Recently I've had a number of discussions with people as to what makes for a good business. A topic that frequently comes up is cashflow and various ways to improve it. These days more people seem to know about cashflow and more people seem to be willing to play games with it.
When you run a business you fairly quickly come to realize that the most important thing is cashflow, even more so than profits. You could have the most profitable product in the world, but if those profits take a long time to come in then the company might not survive long enough to get them. Companies have a lot of expenses that have to be paid immediately like staff wages, if a company can't cover these expenses we say that the company is insolvent. Back in the past trading while insolvent was seen to be unacceptable and was even a crime in many jurisdictions. The law itself can encode the idea that cashflow is most important by enforcing that some expenses must be paid immediately for the company to deserve to continue to exist1.
So if you are running a business you will fairly quickly start to think about cashflow and what you can do to manage it.
On a basic level this means effective billing and contracts. On a more complex level there's a huge number of "games" that can be played with cashflow. Because of the cultural changes we have seen a shift towards financial engineering being more acceptable now as compared with decades past.
This is why you have companies like Amazon where they reported zero profits for years. But yet nobody would have said that Amazon was unsuccessful, so what was going on?
What is EBDITA?
Accounting is the set of practices that grew as a result of a need to be able to accurately keep track of how businesses were performing. Without accounting practices it's hard to know if a business is actually doing well or not. This has over time led to the creation of Generally Acceptable Accounting Guidelines. Scandals like WorldCom and Enron show that messing with the accounting of a company is a way in which it is possible to defraud investors. The laws then try to keep up with these changes although they will always be behind whatever the newest ideas are. The large accounting scandals led to changes in the laws for publicly traded companies in the USA with the passage of the Sabarnes-Oxley act in 2002 which made certain record keeping and auditing a legal requirement and created criminal penalities for non-compliance. In any case sensible accounting practices are especially important for modern businesses and therefore modern economies.
One such accounting "innovation" is Earnings Before Interest, Taxes, Depreciation and Amortization which is frequently referred to by its acronym EBDITA.
The concept is one that you hear about a lot these days but it's a relatively recent invention that is at most 50 years old and only really caught on in the last 30 years or so. Previously Wall Street, which is conceptually somewhat synonymous with institutional investors, was mostly interested in the accounting profits and cashflow of businesses. Businesses like Amazon which proudly pronounced that they were making no profits for years just simply wouldn't have received any large money from institutional investors in the past, so what changed?
Broadly speaking a massive cultural change happened within business and investing in the last 50 years. "Financial innovations" became an increasingly large factor in the business landscape that eventually ended up changing the day to day operations of many businesses. For example you could set up business arrangements with complex loans and terms such that you could shelter a lot of the companies profits away from taxes. Doing this would allow a company to reinvest into its own infrastructure by using the tax money they didn't pay. You might be asking why this didn't happen earlier? I certainly did, this question was on my mind for a while. Part of it is that there's a creative process involved in coming up with these complex business financing deals and someone had to first come up with such a deal. The other part of it appears to be that banks were previously much more conservative with regards to issuing these sorts of loans. Loaning money to a company that wasn't reporting any profits would previously have been seen to be a an imprudent move with high counterparty risks involved.
One of the places where EBDITA first saw usage was in cable TV companies. The book Cable Cowboy by Mark Robichaux talks about how John Malone and his team at Telecommunications Inc came up with some of these arrangements and how they convinced the banks to accept their business model when loaning them money and also how they convinced investors that their new way of doing business made sense.
The gist of it is that they figured out that if they could somehow take their yearly profits and reinvest those directly into infrastructure they wouldn't have to pay as much corporate tax. By doing this they would be able to grow the business much faster than if they went with more traditional financing. The dilemma? In order to get the funding to do these big infrastructure projects they'd need to get some loans but the whole point was to not show profits and that makes selling the idea of the loan far harder. Put yourself in the shoes of the person offering the loan, how comfortable are you going to be loaning money to someone who says they won't have any profits? I'd be uncomfortable about that. And many people in the banks were also uncomfortable with that.
The invention of the concept of EBDITA was a crucial part of getting bankers on board with issuing these loans to TCI.
Later on Amazon would famously take a similar approach. Back in 1997 Bezos wrote in a letter to the shareholders:
We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.
Many reporters commented on Amazon's apparent lack of profitability for many years and this lack of profit deeply confused many people. The confusion came from people misunderstanding that Amazon was aiming to optimize the cash flow but yet this was their exact plan, Amazon would reinvest heavily in infrastructure that would grow the company and then use that to offset against taxes while growing their customer base. Many years later the strategy is much clearer and the articles about how "unprofitable" Amazon is have since stopped.
There are however some downsides to this approach of not optimizing for GAAP accounting. One of them is that getting investors to buy into the idea that success is defined by the metrics that the board and management decide rather than widely held notions of what constitutes success puts investors into very dangerous territory. Accounting standards are what they are because over many generations we have accumulated common knowledge about how to measure business performance and what constitutes business success. Someone striking out on their own and trying to come up with a new way of structuring a business might come across something better but there's definitely risks associated with this.
There's a mental model for investing called "value investing" where the mindset is trying to figure out which companies and organizations are undervalued and then investing in those. To do this effectively requires you to be able to have some way of figuring out how valuable a company is. This of course isn't easy, especially in a day and age where accounting games are frequently played by companies to make them seem more successful than they really are. When there are companies that are growing fast like Amazon but aren't reporting any profits and aren't paying dividends how are you to decide if they are worth investing in? Additionally in the current markets we have incentive structures where people are paid more bonuses if the stock price increases, so the temptation to increase the stock price, even if it doesn't improve the company long term is a very strong one. All of this makes it conceptually harder to figure out if a business is worth investing in that compared to earlier times.2
I came across this video from a Berkshire Hathaway meeting in 2003 where someone in the audience asks about EBDITA. Warren Buffet explains why they have the mindset that they have at Berkshire Hathaway regarding what they think is most important to analyze and how this can differ from the GAAP numbers that are sometimes seen. The argument he makes is that Depreciation can't just be hand waved away, its a very real cost. The example given is that say you build a pipeline, at some point in the future it will need maintenance and eventually it will be disused. The cost of the pipeline must be paid in order to use it and those expenses are immediate cash that must be paid and hence will impact cashflow. Charlie Mungers response seems even more relevant today than it did back then: "Every time you hear EBDITA substitute it with 'bullshit earnings'". I think from a first principles point of view this makes a lot of sense, while accounting games can shelter the company from paying taxes you can't just hand-wave away expenses and report on the earnings as if those expenses didn't exist. It seems a lot of people fall for this however. With enough people falling for this value investing hasn't seen the returns it once had in part because valuations are to some degree just up to the general investing populace. If nobody sees long term value as being worthwhile they might not invest their money in the long term. Such short-termism, as seen with absurd concepts like "Blitzscaling" or ZIRP funded companies, perhaps are an indication of this. I wouldn't be surprised as the business cycle progresses for people to once again reconsider the importance of long term value, though I worry this may only happen as the result of large economic hardship being the forcing factor to get people to reconsider.
One of the most disturbing things about the COVID pandemic, other than the obvious mismanagement of it by many groups, were the various major law changes that were introduced under emergency measures in parts of the world. These laws often didn't have any public input and were frequently done in ways that were either unconstitutional or were directly in contravention the spirit of the laws and customs of the land. One example of this in Australia was that trading while insolvent was "temporarily" made legal. Part of why this was a political expediency were due to games being played about stimulus checks and how that was related to employment. Many people were forced by the threat of force to not go to work and to close their businesses, giving people monetary compensation for this was required to stave off starting a complete societal collapse. Companies were paid this payment called "jobkeeper" where taxpayer money was being paid to companies to then be distributed to staff at those companies. The idea being that if the transfer payment was payed by the government to the company then the company payment to the staff could be categorized as having the staff not be unemployed. This payment probably saved many businesses, even though without coercive intervention to shut them down they wouldn't have needed any help in the first place. Many people however were effectively unemployed though the pandemic and this approach artificially kept the unemployment rates down (unemployment was at crazily high numbers for that period and the economy has not fully recovered even now). The other disturbing thing is the increasing normalization of wage theft in Australia which started long before the pandemic. Many companies have become far more slack about paying their staff their wages in full and on time. In earlier eras the cultural norms of the country made such a thing completely unacceptable and workplace laws were created around this cultural norm. Cultural norms that staff must be paid their wages on time and in full effectively mean that the culture expects the businesses operating within it to have good cashflow as a condition of existing. With these norms eroding you can see that the general culture is becoming more accepting of businesses with poor cashflow and poor ethics. Perhaps it should therefore come as no surprise that we have more zombie companies now than ever before. Even though it may not be obvious or immediate culture always impacts the operation of business. Long term culture is the main thing that matters for the success of commerce in a country. ↩
I suspect the increased complexity of determining how profitable individual businesses are has been a factor in the rise of passive investing. As business structures become more complex the task of analyzing their books gets harder. Many people who have some money to invest either conceptually don't have the tools to do this or don't go to this effort due to the costs of it being higher. Passively investing in some ETFs in comparison is far less demanding on the time and intellect of the investor, but does come with other costs. ↩