In the previous article of this series, we saw Warren Buffett make some significant dents in the efficient market theory and also got to know his take on arbitrage. Let us see what the master has to say in his 1989 letter to shareholders.
Have you ever wondered why despite such enormous wealth and infrastructure, the US economy canters at a mere 3%-4% growth rate per annum and why a country like India, which has very little infrastructure in comparison to the US, is galloping at 7%-8% rate. Or better still, what happened to the 40%-50% growth rates that the Indian IT companies notched up so successfully in the not so recent past? The master has the following explanation to these phenomena:
"In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor."
Indeed, in a world where resources are limited, consistently high growth rates would create pressure on those resources, thus resulting into either exhaustion of the resources or slowing down of growth. To better illustrate this point, let us return to the Indian IT industry. The demand for qualified IT professionals (a limited resource as we can produce only so much per year) has been so high in recent times that this has resulted in a disproportionate rise in salaries and attrition levels, thus impeding profit growth. Further, it is much easy to double revenues on a base of Rs 500 - Rs 600 m than on a base of Rs 50,000 m - Rs 60,000 m. Hence, those who are expecting these companies to grow at the same rate as in the past, might be in for some real surprise.
Another important topic that the master has touched upon in his 1989 letter is the gradual deterioration in the quality of representation of a company's true cash flow by certain promoters and their advisors in order to justify a shaky deal. While earlier, a company's cash flow, to justify its debt carrying capacity took into account its normal capex needs and modest reduction in debt per year, things had come to such a pass that EBITDA emerged as a substitute for a company's cash flow. Important to note that EBITDA not only excludes the normal capex needs of the company, but it was deemed enough to cover just the interest expense on debt and not the repayment of debt. This is what the master had to say on such practices:
"To induce lenders to finance even sillier transactions, they introduced an abomination, EBDIT - Earnings Before Depreciation, Interest and Taxes - as the test of a company's ability to pay interest. Using this sawed-off yardstick, the borrower ignored depreciation as an expense on the theory that it did not require a current cash outlay. Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. As businessmen, Charlie and I relish having competitors who are unable to fund capital expenditures."
Thus, since EBITDA does not even cover the normal capex needs of the company, the master advises investors to be wary of companies and investment bankers who rely on these yardsticks to justify a leveraged deal. The master also touches upon a special type of bond known as the zero coupon bonds and goes on to add that whenever the inherent advantage that these bonds offer (deferring interest payment and not recording them till the maturity of bonds) combine with lax standards for cash flow estimation like the EBITDA, it sure is a recipe for disaster. This is what he has to say on the combination of both:
"Whenever an investment banker starts talking about EBDIT - or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures - zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures."
Article Source : http://www.equitymaster.com
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