Month: December 2014

Buying Russia

I have been busy this week accumulating Russian assets, as the Ruble sell-off reached manic proportions. I even was not able to buy as much as I wanted due to the fact that Tuesday afternoon – at the height of the panic when EURRUB was around 96 – my broker could not find willing counterparts who would trade RUB with him for fear of capital controls.

Yes, that’s right: yours truly almost was lucky enough to get in at what now looks to have been the bottom, but was not able to buy a rapidly depreciating currency in sufficient quantity!

I have traded quite a few EM panics, but I had never experienced anything similar. This left me somewhat perplexed which is why I did not think about the possibility of buying ADRs in London – the only viable option at the height of the panic.

In the next days I will try to find time and explain my rationale in detail, for now I just want to make a few short remarks.

I am supposed you are familiar with the bearish view, as most newspapers are full of gloomy headlines and pundits on TV explain how this looks like a repeat of the 1998-99 Russian crisis. So, I will not repeat them here.

If you have time for maximum negativity, I highly recommend the streetwise professor who is as bearish on Russia as you can get. I do not remember him having said anything positive about Russia ever (the same goes for his followers if the comment section is any guide) – this serves as a valuable anchor.

But now, let’s look at a few facts

According to this Bloomberg article, Russia, in 1999, had less than USD 13bn in reserves versus USD 133bn in external debt, i.e. external debt load amounted to 10x reserves in 1999 – very bad, no doubt!

What about today?

Via FT-Alphaville I got this chart produced by BNP Paribas. It displays the evolution of external debt vs. reserves since 2008.

RussiaReserves

According to the chart, total external debt (private AND government, mind you) stands at USD 600bn (ahem, that’s just slightly higher than Greek government debt) vs. USD 400bn in reserves, i.e. a factor 1.5 x (vs. 10 x in 1999).

It is hard for me to see how this is a repeat of 1998-99, but then I am not a journalist at the FT.

Note, how the team at Paribas only uses central bank reserves and seemingly ignores the FX assets at the National Wealth and Reserve Fund. I deduce this from their headline which says that Russia is twice as levered as in 2008. This statement only makes sense if you compare external debt to central bank reserves only (dotted line) excluding the two funds’ assets.

There is of course no good reason to exclude said funds from our calculation, as all these assets are perfectly available to meet FX refinancing demand.

To summarize: according to this metric Russia was not levered at all in 2008 and is slightly levered today.

Manageable, I would say.

But does the metric (reserves to debt) tell the whole story? After all we know that some Russian companies faced USD shortages and had to be bailed out, despite the fact that aggregate reserves matched external debt in 2008?

As is well-known, an aggregate conceals very important relationships and is a poor basis for decision-making. For instance, when talking about liquidity the maturity structure of the liabilities is often much more important than their size. And indeed, the following chart by Goldman shows how the short-term net cash position of Russian corporates was dangerously depleted going into 2008 – the opposite situation of today, where it stands at a record 90bn. The same goes for Russian banks (second chart).

20141215_GSRUB2_0

Again, judged by this metric the system looks even better prepared than in 2008, let alone 1999!

With the notable exception of Rosneft’s 44bn short-term debt overhang (stemming from a dumb acquisition) most big Russian corporates I have managed to look at in the last few days are comfortably financed until the beginning of 2016. And by then they should have generated enough FX to meet longer term redemptions as well. Many journalists seem to forget that for most of these companies it is prudent to have USD liabilities as their revenues are in USD as well, i.e. they are naturally hedged.

Summary:  that 44bn doesn’t strike me as an unresolvable problem. It certainly isn’t going to ruin Russia.

But what about bank runs? Aren’t the Russians converting their RUB into hard currency?

You bet they are!

But, again, how big is the problem?

The following chart, again via Goldman, compares central bank reserves to aggregate money supply (M2),

RussiaReservestoM2
Interesting: at current USD/RUB rates Russia’s reserves cover basically most of its money supply (physical as well as deposits). In other words: the Russian central bank could redeem all the RUB in circulation and on deposits with the USD, i.e. the RUB is entirely FX backed.  Of course, I do not think this is going to happen, it just helps to put things into perspective.

Conclusion

A fully FX backed currency that pays 17% doesn’t sound like a bad investment to me…

(Disclosure: Long RUB and select Russian stocks and bonds)

 

Follow Up on my shale post

I wrote about my thoughts on shale oil here in October.

Over the weekend David Stockman has come out with a great piece on how the shale boom is nothing but a Fed induced malinvestment spree. This is the best quote:

(…) Obviously, what we have here is another massive deformation of capital markets and the related flow of economic activity. The so-called “shale miracle” was not made in Houston with some technology help from Silicon Valley. The technology of horizontal drilling and well fracking with chemicals has been around for decades. What changed were the economics, and those were made in the Eccles Building with some help from Wall Street (…)

This quote says it all. It looks as if the scepticism of my engineer-friends over here was well founded. The “shale-revolution-based-on-new-technology” story seems to have been merely a canard made up by Wall-Street in order to easier raise capital (mainly debt). And there is nothing better than a new technology storyline to sell financial “products” to credulous investors. Surely lots of journalists were “wined and dined” in order to spread the word about America’s innovative capacity here in Europe. Well done!

The anomaly is this: debt finance is mostly unsuitable for a business model like shale oil whose constant drilling with inevitably high failure rates has risk characteristics of a start-up enterprise.

And start-ups should not be financed with debt!

Further, constant drilling is required because of high depletion rates. David Stockman writes that, on average, 90% of a well’s capacity is exhausted after only two years, effectively resulting in a maturity mismatch between assets and liabilities (typically 5 years) – a toxic combination.

As Mises wrote in his 1912 book “Theory of Money and Credit“: it is not only the amount of debt, but also its structure (maturity, covenants) that matters – something which is still not grasped by most mainstream economists (see, for instance, my post about Eugene Fama on Fed QE here).

To be fair: the fact that financing structure during a boom is subject to changes was also observed (although much later) by the now-popular Keynesian economist Hyman Minsky. Of course, Minsky – an empiricist – merely described what he had observed without providing a theory of why market participants behave the way they do (unless you consider”greed” a scientifically valuable explanation) – and of course without ever explaining why/how government officials who are supposed to regulate all this should know better.

Minsky, was on the right track and his work is a useful collection of data. However, without a proper deductive theory he could not connect the dots.

Conclusion

The wrong kind of investments financed with the wrong instruments hints at a malinvestment boom. This not only means that increased defaults are a certainty unless the oil price recovers, but also that a lot of people have gotten the risk assessment on this part of their portfolio holding completely wrong. A large amount of non-natural holders of risk increases the probability of contagion and spill-overs.

Finally: The Profit margins debate has been settled

The question of elevated profit margins has occupied investors for quite some time. You know what I am talking about: US corporate profit margins, as measured by national accounts NIPA data, have been above average for the better part of the last decade (see chart below).

CorporateNIPAProfits

The question is whether this margin series is mean reverting or not. The issue is not merely academic, but has serious implications for investors: if mean reversion can be expected, current profits, on average, need to be adjusted downward and stocks would have to be considered expensive. In the opposite case, stocks could be reasonably valued on their current PE rations suggesting a fair value and possibly further upside potential.

Who is right?

Eyeballing the chart suggests there is some mean reversion going on. Even better, mean reversion has some theoretical support: Jeremy Grantham of GMO has consistently pointed out that under a capitalist system this chart has to be mean reverting due to the competition which is attracted by above average margins and returns.

Productivity, the service economy and foreign profits

Opponents of the mean reversion story, such as Bruce Greenwald for instance, argue that “this time it is different” pointing out that there have been productivity gains as a result of the IT revolution and that a larger share of the services sector automatically means higher aggregate margins.

Another line of argument says the high NIPA profit margins are a result of an increasing share of foreign earnings for S&P companies: since profits on foreign sales are reflected in profits (numerator) whereas foreign sales are not counted in GDP (denominator) the figure is automatically skewed upwards, without necessarily suggesting above average profitability.

I have tended to be in the mean reversion camp. After all, it is supported by theory and historical evidence. The increased productivity and higher profits margins arguments never convinced me. Such an increase in productivity should materialize in broadly increased wealth. With lower and lower GDP growth rates and a sputtering recovery and I think this case is hard to make with all the social issues pressing the western world.

The same goes for the allegedly higher structural margins of the services sector: first, I fail to see why the margins of the services sector should be structurally higher. Why shouldn’t there be the same competitive pressures as, say, in the manufacturing sector? Given, that the services sector is less capital-intensive, you could even argue its margins should be lower. Second, it is exactly in the high margin services sector that we see most innovation and competition. We have seen plenty of IPOs of companies that try to compete for Google’s ad revenues. It is not unlikely that sooner or later one or more of them will succeed.

However, as you might have inferred from my use of the word “tended,” I have had doubts.

For one, the “foreign profit” argument has been laid out nicely here. Although, I have a few reservations, it is a well laid out case.

Aggregates are a poor basis for decisions

Further, in good old Austrian tradition, I heavily distrust aggregate figures on which most of the arguments of both camps are based.

As is well-known, national accounts are subject to numerous revisions and distortions – the “foreign profit” camp bases its argument on such a distortion – and to a large part they are based on estimates (imputed rent, deflators…) not market prices. Worse, there have been serious methodological changes over time in how the aggregates are constructed. It doesn’t have to be as extreme as was the case in Nigeria where GDP doubled overnight do to a methodological change, but the effect is there. In my view, this cannot be a reliable basis for any decision. But then, I am not Paul Krugman and do not teach at Princeton 🙂

Unfortunately, aggregate stock index data is not much better suffering from survivorship bias, share count changes and the like. Lots of the companies that generated the historical earnings of the S&P index have been replaced by new companies.

For these reasons, I have always thought that the debate can only be meaningfully settled by a bottom up analysis of the current S&P constituents. Since I was too lazy to do it on my own, I was delighted when I stumbled upon an article titled “Why Jeremy Grantham is Right about Corporate Profit Margins” whose authors did exactly that. This is what they did,

(…)Our data sample consists of 1,079 companies that were members of the S&P 500 index between 1989 and 2013. Given that we are performing our analysis utilizing the components of the S&P 500 index, there is some noise in our calculation introduced as a result of inclusions and exclusions of companies in that index. All data, including fundamentals and price data, are from Factset Global.

We have excluded the financial sector from our analysis, given the significant differences between the income statements of financial businesses versus other businesses, i.e., our analysis uses the S&P 500’s non-financial components. This exclusion means that the yearly average number of companies in our analysis is 408, less than what would otherwise have been the case2. For every calendar year, we utilize the fundamental data of all non-financial companies that were a part of the S&P 500 at the beginning of the year. Data reported anytime in a calendar year is assigned to that calendar year.

All calculations were performed on an aggregate basis. For example, instead of calculating profit margins for every company and then applying a weighting process (e.g., equal weighting or market-cap weighting), we calculate total sales and total profits of the index and derived the index’s profit margin using these totals(…)

I think it makes sense to exclude financials, as their earnings are much less reliable due to the big room management has to massage the numbers especially under abundant liquidity conditions. Further, I would argue that over the long-term financial earnings are a function of the health of the corporate sector anyway. It is difficult to lend profitably if your clients do not earn nice margins themselves. This is what they’ve found,

bottom_UP_ProfitMargin

This settles the “foreign profits” argument once and for all. Yes, profit margins are indeed above average and it has nothing to do with the fact that foreign sales are not counted in GDP.

What about the “higher share of services leads to higher margins” argument?

In order to answer this question the authors have looked at sector margins. Below are the charts for the consumer discretionary and consumer staples sectors.ConsumerDiscretionaryBottomUP

Profit_Cons_Staples

Hmm, both of these non-services sectors sport near record margins. It looks, as if Bruce Greenwald’s view doesn’t hold water. Doesn’t convince you? Let’s look at industrials,

IndustrialsMarginbottomup

Wow, the profit margin of industrials is at a record high.

I consider this topic settled: the higher services share cannot explain aggregate high margins either.

What about higher productivity?

In order to assess whether there have been productivity gains, the authors have the following to say:

(…)As we discussed earlier, one of the reasons offered for the structural shift upwards in profit margins is that technological progress we have made over the last couple of decades and the productivity gains achieved have lowered costs. If this were true, we would see a significant improvement in gross profit margins3 as cost of production per dollar of sales would decline (…)

Sounds logical, here is the chart:

EBIDTA_bottom_UP

Uuups, gross profit margins are not only below average, but have been trending lower for the past decade – no productivity gains to see here.

So what are the reasons for the elevated margins?

The authors have identified the following three factors behind the high margins:

  1. Lower depreciation expense as a percentage of sales
  2. Lower SG&A expense (advertising, R&D, software development…)
  3. Lower interest rate expense

I would probably also add the lack of real wage growth and high government deficits. Government business is usually high margin since you are selling to a dumb, non-economic buyer.

Strikingly, both, depreciation expense as well as SG&A expenses have been falling, which I interpret as a sign that capital consumption in the economy runs high – typical for inflationary periods, such as the past 15 years (I define inflation as an increase in money supply). This is also consistent with record high margins for the consumer staples and discretionary sectors.

Conclusion

This is an excellent analysis that has long been overdue. If no methodological mistakes have been made its insights are extremely valuable and profound.

Although, I have doubts on whether our social order can still be considered capitalist and consider the competitive mechanism seriously hampered, I think profit margins nevertheless will mean revert.* One way, that doesn’t rely on competitive forces, would be via capital consumption which has to show up sooner or later in a reduced standard of living (political unrest) and/or higher interest rates via bankruptcies, once the market realized that the cash flow generating capacity on the asset side has been undermined.

* I sympathize highly with Peter Thiel who argues that innovation occurs mainly in unregulated industries (internet etc.) and argues that the lack of creative change in traditional industries is due to excessive regulation, not because of a lack of potential. Clearly, in a world of increasing regulation and taxes incumbents have a huge advantage over potential challengers.