: to sell a stock short, by borrowing the stock and selling it into the open market.

This is important. An investor who understood significant flaws in a business or, in certain cases, discovered outright fraud now has a means to profit off that discovered knowledge, improving price discovery in the process. Without short selling, that same investor would almost certainly not buy the stock, but outside of the regular media (whose incentives are not nearly as strong), there would no direct mechanism to get that negative information into the market.

Activist investors like Hindenburg are the bluntest, loudest, participants filling this role. And the role is important. One of the quotes above notes in relation to the Hindeburg/IEP report that “without the report, [IEP is] still trading at $50”. That hypothetical is a worse outcome.

Imagine, for instance, a world in which knowledge of Nikola’s activities was not known for many more years. There would be hundreds of engineers and other employees leaving their jobs (or graduate programs) to move to the company’s headquarters in Arizona, lured by packages of stock that would prove to be close to worthless. Many more billions of dollars of capital, some of it coming directly or indirectly from pension funds (and thus their often middle-class beneficiaries), would have been invested behind a business which almost certainly would have failed at some point regardless3. Learning about that early saves much greater pain down the line.

FIZZ Gets Popped

In September 2016, a short-selling outfit named Glaucus Research4 released an activist short report on National Beverage . FIZZ had an interesting backstory. The company was actually created in the mid-1980s to fend off a hostile takeover by an installer of cable systems. Three decades later, founder and chief executive officer Nick Caporella owned roughly three-quarters of the stock, leaving a thin float, and little real interest in the name.

But in the mid-1990s, National Beverage had acquired Winterbrook Corp. out of bankruptcy, and in the process picked up the LaCroix sparkling water brand. LaCroix was well-known in the Midwest, but had a vanishingly small presence outside the region. By the middle of the 2010s, however, its sales were picking up steam as consumers started to abandon diet sodas over health and ingredient concerns. By the time Glaucus took aim at the stock, the FIZZ story was gaining a bit of traction, and the stock had more than doubled in a little over a year.

I read the Glaucus report with great interest because, coincidentally, I had bought FIZZ literally two days earlier. The report was well-written, and the short seller made some good points. Glaucus pointed to exceptionally thin disclosures in National Beverage’s SEC filings, including around compensation for the CEO. (Operations were another issue: the company’s commentary in 10-K filings often boiled down an entire year’s performance to only a couple of sentences.) The firm claimed “inexplicable” operating margins, cited a host of concerns around related-party disclosures and, perhaps most damningly, unearthed testimony in a lawsuit that Caporella had referred to “a little jewel box” with which he would manipulate his company’s earnings.

FIZZ tanked double-digits on the day of the release. Clearly, the market believed the report showed real reason for concern. But if you read the report closely, the airtight case for concern slowly started to fall apart. The “inexplicable” margins (which had begun to expand around 2009) actually made sense when considering that LaCroix had grown largely by word of mouth, rather than through an aggressive marketing campaign.

The case for earnings manipulation didn’t make much sense: Caporella owned three-quarters of the business, meaning a higher stock price didn’t do much other than create paper wealth. (Indeed, Glaucus itself argued that Caporella’s refusal to allow proper due diligence tanked an acquisition by Japan’s Asahi, which itself proved the folly of manipulating a controlled stock.) Perhaps more importantly, National Beverage had barely any analyst coverage: it wasn’t clear what the point of manipulating earnings even would be.

Reacting To A Short

And so, what Glaucus actually had done was create an attractive buying opportunity, both short- and long-term:

source: Koyfin; two-year chart starting week of Glaucus release

There’s a question to how Glaucus created that opportunity. Did the firm find a lawsuit relating to a somewhat illiquid, poorly-covered name with thin disclosures and see that as an opportunity to quickly scalp the stock? Or did it make mistakes precisely because of the thin disclosures and the somewhat titillating, if unproven, allegations in the lawsuit?

From an investing perspective, it’s not a question that matters all that much. Whether or not an investor believes in the role of short sellers, and particularly activist short sellers, they can provide opportunities no matter if they’re right or if they’re wrong.

In this case, I was able to average down on FIZZ, increasing my stake at a more attractive price5. In the case of Hindenburg and Nikola, an investor perhaps would have been upset by an ugly day of trading on September 10, 2020, when the report was released. But listening to the firm would have saved far greater losses from that point on:

source: Koyfin; chart since 9/9/20

Hindenburg and IEP

One important thing to remember when it comes to activist shorts is that reputation is paramount. A poor and/or false report erodes credibility, and it’s credibility that makes the entire process work.

So investors should have listened when Hindenburg came out with its short thesis on IEP on May 2nd. Indeed, many did: IEP dropped 20% on the day of the release.

But, as with NKLA, there was time for investors to get out:

source: Koyfin; chart since May 1

There is one notable difference between IEP and NKLA, however. It’s a key reason why IEP is so reflective of the importance of treating activist shorts with respect: Hindenburg’s report on the stock actually wasn’t that impressive.

To be clear, that’s not to say the report was wrong, or filled with errors. Rather, it was exceptionally simple. The Nikola report in 2020 was a legitimate piece of investigative journalism, with at least one clear source on the inside of the company. In contrast, the IEP report, as one of the Tweets cited at the beginning of this article correctly noted, was “a bunch of already public info[rmation]”.

Indeed, the main points were already public. Hindenburg’s estimate that IEP at the time traded at a 218% premium to its indicative net asset value was based on the NAV figure that Icahn Enterprises itself disclosed in its fourth quarter report. The 53% decline in the investment portfolio between 2014 and 2022 was calculated from data in SEC filings. So was the gap between dividend payments ($1.5 billion) and free cash flow (negative $4.9 billion) over the same period.

In fact, more than seven years earlier, Barron’s writer Andrew Bary made basically the same bear case: Both reports even cited year-to-date losses at CVR Energy which had occurred after the most recent publicly-available calculation of indicative NAV. But from the publication of the Barron’s piece to the day before the Hindenburg release, IEP generated total returns of 112%, against 144% for the S&P 500.

All of the gains are gone, and then some. IEP is now -19%, including dividends, since the Barron’s report. Hindenburg had the credibility to move the stock, and it has done so: total returns in IEP are negative 62% since the day before the release.

It’s important to remember that the credibility required to put on the IEP trade only exists because Hindenburg had repeatedly established to the market that it did the work, and did it well. It had repeatedly established that it could, and would, bring new information. It is a bit of an irony, perhaps, that one of its most successful trades came in a report that, essentially, provided no new information at all.

As of this writing, Vince Martin has no positions in any securities mentioned.

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