Charlie Munger & Warren Buffett: The Dangers of EBITDA

If somebody is, if they think you're focusing on EBITDA, they may arrange things so that that number looks bigger than it really is. It's bigger than it really is anyway. I mean, the implication of that number is that it has great meaning. You take telecoms; they're spending every dime that comes in, I mean, in many cases. And there isn't—it isn't cash flow; I mean, the cash is flowing out.

I have two questions. The first one I would like to direct to Mr. Munger, pertaining to cash flow analysis. Given the practices of the numerous corporations of deliberately fabricating cash flow numbers—which occurred in some of the telcos, where they characterize like-kind exchanges as product sales—how do you ferret out this type of fraud? What do you recommend a shareholder, an individual investor, to do, short of obtaining a degree in forensic accounting, to uncover this type of fraud?

And the second question is on a lighter note: what books would either of you gentlemen recommend to shareholders that you read this year that you liked?

Yeah, I think you're asking for a lot if you want some simple way of not being taken in by the frauds of the world. If you stop to think about it, enormously talented people deliberately go into fraud, drift gradually into it because the culture carries them there. The frauds get very sophisticated and they're very slickly done. I think it's part of the business of getting wisdom in life that you avoid getting taken by the frauds. So, I think you're asking a very good question, but I don't think there is any short answer. I think there are whole fields that you can just quit claim because it looks like there's too much fraud in it.

And, I think we do a lot of that, don't we, Warren?

Yeah. How many times have we been defrauded in the last 20 years?

All right, well, damn little that weekend.

It's amazing how little.

Yeah, and I've always said that the guy who takes us is going to have a modest little office and modest demeanor, and he'll carry around Ben Franklin's autobiography. The kind of people who defraud us are not going to be the kind of people who are defrauding everybody else.

Yeah, I mean, it's a very good question; it's tough to answer. But I will tell you that we haven't—and we won't get defrauded often. Now, that may mean we pass up a whole lot of other opportunities too. But, for example, you raised the question about cash flow. I would say the number of times we're going to buy into a company—whether it's through stocks or through the entire company—where people are talking about EBITDA is going to be about zero. I mean, we start out with, if somebody's talking about EBITDA, you know, if we take all the people in the world who've talked about EBITDA and all the people in the world who haven't talked about EBITDA, there are more frauds in the first group, percentage-wise, by a substantial margin. Very substantial.

I mean, it's just a start. Now, that isn't—you know, it's very interesting to me. If you look at some enormously successful companies—Walmart, General Electric, Microsoft—you know, I don't think that term has ever appeared in their annual reports. I mean, they just... So, when people are talking about that sort of thing, either they're trying to con you in some way, or they con themselves to a great degree.

I mean, yeah, well, that often happens. I mean, if you set out to con somebody, after a while you con yourself, which is why some of the people in the Internet stocks, you know, stayed with them.

If somebody is, if they think you're focusing on EBITDA, they may arrange things so that that number looks bigger than it really is. It's bigger than it really is anyway. I mean, the implication of that number is that it has great meaning. And you take telecoms; they're spending every dime that comes in, I mean, in many cases. And there isn't—it isn't cash flow; I mean, the cash is flowing out. But, you know, you can look at the statement and there's billions of dollars supposedly, and depreciation and so on. But, you know, interest is an expense; actually, taxes are going to be an expense.

Anybody that tells you that making a lot of money before taxes—in terms of EBITDA—is meaningful. You know, you get depreciation by laying out money ahead of time; it's the worst kind of expense. We look for float where we get the money and then pay out later on. But depreciation occurs because you buy an asset first and then you get the deduction later on. It's the worst kind of expense there is. And you start paying taxes when you actually make money. And when the depreciation runs out at some point, so this—it just amazes me how widespread the usage of EBITDA has become.

And I would say there have been people who've tried to dress up financial statements in a way to appeal to people who were impressed by such a number. Charlie and I have found, actually, that at least to us, many of the crooks look like crooks. I mean, we have spotted—we haven't shorted them, but we have spotted a lot of frauds over the years in public companies and years before, you know, that the roof fell in. And they usually are people that tell you things that are too good to be true for one thing. I mean, they tell you very mediocre businesses are wonderful businesses for one reason or another, or they just have a—they just have a smell about them, you know.

And, in fact, wouldn’t you say that's true, Charlie?

Well, sometimes it's amazingly obvious. Maxwell of England, his nickname was the bouncing check. And three weeks before he went under, Solomon—Solomon was aggressively seeking more business from him, with both Warren and I on the board.

It shows how much influence outside directors often have.

Yeah, Wall Street is imagining extending credit to a guy whose nickname is the bouncing check. You think if you wrote it to satire, people would say it was too extreme to be funny.

We have read them. I mean, Charlie, it's a hobby keeping track of the Maxwells of the world. And they give off a lot of the same messages. I mean, actually, it was a classic case, but they're time after time. Wall Street is no filter against them. Wall Street loves them as long as, you know, as long as they're pushing out securities and the commissions.

Charlie and I could not have stopped Solomon from making a deal with Maxwell, you know, right to the last 30 seconds before he sunk, you know, down under the ocean.

We didn't stop first Normandy with Lou Simpson and Warren Buffett and Charlie Munger on the board.

Yeah, First Normandy was a case of some guy that manufactured a record out in California that he claimed was promoting a bunch of securities, including Berkshire Hathaway, and he was going to go public. And Solomon was courting him, and the record was, you know, it was total baloney.

And I think they actually went public for a day or so, and then the SEC pulled it back, absolutely. They had the offering, and then they canceled it before the money changed hands. But it was a very embarrassing episode. And when we remonstrated against this obvious insanity, they told us the underwriting committee had approved it.

I don't think they changed underwriting committees either.