Follow up on my GMO post

My recent post (here) on energy companies has led to a lot of interesting responses from readers. One reader has forwarded research by JP Morgan showing that most oil companies they track cover their dividends at around a price of USD 50 per barrel and, therefore, my claim that the currently high dividend yield is unsustainable is wrong. (Interestingly, most commenters have focused on the dividend yield, ignoring my arguments about the other two valuation metrics employed by GMO – a sign of the times?).

Maybe a clarification is in order here to avoid misunderstandings. I never said that every oil company has to cut its dividend. My statement was about the (market-weighted) average that is used by GMO to construct the index referred to in the post. I have chosen Royal Dutch because I was of the opinion that given its 200 billion market cap and high dividend, it is to some extent representative and therefore a good example.

No doubt, there will be companies whose dividends are sustainable at the current price level. Obviously, this doesn’t mean it is true for the sector overall.

Lukoil, for instance, with which I am somewhat familiar due to my bond position (here), looks as if its high dividend yield is fine at current levels. But: Lukoil is exceptionally well positioned on the cost side. Not only is Lukoil a traditional low-cost producer (remember this chart), but it has enjoyed falling costs courtesy of a heavily depreciated Ruble exchange rate. I do not see how Royal Dutch, which sports a similar dividend yield as Lukoil, can match this cost advantage in the near future, even if they are likely to get concessions from suppliers. Either Lukoil’s dividend is supersafe, or Royal Dutch’s is not. I believe the latter. Remember: Lukoil’s dividend yield is high because of the famous Russia discount, not necessarily because of a general undervaluation of the sector.

Apart from that, the responses have triggered my interest and I have decided to have a quick look at the matter. As I do not have access to JP Morgen research, I have looked what Goldman has to say on this issue. In a recent research piece they had this chart,


The chart shows the current dividend yield and the oil price at which Goldman deems the dividend sustainable for the most important (in terms of market cap) players without resorting to debt financing and assuming that their capex estimate is sufficient to maintain production volumes (“organically”). Unsurprisingly, the lower the dividend yield, the lower the required oil price to maintain it. Also note that Royal Dutch needs an oil price of 63 USD – a mere 50 percent above current levels – to keep paying its high dividend over the long – term. The same is true for other major oil companies such as BP, Total, etc.

I would say this confirms my analysis.

The companies whose dividends Goldman thinks safe at current oil price levels, have yields of between 2.5 and 4.4 percent. That’s not bad, but if these yields excite you, I would urge you to have a look at “undiscovered” gems Microsoft (dividend yield: 2.75%) and Cisco (3.34%), both of which I own (here).

Ok, Royal Dutch is doomed, what about the others? Surely, they are good value at nice yields plus a “free option” should oil prices rise?

There is no denying that a 50 percent higher oil price would help – but that’s (bullish) forecasting. Let’s work with what we have and play around with Goldman’s analysis. Let’s focus on the term “organically”.

As explained before, organically in this context means that the capex estimate Goldman uses to estimate the sustainable dividend is high enough to keep current production volumes indefinitely by replenishing reserves 1:1. This is necessary if you are valuing the company as a mature dividend payer. In case Goldman’s capex estimate is too low, your option betting on a higher oil price is not “free”, but paid for by reducing the capital stock. Unfortunately, Goldman is a little unspecific on how they estimate their sustainable level, but they seem to be guided management.

So we have to work around the problem to see whether this is a good idea.

Exxon dominates the sector with its 350 billion market cap. Goldman think’s its yield at 3.5 percent sustainable at current prices. It is considered to be one of the better managed majors, free from the type of government meddling you get with European integrated oil companies. Warren Buffet was a major shareholder until recently calling it a “wonderful business”. In short, the best management.

Nevertheless, despite doubling their annual capex during the oil boom, their reserve replacement ratio has been below 100 percent, if one excludes their acquisition of shale gas play XTO in 2009. That’s according to Jim Chanos (here) who called the integrated oil companies value traps and liquidating trusts for this reason. I observe: even with record capex in the past they were not able to replace their reserves organically.

Now, at lower oil prices capex will have to fall. Who knows, maybe less cash at hand will help focus the mind of management, but it is a bet you have to be willing to make. Also new reserves will likely only come from politically unstable regions (such as Exxon’s Kashgan field in Kasachstan) a risk you also have to factor in. I feel that at current oil prices there is not much margin of safety to compensate for these risks. Cisco’s dividend is safer.

Further, over the weekend there has been an interesting development regarding Exxon mobile’s book value. From the FT (here),

(…) Last week, it emerged that Eric Schneiderman, New York attorney-general, was investigating Exxon’s decisions not to take large charges to its profits for writedowns in the values of its assets following the fall in oil prices. That move built on the probe he launched last year into the company’s statements on climate change.

The SEC is now also looking at Exxon’s reporting of its reserves, asset valuations and writedowns, as well as its disclosures on the risks that climate change creates for its business (…) 

Wow, the SEC is questioning Exxon’s asset valuation, i.e. its book value – although the stock price is trading near its all-time high and nobody has lost any money.

And for a good reason: Management at Exxon, you know the guys who have spent billions on capex when oil was at 100 without actually finding much, think that a halving of the oil price has no consequences for their book value. And what’s better: they seem to be the only ones.

I mean, even Royal Dutch has impaired their assets by USD 8 billion, or 4(!) percent of their asset value. The same goes for Chevron, which at least has reduced book values by USD 4.7 billion.

Message: do not trust these managements (and book values).


Clearly, the oil industry still believes that oil prices will recover significantly. As do many investors who either think the dividend yield is sustainable, or the optionality in case of a higher oil price is worth a lot. This view is embedded in the valuations and therefore this is not a contrarian play. The sector (average stock) is not cheap. Moreover, book value, one of value investor’s favourite metrics appears to be unreliable, just as it was in 2007/2008 with the banks. If oil prices do not recover substantially, we are going to find it out.

They really don’t know what they are doing: QE and Spanish banks

I wrote on how negative rates are destroying the Italian banking system (here). Now, there is a new piece by Exane (here, via valueandopportunity) on how negative rates might play out in Spain. Unsurprisingly, the effects are similar.

Just as in Italy, Spanish banks have heavily invested in government bonds in order to benefit from the free central bank put provided by QE and whatever it takes. Just as in Italy, private sector lending has been crowded out (it probably was too high to begin with) and, just as in Italy, the low hanging fruit has been picked, now that Spanish government bonds yield less than the 10 year US treasury.

The report is entertaining to read, but the most interesting information can be found in this table,


It shows what percentage of the respective bank’s profit before tax (PBT) comes from interest payments and capital gains in the sovereign portfolio. The percentage is lowest for Santander (SAN) and BBVA, as they have substantial operations abroad and had not engaged in foolish real estate lending to begin with. Nevertheless, their dependence on income from their sovereign bond portfolio is substantial. For others, the importance of the sovereign book is way higher. For the seven largest Spanish banks, on average, 93 (!!!) percent of pre-tax net income comes from gains and income on their sovereign books.

The report mentions that the average remaining duration of the sovereign book is between 3-4 years, which means that over the next half decade virtually all of the Pre-tax profit in the Spanish banking system will disappear, if interest rates remain where they are.

Macro economists, as employed by central banks, no doubt would answer that this is exactly the purpose: force banks to lend more and help the economy grow out of the high debt (circular reasoning being a requirement for a PhD in this field).

They forget that in order to lend more to the private sector a bank a.) needs equity and b.) needs to find enough suitable costumers.

As for the equity, most of the equity in Spanish banks consists of tax loss carryforwards, i.e. it is not really there and not available to cover losses – and everybody knows that. Everybody who is not a macro economist, that is.

As for the costumers, Spanish banks are losing their best and biggest clients to – you guessed it – the ECB and to the bond market. Ask yourself: why should big Spanish corporates (Initex, Endesa etc.) pay the overhead costs for such unnecessary things as underwriting departments and bank branches, if they can pay near zero in ETF and central bank dominated bond markets?

Answer: they don’t.

Thus Spanish banks are trying to find costumers by tricking Spaniards into credit card debt with opaque zero cost offers. If the only way you hope to grow your loan book profitably, is to screw your costumers, I would say that this is neither the way to grow your economy, nor sustainable.

There is no conspiracy – central banks really do not know what they are doing.

Why commodity companies might not be as cheap as they seem (and GMO is likely wrong)

Excellent piece by GMO on investing in commodity stocks (I do not know why they call them resource equities, probably for marketing reasons).

There are very useful long-term charts comparing investing in equities vs. investing in the commodity directly. They show that equities in commodity producers have delivered a significant positive return even in the absence of a secular commodity bull market. Further, they demonstrate that for financial investors it is really the only alternative, as the long-term returns from investing in futures are horrible, as a result of negative roll returns. The charts are very useful if you want to market a commodity equity fund.

However, the following statement irritated me,


According to the metric they use, a combination of normalized historical earnings, P/B and Dividend Yield, the valuation of the energy/metals sector has the lowest historical relative valuation on record only matched with 1998 the days of 10 dollar oil.

The reason I was irritated, is that recently when I looked at a few oil mayors, I felt that at the current price level their valuation was excessive and their dividend not sustainable. Moreover this was true across the board, whether it is Exxon mobile or OMV (Austrian integrated oil company).

Just look at Royal Dutch Shell, with a dividend yield of over 6 percent, a normalized (5y) PE of 11 and trading at a price book of 1.3. That’s looks cheap according to GMO’s chosen metric and, no doubt, represents a significant discount the S&P 500.

Just how reliable are these metrics in this case?

The dividend yield at over 6 percent, no doubt is sporty, but in 2014 the dividend cover was a meagre 1.3 whereas in 2015 it dropped to an absolutely unsustainable 0.2. In other words: in the recent past Royal Dutch has paid dividends by tapping the generous debt markets. Clearly, there could be one-off effects on net income that have distorted the dividend cover and we should take that into account.

This brings us to normalized earnings. Obviously, if you believe that the normalized PE of 11 is representative, you will not be overly worried by the low dividend cover of the last two years, as it implies a sustainable 9 percent earnings yield.

But how representative is it?

Let’s look at the main P&L categories to get a better feel for the figures.

Year Net Income EBIT EBITDA
2011 30.9 42.7 55.9
2012 26.7 37.7 52.3
2013 16.4 26.9 48.3
2014 14.9 19.9 44.4
2015 1.9 -3.3 23.5
Average (bn USD) 18.2 24.8 44.9

Unsurprisingly, the figures show that the degree of profitability of any integrated energy company heavily depends on the price of energy. Furthermore it can be seen that 2014, when oil prices started to drop from 94 dollar per barrel to 50 dollar at YE, was still a very good year courtesy of a high average oil price for the whole of 2014. So, for four out of five years used to normalize the earnings saw an oil price trading in the 80-100 USD range – pretty much 100 percent above where we are now.

Normalizing earnings in this case only gives you a good picture if you forecast significantly higher oil prices going forward. But this would involve bold forecasting of oil prices and even Jeremy Grantham contends in his piece that this is impossible.

Unless oil prices significantly increase from here, expect the dividend to be cut or debt to increase further.

Now let’s look at P/B the last metric GMO uses. No doubt, Royal Dutch at a P/B of 1.3 looks cheap relative to the market, but this should not be surprising in a market dominated by tech and service companies with their high (and mostly irrelevant) P/B ratios.

The biggest issue I have with this metric, however, stems from the fact that book value is not what it used to be, i.e. a pure and objective measure of how much has been invested in the business so far. Royal Dutch values most of its assets on an expected cash flow and DCF basis, i.e. it is forward-looking and subjective in nature. Currently they are implying a 6 percent discount rate reflecting the record low-interest rate environment. Put differently, the book value is an implicit bet on low rates.

For this reason I prefer another valuation metric. Given that I cannot forecast oil prices the most reasonable assumption is to take the average price for last year, the first full year of 50-60 USD oil and see what they can earn on that basis. As it seems that net income and EBIT figures for 2015 are somewhat distorted by impairments on assets, I will base my analysis on the EBITDA for 2015 which amounted to 23.5 billion dollars. I will be generous and assume that management is able to cut costs (after all not all profitability depend on the price alone) to deal with the new environment as well as squeeze some synergies from their recent acquisition and postulate that the normalized EBITDA at the current price level can be around 30 billion dollars, i.e. an improvement of 30 percent.

At an enterprise value of 350 billion this translates into a very high normalized EV/EBITDA ratio of slightly below 12. Remember, this is for a business which depends on higher commodity prices and substantial capex for sales growth. Furthermore, the nature of the business is such that constant investment is required to replenish reserves. Over the past 10 years, for instance, Royal Dutch has constantly invested between 150-200 percent of depreciation without significantly increasing its oil reserves (although they have increased their liquefied nat gas capacity), a period over which it has constantly been free cash flow negative.

In line with that, management expects capex spending of about 25 billion per annum for the for the forseeable future. All this results in an expected free cash flow to the firm of 5 billion USD, not even 2 percent of the value of the business. The valuation rests on energy prices rebounding substantially.


All three metrics used by GMO rely on a significant rebound in oil prices in order to be valid. I believe the case of Royal Dutch Shell to be representative to a large extent, at least for the large players. Mr. Grantham implicitly is forecasting higher energy/metals prices. Whether this will happen or not is anybody’s guess, but given that nothing has happened in China yet, I would not bet on it.

Is Investment Spending really too low?

There has been much talk over the past decade about the comparatively low level of aggregate capex spending in the US and Europe. Low investment spending, despite ever lower interest rates, are the main reason why such absurdities as negative rates and endless QE are necessary according to the economic mainstream – because, you know, liquidity trap.

I have been writing about this issue in the past (here) and recently had a discussion in the comment section of the quite interesting moneyness blog (here) on this topic. In essence, I argued that there are many factors affecting investment decisions, the interest rate is just one of many and for some sectors and industries clearly not even the most important one. Economies are too complex to be modelled assuming a simple linear relationship between interest rates and investment spending.

And then I came across this chart,


Who says there has been no capex growth?

With the CNY being more or less fixed to the USD over this time period, it certainly is logical to include China into any analysis involving the effect of Fed policies. As you can also see, investment levels really took off in the aftermath of the financial crisis. Contrary to what one reads, it seems that low interest rates and QE have indeed boosted investment spending. Just not in the US and Europe.

Now, the interesting question: why China, and not the US (or Europe)? Why has there been no corresponding boost in investment spending in the developed economies?

Well, as I already mentioned, there is more than one factor at work. And for various reasons low interest rates seem to have “worked better” in China. From environmental regulations to more flexible labour laws etc. there are ample arguments why China has responded the way it has.

But the most important factor, I believe, is due to the top down decision making process employed by the Chinese mandarins that underlies most investment decisions. Actually, the decision function of Chinese communist leadership likely even resembles the abstruse models the Fed uses to set the “correct” interest rate – similar, that is, in its simplicity of cause and effect. Add to this the supremacy of political objectives over the profit motive, leading to the subsidization of loss making industries ad infinitum and you get the dynamics depicted in the chart above.

Naturally, the decisions made in China, however uneconomic, affect the profit expectations of private businesses in the US and Europe as well. Unless you are a capital goods (think Germany) or commodity exporter (Australia), you will be cautious to expand your business organically knowing you are competing against an irrational market participant with deep, deep pockets. Think steel, think solar panels and many other sectors. Moreover, the announcement of the Chinese to enter into any sector higher up the “value chain” must send shivers down the spine of board members in the respective industries. No wonder buybacks and M&A are more attractive.

The Chinese cannot do this forever, of course as costs are increasing even in the absence of tighter Fed policy. But the capacity of the Chinese leadership to stick with irrational economic decisions is a function of low Fed rates and increasingly so. The lower the opportunity cost of financial folly, the longer it endures and the argument can be made that low Fed rates actually crowd out productive investment in the US in Europe. Which is to say the Fed is responsible. Couple that with the devastating effect negative rates have on banks’ business models and you get the picture (here).

No matter how you look at this, the CNY is at the centre of global economic imbalances. The recent market calm and the likely shake out of the large CNY short position recorded at the beginning of the year (here) have led me to double my CNY short position at reasonable cost.

Disclosure: short CNY, short AUD

Brilliant piece on Tesla

…A headline quacked across my screen: Tesla was having customers sign Non-disclosure agreements (NDAs) in exchange for out of warranty repairs.

No other auto company I am aware of asks customers to sign NDAs in exchange for free out-of-warranty repairs. Regardless of what the company says, there is really only one reason to do that – to suppress bad news that might impact the stock price.

Elon Musk promptly wrote a blog post – in which he attacked the motivations of the journalist who broke the story –  and claimed that the NDAs were never intended to stop a customer from filing a complaint with the National Highway Traffic Safety Administration (NHTSA).  And then Tesla changed the language of the NDAs at the request of NHTSA.

Attacking the messenger, denying the allegation, and then admitting to it.  A crazy red flag…

read the whole piece here (via creditbubblestocks)

Chart of the week and the only question that matters

Whereas the real economy is being squeezed to some extent (see my last post on banking in Italy here), asset markets are enjoying record “inflows” (via Zerohedge)…

And do not forget the crazy lending binge, i.e. “social financing” in China which at least partially is dripping into western asset markets via M&A,


part of which would obviously have to be added to above documented central bank buying.

Most observers focus on retail fund in and outflows since that’s what crashed the dotcom bubble. This is like generals preparing for the last war, fund flows are minuscule compared  to central bank buying. Nowadays, the only question that matters is: how long can central bank buying last and how will it end?


The reason QE and negative interest rates are deflationary

Short answer: Because they destroy the banking system.

For a longer answer let’s start with the following chart (via allhambrapartners),


These are Italian banks’ total holdings of Italian sovereign debt – EUR 725 billion, at last count.

The reason this is so huge (it looks similar all across the Euro periphery) is QE, or in the words of Jeffrey Snider,

In July 2012, the total assets reported by the combined Italian banking system were €3.54 trillion. In April 2016, the latest data available, total assets were €3.48 trillion. Worse for Draghi, of those assets, Italian banks have nearly doubled their holdings of government securities. In other words, the ECB through his promise did not actually encourage monetary expansion into credit expansion but rather front-running into government debt at the expense of total lending. The reason for that is obvious; with Draghi’s promise in their pocket, Italian banks as banks all over Europe found an outlet for “risk free” profit in buying government bonds at huge discounts. It was not an economic consideration. The mechanism for making good on Draghi’s promise was, in essence, a (deeply) negative factor on the further expected monetary transmission!

Remember: from a bank’s perspective buying the sovereign is attractive, as it is not required to hold any capital against it, and does not even have to look at clients or financial markets for funding. Thus you get crowding out of the relatively less attractive private sector loans – the opposite of “stimulus” (and inflation).

Now, you can imagine how bad the underlying situation in Italy must be when, despite this huge riskless profit opportunity, profitability over the last few years was terrible, as evidenced ever declining stock prices and rumors of new capital needs.

But it gets worse: by following their Keynesian logic, where the only thing that matters is interest rates (and “confidence”), the ECB has started to impose negative rates and stepped up QE purchases of corporate bonds thereby driving down yields across the curve further hoping to finally revive lending to the private sector – if it hasn’t worked, try more of it.

However, whereas QE and the associated reduction of interest rates at least subsidized individual banks, if not the “real” economy, courtesy of riskless profits, negative or minuscule interest rates on sovereign bonds have the potential to destroy the banking system.

To illustrate:

Let’s assume Italian banks have earned a net interest margin (NIM) of 3 percent on the sovereign loan book above – say, they bought at an average yield of 4 percent and funded at an average yield of 1 percent. Further, assume they intend to hold the loans to maturity and booked them correspondingly, thereby shielding them form mark to market volatility. A NIM of 3 percent on 725 billion translates into a “riskless” annual operating income of about 22 billion Euros for the entire Italian banking system.

This is big, just compare to the mere 40 billion, as estimated by Prof. Zingales (see here), in capital that is supposedly needed to fix Italian banks (again) and already causing another political stir in the EU.

The problem: those bonds will have to be refinanced at much lower yields in the near future resulting in a collapse in (riskless) income.

Worse, the ECB is now actively competing for Italian (and all other European) banks’ best costumers by buying the bonds of large corporates, hence driving down the margins on the (shrinking) private sector loan book as well.

How on earth, I ask myself, are they going to compensate for the shrinking operating income?

The ECB apparently thinks that starving the banks of income will finally force them to expand their private loan books and thus “stimulate” the economy.

Fine, unfortunately this is almost certainly not going to work.

Here is why:

Assume that the NIM on the average SME or private client in Italy is currently 4 percent (in Austria it is much lower, but let’s be generous). Now, deduct risk costs of, say, 0.5 percent to arrive at a risk adjusted NIM of 3.5 percent. If you agree with my assumptions, it means that banks need to originate about 630 billion in private sector loans (mainly SME, as the margin on the large corporates will me much lower, courtesy of corporate bond QE) – about 1/3 of Italian GDP – to compensate for the missing revenue on the “riskless” government bonds.

This, now doubt, would be inflationary.

But there are technical problems. Not only do banks need to find enough solvent borrowers in what is a market with an aging population and huge structural issues, they also need capital for that – about 60 billion Euros, if you use a 10 percent capital requirement. After all, the low hanging fruit in the form of no-capital government bonds is no more.

(Note that this is a best case: if the Italian banking market would offer that attractive margins, there would almost certainly be heavy competition from German and other yield starved European banks cannibalizing these margins driving up the required loan volume.)

To sum it up: Italian banks need 40 billion in new capital just to deal with their NPLs and about 60 billion of new capital (under very generous assumptions) to be in a position to increase their loan book to offset the decline in operating income from lower rates on government bonds to maintain their meager profitability.

Not going to happen.

What is going to happen, instead, is that the earnings capacity of European banks will be more and more impaired with each passing day of low rates. When the business model is impaired, bank managements either respond by doing dumb things (remember those CDO² that ended up with German Landesbanks?), or by shrinking their business.

Shrinking bank balance sheets are deflationary by definition.

(Disclosure: no position in any bank)




Is Elon Musk a con man?

I was sceptical about Tesla’s business model in the past (here and here) and although there were a lot of red flags in plain sight (accounting, green business, PR etc.) I did not call it a fraud.

The only reason I have not voiced any accusations in this regard is because I have set myself the self-disciplining target to identify weaknesses in the potential fraudster’s business model, rather than hint at qualitative (nevertheless very important) indicators. This worked well for me in the past when I was offered to buy one of Madoff’s many feeder funds: there was simply no way the guy could have achieved his stated track record with the option strategy he claimed to use.

It also helps not to be called a pessimist and miser at cocktail parties (it is not that I don’t enjoy controversy)…

But Elon Musk and the liberal PR machine really make it difficult to stay disciplined.

Fortunately, more and more people are coming out (Jim Chanos recently called Musk ” a very good showman”) and pointing at Musks questionable business practices. The best write-up so far is by the streetwiseprofessor after Musk announced another dodgy transaction yesterday.

Enjoy the read here

(Disclosure: no position in the stock)

Misallocation of capital: the shipping industry

Excellent Bloomberg piece on the madness that is the global shipping industry.

Shipping benefits from economies of scale, i.e. as ships get bigger the unit cost decreases. Indeed, that’s what happened over the last decades as global trade has been increasing. As with all economic phenomena, marginal benefits typically are declining. The shipping business is no exception,

(…)A study last year by the OECD found that economies of scale from today’s mega-boats are four to six times smaller than those in previous periods of upsizing. Around 60 percent of cost savings now comes from engine technologies. In other words: Building smaller boats with better engines would offer more savings than going bigger (…)

But it gets worse, according to the article there are good reasons to believe that marginal benefits from bigger vessels are not only declining, but actually negative,

(…)Then there’s risk. Today’s largest container vessels can cost $200 million and carry many thousands of containers — potentially creating $1 billion in concentrated, floating risk that can only dock at a handful of the world’s biggest ports. Such boats make prime targets for cyberattacks and terrorism, suffer from a dearth of qualified personnel to operate them, and are subject to huge insurance premiums (…)

And these are only the direct costs, the fixed costs of infrastructure increase as ships become gigantic,

(…)Yet the biggest costs associated with these floating behemoths are on land — at the ports that are scrambling to accommodate them. New cranes, taller bridges, environmentally perilous dredging, and even wholesale reconfiguration of container yards are just some of the costly disruptions (…)Even when taxpayers foot the bill for such upgrades, the costs can be passed on to vessel operators in the form of higher port fees (…)

(…) In recent years, mega-vessels have caused traffic jams in the water and on-shore as overwhelmed ports struggle to offload thousands of containers. The expense in worker overtime and cargo delays can be significant. Making matters worse, the bigger ships make fewer port visits, leaving operators wondering if they should invest in costly renovations for what would amount to infrequent stopovers(…)

Add to this the fact that global trade has not really increased much since 2008 and it is no wonder that 18 percent of shipping capacity is not in use (more than in 2009).

By now, everyone should have got the message: don’t’ build more and ever bigger container ships!

Not in our times of QE and negative interest rates. Instead, the article mentions that ship owners are still commissioning more and bigger vessels. In the last quarter, global shipping capacity increased by 7 percent (!) compared to demand growth of 1 percent. Predictably the price of shipping a container fell by nearly half.

What is fascinating is that, this goes beyond the simple misallocation of capital model described in Austrian economics. Remainder: In the classic misallocation model one analyses how entrepreneurs are misled by distorted prices caused by money growth leading them to assume an unrealistically bright and profitable future. The shale gas industry in the US would be a good example.

Here, however, the misallocation is ex ante evident, nobody is assuming a brighter future.

The arguments mentioned in the article against bigger vessels are independent of what expectation you have for the trajectory of world trade, i.e. they are to some extent objective. Further, contrary to overcapacity in some industry where global aggregate data might be misleading due to the local nature of the business, shipping capacity is “fungible”, i.e. an empty ship in the US is roughly equivalent to an empty ship in Hongkong. In other words, there is an objective glut of container capacity.

I am not enough of a shipping expert to know what is causing this odd behaviour, but I suspect it is due to the presence of large players who do not care about economic profitability but some otherworldy goals (“social stability”) like government entities. Helped by low interest rates, they can engage in financial repression on an unprecedented scale in order to preserve the status quo (and their status and privileges). Ordering giant ships is pretty cool from a political standpoint: it gives you headlines and improves job statistics in the short term.

Regardless of who or what is responsible, somebody is financing this folly. I wonder who it is. Whether it is banks or government entities, once the misallocation cannot be concealed, the write-offs will be gigantic as well.

Book Review: Capital Account – A Money Manager’s Reports on a Turbulent Decade

After reading the book review of Capital Return on the excellent “valueandopportunity” blog (here), I got curious about Marathon asset management and their capital cycle approach. Thus, I decided to buy “Capital Account – A Money Manager’s Reports on a Turbulent Decade” a book that covers Marathon’s most important writings from the decade 1993-2002.


Whereas Capital Return is a collection of Marathon’s management letters from the 2012-2015 period, I decided to start with this book as I was not an active market participant back then and I am always looking to add to my limited personal experience by reading historical accounts.

And the book is a gem, indeed.

One of the things I especially enjoyed is the fact that Marathon seems to ask “the right questions”, i.e. they have an uncanny ability to focus on the relevant things when assessing the attractiveness of certain stocks or sectors. This allows them to write down their idea concisely, usually backed-up with some interesting number, but without leaving the reader with a feeling that something has been left out. We are all familiar with analyst reports where important questions are not discussed rendering them virtually worthless. Not so with Marathon’s letters, after reading them one feels satisfaction to have gained a new and fundamental perspective on a certain subject.

Here is a short summary of my main takeaways.

Management quality is paramount

Over time, the bulk of a firm’s equity consists of retained earnings that have been reinvested in the business which highlights the importance of capital allocation skills. Marathon prefers companies where management has been place for a long time, such that capital allocation qualities can be properly judged. This goes hand in hand with the need for evaluating management integrity, i.e. does management really walk the talk, or does it announce one thing, just to do something else. The letters are full of high-profile examples where this is not the case. Oh, before I forget it: they try to avoid companies where the board consists of investment bankers and management consultants – Valeant anyone?

All turnarounds are not equal

When assessing turnaround situations, it is essential to understand how the firm got into the mess in the first place. Interestingly, Marathon thinks it makes a great difference whether the problems have arisen because management was overly aggressive in targeting sales growth, or because of a focus on earnings growth. It is the latter which is relatively more problematic, as it is highly likely that management was saving on essentials (R&D, capex etc.) to reach its goals thereby potentially permanently impairing the product/brand and making high investments (at unfavourable capital costs) necessary for the turnaround to succeed – hence the higher risk.

Earnings quality, EVA and ROIC

When assessing earnings quality most investors (myself included) focus on the interplay between the P&L statement and the balance sheet. Irregularities in the working capital position or serial acquisitions are an indicator that earnings should be taken with a grain of salt, or companies avoided altogether.

Marathon goes a step further: it also looks at the earnings quality from a qualitative viewpoint by analysing capex and R&D dynamics within their capital cycle framework.

In a letter from the end of the 90ies they write how Johnson & Johnson, the consumer goods giant, had delivered earnings growth on the back of cuts in R&D. Marathon judged this to be a sign of weak earnings quality (and proof of a short-term focused management) given that Johnson & Johnson at the time did not have cost problems (high margins), but was lacking sales growth. Thus, by cutting essential costs they were not addressing their main problem, but rather were making it worse.

In their letters they repeatedly caution against the superficial use of metrics such as EVA and ROIC which do not make sense unless properly understood. They often find that the adoption of EVA leads to a short-term management focus to cutting of essential costs to boost margins as this is the easiest way to improve EVA, even if it impairs the long run prospects of the firm in question.

Most interesting, however, I found their discussion of ROIC – a value investor favourite. ROIC can be highly misleading, if not properly corrected for the “product life cycle” of a company’s products. They mention that this is especially important for consumer goods companies which can have high ROICs in combination with short product life cycles forcing them to constantly “reinvent” themselves – a notoriously difficult thing to do. A company with a spectacular ROIC of 40 percent and a three-year product life cycle might still destroy shareholder value, if its capital costs are 10 percent!

Of course, judging the product life cycle is more art than science, but there is no way around it. Keep that in mind next time someone tells you Apple is a no-brainer “buy” at a PE of 10…

Excessive valuations now and then

Given that most of the letters were written around the dotcom bubble, it was especially interesting to see how the situation back then compares to the present.

It is my impression that most observers generally agree that the current market is slightly overvalued, but not worryingly high since we are not observing excesses seen during the dotcom bubble, as evidenced by the following chart,


Yes, the current average 10 year PE for the S&P 500 is substantially above average (thick red line), but it is a far cry from the excesses seen around 2000. Add to this the fact that alternatives such as bonds, Emerging markets etc. seem relatively less attractive than back in the days and one can see why bulls (and the Fed) do not seem overly worried.

This line of reasoning has never appealed to me, however. For one, the market feels “qualitatively” much like a bubble: M&A activity, stock buybacks, proliferation of non-GAAP earnings, rising wealth inequality as well as record levels of conspicuous consumption do no neither look normal nor sustainable. It simple doesn’t feel right.

And then, of course, there is this chart,

MedianPELooking at the median PE and PS ratios one gets a completely different picture than by merely looking at PEs. According to these metrics the market is the most overvalued ever. I personally have liked this metric more, as it confirms my personal “on the ground” experience: it is hideously difficult to find anything meaningfully valued – at least for me.

The question I have been asking myself for some: how can these metrics give such conflicting signals?

I think I have found the answer while reading Marathon’s book.

One topic that comes up repeatedly in their writings at the time is the distorting effect of benchmark hugging mutual funds buying stocks regardless of price. Marathon documents how the effect of this mindless buying is amplified due to the fact that benchmark indices (MSCI et al.) did not adjust the index weights for the available float back then. Thus, a megacap like Deutsche Telekom where a substantial part of the shares was held by the German government was nevertheless fully included in the index, albeit the truly available shares were a fraction of what the weights would suggest, resulting in some sort of artificial shortage. There are plenty of similar examples in the book. Once the shortage was lifted, those stocks collapsed.

It was this artificial “squeeze” of benchmark funds that was responsible for the ludicrous valuations of basically mature businesses. I believe this was the main reason behind the ludicrously high index PE ratios seen at the turn of the millennium

Nowadays the situation, albeit similar, differs in one major respect: most indices that currently serve as benchmarks for ETFs (the index hugging mutual fund of our day) do adjust for available float and hence the type of artificial shortage of shares seen at the time of the millennium is less likely to occur. The overvaluation nowadays is broader as the mindless ETF flows are evenly distributed and it therefore shows up much clearer when looking at median ratios.

In short: a repeat of the mad valuations of large cap stocks, as we saw during the dotcom mania, is highly unlikely. The PE ratios of the indices will not reach new all-time highs and the market is excessively valued already.


The book is fantastic and it should be read and re-read many times over. I am already looking forward to get my hands on Capital Returns, their most recent book.