The (non)-GAAPing holes of the Stock Market and how Wall Street Still Plays Stupid Games
What we didn’t learn from the Great Recession will likely severely hurt us
When America was picking up the pieces of its overleveraged and hypertransacted financial system, the leadership vowed to begin laying the roadwork in surmounting the problem.
Lending practices were changed slightly, the ninja loans were brushed away, Dodd-Frank was passed along with the Consumer Protection Act.
Irony doesn’t simply brush the American economy, though. Just seven years before the Great Recession America found itself with a fully deflated Nasdaq — insiders selling dot-com companies at record rates and institutions bailing invisible paperweights in the ether drove companies to bankruptcy in express time.
Regulation isn’t a foresight in economic policymaking. Regulation is something you do when the fraud is so magnanimous that it causes the tectonic plates of the global financial system to grind down on the masses it victimizes.
“America’s genius has not been in avoiding problems, it’s been in surmounting them once they happen.” — Warren Buffet, CNBC June 2009.
Regulation occurs when the non-obvious magic within unrealistic stock market figures meets obvious evidence for the result. It occurs when the unrealism can be explained with the relatively trivial information that had been missing for so many years. As Warren Buffet so succinctly says, “America’s genius has not been in avoiding problems, it’s been in surmounting them once they happen.” In the last 20 years, our economy has tanked twice. Both times with devastating results.
Jim Rogers, who ran one of the most successful hedge funds in Quantum Fund, said this in 2002 about Fed Chairman Alan Greenspan: “[his policy’s] reaction to the stock market bubble has caused two more bubbles to grow: a real-estate bubble and a consumer-debt bubble.”
Both of those things crescendoed in the apex of moronic lunacy in 2008.
Following 2011, the supercharging has quietly restarted in near secrecy.
Since then, every asset class excluding those directly affected by COVID are up. They’re not up in the sense that they’re steady, they’re up hundreds of percentage points in the last year.
The birth of the non-GAAP adjusted earnings game has aided that direction for many of the new technology companies that are trying to disrupt traditional industries.
But before we get into talking about the mysteriously fancy non-GAAP adjusted earnings, we should run down what the hell GAAP is in the first place. When it comes to financial reporting, the stock market requires that companies standardize the process in which they report the structure, earnings, and losses of their business.
If you can tell where this is going, then you already understand the theme of deregulation hidden in the paperwork. Non-GAAP adjusted earnings are then just a way for companies to shove more items away, thus boosting their earnings or making their losses feel less ugly on paper.
Adjusted earnings, sometimes called EBITDA, — earnings before interest, tax, depreciation, and amortization — could be a great thing for companies that want to selectively move away from one-time occasions.
In a lot of cases, the difference between GAAP figures and the adjusted figures are the result of massive stock-based compensation costs. Charlie Munger, Warren Buffet’s partner, calls the growth of EBITDA “bullshit earnings”:
“Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”
In the recent age of stock market wisdom, the youth have been calling titans like Munger and Buffet outdated, old, and anti-technology. However, their continuous existence, persistence, and growth over so many decades provide a testament for the exact opposite. Berkshire Hathaway reported around $250 billion in revenue in 2019. Their total assets are north of $700 billion. Buffet currently has about $150 billion in cash, to which most in the market believe is foolish.
But Buffet and Munger have been far too smart for things like the dot-com bubble. In Buffet’s 2000 annual letter to shareholders, his words were ominous. Just short of psychic power, a year later, his warnings shifted from the unrealized to the realized:
“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.” — Berkshire Hathaway annual report, 2000.
In Shopify’s second quarter of 2020, ending on June 30th, they reported a GAAP net income of approximately $36 million. The adjusted income, however, was approximately $130 million. After adding the stock-based compensation of $62 million, payroll taxes related to that compensation of $14 million, and impairments on assets of $31 million, the adjusted net income is magically a figure four-fold larger than the standardized one.
Shopify isn’t a unique player in the game. Most of the technology companies that run publicly on markets trade at an all-time high even though the vast majority of their lifespan has been in the red. Shopify, for instance, has been trailing at a loss for the better part of a decade now. The trade value of its stock places its market capitalization at $112 billion. The pattern for Shopify is the pattern for most technology companies: They trail at an all-time high, their adjusted earnings embellish the reality, and they always want to sell more stock at the top. In Shopify’s case, they filed to sell approximately $7.5 billion of mixed securities before their earnings in July 2020. They have a pattern of raising capital without an understanding of what that dilution may result in.
On May 12th, 2020, they completed an offering of over 2 million voting shares at $700 each. That raised $1.5 billion.
On September 18th, 2020, they raised an additional billion dollars through 1.1 million voting shares at $900 each. They also raised an additional billion dollars through debt notes to expire in 2025.
Any company can find financial soundness if the terms of their existence involved infinite funding rounds by diluting the stock. This is especially true where the development of financial statements are treated like magic tricks instead of standardized snapshots of what is actually going on.
Everyone knows that, eventually, the money runs out. Venture capital won’t bankroll the wild rides, institutions won’t hold on to stock that’s regularly diluted, and companies that continuously hide massive losses can’t sweep away what no longer exists.
Crises on Wall Street are always mentioned after-the-fact. It wouldn’t be a crisis if it was well-anticipated by the institutions who explode these companies to massive heights. We’ll look at the past, and we’ll ask ourselves why nobody caught on to the illusionists in time. Then, the regulations will begin, and the financiers of today will find a new thing to exploit.