Monday, November 30, 2009 2 comments ++[ CLICK TO COMMENT ]++

Credit card delinquency rises in China

MarketWatch is reporting that credit card delinquency rate in China has risen:

Credit-card debt at least six months overdue rose 126.5% for the first three quarters of 2009 compared to the same period last year, Xinhua news agency reported, citing People's Bank of China data.

By the end of September, China's banks had issued 175 million credit cards, a 33.3% increase from last year, according to the report -- which said that the central bank has warned of potential risks of mounting overdue credit-card debt.

Accounts overdue by six months or more made up 3.4% of China's total credit-card debt outstanding at the end of the third quarter, a 0.3% increase over the prior period, the report said.

I know very little about credit card debt metrics. I have no idea if a 3.4% delinquency rate is high for China.

I don't know anything about USA's credit card statistics either but Googling produced a TransUnion press release suggesting that the "national credit card delinquency rate (the ratio of bankcard borrowers 90 days or more delinquent on one or more of their credit cards) dropped to 1.10 percent in the third quarter of 2009." According to this somewhat dated Reuters news story, "Equifax, which provides credit data to businesses like banks, credit card issuers and retailers, said the average delinquency rate in Canada as of June 30 was 1.56 percent..." The time periods for the US and Canadian numbers (90+ days) differ from the Chinese one I highlighted above (180+ days) but it should givea a very rough idea.

Also, unlike America or Canada, I suspect that credit card debt is a small portion relative to the total economy (differing collection methods, bankruptcy laws, etc., also make direct comparisons meaningless.) So, I am simply using this news to gauge the situation over there and observe if things are improving or getting worse.

If there is a debt implosion in China, it will have little to do with credit cards (since their usage is limited.) Instead, the big risk in China is real estate. The Chinese government has very strong financial resources (i.e. good foreign reserves and savings) so they can absorb losses as long as it isn't catastrophic (they can't absorb Japan-like losses but I have little reason to suspect a bubble, if it actually exists, is anywhere near 1990 Japan.) However, any large losses will cause huge political problems. Just like how Dubai appears to have lost power and is now thought to be under political control of UAE, which is heavily influenced by Abu Dhabi, a similar thing can materialize in China (my wild guess is that the current "faction" controlling the national government won't survive such a crisis.)


Rationalism vs Empiricism - Can knowledge be advanced through rationalist thought?

(This post has nothing to do with investing and deals with philosophy)

Rationalists vs Empiricists

I ran Alex Hutchinson's thought-provoking article, "Mind Over Matter," in The Walrus recently and, perhaps due to various events unfolding in my life right now, I was reflecting upon something I studied in university. The thoughts in the article deal with the philosophical battle between rationalism and empiricism. The main debate occured a few hundread years ago and one side won and has been influencing society ever since.

Roughly speaking, rationalists believe that additional knowledge can be gained simply by thinking. In contrast, empiricists believed that you can only gain knowledge through your senses (i.e. by testing observations of nature.) As the picture above illustrates, the prominent rationalists were Descartes, Spinoza, and Leibniz; while the main empiricists were Locke, Berkeley, and Hume.

One side won and the debate sort of died off.

The side that won was empiricism. Modern science, which some don't realize is a branch of philosophy, essentially developed out of empiricism. If you look back to your high school days, you'll remember that the core tenets of science revolve around developing a hypothesis and testing it out in real life. That is what empiricist thought entails.

One of the philosophy electives I took in university dealt with this exact topic, of the battle between rationalism and empiricism. I didn't do too well in the course—it was low on my priority list given my other subjects—but it was very influential on me. I havne't done much reading in philosophy but, given how my life is messed up from a career point of view, a part of me says that I should have done that in school. When I studied this topic matter, I was so sure that empiricism was the way. I didn't see what rationalism could provide that empiricism couldn't. Since I was heavily influenced by science, I felt 'reality' depended on real-life experiments.

After reading Alex Hutchinson's article, I am starting to look at this whole debate quite diferently. I wish my prof had mentioned this example:

“At one point, the teacher offhandedly presented Galileo’s argument for why all bodies have to fall at the same rate,” Brown recalls. It’s a classic thought experiment: consider a cannonball, which Aristotle had argued would fall much faster than a light object made of the same material, like a bullet. Now glue them together. If Aristotle were right, the bullet would act as a drag on the cannonball, slowing down the composite object; on the other hand, since the composite is heavier than the cannonball alone it should fall faster. It’s a contradiction that can only be resolved if the two objects fall at the same rate.”


But is this really new knowledge? Some critics argue that thought experiments are simply logical arguments whose conclusions follow from previous experience; others see them as ordinary experiments that, thanks to our intuitions, can yield results without being executed. Brown stakes out the extreme Platonist position, holding that thought experiments like Galileo’s give us new a priori knowledge about nature.


For an example that is less easily dismissed, though rather more complicated to explain, Brown looks to mathematics. In a 1986 experiment by set theorist Chris Freiling of California State University, San Bernardino, we are asked to imagine throwing darts at a board to select, with infinite precision, a pair of numbers between zero and one, leading us eventually to a conclusion that violates the continuum hypothesis articulated by Georg Cantor in 1878. What’s unique here is that the continuum hypothesis can’t be proven or disproven with conventional mathematics (a fact that, itself, can be proven), so Freiling’s darts offer the only route to a resolution. That means that if you accept the result, you have to join Brown in believing that knowledge can arise from the armchair.

Here is the wikipedia entry about the continuum hypothesis. This is an example of something that requires a rationalist approach.

I still think empiricism will be dominant for a few hundread more years, but I have a feeling that rationalism (or some other related thought process) will re-assert itself. We will likely hit a diminishing curve for empiricial observations and then we probably have to pursue alternative thought systems. As pointed out in the above quote, there may be things that are unprovable by physical evidence or an empirical test. If rationalism gains prominence, it may result in the end of science as we know it.

Sunday, November 29, 2009 0 comments ++[ CLICK TO COMMENT ]++

Sunday Spectacle XXXVII


...Fades to Black

(source: Top image uploaded to Flickr on May 21, 2008 by Bu_Saif; Bottom image uploaded to Flickr on July 24, 2008 by Bu_Saif)

Tags: ,
Saturday, November 28, 2009 0 comments ++[ CLICK TO COMMENT ]++

Japan Redux

The World Looked So Different in 1980

From The Economist ("Land of the setting sun." Nov 12th 2009):

IT LEFT American executives quaking in their loafers and cheered a generation of Japanese salarymen. “The extent of Japanese superiority over the United States in industrial competitiveness is underpublicised,” trumpeted Ezra Vogel of Harvard University 30 years ago in “Japan as Number One” (see article), which became one of the most-discussed business books of its time.

The world’s second-largest economy had surpassed America in gross national product per person according to some measures, and looked on course to overtake it. “Vogel’s book helps explain why Japan is the most dynamic of all modern industrial nations,” gushed Foreign Affairs. America was mired in stagflation, with an unemployment rate nearing double digits. Japan seemed to be the better bet.

Yet things didn’t quite work out the way Professor Vogel expected. Japanese industrial production rose by 50% in the decade after 1980—a remarkable trajectory for a country crammed into an area the size of Montana. But growth was driven by financial leverage and overinvestment. Property and share prices bubbled, rising as much as sixfold.

The bubble’s collapse, beginning 20 years ago this December, led to almost two decades of economic doldrums. It took 15 years for industrial production to surpass the 1991 peak. In the current crisis it collapsed to levels last seen in the 1980s. In time America’s fearful “Japan bashing” gave way to sniggering, then indifference. Last month a poll of market professionals by Bloomberg, a news provider, put Tokyo last among several big cities as a financial capital. In the 1980s all of the world’s top ten banks measured by deposits were Japanese.

History never repeats... but it does have a habit of rhyming...


Thoughts on the Dubai default situation

Writing, I'm sure on a dreary March 6th of 2008, with at least one spelling mistake I now notice, I wondered if Dubai, what I termed the city of fortune, was an illusion.

Well, now we know the answer. A lot of it was indeed an illusion. However, the unfolding events appear to be a shock to the investment community. It shouldn't be.

The most overrated story out there is the Dubai situation. The default has been blown out of proportion given the economic impact. The amount involved, if we ignore any potnetial derivatives, off-exchange contracts, and other dubious bets, appears to be very small. Some analyst peg total exposure well under $100 billion. There are some implications but they have little to do with economics and more to do with politics.

If I'm not mistaken, this is the first sovereign default since Argentina so some are shocked. However, sceptics like me have warned about a potential emerging markets bond bubble. I have less confidence in this call (since emerging markets did improve their credit worthiness e.g. Brazil) but it made no sense to me back then, and it still does not, how emerging market bond spreads were so low (refer to the 2nd part of this post to get an idea of how low EM bond spreads fell relative to US Treasuries (note that the chart only goes up to end of 2007 so the situation has changed a bit since then.) Historically, EM bonds were very risky yet investors started treating them as low-risk bonds. Dubai is not an emerging market (I think it is counted as developed) but it resembles an emerging market.

Besides, what did the lenders expect when you build more real estate than is required by the entire population of Dubai and some of its surrounding countries? Build it and they will come? At least other potential bubble regions, like China, have population to back up the need (however, do note that the vast majority of Chinese can't afford the buildings unless you assume real estate always goes up i.e. guaranteed capital gains.)

So the negative economic impact will be minor. In fact, as I had suggested in the past, these buildings will stand for decades or centuries so there may still be some use out of them.

The real negative impact of the Dubai situation is largely political. It's probably not surprising that the business media glosses over this because, well, they only care about money.

The unfortunate thing about the Dubai default is not the losses; rather, it is the fact that UAE will seize control of Dubai. I'm not a fan of Mohammed bin Rashid Al Maktoum, the leader of Dubai, but by Middle Eastern standards, he is very liberal. In a region of extreme religious conservatism, Mohammed bin Rashid Al Maktoum was able to develop a multi-ethnic city with (largely) open travel, bars, nightclubs, hotels, and so forth. So, Mohammed bin Rashid Al Maktoum's planning skills and exuberence may resemble Donald Trump, but at least he had, what I view as, very positive and significant, social impact. Unfortunately, the default is going to roll back all of that.

Once the leadership in UAE takes control, I wonder how Dubai is going to end up. So, maybe I was mistaken; I said this is the final chapter of Dubai (at least for the next decade) and I may never write about it again, but perhaps not. It seems there is still one final chapter left—that being the outcome after UAE takes over.

Thursday, November 26, 2009 0 comments ++[ CLICK TO COMMENT ]++

Final chapter in the Dubai saga - Default

This is the final chapter in the Dubai story. The ending is pretty similar to all other bubbles: default. If Dubai defaults, it will also be the first major sovereign default in a while. MarketWatch reports:

Fears of a potential default in Dubai sent shock waves through financial markets Thursday, weighing on European and Asian equities, lifting government bond prices and pulling the U.S. dollar off of recent lows as investors sought out safe havens.

Dubai late Wednesday said it would restructure Dubai World and announced a six-month "standstill" on repayments of the state-run wide-ranging conglomerate's debt. Ports operator DP World and its debt is excluded from the standstill plan. Read about Dubai World's sprawling empire.

Analysts said Dubai's woes were a blow to sentiment, serving as a reminder that potential trouble spots remain in the world economy.

"I don't see this as a massive issue but it's another warning to where the world got itself last year with loose monetary conditions [and] loose lending," said Naeem Wahid, market strategist at Lloyds TSB. "And, in a few cases, the problems are still out there and we could continue to see these kinds of nasty surprises" in the future.

Government-owned Dubai World is a conglomerate with interests in real estate, ports and the leisure industry. The firm carries around $60 billion in liabilities. Credit agencies Moody's Investors Service and Standard & Poor's downgraded the debt of a range of government-related firms, including DP World, after the restructuring announcement, news reports said.

This always begs the question, who are the losers? Well, the big loser would be the government of Dubai and its autocratic ruler. It appears that UAE will now be calling the shots over Dubai. Apart from that, Middle Eastern banks may take big losses. It also seems that European banks are exposed:

European banks could have as much as $40 billion of exposure to Dubai after helping to arrange a string of bonds and loans linked to the Middle East city-state, according to analysts at Credit Suisse.

The broker said it's identified $10 billion of bonds issued by the government's Dubai World investment vehicle just since 2005, along with a further $26 billion of syndicated loans.

The key thing to remember is that the cited numbers are likely to be maximum exposure. It also does not mean that is the same thing as a loss because there will be recoveries on the bonds and loans. In all likelihood the banks have unloaded a big chunk of them off to smart money (aka wealthy investors, pension funds, hedge funds, etc.) The cited article suggests that banks retain 10% to 15% of the underwritten securities but that may be hedged. I don't think the losses will be significant for the European banks.

This is probably my last post on Dubai for a while. The ending was clear when I wrote my first post on Dubai a few years ago. (I hope I am wrong but if China is indeed furthering a real estate bubble as I believe, the end will be similar to here—except the losses will overwhelm anyone that is even remotely exposed.)

Monday, November 23, 2009 8 comments ++[ CLICK TO COMMENT ]++

Hugh Hendry CNBC Europe Appearance on October 16, 2009

Thanks to for bringing to my attention the following Hugh Hendry CNBC Europe segment (dated October 16th of 2009.) The following videos essentially cover the material in his November 2009 fundholder letter (topics include deflation, US$, China, Russia, metals, central bank policies, world economics, and Japan.) I'm not going to summarize the videos since I went over the fund manager letter in extensive detail.

Part I

Part II

Part III

Part IV

Part V

Part VI

Part VII


I'm becoming a fan of Hugh Hendry—hopefully it's because he is insightful and not because his views agree with mine :| —but I notice that he dodges questions about his performance. As one may expect of anyone skewed towards deflation, his portfolio has performed poorly this year (he is posting around -7.5% YTD vs +22.4% for MSCI World, as of last published info.) Someone challenging your poor performance is always difficult to tackle in public but I'm curious to see how humble he is. I respect those who admit mistakes and, although Hendry does say he can't predict the future and can be wrong, I wish he was a bit firmer about his incorrect calls. Anyway, great contrarian thinker and we'll see if he can post good results going forward.


Gold enters bubble phase

As far as I'm concerned, gold has finally entered the bubble phase. A special report on a mainstream site like MarketWatch (with 8 articles on it) probably portends to its popularity.

None of this means that this is the peak but I have a feeling fundamentals—if there is such a thing for gold—has been thrown out the window.


Opinion: Good investors not necessarily good at personal finance

Many probably assume that good investors are very good at personal finance. After all, if you know something about financial or economic analysis, you would be good at managing your finances too, right? I don't think so. My view shouldn't be that surprising.

It's kind of like how a good mechanical engineer may have skills to design a car but that doesn't necessarily mean that they have the skills to be a mechanic.

You'll notice what I am saying when you look at blogs. I feel that there is almost two seprate ecosystems: one dealing with investing, and another dealing with personal finance. I rarely see much of an overlap in the participants. The investment-oriented bloggers almost always seem to deal with finance, economics, and capital markets. In contrast, the personal finance bloggers all seem to be passive investors and I see very little work dealing with stockpicking, financial statement analysis, macroeconomic theories, and so forth.

Anyway, the best example of what I am saying is Bill Gross. Many in the investment world hold Bill Gross to be, perhaps, the best bond investor of the last 30 years. I don't have such high regard of him but I'm not in the consensus. In any case, I came across the following situation from his latest commentary:

Perhaps remarkably, during the week surrounding the Lehman crisis in September of 2008, yours truly frantically called my wife Sue to empty our two local bank accounts into apparently safer Treasury bills.

Imagine if every American had done what Bill Gross did in September of 2008. Every bank in America would have collapsed. Thankfully, the population isn't as panicky as him.

I'm assuming that, given how he is a billionaire (Forbes pegged his net worth at $1.3 billion in 2007), he is way over the $100,000 (at that time) FDIC limit. So it makes sense to liquidate all your cash above $100k.

But the bigger point, though, is, what was he doing with so much money sitting in a bank account? We don't know how much money he had in the bank accounts but given his panicky withdrawls, I am assuming it is a lot of his liquid cash. That, in my eyes, is horrible management of one's personal wealth. It just goes to show how a billionaire, who apparently is a good investor, can be caught off-guard by misallocating his savings.

Since most people who read this blog are investors, I think all of you, including me, should pay more attention to our personal financial matters. A lot of spend an inordinate amount of time on the investing side but I suspect most of us overlook personal finance and are making mistakes.

Sunday, November 22, 2009 3 comments ++[ CLICK TO COMMENT ]++

Hugh Hendry November 2009 commentary - The deflation argument [very long]

This month I will attempt to answer the entrance examination for the Chinese civil service. That is to say, I will attempt to tell you everything that I know. In doing so, I will argue that this year's rally in inflationary assets, from emerging stock markets to industrial commodities to the fall in the US dollar, could be a FAKE. Let me explain why.

— Hugh Hendry, Nov '09 Eclectica Fund Manager Commentary

One of the difficulties with contrarianism is that it is never clear whether you are being contrarian for the sake of being contrarian; or if you are actually right and the crowd is wrong.

Such is the case with Hugh Hendry of Eclectica Asset Management. Whenever I look at his comments, it is hard to tell if he is going overboard by taking an extreme contrarian stance (I have a habit of doing this too :( ). His latest commentary touches on all sorts of issues and is an interesting read for macro-oriented investors (if link doesn't work, try the posting at Zero Hedge). There are a lot of seemingly differing topics covered in the letter but it should be obvious to macro investors how everything is all inter-connected. Hugh Hendry basically lays out his case for deflation. If you are a contrarian or interested in an extreme contrarian stance, I highly recommend the commentary.

Hugh Hendry is one of the few remaining deflationists. There are many who claim to be scared of deflation, and even expect it in the short term, but do not put their money where their mouth is. Those people cannot be taken seriously. Hendry is betting heavily on deflation and has positioned his portfolio as such. Such a stance bets against the consensus, as well as prominent investors such as John Paulson, David Einhorn, Marc Faber, and Jim Rogers.

As you will see below, when I discuss them in more detail, Hendry's stance makes sense from a contrarian point of view. For instance, it is very hard to debate the point that nearly all investors are underweight goverment bonds from a long-term historical point of view. I have covered this in the past but almost everyone—pension funds, retail investors, corporate investment funds, commercial banks—have a smaller percentage of their assets in government bonds than they did 30 or 40 years ago. The logical contrarian position is to assume that portfolio allocation towards government bonds will increase significantly over the next 20 years. However, I am not quite sold on Hendry's newest revelation, a bearish bet on Japan.

The Big Picture

Sumner is able to take us from the Flemish forger, Van Meegeren, and his horrendous reproductions of the Dutch painter, Vermeer, to the notion that every recession seems unique and special to its protagonists. So just how did Van Meegeren fool the Nazis with paintings that today look so awful, so un-Vermeer? Jonathan Lopez, the noted art historian, argues that a FAKE succeeds owing to its power to sway the contemporary mind. Or in other words, the best forgeries tend to pay homage to the tastes and prejudices of their time. The present is so seductive.

What does this mean?

Controlling the psyche of this generation of investor is the indelible mark of the falling dollar and the associated fear of inflation. Monetary inflation has been the distinguishing feature of the last ten years, and it is now firmly embedded in the contemporary mind. I am sure I need not remind you that gold, along with just about every other commodity, has at least quadrupled in price since 1999. You already know my explanation for why this has happened.

The spectacular rise in the Chinese trade surplus, predominantly with America, to $320bn per annum at its peak in 2007, and the mercantilist desire to prevent currency appreciation drove the Asians and the sheiks to buy Treasuries and print their own currencies. The ability of fractional reserve banking to leverage this liquidity many times over provided the monetary mo-jo to instigate ever higher commodity prices. In other words, quantitative easing, masquerading as a cheap but fixed currency regime, has succeeded where Japan's orthodox version has failed. The QE succeeded because, amongst other features, it raised the velocity of monetary circulation.

However, it was not always like this. As an example, ten years ago it was unthinkable that the dollar would prove so fragile. Recall that back then, when the euro was first launched in 1999, it promptly lost 31% of its value against the greenback. The subsequent reconstruction of modern China, though, intervened. In order to finance the emergence of a new economic superpower, an abundance of dollars was needed. Have no doubt that had we not had the dollar as a reserve currency, the rise of China would not have been as swift nor as decisive.

There are two non-mainstream claims Hugh Hendry makes here. Both go against conventional thinking of academia and the Street (as far as I know, I haven't heard anyone else say this before.) Hugh Hendry is claiming that the fixed exchange rate policy is actually quantitative easing (QE) on a grand scale. Unless I'm misunderstanding his point, I believe the QE he is referring to is the period before the current crisis and one should not confuse what happened pre-crisis with the current QE being undertaken.

Another claim is made in regard to the growth of China. Hendry claims that China wouldn't have risen as quickly if it weren't for the US$. I think most would agree with this view to a large degree. If USA didn't run very large current account deficits, it would have been difficult to successfully carry out the fixed exchange policy pursued by China (the fixed rate refers to the exchange rate between the US$ and the renminbi.)

The US Dollar

...they required the willingness of their trade partners to run trade deficits. The US delivered and, partly as a consequence, the Fed's broader trade weighted dollar index has now fallen 20% since its peak in 2002 (the narrower DXY index compiled by the Intercontinental Exchange has fallen more, but excludes the renminbi and overstates the role of the euro). In return, the world has a new $4trn trading partner: China.

Heady stuff, but not without precedent: recall the Marshall Plan, a watershed American aid program that assisted the reconstruction of the Western European economy during the 1950s and 60s. This was further augmented by America’s willingness to run trade deficits, the modern day equivalent to a gold discovery, which became necessary to sustain the emergence of the new economic trading bloc . This resulted in the dollar's huge devaluation versus gold in the 1970s. However, back then, the broad trade weighted index kept rising. This time it has fallen sharply.


Do not forget that the Chinese could replicate equivalent currency baskets to SDRs at any moment. Instead, they continue to recycle almost three quarters of their trade surplus back into dollars. This is not coercion but simple commercial pragmatism. They know full well that neither Europe nor Japan nor Britain nor Switzerland nor the rest of Asia are willing to sacrifice the implicit loss of manufacturing jobs. They understand that it is only the US that is willing to embrace the benefits of comparative advantage that arise from international trade. Have you ever asked yourself why car prices in America are so low compared with those in Europe? This is my point.

I keep hearing that a dollar devaluation would help matters. I agree; it has. Let me say it again; we have already had the devaluation. That is what the last five years were all about. Now with China rebuilt, and the trade deficit in full retreat (note the -47% contribution from net exports to China's GDP growth in the first 9 months of this year), there are less dollar bills being exported overseas to ungrateful recipients. Is it not time we drop our fascination with the present and consider the future? Is it really inconceivable that the dollar could now strengthen?

I lean towards Hugh Hendry's stance but anyone going long the dollar has been burnt very badly this year. But from a contrarian point of view, a bullish US$ bet is very attractive. The vast majority of investors have placed large bearish bets on the US$—another way of saying this is that the majority have placed a bullish bet on inflation. The question is when will the US$ stop sliding?

The Overcrowded Inflation Trade

The trouble is that we are so anchored to the recent past. Investors are fearful of what now seems so familiar and recognisable; at what they perceive as the reckless behaviour of our monetary authorities. "Inflation is a monetary phenomenon" is their Friedmanite dogma. Their salvation can only be found in the safe sanctuary of gold and the embrace of risky assets, but are they truly safe?

This is my home. Don't be so sure about anything, Big Horace. Not about anything in this world.
—The Orphan's Home Cycle
Horton Foote

And so, just as the Church of England commissioners became convinced by the cult of equity way back in the whimsical days of 1999 and went 100% long the stock market, investors today recant a new mantra of, “anything but the dollar (A-B-D)”. Inflation bets are all the rage. Some would insist that it is their fiduciary duty to protect their clients' capital; I say tell that to the Church of England pension fund, whose assets today are just £461m against liabilities of £813m. Austerity beckons for the clergymen; heaven will have to pay their stipend.

But the spell cast by a contemporary cult is hard to resist. Take another august body, the Harvard Endowment Fund. Not typically renowned as a hotbed of reactionary fervour, the fund is nevertheless radical in its construction and has come to typify the A-B-D stance.

Harvard’s position could well be construed as a one-way bet. Almost half of the fund is invested in emerging market equities, commodities, real-estate, private equity and junk bonds. It is as though the rap artist 50 Cent has taken over the advisory board. The fund is going to, “get rich or die tryin’".

We, on the other hand, approach risk by considering the worst possible outcome. For a current pension scheme the greatest torment would be a repeat of last year's final quarter when 30 year Treasuries yielded just 2.5%. This would require a CAGR of 20% or more from the fund's riskier assets at precisely the time that their future returns would seem most questionable; insolvency would beckon. And yet, they blithely run the risk of ruination.

Harvard Endowment Fund appears to the whipping boy of critics, including me (in Canada, another unfolding disaster is Quebec's Caisse du Depot pension fund, which I haven't covered, or criticized enough ;), on this blog.) Eclectica produces the following graphic breaking out Harvard's portfolio, which Hendry characterizes as akin to 50cent's strategy of get rich or die tryin' (as usual click to enlarge graphic.)

I'm not going to go into the Harvard situation because I have covered it before and I was already shocked when I first realized how vulnerable their portfolio was. Suffice to say, they are representative of the heavily-crowded inflation bet.

The key thing to note from their portfolio is that they have only 6% in high quality bonds!!! Perhaps inflationists would consider it prudent to hold so little in high quality bonds—inflationists such as Marc Faber have suggested that US Treasuries are in a huge bubble, and other government bonds aren't that much better—but if the inflation call is wrong, this fund is going to blow up very badly. A small whiff of deflation will likely topple this portfolio.

China Inc. = Commodities Inc.

Hugh Hendry makes the controversial charge, denied by many commodity bulls, that China is pretty much gambling on commodities and doubling up on winning bets:

Is this not a reincarnation of the 1980 trade of the brothers Hunt? It is hardly an exaggeration to suggest that China, for all intents and purposes, is already the commodity market. For despite providing less than 8% of global GDP, China accounts for more than half of the world's steel production and more than half of global seaborne iron ore freight. Indeed, this peculiarity is circular in nature. Consider that a modern aluminium plant requires 25% of the project's cost to be spent on buying aluminium in the first place. And remember that investments in fixed capital formation (think new aluminium plants et al.) have made up 95% of Chinese GDP growth this year. China Inc. is Commodities Inc.


Surely, the Chinese stash of Treasuries is a prudent elimination of the fat tail risk that private sector deleveraging in the west ends up killing the golden goose of the trade surplus. But instead, in exercising good ol’ Texan tradition, they have opted, like the Hunt brothers did, to double up.


Despite their bubble never coming close to matching China’s prominence in industrial commodities, the loss of Japanese economic growth in the 1990s was nevertheless a major factor in the waterfall crash in commodities. This plunge ultimately saw oil trade for as little as $10 per barrel in the next decade. Just consider how much more devastating the experience would have been had they gone very long the commodity market in 1989 rather than golf courses and Rockefeller Centre. At least the Harvard endowment scheme did not share their enthusiasm for golf. But, this time around, I fear a Mort Subite beckons for the losers in Asia and the pension market.

All sorts of controversial views... I'm not sure what to say about these points.

I think Hugh Hendry needs stronger arguments. The anecdotal or specific examples about aluminum and steel may be misleading. Maybe there is overcapacity in aluminum but how about copper? Or oil? Or how about cement production?

If Hugh Hendry is reading this (I doubt it :( ), I would suggest that he dig up some information related to retail. I think the overcapacity in manufacturing is beaten to death but the question is whether retail consumers are buying any finished goods. There are all sorts of contradictory views out there—some say retail stores are empty and shutting down while others say they see strong consumption trends—and a good, contrarian, thinker like Hendry can probably dig up important insights.

Overall, I share similar views as Hugh Hendry. In the past, I have mentioned my concern with overcapacity in manufacturing and Hendry's points support that view. But I'm not as bearish as he is. Comparing China to the Hunt Brothers seems a bit extreme. The Hunt Brothers were speculators while China isn't quite a speculator like those two brothers.

Argument Against Bond Bears

My intellectual foes, on the other hand, are adamant that long duration government bonds are a short. I even hear that some Wall Street legends are so convinced of the argument made by the likes of Niall Ferguson that they personally own Treasury put options and are actively counselling others to do the same. The argument can be condensed into just two fears.

First, they will suggest that 4.5% is not an adequate return for lending your money to the profligate United States for 30 years. I agree wholeheartedly. Again, I fear it is my accent, but let me stress once more that I do not propose that anyone adopt a buy-and-hold policy for the next thirty years in bonds. However, a nominal rate of 4.5% might prove very profitable over the coming year should breakeven inflation expectations head south again.

Second, the bears contend, a lower Chinese trade surplus will eliminate a very large source of Treasury buyers at a time of burgeoning supply. Again, we find ourselves agreeing vigorously. However, it is our contention that US savings are heading north over the months and years to come. And an America that saves is an America that does not run a current account deficit. It is an American that can finance its own spending domestically. The US produced a small surplus back in the 1990-91 recession, so why not again?

Hugh Hendry goes on to elaborate on issue #2:

I have quoted Don Coxe's definition of a bull market before and I intend to do so again. “The most exciting returns are to be had from an asset class where those who know it best, love it least.” On this point, America has fallen out of love with its own currency and bond market. Foreigners own over half of the outstanding Treasury stock. But, like I said, I think events could reignite some of the natives’ old amour.


...where will the demand for all of this additional government debt come from? Let us review the Fed's Z1 numbers. The US has household wealth of some $67trn. Of that, $20trn is accounted for by real estate and is perhaps out of bounds for our purposes. But $8trn is held in the form of private pensions and insurance funds. And yet, remarkably, these institutions presently allocate just $630bn to Treasuries et al. Households have a further $22trn in time deposits and other financial assets. But again they own just $500bn of Treasuries, and commercial banks own a tiny $130bn or, 1% of their total asset base of $12trn.

Consider that in 1952, at the very end of the supernova bond bull market formed from the ashes of the Great Depression and the Liberty Bonds that financed the Second World War, US banks held 40% of their gross assets in Treasuries. That is a potential $5trn of demand from this one source alone, albeit spread out over a number of years. And again, the Japan experience lends support. Japanese financial institutions have quadrupled the percentage of their assets held in JGBs.

Furthermore, their households have lifted their government bond weightings five-fold over the last ten years. Should the same pattern repeat itself stateside, American households would need to buy another $2.5trn, but again, over ten years.

I have suggested similar thoughts in the past. In fact, anyone following the data would have seen how US households ratcheted up their savings over the year, and commercial bank holdings of US debt had either risen or held steady. I don't think financing the US deficits will be much of an issue.

On Economic Growth

Again, it all really comes down to your take on the ratio of total debt-to-GDP. If you believe, like I do, that it peaked in 2007 then the repercussions are enormous. The leverage does not necessarily have to come down (after peaking in 1932 at 300% it troughed 20 years later at 150%). Rather, it may well be that low interest rates allow the mountain of debt to continue to be serviced. This has been the Japanese experience to date. However, everything in our economic life exists at the margin, and the consequences of just maintaining the leverage constant would be a very low delta in nominal GDP growth. Consider that the Japanese, under these very circumstances, have managed to grow nominal GDP at just 1% compound since 1990.

I think Hugh is correct in speculating that debt-to-GDP may have peaked in 2007. The numerator, debt, likely peaked without any doubt in 2007 (recall that this was right before the massive markdowns of real estate and stocks.) The denominator, GDP, probably didn't hit a bottom in 2007 but probably did so in 2008. It is likely that the GDP will increase going forward (it has already risen in the last quarter) so the debt-to-gdp ratio will shrink.

USA is following the Japan strategy—they have no other choice—and, as Hugh Hendry suggests, the low rates will help immensely with paying down debt.

I think the outcome in USA is more optimistic than in Japan. Japan grew around 1% but this was with real estate and stock market bubbles that were far larger than in America (relative to their economy.) Also, Japanese businesses were never as flexible and dynamic as American businesses—say what you will about America but the best capitalists and business executives are still working in America. Finally, and most importantly, Japan entered a serious demographic decline during that time period whereas America won't. Given all that, I think we can add at least 1% more to GDP growth to end up with an overall GDP growth rate of 2%.

China & Its Overcapacity Problem

I'm not sure if I dig Hendry's writing style of switching between topics almost at will but the points cannot be ignored. He summarizes the oft-repeated overcapacity argument by China bears:

This [low GDP growth in USA and others] is why China's mad dash for commodities and its investment splurge this year is so worrying...The Chinese are building capacity to meet a world where US nominal GDP is $25trn in ten years time. I fear they could be in for a nasty shock.

Now with China having been on such an expansionary tear, it may not surprise you to hear that finished Chinese steel prices today trade below their production cost.
Furthermore, import license applications to sell steel in the US, the world's largest export market, rose 24% last month. Now, mostly this comes from Mexican and Korean producers, but clearly there is the implicit threat that their Chinese competitors might also be tempted.

...It is quite chilling to note that steel production in America is on a par with output back in 1938, when GDP was a mere 7% of its current size. The industry's run rate dropped to a paltry 13% during the Great Depression. However, output only troughed at its 1908 level; a twenty year retracement that is a far cry from our 70 year retracement. So the physical developments in the western steel markets should raise some concern. However, with an active steel futures market in China turning over $15bn a day (consult the Bloomberg page ), speculative fears concerning the dollar have overcome the paucity of industrial demand in the west.

Of course, it is not just steel. Consider the aluminium market. We recently had a very bearish meeting with the Norwegian company Norsk Hydro. Admittedly, their strong petro-currency does not help and you have to discount the solace I seek in finding people even more miserable than myself. Even so, the aluminium situation mimics that of steel, but with an even mightier inventory overhang. Four and a half million tons reside at the London Metal Exchange, perhaps 20% of world ex-China annual capacity. It is probable that 75% of this surplus stock is accounted for by financial players exploiting a contango.

I think the steel example is inconclusive and possibly erroneous. American steel production cannot be compared to the distant past. The reason is because most of the manufacturing has been permanently lost, especially in the 80's. So, the fact that steel declined to 30-year lows during the Great Depression, while it declined to 70-year lows during the current implosion doesn't surprise me and may not mean much.

The aluminum situation is a better example but these contango arbitrage trades, if true, are complicated and hard to figure out. I have no idea if the implication is bearish or bullish. Recall how oil was in contango late last year to early this year but has rise substancially since then.

Hendry also refers to this interesting video clip showing Vladimir Putin bossing around Depriska, the billionaire power player out of Russia:

Furthermore, the big Russian players like Rusal are under intense pressure from Putin not to cut capacity (check out ‘Putin bitch slaps Deripaska’ on, and are rumoured to be surviving only by not paying their electricity bills.

It's hard to tell if this is for show (i.e. propaganda) or something real; but whatever the case may be, it shows how powerful the politicians, particularly the inner circle of Putin, the Siloviki, are in Russia. What Putin does to Deripaska solves a political problem but turns it into an economic problem. The political problem, obviously, is that workers weren't paid salaries, were unemployed, and were revolting; but by forcing factories to be run at losses, it misallocates capital and wastes resources in the long run. There is no easy solution for these difficult problems.

Hugh Hendry's Core Argument

So I fall back on my old argument. It is perhaps too subtle, but at its core lies today’s most pertinent question. What if Bernanke, the Chinese, Putin, Obama, his Congress, and all the other interventionists, are simply impotent? What if they do not matter? Perhaps it is the debt, stupid. Perhaps the incremental GDP from all of this additional stimulus spending is zero. And, as Japan has foretold, perhaps all of this year’s interventions will be unable to lift the global economy from its funk. If this is so, you will not require all those inflation hedges; you have been sold a FAKE.

This parallels my feeling, although I'm not as critical as Hendry is.

We must also ask the opposite question. Namely, why are all the inflationists, including successful investors like John Paulson, David Einhorn, Jim Rogers, and so forth, spending hundreads of millions on the inflation bets? Have they actually fallen for the fakery?

Or are the deflationists wrong?

What keeps me from doing anything is my uneasy feeling that I am missing something...something critical.

Bearish Bet On Japan

In a new development (at least to me), Hendry bets against Japan. Instead of betting against the country, he chooses to bet against Tokyo Electric Power (TSE: 9501):

But first, it may require the spectacle of seeing Japan implode and so we have been actively positioning the Fund to profit from such a scenario. As many of you know, the fiscal situation in Japan is rapidly rising out of control.

Government tax receipts are down 14% over the last 12 months; government spending is twice the receipts and the trade surplus appears structurally impaired. We have to go back to 1991 to find the last time they ran a primary surplus sufficient to meet their national debt’s interest payments. Today they would need the equivalent of 4.4% of GDP. Failing this, and assuming they do not shorten the debt maturity of the JGBs that they sell to the public, then the ratio of public debt to GDP is guaranteed to rise further. It is currently 196% of GDP with the IMF estimating that it will rise to 234% by 2014.

This situation has not gone unnoticed. The sovereign dollar default swap has doubled to 75bps since August, and Japan is now themost expensive credit to insure against a dollar default in the G10. However, we have been active buyers of corporate debt default swaps. We find it remarkable that one can insure highly leveraged utilities at 23bps despite their considerable yen debt. Consider the Tokyo Electric Power Co. (9501 JP) with a market capitalisation of $32bn and net debt of $81bn. The debt is 7x EBITDA, the interest cover is 1.9x, and the average interest cost for now is thankfully just 1.9% p.a.

The Japanese government has been sensible in one area; two thirds of all their JGB issuance has been in maturities of ten years or more whereas the US has a skew to shorter dated issuance. However, it is probable that the public sector in Japan is crowding out the private sector from the long end, for whilst only 24% of the government debt is of 2-5 year maturity, the corresponding figure for the utility company is 57%. Furthermore, they are dependent on 70% of their debt being sourced from non-banking sources, i.e., from the market place. Clearly there are two prominent risks: debt rollover and higher interest rates. The “cheap” risk is a normalisation of interest rates brought about by a dearth of buyers at these levels. Should Tokyo Electric’s interest cost double to 4.6%, the company’s EBITDA-less-CAPEX would just cover the interest bill. What cost would credit underwriters insist for the CDS in this scenario?

We have a notional exposure representing almost 40% of the Fund’s NAV. It represents a large notional risk exposure with a quantifiable and manageable downside loss of just 9 bps of the Fund’s NAV every year for five years. However, the potential return to the Fund in the event of a default would be 23% of NAV, or 250x our annual outlay. Whilst we would still make 1% point of NAV should it trade in line with the sovereign credit risk, or 10x our annual cost. We might get rich but we certainly will not die tryin’.

I have a bad feeling about this position. If I'm not mistaken, Tokyo Electric is one of the largest power providers in Japan. I have a feeling that the government may bail them out if the utility runs into problems. Perhaps Hendry can sell the CDS after it rallies during a crisis but if he is forced to hold it until default, I can see him losing money. After all, several American banks were in far worse shape and would have gone bankrupt but they never did (due to government support.)

Portfolio Strategy

Hugh Hendry finishes off his lengthy, and somewhat confusing, letter by laying out his present strategy:

The above is typical of our portfolio today. Gone are the cavalier days of large gross exposures across multiple asset classes and large monthly volatility. Instead we own a basket of cheap sovereign and corporate default swaps and the asymmetry of interest rate option packages which enjoy high pay-offs should the enormous debt load of the private sector keep rates lower for longer.

Many value investors would probably consider the above to be gambling, but it is par for macro investors. I've actually been thinking of either buying the long bond ETF (TLT) or options on the ETF.

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Sunday Spectacle XXXVI

US Tourism Down and Out

My company is exposed to US tourism and it has been hit hard by the big downturn in tourism. The surprising thing to me is how OTA (online travel agents) have done so well this year. Expedia and Priceline are up over 300% from their bottom, with Priceline trading at an all-time high, way above the peak in 2008.

(Graphic source: US travel and tourism are going nowhere, BusinessWeek)

Friday, November 20, 2009 3 comments ++[ CLICK TO COMMENT ]++

Second part of the Bruce Greenwald interview at Advisor Perspectives

Robert Huebscher of Advisor Perspectives continues his superb interview with Bruce Greenwald, with the 2nd part being posted online (Thanks to GuruFocus for bringing it to my attention.)

The first interview was controversial and insightful. And the second interview continues in that tradition. I don't know much about Bruce Greenwald but never knew he was outspoken and expresses his opinions. Bruce Greenwald holds no punches back and even criticizes Warren Buffett's offer to buy Burlington Northern Santa Fe—he even goes as far as saying "he [Buffett] has lost his mind."

I highly recommended the first interview for macro-oriented investors while I recommend the second one for all investors. For those willing to entertain my ramblings, read on for my opinions to some of his thoughts.

Value Investing, You Say?

Again, thanks to Robert Huebscher for conducting such an insightful interview and making it freely available. When asked about how his value investing has changed due to the financial chaos of the last few years:

The first principle is that the quickest way to permanently impair your capital is to overpay for something. So you always want to have a margin of safety.

The second issue is that, you go wrong with your margin of safety because your intrinsic value is wrong. Something happens that surprises you. That is almost always – if it’s a permanent impairment of capital – a company problem, where a product doesn’t work or a competitor comes in, or an industry problem, like newspapers, where they get destroyed. Sometimes it’s a particular national problem, like in Venezuela. But those risks tend to be diversifiable. So the value investors who had always been very concentrated, like Glen Greenberg, who is a wonderful investor, got burned. He had five to seven positions.

For the sake of risk management, you’ve got to have at least 20 to 30 globally diversified positions...

The third rule is that, even within a diversified portfolio, if you have if you have a total loss that affects 3% to 4% of your portfolio, you are asking for trouble. The thing that will convert temporary impairments, which are the macro fluctuations, to permanent impairments is leverage. We’ve always been extremely careful when it comes to leverage.

I think the value community has learned this lesson. The guys like Marty Whitman who got burned were in financial services, where there were enormous amounts of leverage. We’ve learned that if you want to do a stub, which is a highly leveraged position, you want a five- to six-times upside, because the downside is zero. You’ve got to start thinking in those terms. People have learned to think about leverage differently and to be warier of leverage, and only be willing to do it in a restricted part of a diversified portfolio.

The fourth thing we’ve learned is that when you build your portfolio you have to think about macro risks in terms of scenarios. Basically it comes down to two scenarios: You can have stagnation and deflation and a recession for extended periods with inadequate demand, or you can have inflation. You have to know, holding by holding, what your vulnerability is. For example, real assets – real estate, natural resources, and things like that – are going to do very well in an inflationary environment but are going to get killed in a deflationary environment. Fixed income is going to do very well in a deflationary environment and is going to get killed in an inflationary environment.

The first point (paying too much) is very obvious to anyone who has been investing for a while, and is in fact, one key reason some people pursue contrarian-type investing.

I completely disagree with point #2 (about diversification.) Since I'm a concentrated investor, I suspect I will never agree with Greenwald (but I'll challenge this view in a future post if I get time to write it up.) There is some merit in holding investments in 3 or 4 sectors but the notion of "20 to 30 globally diversified positions" is not something I subscribe to. If anything, the recent crash should have shown everyone that so-called diversification didn't save anyone. For example, some of the hardest hit investors are pension funds, who tend to follow passive investing strategies and are widely diversified across many different assets and regions. A lot of pension funds were down around 15% to 30% last year (that doesn't look bad compared to the -40% for the market but keep in mind that these funds are supposed to be "safe" and hold bonds. If you strip out the bonds, they posted horrible numbers even though they were widely diversified.)

The third point about leverage is well worth keeping in mind. Be careful about leverage. I may be way too cautious (I was nervous about Diageo's debt even though it is the #1 player with massive moat) but at least I avoid surprises. I'm not sure what a stub is—the stub I know of doesn't seem like it's related to what he is talking about here—but if he were referring to distressed companies, I would say that high-risk bets should have potential return skewed heavily towards the positive. If you are looking at collapsed stocks, usually the potential returns are skewed (but do note that this says nothing of the probabilities.) This is one reason I usually don't like looking at seriously distressed companies until they have fallen at least 50%. If someone falls 50%, it at least has 100% upside if it were to go back to prior price. If something falls 70%+ then the upside is several times more.

The fourth point surprises me but I'm seeing more and more of it. For some unexplainable reason, many value investors are paying attention to macro all of a sudden. I find this bizarre because my impression is that value investing has historically not placed much weight on macro issues. Furthermore, value investors are not good at making macro calls—there is nothing to say they are good at it all of a sudden—and it remains to be seen if they can beat macro-oriented investors if they enter the game—do note that investing is competitive and you are constantly competing.

Best Overall Investments
Robert Huebscher: Which assets give you the best overall protection?

Bruce Greenwald: The assets that are most attractive are the franchise businesses that have pricing power, because you can pass along inflationary price increases and you are not subject to competition from excess capacity, the way you are in industries like autos and steel. You have much more control on the downside.

Like a lot of things in investing, what sounds easy is very difficult in practice. I'm sure nearly all value investors would agree with the statement above. After all, didn't Warren Buffett himself allude to the view that franchise businesses with pricing power are the best?

Well, the reality is that it is very hard to find so-called franchises at good prices. Even when you find one, it's never clear how big their moat is. For instance, the classic franchise is something like McDonald's. Seems simple enough. But do you know how many other fast-food competitors there are? How can you be confident that McDonald's is going to do well and not Harvey's? Or Burger King? Or Taco Bell? Or KFC? Or whatever? No one has said this but how can you be sure that McDonald's doesn't face "overcapacity"? After all, when there are 5 restaurants in every major block, isn't that overcapacity?

Anyway, the franchise investment Bruce Greenwald mentions is John Deere, the farm equipment maker. I'm not sure I agree with Greenwald's perception of John Deere. He says (not quoted on this page) that it didn't post a big loss but how much of that is from the commodity boom? My feeling is that John Deere's performance should be ascribed to the commodity boom, and not the franchise-like characteristics.

Having said all that, there are many investment strategies that can work depending on your skill. One such stategy that goes against the franchise suggestion above is the contrarian tactic of buying cyclicals when they are out of favour. Benjamin Graham suggested in The Intelligent Investor (click here for my summary of the book) that buying cyclicals near a trough can be a worthwhile stategy. So, although autos and steel are bad businesses to own for the long run, buying them near a trough can be far more profitable than buying and holding franchise companies. This cylical-purchase strategy is very difficult because it is difficult to separate negative secular effects from cyclical effects. For instance, a lot of investors misjudged homebuilders—recall how Bill Miller was buying them a few years—and forestry stocks (you may remember Fairfax and Third Avenue buying forestry stocks that, subsequently, suffered massive declines.)

Bullish On American Express

Greenwald says he likes Microsoft and American Express. The latter is a very risky bet. He isn't happy with the CEO and openly criticizes him:
American Express is unbelievable. It has sustainable earnings of a minimum of $3/share. If they manage their costs at all – and that could happen if Ken Chenault leaves the company – they could easily make another $2.50/share pre-tax by cutting costs. You’re talking about making $5/share after-tax in sustainable earnings. When the price is $10, that’s two times earnings – a 50% earnings return.

If you think it is $3 or $3.50 with a potential of $5.00, you’re talking about an earnings return on American Express that’s 10% and up. They’ve got some organic growth because they earn 1.1 % on their billings [through merchant fees] without any significant impact on receivables. Rich people are clearly doing better than poor people, as they have for the last 40 years. The surprise is that these stocks, which you would not think are ugly or obscure, are this cheap. People have just gotten scared.

Bruce Greenwald sticks to his value investing knitting but by doing so, he misses what macro-oriented investors like me perceive as the biggest risk. The problem with Amex isn't its earnings; rather, it is the credit exposure to the consumer. You have to get the credit card default projection right or else you are toast. The fact that Amex had to turn itself into a bank and get government aid sort of illustrates the reason why investors have been fleeing this company. None of this means that this is a bad investment but I do think that it isn't as clean an investment as it seems.

On Burlington Northern Santa Fe

Bruce Greenwald does not like Berkshire Hathaway's bid for Burlington Northern Santa Fe. He thinks it is a bad investment. I hope I'm not breaking any fair-use laws by quoting the entire answer:
It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex. So they are under-depreciating, and their profit numbers are lower than the true profit numbers – and in a bad way, because the tax shield for the depreciation is undergone too. Their profitability is much lower than it looks.

Buffett’s paying 18-times [at $100/share] and at $75 he was paying 16-times. Our calculation is he was paying 21-times.

Secondly, there are two kinds of assets. There are the rights-of-way, which you can’t get rid of. So there’s no issue about having to earn a return on them because you have to keep it in the business, and because there’s nothing they can do with those rights-of-way. If you look at the asset value of the non-right-of-way equipment, and you write it up because it’s more expensive than it was originally, you get an asset value that’s very close to the earnings power value. We didn’t see a lot franchise value or hidden asset value.

The other thing is that if you try to calculate sustainable earnings, you have to cope with the fact that earnings are up enormously since 2003, when oil went up. There is a simple calculation you can do, which compares the cost-per-ton-mile for freight for a truck versus a railroad. If you build the increase in the price of diesel fuel into the post-2003 experience, when revenues suddenly start to grow, what you see is that the entire growth of the revenue is accounted for by the energy advantage that the railroads have and therefore how much business they can capture from the truckers, and how much pricing they can get because the competition is now more expensive.

There is nothing special about the railroads. It’s entirely an energy play.

If you look at what their margins should have gone up by, given the energy efficiency, the margins go up by only about half of that. So you don’t have a good aggressive management over these five years producing outsized returns.

We looked back at when they did the merger with Santa Fe, because then they did increase margins. But they got bored with it, and margins started to come down. The same thing happened recently. We don’t see a lot of hidden profitability in the culture of the company.

It looked to us like an oil play. He has a history of making bad oil play decisions. And that was at $75/share, we thought there were better oil plays. At $100/share we think he has lost his mind.

I looked at railroads a few years ago (before I had a blog) and I didn't like them because they were largely a play on the commodity boom and the trade boom. Bruce Greenwald also suggests that BNSF's strong performance in the last decade was largely due to the oil boom.

I agree with Greenwald that Warren Buffett is not very good with oil (or macro trends in general.) The latest news reports suggest that Berkshire Hathaway is buying ExxonMobil and, I'm not sure if that is a Buffett decision or someone else within the firm, but it looks like another bad bet.

Overall, the BNSF deal is a mystery. But so was the Coca-Cola purchase in the late 1980's and everyone thought Buffett was overpaying for a saturated business. The critics ended up being wrong.

The Media Industry

Bruce Greenwald apparently has written a book about the media industry (I haven't read it) and he offers his thoughts on it. Interesting thoughts but I disagree with some of it:
When you look at the media business, there are three parts to it. There are the content providers (who never made any money), which are the production houses in the movies and the imprints in the record houses. There are no barriers to entry there. If you look at the last 20 years, everything went right for the movies. First they got VCRs, then cable, then DVDs, then good foreign distribution. Revenues grew by about 8.5%. Costs per movie grew by about 9.8% and the number of movies grew by 1.2% annually. There are going to be good years and bad years. So, when everyone says content is king, remember that content production is not king.

The second part of the business is the aggregators. The movie companies and the record companies used to do the aggregating. For example, the record companies pressed the records and shipped them to the stores in bulk. What kept their advantage, and why there were four majors, was because it’s expensive to do that. It’s hard for an entrant to do that. That went away with electronic distribution.

Once you can do that electronically, that advantage is gone, and they got killed. If you think about the aggregation of newspapers, the same thing happened. They had to put the news together, print it, and so on. Electronic news distribution destroyed their business model.

The aggregation profits now are in the cable networks. To do a cable network, you need a full slate of programming. If you dominate a specialty niche, like Discovery does, it’s hard for others to pay for that programming. If you have the best distribution for that kind of programming, you get the best prices and all the advantages of economies of scale.

But if that model evolves to where you have all the content on a web site, such as the Discovery Channel web site, everyone just picks and chooses, and all of a sudden that barrier to entry is way down We’re very leery of these businesses. We want high returns – much higher than the NBC-Universal deal – on the aggregators, because the history has been that the aggregators can go away, just as continuous content has gone away. It used to be that nightly news or the soaps were a big thing that you had to do every day, and they were hard to produce. Now people can make one-off soaps.


The content business was never very profitable and the aggregation business went away with electronic distribution, so you are left with the final distribution – the pipelines. They ought to get correspondingly more valuable. They are Comcast and Verizon. They have local monopolies. Nobody is going to build infrastructure to compete with them.

No offense to Greenwald but this looks very much like looking in the rear mirror. I could be wrong but what if content, which he says wasn't very profitable, becomes valuable all of a sudden?

Also, the profitability of the aggregators may change but I'm not sure they will dissapear. I remember one of the arguments heavy metal band Metallica were making against Napster almost a decade ago was that the music studios act as financiers for emerging artists. I would say that, in some sense, the record companies are like venture capital. If they dissapear, who takes their role? Who will finance a new artist who has zero sales and spend money on marketing and promotions? ITunes, for example, has shifted the profit to itself, and away from the studios, but I have a feeling it will shift back towards the venture-capital-like firms. (Do note that this doesn't necessarily mean that an existing studio will do it. It could be a newly founded entity but the point is that someone has to provide a few hundread thoursand to an artist before they have a single sale.)

Greenwald says he likes Comcast:
The one that we like best, even though they break our hearts with their stupidity, is Comcast, which is trading at a 13% earnings return because they are way over-depreciating. We think they ought to have huge pricing power.


What will happen is that you will have a cable wire into your house, and then everything will be wirelessly distributed. In that world, their costs go to nothing. If they keep their prices up – and they can probably charge $300/month, because it will cover your cell phone, regular phone, internet access, and on-demand programming – and they collaborate, they can charge a lot and make a ton of money.

Greenwald's view sort of parallels the consensus view (at least based on some random articles and analyst reports I have read.)

The risk is that the distribution companies require very high capex and are vulnerable to technology advances. Obviously cable investors are expecting the buildout of cable/high-speed-networks/etc to be a one-time thing but it remains to be seen. If someone asked around 15 years ago, many would have probably said that telecoms had the advantage but that's not true right now. What if cable goes the same way?

The pricing power also seems questionable. I already seem a developing backlash against cable companies in Canada—one just needs to read user comments at newspapers sites—and I don't know how much longer they can continuously keep increasing rates without any improvement. The figure cited by Greenwald for full service ($300/month) also seems quite high to me. I pay around $120 but I'm in the lower income category and only have moderate speed cable, low-end mobile phone, etc. The vast majority of the population are closer to me than the high end. Even if you assume his figures are for a family of 4 (mine are just for one person), I'm not sure if such costs can be maintained. There is a real possibility of prices deflating, especially if technology keeps advancing.

Greatest Danger
Robert Huebscher: What is your greatest fear?

Bruce Greenwald: The killer would be inflation. Normally, for inflation to take off you need expectations, which there are, and you need wage pressures, which I don’t see. But if inflation takes off, policy is going to be emasculated. The view that output demand can be stabilized by government policy is not going to be true any more. It’s going to be painful. The nice thing is that our natural-resource and franchise businesses can really do well in that environment.

But, in terms of a macro fear, that’s really going to be painful. If you get stagflation at these levels of unemployment, watch out.

My biggest fear would be deflation. Although high inflation won't be pretty, I think policymakers, economists, investors, businesspeople, and citizens understand it much better. On top of the power of any potential deflation—deflationary forces are great because debt is very large and there is massive overcapacity in China—the scary thing about deflation is that policymakers don't have much understanding or the tools to combat it. The only solution to deflation appears to involve printing large amounts of money and dropping them from helicopters—and this isn't guaranteed to work either!

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Thursday, November 19, 2009 0 comments ++[ CLICK TO COMMENT ]++

Emergence of capital controls

Still too early to say if this the start of something new and big, but it appears that countries are enacting more controls on capital flows into their countries. The Globe & Mail picks up an FT story that may be foreshadowing the new investment environment:

Brazil moved overnight to close a loophole that had allowed investors to avoid a 2 per cent tax on foreign investment in equities and bonds announced last month.

The government announced a 1.5 per cent tax on American Depositary Receipts. Guido Mantega, Brazil’s finance minister, said some foreign investors had been buying ADRs to get exposure to the local equity market while avoiding the tax.

With interest rates in major economies at record lows as their economies crawl out of recession, speculative investors have poured funds into faster-growing emerging markets in recent months in search of yield.

Those speculative flows have now reached the point where many emerging market currencies have hit levels that threaten to undermine their export sectors.

So far most emerging market economies have managed the problem by intervening in currency markets to slow the appreciation of their currencies.


Indeed, the Indonesian rupiah dropped sharply after the country’s central bank said it was considering steps to limit inflows on Thursday.

Darmin Nasution, deputy governor of Bank Indonesia, said the central bank was “seriously” studying the option of limiting inflows into short-term government bonds.

The rupiah, which has risen more than 17 per cent against the dollar so far this year and is Asia’s best-performing currency, dropped 1.6 per cent to Rp9,525 against the dollar.

Meanwhile, the Indian rupee lost ground on reports that the government was planning set quotas on corporate foreign borrowing in a bid to stem the rupee’s advance.


Elsewhere, Taiwan, which earlier this month banned foreigners from putting money into time deposits in a bid to keep a lid on its currency’s gains, said some of the speculative money had already left the country.

The world has largely been on a liberalizing trend for the last decade, with more and more countries opening up their markets to capital flows, but I wonder if the trend is starting to go in the opposite direction now. In the late 90's, capital inflows were blamed for the bubbles with the Asian Tigers but the cause is never clear. Do capital flows worsen bubbles, or are they simply the result of bubbles?

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Thriftville vs Squanderville

I came a nice video clip hosted at YouTube where Warren Buffett characterizes the squandering of wealth by those who live outside their means versus those that save. Thanks to The Big Picture for bringing it to my attention.

I think most people who are into macro stuff already know all this stuff but newbies and others may find something new.

The difficulty, of course, is that no one has direct control over any of this. It is easy to blame the over-consuming American or Canadian, or some faceless entity like the government, but it's hard to go up to someone and say that they are doing something wrong. As I have suggested in the past—this is something pure capitalists and those on the right never admit—cheap credit is the drug of capitalism. It's easy to say what should or should not be done but the reality is that, if someone offers a 1% to 2% loan to buy a car or a television or whatever, the consumer will almost always accept that deal. This is definitely true if you are middle class or lower and haven't seen real wage growth in more than 10 years.

As long as the free market keeps forcing long-term bond yields low, consumers, as well as businesses, will be addicted to credit. It's the flaw with capitalism.

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Wednesday, November 18, 2009 3 comments ++[ CLICK TO COMMENT ]++

Sold: Aspen (ASPN) ... big mistake...important note about dividends

This might be one of the most important things you will probably learn from this blog and I suggest you read this post even if you have no interest in my investments (especially if you are into special situation investing and may deal with dividends that are 25% or more of the security's value.) It comes from a mistake I made.

Yesterday I was wondering why Aspen (ASPN) didn't gap down after the dividend recordholder date had surpassed and I found out the hard way, after unloading my stake at a loss.

Thanks to a post at Greenbackd by reader Wes (refer to comments at the bottom) for clarifying the situation. Aspen also released a press release late in the afternoon clarifying the confusion. Essentially, the ex-div date follows a different methodology if the company is paying out more than 25% or more of the security's value. Surprising to me, the ex-div date is actually well after the recordholder date in such cases (recall how ex-div is usually 2 or more days before the recordholder date for regular dividends.) In fact, the ex-div date is after the payable date too.

You can read the FINRA document detailing ex-div dates here. Let me also quote Aspen's press release:

Aspen Exploration Corporation (OTC.BB:ASPN - News) viewed what appeared to be unusual market activity yesterday and today in light of its previous announcement of November 3, 2009. That announcement advised the public that a cash dividend of $0.73 per share will be payable to stockholders of record on November 16, 2009, with the dividend being paid on or about December 2, 2009. Notwithstanding the Board's declaration of a record date, Aspen has been advised by the Financial Industry Regulatory Authority (FINRA) of the application of Nasdaq Rule 11140(b)(2) which states: "In respect to cash dividends or distributions, stock dividends and/or splits, and the distribution of warrants, which are 25% or greater of the value of the subject security, the ex-dividend date shall be the first business day following the payable date." Persons needing further information or interpretation should consult with their broker-dealer or legal advisors.

Unfortunately I never knew this until today, and ended up selling my shares at a loss.

I wish I had run across the information earlier but, as is generally the case with investing—or anything else in life for that matter—one is always tasked with making a decision really quickly or waiting and possibly missing the opportunity. I was thinking all this morning, as well as yesterday night, whether I should sell or wait. I picked the wrong choice. I didn't want to wait (wasn't comfortable with what management might do with the remaining money) so I made the decision to sell before the information became available.

I have historically been too patient but, alas, this time, I was too aggressive.

This example is also a good case study for concentrated investors. Although it's a moderately concentrated bet for me (approximately 15% of portfolio), it wasn't as big as it may have been. When I was initially buying Aspen, I would have purchased a bit more (although not as much as in other cases because I didn't know what management was going to do with the leftover money.) If I had made a bigger bet, the losses would obviously have been much bigger.

One of the great things about concentrated investing is that it gives flexibility with sizing. If you look at two of the risk arbitrage deals in the last year, I made a huge bet on Puget Sound Energy and a moderate bet on Bell Canada Enterprises. BCE was a failure while Puget Sound was a success. If you diversify heavily or equally across investments, you don't get this power—the ability to heavily overload certain investments if you are confident. Like all concentrated investors, I think I need to improve upon the sizing of positions. Anyway, I'm just mentioning this point because I am always puzzled by the amount I should invest, especially for special situations.

In my post yesterday, I said this has been a learning experience. Well, I never quite expected to learn about dividends and end up losing money along the way :( But one thing is certain: I now know how large dividends work in American markets and I hope you learned about them too.

Oh one last thing... I'm not sure if I should re-buy Aspen, hopefully at a lower price. The original investment thesis hasn't changed ;) That would be weird if I purchased it back...

Sale Price: $0.92 (approx)
Return: -4.9%

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Opinion: Goldman Sachs and Warren Buffett start PR campaign to repair damaged reputation

You know things must be really getting out of control when Goldman Sachs, the bastion of capitalism according to some, starts being criticized by conservatives, who tend to be supportive of capitalists. One just needs to peruse the user comments at a news site like MarketWatch, which, like most business sites, is heavily represented by conservatives, to notice all the harsh comments and attacks.

Thus it should not be a surprise to see something that has probably not happened since the 1930's: a public apology by a powerful investment bank. Llyod Blankfein, CEO of Goldman Sachs, is said to have said "We participated in things that were clearly wrong and have reason to regret..." Such an apology from a leading investment bank would have been unthinkable as recently as two years ago.

Warren Buffett is also chipping in to repair the damage. Apparently, Goldman Sachs will provide $500 million to support up to 10,000 small businesses with financial support and business education, channelled through colleges, universities, and the like. Warren Buffett and Michael Porter will be playing an advisory role. The program appears to have been set up several years ago but Goldman Sachs is significantly increasing its contribution.

It remains to be seen how much of an impact this has on public opinion and government policy. It's probably not an understatement to suggest that Goldman Sachs is public enemy #1 for the typical American. Michael Moore may have attacked AIG but my feeling is that Americans are more disgruntled with Goldman Sachs. Rightly or wrongly, it has come to symbolize all that has gone wrong in the financial services industry in the last decade.

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Tuesday, November 17, 2009 0 comments ++[ CLICK TO COMMENT ]++

Low quality stocks starting to weaken

As is normally the case, so-called "junk stocks" (i.e. low quality stocks) have done exceptionally well off the bottom. The Globe & Mail has a nice article quoting a study by Scotia Capital showing companies with S&P credit ratings of BBB or below have significantly outperformed higher-rated stocks from March 9 to September 30. The study also shows that higher quality companies are starting to outperform. Since September 30, companies rated AA or above have outperformed.

All I can say is... be careful if you deal with low quality stocks (many small-caps and distressed companies are.) Looking around the web, I notice many value investors and contrarian investors deal in low quality stocks so make sure you have a good thesis for owning what you do. Everyone looked like a genius in the last 9 months but things are going to get tough pretty soon.

The worst thing about strong rallies is that, it's hard to tell if one's investment arguments are correct or if they are simply riding a wave. Godess of fortune likes to play around with humans ;)