Since about September of last year, I have smelled a rat in the kitchen. The enormous gains were built on several irregularities that were, in reality, weaknesses disguised as strengths. First, government policies. Second, Capital Allocations. Third, Financial reporting fraud. When the market rises, nobody notices these things, but you better believe that I lost sleep over these things for months.
Lately, you may have noticed that the Federal reserve has pledged more than half of its balance sheet to ‘provide liquidity’. Very nebulous term which is really a masquerade for ‘avoid bankruptcy’ to discerning analysts. So how did we get to this point?
Tax cuts produced more privately controlled capital, as they are supposed to. More privately controlled capital and low interest rates produced more capital for unsophisticated borrowers, as they are supposed to. So we have three actors at least – governments, institutions, and unsophisticated borrowers. We could go on and on about which actors engender the most economic productivity, but that is irrelevant in my mind. More money in unsophisticated hands has a higher probability of causing excessive leverage, thereby weakening the economy (read: borrowers). Hence, my educated guess is that the economy has been stripped down of all armor and has been extremely vulnerable. With rates cut to zero, those borrowers are even more vulnerable.
The question now is, “Do we continue bailing companies out for months or do we quarantine?” Either way, I expect businesses to continue getting weaker.
So we have gotten terribly weak over the past four years. That weakness of course was expressed as strength in a rising market, but just as when bets go against you, we are now seeing the weaknesses caused by removing escape hatches (such as tax cuts, rate cuts, etc.). We cannot and should not recover from here. If we do make it back to highs from here, we will only fall harder when another issue hits.
This is nobody’s fault. However, we are operating on an opposing extreme to common sense- now the GOP is giving those unsophisticated borrowers bailouts and $1,200 checks in the mail for free and out of thin air. This further weakens those same borrowers, but they aren’t sophisticated enough to know it.
Of course, any economist worth his salt knows that the next policy change will be a cut of welfare programs. I expect welfare programs are already mostly cut by now, but that certainly won’t be on any front pages yet. So to all those people earning under $75,000 – “Here’s $1,200, sorry you won’t get very much in unemployment or disability checks.”
On to the corporate world.
I have been looking through analyst reports this week that have shifted dramatically from last year. The narrative was: this company’s profitability isn’t great, but it will improve because x and y, so buy it. The narrative this week is: this company has enough cash to survive for three months, so buy it. Cash is king, not profits.
If company A survives, what about companies B and C? How will the failure of B and C affect the business model of A? How is the valuation of A affected by the failure of B and C? Will it be valued the same, more, or less as before B and C failed?
Is it impractical to have the same price targets as last year simply because Company A has enough cash to survive this spring? I think so.
Everyone knows analysts shouldn’t be trusted, so let’s discuss capital allocations and fraudulent reporting.
Above are two financial statements from the SEC’s EDGAR filings. The first is from Uber’s annual 2019 income statement, and the second is Home Depot’s 3rd quarter 2019 Balance sheet.
The issues around everything wrong with the economy may lie in these two statements alone. In the first, we see incredibly troubling losses and in the second we see the effect of inefficient share buyback programs.
The first few lines from Uber’s press release….
February 06, 2020
Revenue of $4.1 billion, growing 37% year-over-year or 39% on a constant currency basis
Rides Adjusted EBITDA of $742 million, with continued margin expansion
Just like that, the losses vanish.
Now, if this isn’t outright fraud, I don’t know what is. Clearly, the 2019 “Loss from Operations” for Uber was around $8.6 Billion. This is GAAP EBITDA. Nonetheless, the headline on the press release was a +$742 Million EBITDA. I don’t know who started the trend of lying to investors, but if you can lie so blatantly to investors, you probably have more skeletons in the closet rather than the opposite.
Bottom line – Uber took in $14 Billion in sales and spent $22 Billion… in a year of immense economic growth. How can they do any better in the current environment?
Now onto Home Depot. The left column is the most recent snapshot. You will notice that instead of paying down a massive debt pile, the company decided it was best to push the envelope further and buy more stock AT ALL TIME HIGHS. This is similar to winning a bet 9 times in a row and saying, “How about double or nothing this time?”
I don’t blame Home Depot or the majority of mature companies for massive buybacks using borrowed money. First of all, they are borrowing at irrationally low rates, which as we know encourages excess. However, most important and darker still, many companies likely believe no matter what, they will be bailed out. So it goes that if they win the double or nothing bet, great! But if they lose, they really don’t lose.
The bailouts of airlines and Boeing should not be allowed for these reasons, and it sickens me how despicable these “leaders” are. I have never invested in Home Depot or any company that has a significant buyback because of the economics of cash flows, but also because this idea is likely a motivating factor for taking the big risks – there is no financial downside for the corporation and incredible upside.
Will the government bail out the folks that will lose their net worths because of this? If the failure of these companies due to the excess causes a large downturn, will the government make 401(k) accounts whole? If a business owner loses his American Dream, where is her money?
The argument of ‘strategic assets’ arises: Who decides strategic assets and who then supervises them? If the people are responsible for a bailout, shouldn’t the people benefit from the good times too? I argue for government control or no bailouts.
Where does this leave investors?
- Stocks are low. The NASDAQ June expectation early this morning was above 7500, a price first seen in June of 2018. This is a drop of 22% from all time highs.
- The virus passing in the near term.
How anyone can buy right now is beyond me. Not due to my own misanthropy, but because there have been no significant earnings reports showing credit crunches yet, nor are there reports showing incredible, broad corporate expansions. Because of this, buying now seems superficial to me.
We have, however, seen incredible efforts in both fiscal and monetary policies to rescue corporations, which leads me to believe that we will not have incredibly broad corporate expansion from here.
Disclosure – I am/ we are short Uber