…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…
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?
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.
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)
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)
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.
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,
Looking 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.
Excellent bloomberg article on banks’/investors’ commodity exposure.
Here are the most interesting quotes,
Yield-hungry bond investors sucked up a lot of the debt that was issued and now hold about $2.1 trillion of outstanding notes. They’ll be first to feel the pain considering Standard & Poor’s has already downgraded securities equivalent to 47 percent of that amount and made some 400 negative-ratings moves in the basic materials and energy sectors over the past 12 months alone. Such scale and depth is reminiscent of the way banks were slaughtered by ratings companies during the 2008 financial crisis.
It’s unclear where the other portion of the $3.6 trillion in liabilities lies but probably, most of it is owed to banks. If the remaining $1.5 trillion is indeed on the balance sheets of financial institutions, that would represent about 1.5 percent of the total assets of all the world’s publicly traded banks. That doesn’t seem very significant, or any cause for concern. But to put it in some context, U.S. subprime mortgages represented less than 1 percent of listed banks’ assets at the end of 2007.
1.5 percent of listed banks’ assets is a significant amount given equity ratios of about 5 percent on average, and taking into account that the bad loans from the previous crisis have not yet been dealt with (curtesy of low interest rates), as evidenced by stubbornly high NPL ratios across Europe.
Also do not forget that these loans are not evenly distributed, but on the books of banks with close connections to the commodity industry. The average doesn’t tell the whole story. Since the modern financial system is based nothing but confidence, one can see how one major player’s difficulties can translate into a financial crisis.
Make no mistake: the comparison with subprime is well deserved,
Five years ago, those companies tracked by Bloomberg had more operating income than debt, on average. Now, it would take them more than eight years’ worth of current earnings, without provisioning for interest, taxes, depreciation or amortization, to clear their combined net obligations.
An average net debt/EBITDA of 8.1 means these are really bad credits. The average energy loan is well worth less than par. Especially since depreciation is a very real expense in an industry where assets deplete rapidly…
One can see the potential…
There has been increasing coverage on China’s capital flight problem over the past few weeks. The press love a good story and it has become one after statements by a few well-known hedge fund managers on shorting the Chinese currency have triggered an angry response by Chinese officials. This FT article pretty much captures the mood,
If currency investors were in any doubt over how to characterise the renminbi’s rollercoaster drama last month — a scuffle perhaps, or a skirmish — then China’s ruling Communist Party made it clear: this is war.
Last week the Chinese party mouthpiece, the People’s Daily used a front-page editorial to warn hedge fund manager George Soros off a fight over the renminbi and the Hong Kong dollar in a piece titled “Declaring war on China’s currency? Ha ha”.
So the PBoC is fighting speculators putting pressure on the Yuan peg. No man, no problem.
But, what if those speculators are less important than commonly thought?
Worse, what if “capital flight” has less to do with classic capital flows, i.e. the capital account, but is a result of activities in the “real economy”?
Then fighting those speculators is pointless.
The chart above that depicts China’s gross current account statistics. This is an unusual sight, as we usually only look at the net numbers such as surpluses or deficits. Looking at the gross figures, one can see that the export and import flows (leftmost bars) dwarf the amounts on the capital account side, i.e. those that are labelled “capital flows”. In other words: they are the “real thing”, not the speculators.
The author argues that by looking only at the net number, the trade surplus/deficit for instance, as a proxy for hard currency inflows, one implicitly assumes that all FX earned through exports is converted to the local currency (i.e. leads to an equivalent rise in FX reserves), whereas all exports have to be paid in FX (i.e. are a drain on reserves). This is a big assumption.
There have been rumours of how the Chinese use invoicing tricks to circumvent the capital controls for a long time. Indeed, I have shown in my last post (here), that the use of CNY outside China (offshore deposits) has indeed increased massively over the last five years thereby implying that not all imports have to be paid in FX, but that this is rather a function of appreciation/depreciation expectations.
The author goes on to show how the conversion ratios for imports and exports have developed over the years,
And the result is very interesting (at least for me): around the beginning of 2014 exporters have decided to swap less FX into CNY, just as exporters to China have increasingly insisted on being paid in FX (rather than CNH). Not for nothing have those offshore deposits (see here) peaked around the same time. In short: there must have been a shift in expectations long before the PBOC devalued the CNH this summer.
As I said, pretty interesting; and to a large extent outside the control of the PBOC as it cannot influence the preferences of exporters to China on how they want to get paid.
Now, do I feel more confident that my trade will work out in the near future?
Unfortunately, the answer is no and it has to do with this statement from the above mentioned FT article,
(…) Name me a US hedge fund that isn’t short the renminbi still,” says one Asia-based strategist. “They all have to be — their investors expect it — even if they’re not sure what will happen next (…)
I do not want to sound too cynical, but there is no way that a lot of hedge funds will profit from this trade – markets simply do not work like that.
So I don’t expect a devaluation before 2017…
Disclosure (CNH, AUD)
Via today’s FT (here) comes this interesting chart,
It shows the evolution of offshore renmimbi deposits over the last decade. Unsurprisingly, demand for Yuan has been falling recently after literally exploding since 2009.
But how far will it go? Will it stabilize at this level?
I believe the outstanding will revert back to its pre-2009 (i.e. pre-QE) level, as most of the demand has been speculative in nature. If offshore renmimbi accounts had been necessary for conducting Chinese trade, they would have existed before 2007 when global trade was booming. In other words: it is not a coincidence that those deposits took-off after the fed had committed itself to an easy money policy luring speculators (mostly Chinese corporations) into the carry trade. Now that this trade has become unattractive, so has holding renmimbi outside of China where you do not need it to pay your bills/taxes.
At a more fundamental level, it is atypical to see a currency offshore, unless – of course – if you are talking about the reserve currency (the USD and the EURO in CEE).
But is the CNY not a reserve currency, now that it has been included into the SDR basket and thus shouldn’t we expect it to “appear” offshore?
No, no and no!
A reserve currency CANNOT be introduced by political fiat, it is the result of preferences of market actors globally. Second, reserve currency status seems to be something of a “winner takes all” phenomenon, given that even the mighty EUR and JPY don’t appear in offshore accounts that much. With the USD rising, its reserve currency status seems certain for the forseeable future…
Ask yourself: how likely is it that market participants will voluntarily choose to transact in a currency that is not freely convertible and whose percieved short-sellers are threatened with jail or worse?
Now you know where demand for CNY is headed…
Disclosure: short CNH and AUD
As suspected in my last post (here) capital outflows are increasing, rather than abating. From Deutsche Bank,
China Dec FX reserves was just released at $3.33trn, a drop of $108bn from prior. This was much worse than market expectation and the lowest level since December 2012. After adjusting for FX valuation ($17.2bn), our model estimate possible intervention to be around $125.5bn. This would be the largest USD selling performed by the authorities on record. Do note in August when China had a one-off devaluation, USD selling was only around -$100bn. Given the sizeable drop in FX reserves, FX outflows could be around $156bn, also the largest on record.
I do not believe for one second that China is not massaging its reserves – that’s what central banks have done historically when it gets tough. You can safely assume that the true picture is likely to be uglier…
This is by no means confined to the Chinese. Before Christmas some eminent German newspapers came out with a story that the ECB has purchased much more government (read:PIIGS) bonds than previously disclosed. See the full story (here, unfortunately only in German). The english-speaking press has curiously remained silent over this issue, at least I could not find anything.
Is this because they are predominantly Keynesian and think it is a good thing anyway, if markets (and Germany) are duped into doing the “right thing”?
Disclosure: short AUD, short CNH