Source: www.lanoonan.com
This saying has been widely quoted by Warren Buffett and with the COVID 19 pandemic sweeping through the world and causing havoc, the saying is very timely right now. What this saying essentially means is that someone is hiding something. Sometimes the hiding is done in an obvious way and sometimes it is done in a non-obvious way.
Let me explain…
During normal or euphoric times, it is much easier to hide problems but as adversity hits, those problems come to the surface and can no longer be hidden and avoided so easily. They must be dealt with or even worse, they can’t be dealt with because the problem has been going on for so long that too much work and effort needs to be done in too little amount of time.
In other words, the longer the conflicts have been hidden for, the harder it is to fix them as the damage has irreparably been done already. I always thought that Warren Buffett was only referring to highly leveraged businesses when he was using this quote. Once the economy slows down and goes into recession, which it always does on average around every 7 to 10 years, the businesses that take on too much debt during the business cycle expansion now see a quick downturn in their revenues, resulting in less cash flow and earnings to repay their debt.
Sometimes leverage is used in a less obvious way like most of the banks were doing in 2008 with off-balance sheet liabilities or a black box of derivatives listed on their balance sheets that you couldn’t figure out what their actual exposure was. It could also be done in a less obvious way, like Enron was fraudulently doing by creating special purpose entities to hide troubled assets and losses.
Businesses could also be swimming naked in a more obvious way like Hertz is doing today. Hertz took on a lot of debt to finance cars so they could operate and expand their business, but they didn’t plan on their operations being shut down for a couple months. The shut down prevented them from earning an adequate amount of cash flow to service that debt.
Hertz is a more obvious way of swimming naked because their income statement, cash flow statement and their balance sheet are publicly available for everyone to see. The others are less obvious because it wasn’t as easy to figure out how much leverage was actually used.
A business like Hertz needs to raise more capital to pay off the interest and upcoming principal payments to survive or somehow earn enough cash flow. The problem of raising capital during turbulent times is that capital usually dries up.
The banks that were willing to lend money during good times now all of a sudden stop lending because they need to preserve capital so they can survive. The lender’s risk tolerance changes also and now they don’t want to take the risk because there are better alternatives to allocate capital.
Or they are just simply afraid they won’t get paid back. Hertz earning cash flow from their existing operations won’t be enough to cover their upcoming obligations and asset sales can be too lengthy and time consuming in an environment where potential buyers are becoming more cautious themselves.
They most recently did a $1 billion equity offering. If Hertz is able to find buyers for the equity offering and is able to raise $1 billion and that helps them pay off their obligations and get out of bankruptcy then it would be a great deal for the equity holders and even the debt holders since they would much more likely get paid back in full. If they can’t raise $1 billion in the equity offering or it turns out that $1 billion isn’t enough to pay back the upcoming debt then it would be a really bad deal for the buyers who bought the equity because the shares would end up being worth nothing.
You may be thinking that if the debt is on the balance sheet for everyone to see in their public filings then how are they hiding something and that’s a good question. But there is something they are actually hiding and that something is caution. We live in an uncertain world where our plans can go wrong at the wrong time.
Businesses can play offense and take on leverage to expand operations and grow the business or they can play defense by not taking on leverage and taking the cautious route of preserving what they already have at the expense of growth. Hertz got caught at the wrong time playing too much offense and not exerting enough caution. I just recently saw a video from Phil Town who discussed Warren’s quote but he used it in a different context. He discussed a 1 Michelin star restaurant that had no plans of reopening once it was allowed to because the restaurant is struggling to survive.
The restaurant owner was swimming naked. Despite the appearance of the restaurant doing really well, she’s surviving but not as easily as it appears to be because the business is fragile. As the pandemic hits, she has to shut down and it’s probably too cumbersome and costly to get it started back up again.
Also, the restaurant may have to lose money for a couple years as they wait for customers to return. After all, it’s a restaurant that sells very expensive dishes in what is turning out to be a pretty dire economy so the owner may not view the wait as worth her time and effort. Another famous example that comes to mind of an emperor swimming naked whom nobody knew was swimming naked until the tide went out was Bernie Madoff. For decades he was running a Ponzi scheme that he was able to hide because he was always able to bring in new money from investors and he had very few investors who were taking money out of the fund. But what we know now is that Bernie was faking his returns and lying to his investors for decades. And it was the 2008 financial crisis that led to the tide going out because everyone was worried about liquidity at the time.
Even very wealthy investors with tens or hundreds of millions of dollars were worried about their liquidity and their investments since markets were tanking and prestigious financial firms that have been around for a long time like Bear Stearns, AIG and Lehman Brothers were going bankrupt or were on the verge of bankruptcy.
This fear caused so many of Bernie Madoff’s investors to pull their money out of his fund that Madoff needed to raise more capital just to pay off the investors that he stole money from. There is a famous story about Bernie going to Ken Langone to tell him that he was raising money for a new fund and he was giving Ken a very early opportunity to invest that Ken shouldn’t miss out on. Ken was suspicious since he never invested with Bernie before so he didn’t see any reason why he would be one of the first to receive this great opportunity instead of all of the people that were already investing with Bernie for decades. Ken, being suspicious of this “golden opportunity”, declined to invest and since Bernie couldn’t raise enough new capital from other investors to pay off all of his existing investors that were taking their money out, Bernie had no choice but to admit that he was running the biggest Ponzi scheme ever. So lots of liquidity plus a pretty resilient and rising stock market for several decades was the tide that was able to keep Bernie’s firm afloat and help him hide the problem that he had stolen investors’ money for decades. Then once the financial crisis hit and all his investors started redeeming their money at the same time, Bernie couldn’t meet the redemptions and had no choice but to admit fraud and show everyone he had been swimming naked all this time.
In other words, like Phil Town said, he was struggling to survive.
The most recent place where I saw a use of this popular Warren Buffett quote was from the founder of Double Line Capital, Jeff Gundlach. Jeff had an interesting and different example of using Warren’s quote that still has one thing in common with all of the other uses — something is being hidden. And whatever is being hidden doesn’t have to be hidden deliberately.
With the current pandemic forcing so many office employees to work from home instead of at the office, Jeff noticed something interesting.
He noticed that a lot of the lower level employees were quick to respond to emails and to communicate. He came to the conclusion after his own observations and in speaking with some of his peers from other companies that there are a lot of mid-level managers who weren’t doing much work to justify their 6 figure salaries.
They were instead delegating a lot of their work to their subordinates. Jeff is now wondering if he needs this many mid-level managers at his firm and he is also expecting upcoming job cuts that will start to affect white-collar workers over the next couple of months after many other companies catch on to this as well.
So here we have 3 different examples of Warren Buffet’s popular quote, “When the tide goes out, you find out who is swimming naked” being used and applied to different scenarios.
And whereas I used to think the quote only applied to leveraged companies, I now realize that it applies to much more than that.
It could apply to companies that are struggling to survive because the amount of effort and time it takes to get a business back up and running is too much, it could apply to frauds such as Ponzi schemes and it could apply to white collar workers, but despite the different situations, what it does consistently have in common across all of these examples is that all of these swimmers are hiding something.