Barron's Streetwise - Ebitda vs. Ugly. Plus, TIPS, QQQ ads, and the Innie Yield Curve

Episode Date: November 17, 2023

It’s a listener question special. No big whoop. Learn more about your ad choices. Visit megaphone.fm/adchoices

Calling all sellers, Salesforce is hiring account executives to join us on the cutting edge of technology. Here, innovation isn't a buzzword. It's a way of life. You'll be solving customer challenges faster with agents, winning with purpose, and showing the world what AI was meant to be. Let's create the agent-first future together. Head to salesforce.com slash careers to learn more. Hi, it's Jack Howe. This is the Barron Streetwise podcast, and it's a listener question special. I'm going to go ahead and start singing the listener question theme song while I explain to people what's going to happen.

Exactly. We've got some of your questions. They're mostly recorded, I think, so we're going to hear from some of our listeners. We're going to answer questions. We'll go through a bunch of them. I'll get through as many as I can. And no big whoop, right? Nope. Who am I kidding? It's a huge whoop. Listening in is our audio producer Meta. Hi Meta. Hi Jack. Who do we have up first? So first up is Ray and he actually has sent in a question once before and had it answered. A two-timer. He's a two-timer. Yeah. That doesn't, you know what, that's not, he's a, he's a second timer. Let's see. Let's call Ray that. Yeah, that's probably better. Anyway, he starts off with a comment. Let's hear it. Jack, I looked at your portrait sketch on the podcast logo and I see a Clark Kent, not a Jack. And if I take the glasses off mentally, I see Superman. So I assume during the day you

educate the financially illiterate and at night you fight the villains and help the needy. Thank you for that. Let me jump in here, Ray. It's an important question. I'm not actually a superhero. I did, ahead of the winter season, buy from a catalog clothing retailer what are called soft sleep pants. And there's a matching soft sleep shirt that goes with them. And I guess maybe they look like part of a superhero costume,

but there's no cape. And I don't think they're ideal for fighting crime. So I'm probably just going to stick with podcasting. Go ahead. And the question for you is, I hear EBITDA all the time in annual report and TV, Barron's, but I also saw in an annual meeting by Berkshire Hathaway back in 2013 on YouTube, I think, by Charlie Munger and Warren Buffett, which they basically said is not reliable and they only go by cash flow.

So what's your view when individuals look at the valuation and during a stock due diligence, how much weight do you really put on EBITDA or all the variation of it? Thank you very much. Great question, Ray. How much weight should you put on EBITDA, earnings before interest taxes, depreciation, and amortization? I'll tell you a little bit more about it in just a moment. First, Meta, I'm going to need your help with something. I'm sending you a link from what used to be called Twitter. See if you can open that up.

I can. This is a meme that has been shared, I guess, by investors on social media. And it says adjusted EBITDA versus free cash flow. And behind the label adjusted EBITDA, there's a picture of someone I recognize as Jennifer Aniston, you know, the famous actress. And she is, of course, beautiful. She has kind of, I don't know how I would describe her hair color in this picture. It's golden. Golden. She has golden hair.

Now, in the next pane over from that, it's labeled Free Cash Flow. And behind that picture is someone who also has golden hair, but his hair looks like kind of a raggedy mop. And his face, it just looks like he's seen some things. Seen some things and done some things. He's lived hard. That might be a mugshot. I don't know who that person is. I guess my question for you, Meta, is, is that a celebrity?

Because I don't recognize this person. I think it looks like someone who lived a long life in rock and roll. I guess. Yeah. And this, I mean, I'm going to say that the gentleman in this picture is 70, but he also could be 25. I'm not sure. I guess the point here is that adjusted EBITDA, which is kind of redundant because EBITDA already is a pretty adjusted figure. It tends to make things appear more beautiful than they are. And when you look at free cash flow, it shows things for their true self. And it's true. But I don't think it means that EBITDA is a totally useless figure in all cases. Let me explain. Let me start with a company financial statement. There's three main parts. There's a balance sheet, there's a cash

flow statement, and there's an income statement. Income in this case is another word for earnings. That's where you, if you're looking, you know, you want to see how much a company earned in a given quarter, that's where you look. Now, the balance sheet is a measure of the value of the stuff a company has and how much it owes, right? Both the cash flow statement and the income statement are measurements of how much money the company makes. Why would you have two statements to measure the same thing? Because they measure it in different ways. The income statement is designed to tell a story. Earnings, if you don't know, aren't real. When we say that a company is going to earn this much this year, it doesn't mean that that's how much money it will collect and set aside and have to show for itself at the

end of the year. Earnings are calculated using an accounting principle called the matching principle. And basically what you do is you look at the money a company spends and you look at what it's trying to get for that money. Let's say that it's buying a factory and it's going to make money from that factory over the next 20 years. It's going to spend a lot of money to buy that factory. Well, you wouldn't just deduct the entire cost of the factory right now because that would show an enormous negative number. And then you'd have all the money that's made from operating that factory over the next 20 years, but that wouldn't

really tell you how the cost compares with what you're getting out of the factory. So what you do is you break down the cost of that factory and you deduct it little by little from your earnings over the projected useful life of the factory. Does that make sense? That's one example among many of how you use the matching principle to try to pair up expenses and resulting revenues. The reason you do that is you want to smooth things out. You want to tell a story to investors. Investors want to look at a company and they want to see a trajectory. Is this company growing? Is it making more money this year than it made last year? Are the margins improving? And so on.

And that's what you get from the income statement. Now, the cash flow statement does not care about storytelling. The cash flow statement cares about cash. It measures the money coming in and the money coming out, and it doesn't match up anything. And the cash flow statement is interesting to creditors. You want to know if a company can pay its bills. You want to know if a company can pay you back the money you're about to lend it. You look at the cash flow statement. I'm not going to get too into the weeds on this, but EBITDA is basically designed to start with that bottom line on the income statement earnings and then make a series of adjustments to it so that it becomes a more cash flow like figure, right? You add back in some non-cash charges that you would deduct year after year.

And of course, you ignore interest and taxes. Why would you do that? Well, one reason you might do it is let's say you wanted to run a screen, a stock screen for companies in an industry that tends to have some big ticket expenses. And you wanted to back out the remaining accountment treatment for those big ticket expenses and just try to get a sense of core profitability and how these companies compare. That's a legitimate use of EBITDA. I suppose you could also use it to make some long-term projections on a company's credit worthiness. But you could also use it to overstate a company's profitability or even make unprofitable

companies sound like they're profitable. And that has happened in the past during hot periods for the stock market and investors have felt misled so EBITDA has come to have a pretty bad name. If you want my opinion on the matter, the best thing you can do as an investor is to become sufficiently familiar with company financial statements that you don't need to take someone else's pre-packaged measure of core profitability at face value. You can sort of do the math for yourself. You can figure, okay, the most important thing for a business long-term is the amount of free cash that the company will generate over time, but also that free cash generation can be lumpy. Some years,

it's going to be higher than normal, let's say if there's a big asset sale. Some years it's going to be lower than normal if there's a big expenditure. So you need to ask yourself as you go along, what level of free cash flow is normal for this business right now? At what level will be normal for the business, let's say five or more years down the road, if it does what I think it's going to do. I guess what I'm saying is that EBITDA isn't totally useless, but investors can generally do without it, especially because it can sometimes be used to mislead. Meta, I just figured out who that person is on the right side of that meme, that sort of rough looking character. And now I feel like I shouldn't name him because we haven't been that flattering about him, but it is a rock star. An older gentleman.

Yeah, he's an older gentleman. I saw it on a different meme. It was the same pictures, but this one is labeled above Jennifer Aniston. It says guacamole right after you make it. And above this rough looking rock star, it says by the time your guests arrive. Fair, right? How about another question? Yeah, we have Michael.

Hi, Jack. My question involves Invesco QQQ, the self-described innovation ETF. Commercials for the fund are difficult to avoid, especially during telecasts of marquee sporting events. Invest in QQQ and instantly become a tech investor. I was swept up in the enthusiasm and about to sign up when I started to wonder about all of these undoubtedly very expensive ads for the fund. Who pays for these ads? Is it a part of the fund expenses? Does Invesco pay for them out of its SG&A? Will this cut into investment earnings in any way?

And if the ads are wildly successful and the assets under management balloon, does that really benefit the individual investor in the fund? How does all of this advertisement affect my bottom line? Thanks. Thank you, Michael. I have seen those ads for the Invesco QQQ. They're everywhere. When I'm not selling hot dogs, I invest in a fund that advances innovations like robotics. Fresh, warm hot dogs straight out of my torso. One for you, one for you. Oh, you're a messy one.

Cool, right? How does an ETF's advertising affect the holders of that ETF? Well, the cost of the ads, as you suggest, are deducted from the fund's expenses. That Invesco QQQ fund lists an annual expense ratio of 0.2%, two-tenths of 1% for yearly expenses. That's pretty low, but there are some super cheap index ETFs out there. The Vanguard S&P 500 ETF, for example, has expenses of 0.03% per year, or three one-hundredths of one percent. So would all that advertising help if it brought money into the fund and into the index? Not really. I mean, I guess you could say if money flooded in,

it would be more people buying those stocks and it would help push the prices of those stocks up over time. But in this case, the stocks we're talking about are pretty big and pretty liquid. The top holdings in that Invesco QQQ fund recently were Apple, Microsoft, Amazon, Nvidia, Meta, Broadcom, Alphabet, Tesla, Adobe. So I would call that effect negligible in this case. Let me just add that they call this ETF the innovation ETF, and I think that's a nice bit of marketing, but I'm not exactly sure who this ETF is for. Let me explain. The index underlying the ETF is the NASDAQ 100 index,

and that tracks the 100 largest non-financial companies listed on the NASDAQ. And the NASDAQ is known for a lot of tech listings. So if you look at the fund breakdown, 57% of the fund recently was technology. I guess that's where the innovation label comes from. But if you're someone who wants a pure technology fund, why not just buy a pure technology fund? There are loads of them out there. iShares, US Technology, for example. And you might say, well, the tech sector isn't the only source of innovation out there. I want that NASDAQ ETF because I also want all the healthcare innovation. And that's fine. But healthcare is the third largest weighting in the fund and the second is consumer discretionary. That includes companies like Costco Wholesale and Dollar Tree and Ross Stores, Starbucks. I've seen an innovative latte or two

come out of Starbucks, but I'm not sure that that's what innovation investors are looking for. And you might say, well, I don't want all innovation. I just want a heavy weighting in innovation. That's fine, but you're already getting that in that cheap S&P 500 ETF. The biggest sector by far is information technology at 28%. And it's actually bigger than that because there are some big, arguably tech companies like Amazon and Tesla that aren't categorized as tech in the index. I guess the point here is that an index is designed to give you exposure to

something, right? If you're buying an S&P 500 fund, you're saying, I want exposure broadly to the U.S. stock market, or at least to the biggest companies in the U.S. stock market. If you're buying a tech sector ETF, you're saying, I want exposure to tech. But if you're buying that QQQ ETF, you're saying, I want exposure to companies that are listed on the NASDAQ. And I'm just not clear on why the trading venue matters. It's the company or the type of company that matters, not necessarily where it trades. I think what people are really doing when they're buying that QQQ is they're saying to themselves, hey wait a second this thing has gone up faster than the S&P 500 so I want to buy the thing that makes more money. And indeed if you look at the past five years that QQQ fund has made 137% as a total return for investors, and that is better than the 79% for that Vanguard S&P 500 fund, I guess you just have to ask yourself if that's going to always

continue to be the case. If those big tech stocks will continue to lead the market year in and year out. Or if maybe we're at the end of a period of a big run-up in price for these companies and you might like a more balanced portfolio that's more reflective of the U.S. stock market. Either way, I think you're going to get plenty of innovation and maybe some lower fees. Meta, I've just pulled up starbucks.com and I'm seeing iced sugar cookie almond milk latte, which if that's not innovation, right? Yeah. It says your holla yay favorites are here. I think that's a play on holiday, but with more yay.

So by the way, let me just point out, this is not a paid promotion. Okay. I have pretty mixed feelings on milking almonds. So probably good time for a break. What do you think, Mata? I think when you start talking about milking almonds, I think we need a break. And we'll be back right after this. Welcome back to the Big Listener Question Special. We are tearing through questions

like, what are we tearing through them like, Meta? Tornado. You said tomato or tornado? Both. What do you prefer? Let's tomato our way right to the next one. Who do we have? We've got a question from Eric.

Hey, Jack. Eric here from Los Angeles. I've been noticing a lot of headlines lately about consumer debt issues. Things like auto loan and credit card delinquency rates rising and savings drying up. So I hopped on the FRED website and took a look at the charts and I noticed that yes, in fact, credit card delinquency rates have shot up very significantly within the last year. So I was wondering, how does this affect companies and creditors like Visa and MasterCard? Thanks in advance. Nice to hear from you, Eric. And you're right, credit cards might be a problem. Balances recently hit a new high, $1.08 trillion. The increase from the year

before, that was a record in data going back to 1999. I saw one report that said the average balance is now more than $6,000. That's the highest in 10 years. And the delinquency rate, that's folks who are 90 days or more behind on their payments, that's the highest since 2011. At the same time, we keep hearing reports that the economy is okay. There seems to be a decent chance of a soft landing for the economy. Maybe we can avoid a recession. The unemployment rate is still exceptionally low. But of course, not everyone is benefiting

equally from this economy. And that credit card data says to me that families out there are struggling to afford basic things. They're putting more purchases on their credit cards. And just because the inflation rate is easing, that's the percentage year-over-year price increase. It doesn't do anything to change those past price increases, which have been pretty high in recent years. So in other words, if a company raised their prices just because inflation rates are going down, those prices remain high, just not continuing to increase? Exactly right. I mean, there are some cases where prices might fall. You can be in a business like air travel where you can

get into a price war and prices will actually decline. But if you're a packaged good maker who sells food at the supermarket and you raised your prices when inflation was high, now the inflation rate is coming down. It's not like you're going to go back and discount your prices. Those price increases are going to stick. And maybe they've run ahead of incomes for some of these families. And Eric, your question was, how does this affect companies and creditors like Visa and MasterCard? Well, those two in particular, there's not much effect because those are actually financial exchanges. When you look at your credit card, it might say Visa or say MasterCard on it, but that's not who you owe the money to.

That's not who the payments are going to. That's the electronic network that facilitates the transactions. The banks that are listed on the card, those are the actual creditors. And if delinquencies rise, then these banks could have losses. Of course, those are offset by super high interest rates. Typical credit card rate is now over 20%. I think banks certainly could take losses from this. I mean, if customers carry revolving balances, even if those balances are delinquent, but ultimately they're able to pay back that money, then maybe banks could avoid increased credit losses. But of course, if those delinquencies turn into defaults, then banks would record losses. by the way if I run a screen of the S&P 500 and I rank companies by a simple measure of valuation the price to earnings ratio based on the next four quarters of earnings and I look for what are the cheapest companies in the S&P 500 right now or another way of saying that is what are the

companies that have the most pessimistic valuations? I see some legacy car makers. I see some legacy airlines. But I also see companies like Synchrony Financial and Discover Financial and some of the regional banks that are known for a lot of exposure to credit cards. So maybe that's some investor pessimism on credit losses that's already priced in. Maybe that's some investor pessimism on credit losses that's already priced in. Meta, let's hear another question. While you're playing it, I'm just going to take a spoonful of this steaming bowl of pea soup, even though it is 1030 in the a.m. as we speak.

Please don't judge. The next question is from our friend Fritz. Hi, Jack and Meta. This is your old friend Fritz. I had a question about treasury inflation protected securities or TIPS as they're known. The more I read about these things, the less I understand. One of the articles mentioned that when interest rates go higher, that's a bad thing for TIPS. I can't fathom why. Could you please explain it? Simplify it, Jack, please. Thank you. Hiya, Fritz. Nice to hear from you again. And thanks for your question. We're talking about tips. Those are treasury inflation protected securities. Does everyone

know how these things work? No, Jack, I'm not sure about some of the details. Maybe you could explain it to us. Wait, who is that? I don't know. We might have been hacked. Tips are like regular treasuries in that they're super safe from a credit standpoint, and you get a yield when you buy them. Let me pull up some fairly fresh numbers here. Five-year regular treasury, you get 4.4% recently. And if you buy a five-year tips, that one's about 2.2%. So lower yield on the TIPS, but their super secret power is that they adjust according to the

inflation rate. If you have inflation of 3%, let's say over the next year, then your TIPS will add 3% to the face value. So if you hold your treasuries until maturity on the regular ones you're just going to get your $1,000 regular face value per bond whereas on the tips you'll get something higher than that that will account for all the inflation that you've seen. And if you subtract the regular Treasury yield from the tips yield you can get kind of a guess about what the market is saying inflation is going to look like over the next five years. In this case, 2.2% per year. There are some quirks to tips. That amount for inflation that gets added to the face value, that's not really money that goes in your pocket like a yield. You don't see that money to the end,

but it is taxed along the way. That's called phantom income. Phantom income is when you pay taxes on something that hasn't quite gone into your pocket. So that's something to be aware about if you hold tips in a cash account and an account that's not shielded from taxes, in other words. And as you point out, Fritz, if interest rates rise, then the value of tips could fall. But there's some complications. With a typical bond, if yields broadly rise, right, now you have bonds with higher yields that are readily available. You can just buy them. So something has to happen to your bond in order to bring it in line with the other bonds that are out there. And that something is a decline in the price. As the price

falls, that fixed coupon payment from the bond is going to make for a higher percentage yield. The yield on your bond is going to go up, not for you, but for new buyers. Now if you hold the bond to maturity, that doesn't matter. You're still getting face value. This change in price, according to the outside level of yields, that's only something that matters to someone who's going to sell their bond before maturity. In the case of a TIPS, the same thing happens, but it's offset. It's offset by that inflation adjustment. So if inflation were to suddenly roar and that's what made bond yields go higher, you'd have a price decline on your bond, but that would be offset by the amount that would be tacked on for that higher inflation. Does that make sense?

If you had yields broadly rise for some other reason, if inflation was low and yields went up anyway, that would stink if you held tips because then your bond would decline in value and you wouldn't get that big inflation adjustment. Anyhow, that's neither good nor bad. Those are just some quirks involved with tips and they could be a plenty useful part of a diversified bond portfolio for long-term savers. How's that for a place to end it? Good. Can I ask a question? Yeah. First, you have to record yourself on your phone and send it to Jack. You know what? You go ahead. I'll let you ask one on the fly. Go ahead.

But if we're talking about yields of like 2 point something, wouldn't you just be better off keeping your money in a cash saving account? I mean, you might make five percent in that cash savings account right away. The reason you would buy a tips, first of all, you would lock in that yield for longer. Maybe you think that yields are going to decline going forward. So maybe you want to lock in a yield for longer. If you've got a savings account and rates fall, your rate is going to fall right away. And the other reason you buy a TIPS is if you were worried that inflation

is going to pick back up, there's going to be something that happens that's going to cause a high inflation rate, or you just don't want to have to think about it. You want something that's going to help you to keep the value of your portfolio up with rises in consumer prices. But you could definitely, as you suggest, you put money into your cash account, you're getting 5%, let's say things don't change much, it's entirely possible that you could come out ahead.

Who's up next, Meta? Our listener, Brad, is up next. And I've just sent you an email. I forwarded an email. Ooh, hold on, Let me look here. I do have 92,000 emails in my inbox, but let's see. Here you are, and there is a picture. Yeah, check out the picture.

Ah. He says, love the show. Question attached per instruction from yesterday's edition. Thanks, Brad. I see what you've done here, Brad. And you should be, I'm going to say proud of yourself. It says, Jack, why do you prefer the questions to be taped on my phone? Question mark.

Thanks, Brad. And that's written on a note, which is taped with masking tape to his phone. Thank you, Brad, for that moment of levity and for the effort that was involved getting the tape out of the closet and then asking for someone else's phone so that you could take a picture of your own phone. We really appreciate it. Meta, who's next? All right, we've got time for one more question. It's from our listener Alec, but it's not recorded. It's in print. How about I read the question for Alec? I will bring it to life using my podcasting skills. What

do you say? Sounds great. I mean, I'll read most of it. I'm a busy man here, Meta. It starts off, howdy Jack! Strong. It's a strong opening. Two-year bonds are at five percent whereas 30-year bond is at 4.8 okay i'm gonna i'll check those numbers soon and see if they need to be updated i understand that this is what's called the inverted yield curve but why does anyone buy a 30-year below five when you are getting two-year at five is it because you're worried that after two years for an extended period of time, you wouldn't be able to get that higher rate, so you must lock it in now, even

if it requires some near-term loss? Love your pod... Well, hold on. This is the best part. Is it self-serving to read the lovey-dovey stuff at the end? And is it more self-serving to call attention to it like this?

Love your podcast. It's funny, stimulating, and useful. Thanks, Alec. Alec, thanks so much for your question. You are right that we have what's called an inverted yield curve. Meta made me promise to stop calling it an any, but that's where we are. The short yields, in other words, are higher than the long yields.

It's supposed to be the other way around under normal circumstances. So why would that happen? Well, that's the bond market's way of telling you that it thinks that yields are about to fall. And maybe the bond market's right. I mean, just in recent days, we got a reading on inflation that was pretty tame and bond prices have jumped to bringing yields lower. If I look at that 10-year treasury yield, that was recently 4.44%. And that's down from, well, you know, in late October, it hit 4.95%. So that's down a half a percentage point in a matter of a couple of weeks. So if you had gone back to that point in late October,

when it was 4.95%, you might've said to yourself, why should I lock in this 10 year treasury yield at 495? I can buy something real short and get 5.5%. Well, the answer is that maybe yields that high won't stick around for long. And that is, as you suggest, the basic reason why someone would accept a lower yield to lock in a longer bond. I don't know which way yields are going from here, so I can't tell you which way to bet. One thing investors like to do is ladder out their bonds so they have a little bit of money coming due each year or couple of years. Another thing they do is to use a barbell approach

where they have some money in the short term, catching those high yields right now, and some money that's longer term, say 10 years, and getting less of a yield but locking it in for longer. That way, whether we stay in an innie, move to an outie, or go to an in-betweenie, you'll be okay. Matter of in-betweenies okay, right? Definitely not. I'm going to try and cut that. I want to thank, oh boy, we have a list here. Ray, Michael, Eric, Fritz, Alec, and Brad. We're going to do another listener question special.

I don't know, sometime this year. Let's put it that way. So if you have a question, tape it on your phone, use the voice memo app, and you can send it to jack.how. That's H-O-U-G-H at barons.com. Meta Lutsoft is our producer. Meta, the headphones that you're wearing, do they not have a cord? They do. Where is it?

I blurred my Zoom background. Oh, and it blurs your cord. Oh, it looks like they're just wireless on your head like that. Sorry, is everyone still listening? You can subscribe to the thing. There's a button probably on Apple and Spotify and whatnot. And if you listen on Apple,

you can write us a review. And thanks, and we'll see you next week.