My full notes and analysis on the Wall Street Journal from the past week: January 17-22, 2017 (Week 3). Please Enjoy.
Buffett & AIG
AIG paid Berkshire Hathaway $10 billion to bring “stability to their balance sheet” and gives them “greater certainty”. (link)
Meanwhile, Warren Buffett has said, “We pay a high price for certainty.” Howard Marks added to this comment, “People who want to buy bargains should prefer uncertainty.”
Translation: AIG paid a high price and Buffett got a bargain.
China & Autocatalytic Reactions
China’s economy achieved yet another year of “stable” GDP growth, but their growth comes at the expense of increasing disorder everywhere else in their economy. This type of behavior is known as an “autocatalytic reaction.”, which is a mental model that I now use to think about China’s economy.
Autocatalytic Reaction: “Order can be created in a system by an even greater decrease in order of the systems surroundings…The order of the Earth’s atmosphere increases, but at the expense of the order of the sun. The sun is becoming more disorderly as it ages and throws off light and material to the rest of the universe.” (wikipedia)
China creates GDP Stability at the expense of Economic Chaos everywhere else. Below are examples of China’s autocatalytic economy in action.
- IMF Raises Growth Forecast for U.S. Economy (link)
“(China) is laboring to keep growth chugging along…the government used its long-worn playbook of state policies to stimulate growth.”
- China Hits Growth Goal On Big Does of Stimulus (link)
“Beijing is expected to double down on old growth drivers this year – including fiscal spending and the property market- to keep the economy stable in an important year of leadership change.”
“Beijing posted the lowest annual growth in a quarter-century, and economists say it only got there by relying heavily on short-term measures that are likely to delay much-needed reforms to bloated state-owned companies and the country’s inefficient financial system.”
- A Risky Twist on Repo Trade in China (link)
These “dai chi” agreements are outrageous…Used to temporarily move funds around in order to skirt government audits, as well as take on more risk. Doesn’t this sound familiar to AIG and credit default swaps?
“A little-regulated practice that companies have used to borrow hundreds of billions of dollars and move risky assets temporarily off their book.”
“The risk is that dai chi agreements tend to be informal and often don’t leave a paper trail.”
“These transactions, by one estimate, may easily top $1 Trillion in value. The practice is just one of the many unexpected risks that have sprouted up in China’s long credit boom.”
China’s credit boom has “helped send Chinese bond prices to a 14 year high in mid-August and pumped up markets for everything from iron ore to garlic.”
“Traders say the deals are so opaque that even estimates are hard to make.”
“Banks sometimes use the dai chi agreements to move risky assets temporarily off their books during earnings periods or audits, the people said. Brokers like Sealand typically use them to borrow quickly and flexibly-leveraging their investments many times over,”
- Copper Tethered to Dollars’ Moves (link)
Chinese investors are grasping for any investments to get their money out of China or the Yuan. As a result, they are creating volatile and unusual behavior in Copper prices, among other asset classes.
“Metals and other commodities that are priced in dollars tend to fall when the dollar appreciates…But copper and the dollar have been moving nearly in lockstep recently, a phenomenon that many analysts attribute to rising appetite for copper among Chinese investors seeking to protect their wealth against the risk of a sharp Yuan depreciation against other global currencies, primarily the dollar.”
“In November, the correlation between copper and the WSJ Dollar Index reached its highest level since 2007.”
“In five hours on one day, we say (copper) prices trade in a range that would normally take a year” to play out.
- Bitcoin Trading Faces Greater Scrutiny in China (link)
“China is trying to limit the ability of Chinese individuals and companies to move their wealth abroad, a trend that contributes to a depreciating Chinese yuan and risks destabilizing the broader financial system.”
Trump & China
If Trump stops China from dumping highly subsided products into our markets (link), I think he’ll unintentionally destroy the lynch-pin holding together China’s economy…highly subsidized factories.
To give more detail to this picture, this is what I imagine much of China’s economy looks like:
- China’s local governments fund themselves by land sales and real estate development. But the land is only valuable if there are people and jobs.
- The easiest way to create jobs is to subsidize industries which can generate LOTS of jobs, like steel production. Steel production creates jobs in mining, transportation, energy, engineering, and of course factory workers.
- With lots of people working, or soon to be working, demand for real estate skyrockets. This in turn creates more jobs because workers are needed to build all this new real estate.
- It might be ok if only a few cities in China used this model, but I believe this to be pervasive. As a result, China is creating WAY too much steel and other products. With an oversupply of subsidized goods, they must dump them into U.S., and global markets for whatever prices they can get.
If the Trump administration stops China from dumping its highly subsidized products into the U.S., subsidized factories all over China will quickly implode and take entire cities with it. Being so highly leveraged, China is not in a position to handle the impact of such an event.
This of course is just my hypothesis, and I welcome any disconfirming evidence.
“Retail Meritocracy” & Deteriorating Moats
It feels like we’ve entered a new area that I’d like to call “retail meritocracy”. Brand names use to serve an important role in signaling both value and quality to consumers. But with easy access to internet reviews and scores, brand name goodwill seems to be rapidly deteriorating for many companies.
Luxottica appears to be a good example. Luxottica has a dominant position in the old world distribution and marketing platform of sunglasses and eyewear. In this old model, floor space and brand names served as a solid barrier to entry. But there’s been a trend towards commoditization of sunglasses and eyewear as consumers become more comfortable with buying off-brand names like Warby Parker. Online reviews, ratings, etc. have weakened Luxottica’s competitive moat.
- Merger to Create Eyewear Giant (link)
“The merger joins two companies that previously risked stepping on each other’s toes as Luxottica expanded into lens manufacturing and Essilor moved into frames…both companies could shrink because of a harsher price competition for frames and lenses.”
- Why Golfers Covet the Costco Ball (link)
In another example of “retail meritocracy”, Kirkland brand golf balls became a hot selling items when it was discovered that they perform nearly as good as Titleist Pro VI golf balls. “This is just a perception killer,” The Kirkland golf balls retailed for $1.25/ball, while Pro VI’s retailed for ~$4/ball.
We have entered a time of retail meritocracy where many brand-name-moats are being eroded more quickly than anticipated.
Know what’s being measured
It’s important to know what’s being measured. Sometimes we forget. Here are some examples:
- Private Prison Industry Gets Boost From Election (link)
A likely example of lying with statistics.
The DOJ found that private prisons were more dangerous than government-run facilities.
“Contractors criticized the report, saying it compared private and government-run prisons even thought they house different types of criminals.”
“The private facilities are dominated by lower-security, illegal immigrants who have committed crimes, a demographic in which gangs are prevalent.”
- Rocky Route for Rail Line (link)
“If you cut 30 minutes off, I’d be for it,”
Note: Nowhere in his comment does this frequent Amtrak traveler consider the $120 billion cost.
- Fed Officials Shift focus on Growth (link)
When the Fed and U.S. Government talk about the success of their economic programs they largely speak of 1) an increase in overall demand and 2) a reduction in unemployment. When they say the economy is “healed”, they are likely measuring it by overall demand and unemployment numbers.
Global Growth Fuels Netflix Surge (link)
“The streaming video giant has prioritized growth over profit as it pursues its international rollout”
Success is being measured by user growth…which is the same metric used by Netflix’s competitors. All of its competitors are foregoing profits for revenues…
Oops! When Little Errors = Big Mistakes.
Two examples of little mistakes that lead to big errors.
- Student-Debt Picture Darkens (link)
The U.S. government WAY underestimated how many students have “defaulted on or failed to pay back their college loans.”
Previous numbers “overstated repayment rates for 99.8% of all colleges and trade schools in the country.”
“The new analysis shows that at more than 1,000 colleges and trade schools, or about a quarter of the total, at least half the students had defaulted or failed to pay down at least $1 on their debt within seven years.”
In 2015, the reported number was 347 colleges. Today it stands at 1,029.
- Afghan Payroll Cut in Corruption Fight (link)
The U.S. military was paying 30,000 Afghan soldiers that didn’t exist! That came out to $13 million per month. Now, the U.S. military will only pay Afghan soldiers who were biometrically enrolled in the nation’s army.
The Growth Promise
Why does it seem that troubled companies always insist upon expanding into growth markets? Why are they so eager to grow a business model with fundamental problems? Examples include:
- Pearson Drops as Future Darkens (link)
“Pearson said its revenue fell 30% in the fourth quarter making for a full-year decline of 18% that it called unprecedented.”
“…which has put pressure on Pearson’s business even as it seeks new sources of growth in emerging economies such as Brazil and China.”
- Can Revlon Regain Some of Its Lost Luster? (link)
“One way Mr. Garcia intends to lessen Revlon’s reliance on the U.S. is by entering China.”
I’m Curious. Is this an Accounting Illusion, Real, or Both?
Railroad Mavrick Buoys Investors (link)
I’m curious about this case. I wonder if Mr. Harrison’s operating efficiencies are real or are merely accounting related. After all, he’s able to do what no one else in the industry is capable of doing, which should raise some questions.
“Each time the message was similar: Mr. Harrison has proved himself able to cut costs and improve operations and is a better executive than you current team.”
On the backs of the second longest bull-market in history, artificially low interest rates have created intense competition among investors for any yield whatsoever. Furthermore, ultra-low interest rates have incentivized land-lords not to sell, which has reduced supply and intensified competition further.
- Texas Billionaires Joined to Strike Deal (link)
Plano Texas’s raw land has gone from $8 to $10 a square foot a few years ago to $60 today. Due to growing appeal to corporate tenants.
“The property attracted the attention of about 40 investors.”
Ultimately it was won by the investor able to secure a high loan to equity ratio.
“It’s unusual for an investor group to be able to borrow such a high percentage of a deal’s value, as Mr. Ware’s group did.
Participants said it worked because the bank will get an equity like return if the group hits the “jackpot” with the new leasing and land development.
- Investors Pump In Cash But Supply Is Lacking (link)
Investors piling money in: “Investors are piling money into real estate funds, but fund managers are finding it challenging to spend it.”
Hunt for returns in an Ultra low interest rate environment: “The record level of dry powder comes as investors increasingly have turned to commercial real estate in a hunt for returns. Ultra low interest rates at global central banks have made returns on offices and shopping malls look attractive compared with other asset classes such as bonds.
On par with 2005 to 2008: “Global fund managers have raised $446 billion for commercial property in the past four years, on par with the total raised from 2005 to 2008 in the run-up to the global financial crisis,”
Fierce competition for few properties: “With competition for deals fierce, “it has been much more challenging to invest,”…”There are very few forced sellers,”
“Landlords aren’t willing to sell. Their low debt levels and readily available bank financing have made it easy to hold on to properties longer in hopes of reaping bigger paydays later,”
Increasing demand: Deflation & Inflation
- ‘Rideables’ Could Curb Car Ownership (link)
Increased demand can have either an inflationary effect or a deflationary effect. Which way it goes is largely dependent upon two factors:
1) The speed at which supply can expand to meet demand and
2) economies of scale.
In the case of electric vehicles, increasing demand has had a deflationary effect:
“…the rapid expansion of the market has led to demand for parts, making them in turn cheaper and more available, much like what happened with mobile phones.”
“batteries are getting cheaper at 4% to 8% a year, and that compounding over the last five years has had a massive impact” on the electronic-vehicle industry.
Meanwhile, increasing demand has had an inflationary effect on price of oil and gas service providers (link).
Significant Housing Developments
- Mortgage Lending Shift Spurs Worry Over Risk (link)
There’s been a big shift in the FHA lending market for single-family mortgage market over the past 10 years.
Topped $1 trillion: “Bonds backed by certain risky single-family mortgages topped $1 trillion for the first time in November, crossing that threshold amid warnings about that corner of the U.S. housing market.”
Banks have all but stopped participating: “The result: In the first three quarters of 2016, banks accounted for 9% of mortgage dollars originated by the FHA’s top 50 lenders, versus 62% for all of 2010, according to Inside Mortgage Finance. Nonbank lenders accounted for 80% of mortgage bonds backed by single-family FHA loans in July 2016, versus 9% the same month in 2010…This is the biggest shift in mortgage lending since the savings-and-loans debacle in the 1980’s.”
“It’s too costly to originate”: “J.P. Morgan Chase & Co., the nation’s largest bank by assets, isn’t among the 50 largest FHA lenders. In 2013, it was the third largest,”…”It simply is too costly and too risky to originate these kinds of mortgages,” Jamie Diamon wrote.
FHA share of the mortgage market has tripled: “the FHA share of the overall mortgage market is larger than during the last housing boom. In the years leading up to the housing bust, FHA loans accounted for less than 5% of annual mortgage volume. Since the meltdown, the share has ranged from 11% to 15% of originations.
FHA loans under Ginnie Mae has Quadrupled since 2007: “That growth has boosted the amount of bonds Ginnie Mae backs. The $1 trillion of outstanding FHA single-family loans in November that it guaranteed compares with $272 billion at the end of 2007. Overall, Ginnie Mae now backs more than $1.7 trillion in bonds, which includes loans backed by other agencies such as the Department of Veterans Affairs as well as the FHA.”
Nonbank lending creates market risks: “The funding issue arises because nonbanks don’t hold deposits. So they rely on short-term financing, often from banks, mostly to originate new loans. That can dry up in stressed times.”
As Power Changes Hands, HUD Makes Swift Move (link)
The Trump administration seems likely to curb large housing affordability programs which make mortgages more accessible to lower income families, but at the same time distort free market dynamics. This would likely put downward pressure on home prices.
Challenges Lurk in the Economy (link)
“The U.S. home ownership rate is near a 50-year low, and the average debt load for college students is rising.”
The Confidence Illusion
There’s a lot of certainty and confidence going on. Investors are feeling much more confident, the fed is feeling much more confident, consumers are feeling much more confident, etc. But should we trust them? Caution would be the prudent advice.
The article, “Don’t Let Others Sway You When Making Investment Decisions” (link), points out that we can be heavily influenced by people with an intense belief in ignorant views.
“We’re biologically equipped with the potential to allow more-confident people to have greater sway over our own beliefs,”
“In a paper published in 2000, Prof. Shiller showed that confidence varies, often going up after the market rises and falling after it goes down. The confidence of individual investors rose 4% in July 2008, for instance, right before the market got sucked into the black hole of the financial crisis.
“So you could visualize the stock market as a poltergeist or hobgoblin who takes a twisted delight in play pranks on the expectations of the investing public.”
1. Treasury Yields Resume Ascent (link)
Janet Yellen is viewing things positively.
“In a speech Thursday at Stanford University, Ms. Yellen said she doesn’t see the U.S. economy at risk of overheating and doesn’t expect growth to pick up much soon,”
But be careful to give too much weight to her comments. Remember that after the financial crisis, Alan Greenspan wrote:
“In the run-up to the crisis, the Federal Reserve Board’s sophisticated forecasting system did not foresee the major risks to the global economy. Nor did the model developed by the IMF, which concluded as late as the spring of 2007 that “global economic risks [had] declined” since 2006 and that “the overall U.S. economy is holding up well…[and] the signs elsewhere are very encouraging.” (link)
Service Providers with High Fixed Costs
- For Shale Drillers, Rising Oil Prices Also Come With Rising Costs (link)
Interesting story for a case study:
During a dramatic drop in oil prices, oil & gas companies get a sort of mini-bailout by their service providers. These service providers effectively absorb some of the losses from oil & gas companies, thereby shielding them and making the decline more manageable.
But the effect is a two-way street. When oil price rebound, service providers are quick to raise prices and dampen the benefits of rising prices.
Why does this happen?
The service providers have high fixed costs. Upon declining oil prices, oil & gas companies cut demand for their services. Because service providers have high fixed costs, they will continue to provide services at a loss, sometimes just as long as their variable costs are covered.
I believe you could say that, to some extent, the fixed costs of your service providers or suppliers act as a shield in bad times. They will/must lower their service fees, thereby making the hard times more tolerable.
What should we learn from this?
1) We should look at service providers and suppliers and determine the level of their fixed costs and variable costs.
2) Oil & Gas companies should really position themselves better to take advantage of a decline in oil prices.
Before the decline in oil & gas prices, the whole industry had positioned themselves aggressively. When the crash came, no company was in a position to exploit the lower costs offered by service providers. Or buy oil assets at discounted prices.
Instead, they all waited for a rebound in prices to start working again, at which point, they completely missed out on compelling market opportunities.
The problem with that strategy is that it’s hard to do. But as Charlie Munger says, “It takes character to sit there with..cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”
Government Corruption & Lee Kuan Yew’s Advice
- Scandal Rocks Samsung (link)
“(President Park Geun-hye) was impeached last month over allegations that her confidante, Choi Soon-sil, sought to shake down the country’s biggest conglomerates for donations in exchange for political favors.”
There’s just so much corruption being exposed in governments around the world right now. If you’re interested in learning more about the roots of corruption and how to stop it, I suggest reading the chapter “Keeping the Government Clean” from Lee Kuan Yew’s book, “From Third World to First”. Here are a few great quotes:
“Human ingenuity is infinite when translating power and discretion into personal gain.” – Lee Kuan Yew
“A precondition for an honest government is that candidates must not need large sums of money to get elected, or it must trigger off the cycle of corruption. The bane of most countries in Asia has been the high cost of elections. Having spent a lot to get elected, winners must recover their costs and accumulate funds for the next election. The system is self-perpetuating.” – Lee Kuan Yew
Re: government corruption, we should expect governments to become more corrupt the larger they are and the more resources they have, as there is more at stake. The cost and scale of elections are a symptom, not a cause. (Ceteris paribus controlling for local cultural factors.)
You may be interested in my extended review of LKY’s book: http://www.ahouserises.com/books/review-from-third-world-to-first-the-singapore-story-singapore-history-economics-politics-books/
Nice blog post!