Thinking aloud about bank margins - Part 1

Pre-warning: this series of posts is called "thinking aloud about..." because I do not know where it ends. I am genuinely exploring things that I do not understand very well - but are central to how the economic world and how markets will turn out over the next year or two and maybe the next decade. I do not know the answers and maybe this blog series will not end or will fizzle out....

Also I will be on the road for six weeks. Expect the posts to be sporadic at best.

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The most interesting thing I have seen in the past three months was an interview on Real Vision by Shannon McConaghy of Horseman Capital entitled "Prepare for a Japanese Banking Meltdown?".

The title on the interview has a question mark. I am not sure that Shannon would include the question mark.

But the argument is pretty simple really. Japanese regional banks have - for decades - had excess funds. They have found it extremely hard to lend at adequate rates as excess funds is the Japanese condition. Rates the banks can achieve on loans are very low.

The result is that Japanese banks (especially regional banks) have very low returns on equity and generally trade below book.

As an extreme example about fifteen years ago I asked Bank of Kagoshima why they could not achieve their four percent ROE target and they said that it would "put too much strain on the local community." That bank is gone now - but the problem remains right across Japanese banking.

Shannon McConaghy's thesis is that "Abenomics" has made the problem much worse. He states that the average interest rate achieved on a loan by a Japanese regional bank in the first half of this year was about 79 basis points. The rate was 62 basis points in May but there may be some seasonality.* He thinks it costs about a percent to run the bank. There are staff and systems to pay and the like. So he thinks that Japanese regional banks will be loss making before they have any credit losses. Then of course they have been rolling credit losses in zombie businesses for decades and so after the credit losses settle there won't be any equity left to earn any return on anyway.

Shannon thinks the problem has been masked because the banks have typically invested their excess funds in Japanese Government Bonds (JGBs) and the yield on JGBs has gone pretty sharply negative. The banks this decade have sold significant amounts of these JGBs and reflected the gains on these sales as one-off income. They then shifted much of their securities holdings into a unique type of investment trust, largely invested in domestic equities, which under unusual accounting conventions allowed the banks to report capital gains as interest income. This means they are still showing positive ROEs but earnings are highly reliant on a constantly rising domestic equity market to generate gains, which is problematic as the Japanese equity market is still down by more than 10% from its peak last year. The situation is unlikely to improve as the underlying margins are already near zero and incremental loans actually lose money after costs.

[Shannon runs a Japan fund. This talk was so interesting I wrote to Shannon and got on his mailing list. I recommend readers do the same. There is plenty there that is interesting.]

Anyway all this accords a little with my view of bank margins and crises. The determining factor of how well your banks recovered from the financial crisis by-and-large wasn't how many or few losses your banks took (Iceland excepted), rather it was what was the underlying pre-tax, pre-provision profitability of your banking sector.

The US banking sector has pretty decent margins - and pre-tax, pre-provision profits were about $300 billion per year. In three and a bit years they had covered a trillion dollars in losses. The banks are mostly okay now.

German banks have very thin margins and whilst they had less credit losses they had considerably less income to offset them. The German banks (notably Deutsche and Commerzbank) look deeply problematic. Italian banks are also very low margin and slightly higher credit losses and they have been catastrophic investments.

Bank margins are really important

Bank margins were once a concern to bank investors and not really to the general public. After all low margins generally meant cheaper finance. High margin banks (like Australian banks) leave you with the uneasy feeling you are being ripped off.

But the world has changed. Abenomics - which includes the deliberate pushing of interest rates to very low or negative levels may suppress bank margins. And if you suppress bank margins enough your banks go bust. And if your banks are stressed they stop lending and your economy slows down.

In this view of the world monetary policy (cutting rates when you need a stimulus) not only stops working but becomes counter-productive. It blows up your bank and causes an economic crisis.

The Raoul Pal view of the world

Raul Pal runs real vision and has a twitter account that is absolutely worth following. He has been harping on about a single chart - the Eurostoxx Bank Index going back for thirty years.

This index is bouncing along its thirty year low. [No dear Americans, stocks do not always go up over a generation.]

Raoul rather grandly says that "this level in the Eurostoxx Banks Index is probably THE most important level of ANY chart pattern in the history of equity markets". [Emphasis is in the original.]

And to some extend I think he is right. What the Bank of Japan is doing to Japanese regional banks the European Central Bank is doing to European banks. The possibilities are that:

1. The ECB cuts rates further, blowing up the banking sector and causing the mother of all recessions starting with the weakest banks outwards (ie starting in Germany) or

2. At some point they can't cut rates and you get a recession anyway and as the banks have almost no margin left the credit losses leave them pretty darn impaired.

And the stakes couldn't be higher. A generalised collapse of the European banks would be a pretty big risk to the European experiment. It won't have been caused by Europe per-se, the English banks look pretty dire too, but it will be blamed on Europe, and the resultant unemployment will have large political consequences. When Raoul suggests that "this level in the Eurostoxx Banks Index is probably the most important level of any chart pattern in the history of equity markets" he is being appropriately alarmist - at least if the Eurocrats do not act accordingly.

Whatever - the Raoul Pal view of the world is unremittingly bearish. The usual central banks will bail us out narrative gets exposed as impossible. It gets ugly from here.

My view

I am not sure it is that simple always - but the reason Shannon McConaghy thinks that Japanese regional banks are uninvestable is the same reason European mega-banks and the Eurostoxx Bank Index is uninvestable. The European banks are deeply problematic.

But it doesn't have to be that way and it isn't irrevocably that way for the whole sector. And the ECB isn't totally trapped either.

But those are really the subject of the next few blog posts.




John

PS. I have mostly equity market readers. For this series I probably should have a few readers in the central banks too. Pass it on if you can.


J

*I asked Shannon for the source of this data - he sent me this link.

Also for avoidance of doubt I am long some European banks and currently short only one. The banks look super-cheap. But Japanese regionals looked super-cheap for decades and got cheaper and cheaper and cheaper.

If I entirely believed the Raoul Pal view of the world I would not hold any European banking stocks. My doubts about th Raoul Pal view are explored in the next few posts.

One more brief comment on the Markopolis GE paper

The absolute core of the Harry Markopolis paper is that GE is dramatically under-reserved for long term care insurance.

And it clearly has been. It took a charge (ie recognised future losses) in 2017 and 2018. In accounting parlance they RECOGNISED huge losses in 2017 and 2018 for payments they will have to make in the future.

And Markopolis points to these charges as the evidence that GE has the worst long term care business in insurance.

Here is a slide that had my jaw dropping:

GE's Employer Re subsidiary (one of the two places it has long term care policies) it seems has a 527 percent loss ratio.

Yes, it does, in the year they take the huge reserve hit.

Markopolis is arguing the provisions they have already taken is proof that the book is bad. And he doesn't recognise current payments are way way below these provisions.

The Employers Re cash flow statement

So here is another way of looking at it. This is the operating part of the cash flow statement of Employers Re taken from the statutory statements. You can find the original here.

Yes, you see this right. The company had 500 million of premiums collected and 597 million of investment income. It paid out 893 million in benefit loss related payments. After all the sundry expenses Employers Re was still operating cash flow positive by more than 80 million.

The main source of the massive cash draw central to the Markopolis thesis is still cash flow positive. The 527 percent loss reserve above isn't a current payment by Employers Re - it is an estimate of their future payments. Current payments are completely manageable.

Union Fidelity Life - the other GE insurance company - the one with a mere 280 percent combined ratio - is actually cash flow negative. And the combined is marginally cash flow negative.

But that is not the point. Current cash flows are not the issue. And the combined ratio that Markopolis trumpets are not indicative of current cash flow. They are the provisions that GE is making for future cash flows.

Future cash flows at the insurance companies

Employers Re will not stay cash flow positive. Not close. Several things are going to happen to make it worse. These things will also happen at Union Life and both companies will become deeply cash flow negative.
First investment income is going to go down. This is inevitable. These policies were written 15 years ago or more and some of the bonds that back these policies were also purchased 15 years ago. As investment income goes down the cash-flow of the book will deteriorate.

Further as time goes on the insured get older. And as they pass through their 80s they will be more likely to wind up in nursing homes. Claims will increase.

Finally, for better or for worse some of the insured will stop making payments. The main reason this happens is that they die. The average age of insured here is in the late 70s.

When everyone has stopped making payments of course the business has run-off. Any cash left in the holding company can finally be distributed to the holding company (that is ultimately the GE parent company).

So how did this impact GE holding company cash flow so negatively?

GE has an agreement with the insurance commissioner to maintain a 300 percent risk based capital ratio at these subsidiaries. When the subsidiaries take additional provisions for future claims it can cause a cash draw on the parent company even if the actual insurance companies are cash flow positive.

At year end last year the two companies had a capital adequacy ratio of 365 and 426 percent. They can take small hits from here without any cash charge to the parent company. But that is only after they took accounts of massive capital contributions by the GE parent company.

How does this run off?

After the capital contributions there are tens of billions of excess at the insurance companies. Alas this cannot be accessed for decades because of the promise to maintain 300 percent capital adequacy ratios. My guess - and at this point it is only an educated guess - that the company will still be under-reserved and further losses will be booked. But those losses will be insufficient to absorb the excess capital at the insurance companies. Over the next thirty years these insurance companies will be both a source of losses (provisioning) and a source of parent company cash (as the excess reserves get released).

This is so far from the Markopolis view as to be comical.

Scoping it

The average cost of a month in a nursing home is about $7000.

There are about 270 thousand policies outstanding. That number falls all the time because there are a lot of ninety year olds in the book and they die.

The statutory reserves per policy outstanding is about $75000. [You can multiply this out. It is a lot.]

In other words give-or-take there is about 11 months in a nursing home provisioned per policy holder.

The average length of stay in a nursing home seems to be about 29 months as per this.

According to this a senior citizen has about a one in four chance of winding up in a nursing home at some point.

So this looks fine. If the claim rate winds up being one in four and there is 11 months provisioned per policy holder it looks like there is 44 months provisioned per claimant. And the average claim is only 29 months.

But it is not so simple. People who are insured are more likely to wind up in a nursing home because either it is already paid for or at least it is already partially paid for.

If you know the claims rate (by age and sex) on their book and the age and sex distribution of insured you could work out whether the book was under-reserved for or not.

I suspect the provisioning is line-ball accurate here now. They haven't written a new policy in over a decade so the way the book runs off should be utterly obvious to GE now.

But I do not have the claim curves.

I guess this was the sort of information I was hoping for from Harry.

But I didn't get it.





John

The flat-out silly Markopolos GE report

GE is a deeply problematic company. It might not make it. And Harry Markopolos - the Madoff whistleblower - has put out a report on GE.

The report is I highly negative and I believe utterly misleading.

This report focuses on the Long Term Care business.

That business is

a) both having reserving problems and 

b) is for good reason the best performed Long Term Care business in the world.

Long Term Care - the business of insuring people against the need to go into a nursing home - has hurt everyone who touched it.

GE used to own Genworth - and when they spun it out they reinsured Genworth's policies. Those reinsurance contracts have bitten GE pretty hard. But they were - by the standard of Long Term Care policies really well underwritten.

I wrote a blog post a few years ago about how those policies were written. Read it and the ask yourself how valid is Markopolos's comparison with other companies.

http://brontecapital.blogspot.com/2012/05/thoughts-on-berkshire-meeting-and.html

Strangely and just to prove poor Harry's incompetence one of the companies he compares GE's business to is Genworth. This is bizarre. GE reinsured Genworth. They are the same policies.

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But outside Long Term Care is where the report gets really silly. Here is a slide comparing GE's industrial margins to Madoff returns:

He states GE Industrial Margin of 14.7 percent is "too good to be true".

Let's give him some comparisons:

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Honeywell	19.6%
United Technologies	13.3%
Emerson Electric	16.4%
Illinois Toolworks	24.3%
Roper Technologies	27.4%
Rockwell Automation	20.4%

I guess all of these are "too good to be true" too. Indeed the entire high-end of US manufacturing is worse than Madoff if you believe Mr Markopolis.

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I think the alternative is more likely. Say what you will, GE remains the unequivocal leader in medical imaging technology and the unequivocal leader in jet engines. In both these there are very few competitors and it would be near impossible to eat into GE's lead.

My guess - and it is a guess - that over time GE's industrial margin goes back towards the upper-end of the above-mentioned comparables.

Harry's report is silly. The market should ignore it.

John



For disclosure: we are long a little bit of GE with the emphasis on "small". GE is a problematic company and a zero is a possibility. However the Markopolis report is not an accurate guide to GE's problems.

The latest Ken Henry blow-up

Warren Buffett - quite regularly at his annual meetings - observes that almost 400 thousand people work at Berkshire - in other words a medium sized city.

In those 400 thousand people (as in any medium sized city) there are almost certainly people doing things that they should not and things that you would not want to see on the front page of the local paper. They are selling products that rip off customers, they are doing things that threaten the reputation of Berkshire.

It is unreasonable in any large company to expect that there is no corporate mischief, no customers that are being misled, no staff doing things that are wrong.

But you can expect the management to monitor staff behaviour and to create incentives to do the right thing and to appropriately deal with staff that do the wrong thing. You should also expect them to compensate customers who fall victim and that compensation should be expensive.

Warren Buffett will also endlessly talk about the things he is doing to ensure that integrity is what is rewarded at Berkshire.

The Sydney Morning Herald today led with a headline that in leaked letters to consultants Dr Ken Henry (then Chair of National Australia Bank) had said that bad things were being done - even as they spoke - at National Australia Bank. To quote:

[Dr Henry is] confident that there are products currently being sold now that they will need to remediate in the future ([and he] highlighted an example of SMSF borrowing to invest in managed funds).

This looks pretty like the thing that Warren Buffett said about Berkshire. And it was said - as the context makes clear - to have the consultants who were hired to help in remediating the matter. In other words the admission is what is required to fix the problem.

A while ago I went to look at the lending practices of the Australian banks and I am confident that all four big banks had bad processes, and ripped off customers. As I have stated elsewhere I think that National Australia was the least bad of a bad lot. But it clearly had things to fix.

I still think NAB has things to fix. So does Westpac, CBA and ANZ [in that order I believe]. Stating it and acting on it is a necessary part of the process.

That Ken Henry actually stated it and presumably to a consultant he had hired to help reflects well, not poorly on him.



 
John

PS. I also think alas that Dr Henry is right. The mis-selling scandals cost British banks billions of pounds. PPI mis-selling alone was above 20 billion pounds. There has been so much mischief at Australian banks that this issue is certain to bite them in the future. Dr Henry clearly identified the issue and wanted to do something about it. He should be applauded.

Anzac Day

It is ANZAC Day morning and I can't sleep quite right. I am going to the Dawn Service - but it isn't the same without Alice.

Alice was a war-widow who looked after me as a child, and I looked after a little in old age.

In memory, here is a post from 2009, the last time I went to the remembrance parade with Alice.

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The original ANZACs were the Australian and New Zealand Army Corps.  They landed on 25 April 1915 at Galipoli in the Dardenelles for what was to become a protracted and punishing military defeat.

Australians (and New Zealanders) still commemorate Anzac Day as their national day of remembrance and with numerous dawn services, remembrance parades followed by war stories, stories about the (great) grandkids and drinking with your mates.  It’s a day that is both sombre and joyous, reverential and light-hearted.  We remember our dead in a peculiarly Australian fashion.  

Today I was privileged to go to the ceremony with Alice.  Alice looked after me as a child and I return the favour in her old age.

Alice served as a nurse in the Second World War.  Her first husband served in Palestine, Tobruk and possibly El Alamein – but paid with his life at the true battle for Australia – at Kokoda.  (The reason I am not sure he fought at El Alamein is timeline.  He may have been at El Alamein and he was certainly in Egypt but the main battle was fought at El Alamein in late 1942 and the Kokoda battles were already happening by then.)  

Alice’s family sacrifice did not end there – her second husband had what I suspect were continued psychological problems after New Guinea.  Alice’s son (Richard) served in Vietnam.  (It is possible however that Alice's second husband fought at El Alamein - and she confuses which battles they fought in.)  

I pushed Alice in her wheelchair at the Legacy War Widows Service in Sydney.  The ranks of World War II War Widows are getting thinner – and Alice may have been amongst the oldest.  She is the youngest (and one of only two surviving) of more than a dozen children.  Being the youngest of many her father was not young when she was born – and – possibly uniquely – she was wearing her father’s Boer War medals.  The medals proudly were issued under Queen Victoria and Edward VII and showed their heads – reminding us that Australia has always fought under the auspices of the British Crown.

The ceremony was short and moving – and whilst I was pushing a wheelchair I did not feel that I belonged in the march.  Other people had sacrificed much and I was a beneficiary not a victim.  Still many tears were shed.

It was about an hour till the main march went through.  Richard disappeared to march with his Vietnam buddies.  I was left chatting with a bunch of mostly spritely women in their 80s whose husbands had died when they were 18-20.  Most did not remarry though one did and the second husband died in the Korean War.

Their husbands mostly died in campaigns against the Japanese after fighting the Germans.  The woman who sat next to me told me her husband served on HMAS Australia and was killed by a kamikaze at the Battle of the Coral Sea.  I was surprised as I did not know that kamikazes had been used as early as the Battle of the Coral Sea (1942).  Moreover it did not gel with her age as she was 18 married and pregnant when the war ended (1945) so it was unlikely that he was killed in 1942.  But HMAS Australia was the victim of a kamikaze – possibly the first kamikaze and there were many dead.  The date of that attack (January 1945) matched the age of her child.  Not to quibble.  She bought up a very well adjusted child as a very young widow – and she never remarried.  It does talk however to how inaccurate memory is – even of very important things.  Her mixed up memory matched Alice's doubt about which husband (if any) fought at El Alamein.  

The march itself was charming, lighthearted, sad and poignant.  And most of those things all at once.

It was led by a group of horses in full nineteenth century military regalia.  After a decent interval came a man with a wheelie bin and a shovel who – to cheers from the crowd – cleaned up the horse dung.

Then came a riderless horse called Galant in lieu of any surviving veterans from the Boer War.  Another riderless horse represented the First World War which was dated 1914-1918.  Flags representing all Australian divisions that fought in that war were carried by serving military officers.

There was no horse and no other representation for Australia’s (minor) involvement in the Russian Civil War (1919).  Australia played a very small role in that war – and there were few Australian dead – but the parade did not honour them.  The Australians fought in British units – though – according to this minor history at the Australian War Memorial web site Australia did send naval ships for reconnaissance.  

After a decent interval came a formal precession led by Professor Marie Bashir.  Marie Bashir is the Governor of New South Wales – and hence the representative of Her Majesty the Queen of Australia.  Governor Bashir is I think 78 years old – but my spritely war-widow companions thought she looked young and fantastic.  

Then came a large number of divisions of Second World War veterans.  Some were carried in taxis, some in military vehicles, some in wheel chairs – but most marched.  A few dropped out of the march to flirt with the war widows which I found hilarious and the widows found flattering.  Many saluted as they went past us.

The women tended to look a little better than the men (which is not atypical amongst 85 year olds).  Most colourful were the women who served in field hospitals who were dressed to the nines and all wearing gleaming (and elegant) white gloves.  Interspersed were marching bands mostly provided by various high schools including my high school.  My old high school (Sydney High) is an academically selective school with a history of taking the upwardly mobile children of the latest generation of immigrants.  In the days that Jim Wolfenson went there it was full of Jews and other children of Eastern European refugees.  It now is the children of Indians and Middle Eastern Muslims as well as South East Asians.  The band filled me with hope for Australia – and the racial mix of the students in it differed dramatically from the all-white Second World War returned soldiers.  

The troops went past largely in order of the campaigns they fought.  Most of the campaigns I knew Australians were involved in – but there were groups that fought with Americans and other services (usually in specialised roles) that I did not know about.  One example were the Polar Bears – a naval group covering arctic supply lines.  

There were contingents from Korea, the Malaya Emergency and extensive Vietnam Veterans.  There were small groups from the first Gulf War, East Timor, Iraq and Afghanistan.  

Finally there were groups representing allies we fought with in various wars.  There were for instance a small group of Dutch soldiers who were assigned to Australian Divisions after Dunkirk.  There were Americans (mostly from Vietnam), Ghurkhas and other assorted South Asians.  The largest group were Vietnamese who fought for the South and later settled in Australia as refugees.

To me though one of the most moving parts of the whole parade happened by fluke.  We tried to find a bathroom for Alice – and a woman who worked for Legacy led us to a disabled toilet.  Legacy is a charity for families of war dead – and it was Legacy who had organised the War Widows special ceremony.  They have a group for the children of war dead – and – for the first time – she had organised them a place in the parade.  They were led by a military truck and in the back was their oldest member – a son of a soldier who died in the Great War – and their youngest member – a son of a soldier who died in Afghanistan.  I would not have understood the significance of that baby had I not met the organiser.  

And whilst I am sad for the child – if I judge it by the children of the war widows I sat with then the boy will turn out OK, and in sixty five years he will still be honouring his father’s sacrifice.

John

PS.  I have to repeat one of the comments.

My mother was raised in an orphanage in Brisbane run by Legacy. As far as I know, she doesn't go to A.N.Z.A.C. Day parades, but does go to the Dawn Service. The "Legacy Kids"/orphans have their own get-togethers. Every August for the past 26 years, the orphans have a re-union on the birthday of the woman who ran the orphanage. She was a Legacy employee who had lost her husband on the Kokoda Track. One of her brothers was a Rat of Tobrook (9th Division) and El Alemein veteran, who later lost an arm at Milne Bay in Papua New Guinea. Another of her brothers is buried in France, killed while flying for the RAF. After her husband died, she lost her only child. She later gave back by running the orphanage for Legacy. She touched hundreds of orphan's lives. They never forgot her. She was also my Godmother.

My Grandfather was killed in Sydney during WWII while serving in the Australian Army. My mother has never visited his grave - its just too painful, even after all these years. My father has an uncle buried in northern France, a casualty of WWI's Battle of the Somme. No one from our family has ever visited his grave to pay our respects. There are many families like ours in Australia with similar stories to tell.

Lest We Forget.

PPS.  I have been a little perplexed by the stories told by the War Widows.  They are sometimes embellished, sometimes the stories are compressed.  I gather Alice's first husband fought with the 7th division.  He could not have fought at El Alamein as he would have been in New Guinea by that time.  Here is a history from the 7th's website.  Almost all of what Alice told me (and the medals she wore) are consistent with this history - though she mixes her two husband's campaigns up.  

The 7th Division left Australia in October 1940 for the Middle East.  Over the next two months, the 7th was concentrated in Palestine.  It was slotted for a move to Greece to help in the defence against Axis invasion, but instead moved into defensive positions in the Western Desert.  Parts of the Division under the command of Maj General Allen crossed into Syria and fought a hard won victory in the campaign against the Vichy French .  18th Brigade excelled itself as part of the defence of Tobruk.   With Japanese invasion of Australia imminent, the Division was recalled home.  Elements of the Division (2/3rd Machine Gun Battalion, 2/2 Pioneer Battalion, 2/2 CCS,2/6 Fld Pk Coy and 105 Gen Tpt Coy)were diverted to Java. They fought a defensive campaign against overwhelming Japanese odds and were only forced to surrender after an early capitulation by the Dutch forces there. 

The Division moved to New Guinea and established headquarters in Port Moresby.  The timely arrival of the Division in New Guinea helped to halt the Japanese advance..  21st Brigade fought a bitter campaign of attrition on the Kokoda Track,until replaced by 25th Brigade who slowly forced the Japanese northwards.  18th Brigade and other Australian units inflicted the first decisive defeat of the Japanese on land in World War 11 at Milne Bay and then at Buna and Sanananda in January 1943.   21st Brigade and the militia 39tth Battalion won a costly victory at Gona in December 1942.    George Vasey took over command of the Division in October 1942, until his death in a plane crash in 1945.  Major General Milford then took over command until the end of the war.    In 1943, the Division was airlifted from Port Moresby to Nadzab in the Markham Valley.  After an advance on Lae, the Markham and Ramu Valleys were soon swept clear of Japanese troops.  A bloody campaign in the mountains of the Finisterre Ranges followed. 

Mattel: Buybacks, Barbie and dead babies

I used to be of the view that suggested that buybacks were just another way of distributing to shareholders - a bit like dividends, selectively applied.

You could turn a buyback into a dividend by selling your own shares in precisely the proportion that the company bought shares back. Then your percentage ownership was unchanged and you would have (in cash) your share of the monies that the company distributed to its owners.

I used to think that. But it isn't quite true because companies can impair themselves with buybacks in ways that you just couldn't with dividends. Few companies support paying dividends at 2x underlying cash generation. But debt funded buybacks of this size are alas fairly common.

Debt funded buybacks, applied to their illogical limit, will corrupt you, and turn you into a gebbeth - inhabited by the debt (and its evils) you have allowed into your body.

First however I need to recount a parable about how leverage corrupts morality.

Valeant and the price of Syprine

Syprine is an old drug, out of patent for years that is a treatment for Wilsons disease. Wilsons disease is a disorder where copper builds up in your blood eventually killing you. If you take Syprine you lead a symptom-free normal life. 

There are a few thousand people with Wilsons disease in the United States and as it was a minor disorder there was a single supplier of Syprine.

Valeant bought this single supplier. They cranked the price to $400,000 for a years supply and took every asset of every sufferer they could find.

Pay up or die.

Valeant instituted a patient subsidy program so that they could crank the prices to levels that no patient could afford and then drop the price (through the subsidy) to a level where they could strip every asset of every sufferer. They found precisely how much a Wilson's disease sufferer had, and they took the lot.

Valeant bought up all the raw-material suppliers for the drug so no alternative supply could make it the market. They either bought up or intimidated all the veterinary suppliers of Syprine so that veterinary supplies couldn't be diverted. Horses get Wilsons disease too but a few (hundred) dead horses were the collateral damage in Valeant's plan to extract huge rents from an old-and-out-patent drug.

Eventually this got to a Congressional hearing and Bill Ackman (the activist investor then on the board of directors of Valeant) promised to go to a director meeting and get Valeant to drop their prices on Syprine.

But Valeant didn't drop its price despite the promises of its (then) largest shareholder, because if they had dropped their prices on Syprine they would not have been able to pay their debt.

Normal people do not tell Congress they will do something and then do the exact opposite. But add in enough debt and decent people will become evil. 

That is what happened with Syprine and Valeant.

In the Valeant case the debt came from buying pharmaceutical companies at very high prices. But in the case I am going to show you (Mattel) the leverage can just come from buying back stock.

And the lesson for management teams is if you buy back enough stock at the wrong price you too can become evil.

But let's start with what went wrong with Mattel.

Mattel, a toy story

Toys are not an easy business. They have a competitor: computer games. Once upon a time if you looked at Mattel it broke down into girls toys and boys toys. Girls toys meant Barbie. Boys toys meant Matchbox (cars) and Hot Wheels. 

These were evergreen, growing sales year after year, decade after decade. 

Then along came computer games. And boys toys in particular were hit badly. Once upon a time you could sell a Matchbox car to a nine year old. Nowadays the competition is Mario Kart, and frankly Mario Kart is more exciting.

These days the only people who buy Matchbox cars are 3 years olds and creepy 45 year old men. 

It is not as if you can't grow a toy company - but the focus is generally younger and younger. Spin Master grew a large (listed) toy company from nowhere on the success of Hatchimals. A fairly large unlisted toy company was built on the success of Shopkins and other toys aimed at younger children. 

With a savvy enough social media strategy you could even make a success of some traditional boys toys. Nerf is an amazing success at least in part based on a craze for making astonishingly violent Nerf War videos and showing them to legions of fans on YouTube.

But that was Hasbro. Mattel was devoid of such success.

And Mattel had some failures too. The most notable one was American Girl an iconic up-market branded doll which Mattel took downmarket (stocking in Toys R Us) and blew up the cachet of the brand.

Once upon a time you could go with your precious daughter to an American Girl shop and have her clothed and her hair cut to match the doll. It was quite the experience. Stocking in mass market shops destroyed this.

What Mattel did have however was buybacks. Lots and lots of buybacks and they kept the earnings per share on a pleasant enough path. 

Mattel's buybacks

The extraordinary buyback binge undertaken by Mattel is best seen in their cashflow statement. If you want the full version I have prepared Mattel's accounts for over 20 years, standardised and as presented (courtesy of the wonderful CapitalIQ.com).

Here however is the key summary of the last few years of this binge:

Year	Buybacks ($M)
2010	447
2011	524
2012	67
2013	493
2014	177

The buybacks (plus ordinary dividends) were way in excess of available cash generated and Mattel accumulated a lot of debt.

The credit rating is now firmly in "junk" territory and is trading (slightly) distressed. The debt trades in the low 90s.

There are now no buybacks now or dividends as cash flow has evaporated.

It is hard to imagine that Mattel, owners of such staples as Barbie, could get itself so knotted, but net debt is now over $2.2 billion. And when there hasn't been a lick of operating cash flow for two years that becomes difficult.

And even Barbie is a little problematic these days. Comparing Barbie to other dolls on Amazon reveals a lack of pricing power. Indeed it seems the only place with pricing power is the collectables market (and with Barbie that means really creepy forty five year old men).

Why I am short Mattel

I am short Mattel based on seemingly dysfunctional management and too much debt. I regarded these in part as flip sides of the same problem. Too much debt meant that Mattel found it hard to take risks, to invent new toys, to hire and nurture the talent that keeps a toy company fresh.

Debt meant that Mattel had to "milk" brands, prioritising short-term cash for stock repurchase and eventually for interest payments. This led to cashing the iconic American Girl brand in for a short-term sugar hit when it was stocked in Toys R Us.

I knew management were dysfunctional. Churn in the c-suite proves it. But recent stories leave me reeling. Mattel have morphed into a truly evil company. One that kills babies.

Dead babies

The recent big news was that Mattel has recalled the Fisher-Price’s Rock ’n Play sleeper. The story is well told in the New York Times.

Here is the key quote:

When Fisher-Price agreed last week to recall all 4.7 million Rock ’n Plays on the market, it said it was not at fault for the more than 30 infant deaths the Consumer Product Safety Commission had linked to the sleeper. 

Instead, the company said the reported deaths stemmed from the sleeper’s being “used contrary to safety warnings and instructions” to buckle babies in with the harness and avoid putting other items in the sleeper. (The safety commission advises that it should not be used once children reach 3 months or show signs of being able to roll over.)

I want you to understand how twisted this is. The company knew babies were dying in this sleeper. But the company wasn't at fault - it was the parents who used the sleeper in ways that seem obvious if contrary to instructions.

The New York Times demonstrate that the ways people used the sleeper were consistent with Mattel's advertising/promotions but whatever. 

Parents bought this thing and their babies died.

And it wasn't one death. One death is an accident. At the second death you are probably wondering "is this a product design issue". At the third death if you are not having serious doubts then you probably lacking basic human morality.

But this was over thirty deaths. 

That is thirty families that held funerals for their baby.

I don't know what you say to parent number 17 whose child died well after it was patently obvious that this thing was killing babies.

One day I guess we will find out what Mattel will say to a jury.

But this is a moral failure truly extraordinary for a company whose key staff have to love children, understand children and design things to make children happy.

Understanding children and designing and marketing things to make children happy

But from what I hear that isn't what Mattel is about any more. Their management were once from fast moving consumer goods companies (really attuned to milking brands).

Now they are Silicon Valley/social media types (which Hasbro has shown with Nerf might be better), but they seem too focused on selling their existing characters to Hollywood. 

But Hatchimals (to pick a success from Spin Master) was a toy aimed at young children designed by someone with flair and a deep empathy with the young children who are the target market. 

An empathy and an understanding that seems lacking at Mattel.

The morality of short-selling

I am a short-seller, and sometimes I am betting things fail when I really hope (for society) that they survive.

I am short a very small amount of Tesla and strangely I hope I lose on that bet. Elon Musk has demonstrated that electric cars can be better than internal combustion engines. He has improved the world. I think his finances are a mess and he has other problems. But deep down I hope he succeeds. I feel slightly dirty betting against what is fundamentally a good thing.

And I felt a little dirty betting against Barbie too. After all what is wrong with a toy company?

But there is plenty wrong with this toy company. It kills babies. It fails the basic test of a toy company. 

And it will probably go bust too. And it will be deserved. The world will be a better place when the toy company which doesn't love children and doesn't design things to make them happy finally fails.

And maybe the next deadly toy won't stay on the market quite as long. And there will be less grieving parents because this thing has finally filed chapter 11.

I truly hope so.

John

Visa, Mastercard, Huawei and spying

In the days before smart-phones if I wanted to develop a ubiquitous mechanism of spying on people I would probably start with an electronic payment system that tracked everything that people bought and where.

This is not an original thought - and there is a reason why Visa and Mastercard cannot crack the Chinese market.

But the Chinese government and its (compromised or stupid) proxies in the West tell us we should open ourselves to Huawei (which provides a much better mechanism for spying).

I would normally bet that wouldn't happen - but given the quality of Western political leadership these days nothing much would surprise me.

Just making an obvious observation that I have not seen elsewhere.




John

A quick note on the resignations at the top of National Australia Bank

The Chairman (Dr Henry) and the CEO (Andrew Thorburn) of National Australia Bank have just resigned following criticism by the Australian Banking Royal Commissioner.

I do not know Andrew Thorburn, but I know Dr Ken Henry well and am proud to count him as a friend.

In February 2016 Jonathan Tepper (of the English research firm Variant Perception) and I spent a week traipsing around the outer suburbs of Sydney checking out property developers, mortgage brokers and even some bank branches.

It was dead easy to find widespread evidence of mortgage fraud. It was pervasive - fraud was the way of doing business. Jonathan Tepper wrote it up in a now infamous report on the state of the Australian property market.

Jonathan Tepper was widely mocked in the Australian press when our findings were published. However the findings we had were confirmed by the evidence put before the recent Royal Commission.

For the record we found that all four Australian banks were problematic but that National Australia Bank was the least bad of a bad lot.

I went to have a chat with Dr Henry who took our findings seriously and began the (admittedly difficult) task of improving the National Australia Bank.

He was open about the difficulties in doing so, open about the incentives both within the bank and outside the bank and was cognoscente how difficult this was going to be. But he started.

I am not trying to defend National Australia Bank. It was the best of a (very) bad lot. But it was still not very good and Dr Henry started the task of making it directionally better.

--

Anyway come the Royal Commission Dr Henry talked to the Commission in a frank and open way about the problems. It was Dr Henry being Dr Henry: honest, competent, and realistic.

It came off badly. I remember the grilling he got from the Royal Commission and understood what was happening. It was clear that what was required from the Royal Commission was kowtow, rather than honest frank discussion. Dr Henry looked bad even though he was probably the single most reliable and honest witness the banks put up.

The Royal Commissioner made specific findings against Dr Henry and Andrew Thornburn. This surprised me because on my research National Australia Bank was the best of a bad lot, both in absolute level of moral decay and in direction.

The Royal Commissioner I believe misinterpreted the relative honesty of National Australia Bank.

Direct criticism was made of Dr Henry and Andrew Thornburn and today they resigned.

I am not sure that any Australian banker deserved to come out of the Royal Commission unscathed, but in a relative sense injustice has been done. The most honest party at the Royal Commission has paid with their career for their honesty.

I don't think Kenneth Hayne (the Commissioner) has done the country or the cause of banking reform a good job. And that is a pity.





John Hempton



A post script is warranted: one of the key conversations I had with Dr Henry I had in the presence of Rob Shears from Valor Private Wealth.

Rob is a financial planner and a friend of mine.

He has regularly (and appropriately anonymised) told me of the financial condition of prospective clients, many of whom are loaded with inappropriate mortgages on (sometimes multiple) investment properties.

He is a very good window on bad bank underwriting.

Anyway he was in the room when I had a phone conversation.

Today he tweeted this:

One of our clients friends is a bank manager of a NAB branch. Within 48 hours of the phone call you made to Ken a few years ago (I was in your office at the time) there were significant restrictions put on certain investor loans immediately. Ken is honest and competent.

I was unaware at the speed at which NAB acted when reliably informed of bad practices. But it confirms my impression of how NAB (and NAB alone) took our report seriously.

The Myth of Capitalism: Monopolies and the Death of Competition. Jonathan Tepper and Denise Hearn. A review...

The Myth of Capitalism is a polemic about the reduction in competition in many industries in the US. And it starts in an entirely appropriate place.

Dr Dao - a doctor with patients to serve the next day - was "selected" by United Airlines to be removed from an overbooked plane.

As he had patients to tend the next day he did not think he should leave the plane. So the airline sent thugs to bash him up and forcibly removed him.

The video (truly sickening) went viral. But the airline did not apologise. The problem it seems was caused by customer intransigence. 

They apologised after what Tepper and Hearn think was true public revolt, but what I think was more likely the realistic threat to ban United Airlines from China because of the racial undertones underlying that incident.

If a "normal" company sent thugs to brutalise its customers it would go out of business. But United went from strength to strength.

The reason the authors assert was that United has so much market power you have no choice to fly them anyway - and by demonstrating they had the power to kick your teeth in they also demonstrated that they had the power to raise prices. The stock went up pretty sharply in the end.

Oligopoly - extreme market power - not only makes airlines super-profitable. It gives them the licence to behave like complete jerks. 

But what is true of airlines is true of industry after industry in the United States. Hospital mergers have left many towns with one or two hospitals. Health insurance is consolidated to the point where in most states there is only one or two realistic choices. Even the chicken-farming industry is consolidated to the point where the relatively unskilled and non-technical industry makes super-normal profits. Tepper and Hearn have assembled many other examples.

Two other assertions lace this book. Firstly - and somewhat controversially - the authors assert that low levels of competition lead to low levels of innovation (and hence lower levels of economic growth). This is controversial because Silicon Valley produces companies with very little competition (Google for example) that are clearly innovative.

The second assertion is that companies with market power use their power both ways - firstly to raise prices to customers, but just as importantly to squeeze suppliers, especially employees.

Oligopoly and innovation

Peter Thiel (one of the anti-heroes of this book) has long argued that market power and super-normal profits are the goal of innovation and that innovative firms innovate to keep the good times rolling. And indeed this is part of the model of Silicon Valley. Thiel's receives consistent support from economists who receive sponsorship/grants/work from monopolists. Tepper suggests that these economists might be compared to prostitutes - except that would be grossly unfair to prostitutes. 

I am going to add my two-bits worth here. Thiel is almost certainly right in Silicon Valley. Innovation is both the source of and funded by high-levels of market power.

But Thiel is wrong in much of the world. I live in Australia - the land of oligopolies. The Sydney business community is possibly the most conservative business community that size in the world. If you are a businessman here your job is to (largely) to milk the excessive market power that your business has in what is a small and isolated market. Disruption is to be feared and discouraged because it is a threat to the gravy train. This differs a lot from Thiel's world - but I suspect that in many industries oligopolists are innovation phobic. 

Oligopoly and suppliers

Perhaps the biggest contribution this book makes to the policy debate is to examine how market power is used to squeeze suppliers and not just customers. This is - in the authors view - why in this cycle wages have not risen as the economy comes close to full employment. They just think that monopsony employers squeeze wages. They do because of market power - and because of unfair clauses in employment contracts like non-compete clauses. There is an argument for non-compete clauses where staff could walk with intellectual property - but the book notes widespread non-compete clauses in the fast food industry. A non-compete for flipping burgers is just a mechanism that allows employers to suppress wages.

Tepper and Hearn note that wage growth is slower in areas with few employment choices (especially areas with just one large employer in town). The rural-urban wage divide in America is - the author argue - exacerbated by this. 

When you interview Trump voters in rural areas about why they voted for Trump they often state that they think the system is rigged against them. Tepper and Hearn argue that is because the system really is rigged against them.

Low prices and oligopoly

There is a form of American industry that doesn't try to raise prices. Amazon, Costco and above all WalMart are the key example.

Walmart for years used to talk in their conference calls about all the cost savings they were implementing. And analysts would want to put those cost savings into their model as earnings. Walmart would disabuse you of this. Cost savings are passed to customers. 

By doing this Walmart squeezed competitors until in many places it is the only local supplier of note. But it did this by the pro-market tactic of lower prices.

This doesn't look supportive of the Tepper/Hearn thesis - except that they argue that Walmart and Amazon (but to a much lesser extent Costco) then use the considerable market power they accrue to squeeze their suppliers (especially their workers). Walmart famously pays low wages. Amazon uses veritable armies of lowly paid contractors. 

Market power gives licence to corporate management to behave like jerks, whether it be kicking in the teeth of their customers (United Airways) or paying their workers poverty wages (Walmart).

The Costco counter-example

Costco is almost the only company in this book that comes off well. Sure they win by having lower prices - but they also win by having well paid and happier workers (and much lower staff turnover). Costco management are not jerks. And in that they provide a decent counterexample to management described throughout this book.

But even Costco squeezes suppliers. This example is recent and not in the book. Costco is entering the business of breeding chickens for meat - and it is doing it in a spectacularly large way. Obviously this is not core business. But they came up against the chicken meat oligopoly (discussed in the book) and Costco thought they would win by disrupting their oligopolistic suppliers.

An angry book is not much use to me

Tepper and Hearn have written an angry book. It is angry at the regulators that have allowed non-competitive mergers to happen. It is angry at politicians and lobbyists in the pocket of supernormally profitable corporations.

The solution to the problem in capitalism according to the authors is more capitalism. They want more entrepreneurism, less barriers to entry in companies but also they want regulators to view skeptically (and stop) anti-competitive mergers. They endorse measures against tech companies that stop them leveraging monopolies on one sector into monopolies in another sector. They would have endorsed the break-up of Microsoft into an operating system company and an applications company.

They provide a reasonable agenda for a market-friendly politician or regulator who believes in competition and doesn't want to be on the lobbyist tit. 

All well and good but I have no use for their anger. I am not a regulator or a lobbyist or a politician. And there are plenty of other things in the world to be angry about. 

But that doesn't mean I regret reading the book. I don't. I am a hedge fund manager and my job is to make money for my clients. 

And the simple question I ask about a book like this is "will it help me make money for my clients".

In this case the answer is yes. 

It gave me a few direct clues on how to make money. But I am not going to tell you those. Read the book. 

But it also gave me some useful analytical tools which I will use fairly regularly. That I demonstrate by example.

French fries and (economic) freedom

Lamb Weston - the world's biggest marker of french fries is a minor obsession of mine. Margins have crept up and are now over 17 percent. If you go back 20 years (well before the company was spun out of Conagra) the company business faced gluts and made losses. 

Profitability has been rising for years. Operating margins are now two thirds of Apple. But Apple do cool sophisticated and expensive stuff for those margins. Lamb Weston processes and distributes potatoes.

The business used to be cyclic. There is an article in the New York Times in 1997 about about a glut laying waste to the industry. 

But it doesn't look like that now - and it hasn't for years. 

The market values Lamb Weston at 3.4 times sales. [Ratio is (net debt + market cap)/revenue.]

By contrast Apple - a company that has huge market power and very fat margins - is valued at 2.9 times sales.

To me this looks absurd. The market values wholesale sales of french fries considerably higher than it values Apple's sales.

Apple does a huge amount for its sales. They develop and manufacture sophisticated and groovy devices with sophisticated software. They have redefined corporate cool. And they smell hyper-profitable.

Except that buying potatoes cutting them into french fries, par cooking them, freezing them and distributing them to fast-food chains is valued more highly by the market. (Again my measure is EV to sales but this is true by most measures...)

And it is not as if french fries are high growth either. They grow low single digit - and there are good reasons (mostly health) as to why that should slow too. 

I have to ask myself why shouldn't I short Lamb Weston. Surely competition is going to rip those margins lower at some point.

Tepper and Hearn provide one explanation as to why I should not put on the obvious trade - oligopoly.

And it is pretty clear that they are right. French fries is a super-profitable business.

In conference calls Lamb Weston signal extremely modest expansions in capacity. It is like the many companies who signal in conference calls that they are happy with their market share. They are of course signalling that they are not interested in a price war.

Of course an oligopoly is vulnerable if someone well funded wants to enter the industry. And in a country with true economic freedom that shouldn't he hard. There isn't anything spectacularly technical about making french fries.

That the margin has stayed this high (and indeed grown) is a signal of a lack of economic freedom. Nobody seems able or willing to break the french fry oligopoly - and that has to be in some sense political.

We shouldn't call them "freedom fries". May I propose "economic oppression fries". It seems more accurate.

The politics of the french fry oligopoly

French fries it seems are absurdly profitable. The return on assets is in the teens (which seems kind-of-good in this low return world). Margins keep rising and yet there is no obvious emerging competition.

It may be a good investment even though it looks pretty expensive. But if competition comes Lamb Weston could be a terrible stock.

There has been plenty of consolidation in this industry. Sure many of the mergers shouldn't have been approved by regulators - but they were - and the industry has become oligopolistic.

But this is not a complicated industry - it is not obvious why competition doesn't come. 

Bluntly I really don't have a clue what keeps the competition out.

It could be regulation (and captured regulators). It might be the farmers don't want further entries.

Whatever there is not much policy ground for lowering the cost of french fries. They don't exactly meet public health objectives.

Tepper and Hearn would argue that the oligopoly is used to suppress payments to suppliers - and the main supplier here are Idaho farmers. Usually they would be pretty good at lobbying. But there is another possibility - which is that the oligopoly is super-strong - and some of the excess profits are used to pay over-market prices to the farmers and maybe the farmers have (in their own interest) chosen to lock up the industry with regulation (and lobbying).

This is the sort of thing that is never spelled out in the accounts. After all if the company makes its profits by screwing the public it isn't going to tell you. [Unless they are United Airways who are just jerks.]

So without a detailed knowledge of the politics of rural Idaho I can't really analyse this situation. But hey - after reading this rather good book I know the questions to ask.

If anyone is really familiar with this oligopoly (particularly any potato farmers) I would really love to talk to you.

Till then I will just try to find another interesting book to read.

John

Afterpay: a regulator view

The Australian Securities regulator (ASIC) has come out with a long review of buy-now-pay later arrangements in which it has decided to do nothing monitor the companies going forward.

This is perceived by some as very bullish for Afterpay. The stock is up fairly hard as I write this.

Afterpay (ASX:APT) is the big player in this industry and a cult stock and cult product amongst Australian millennials. There are several other players and ASIC's study covered six of them.

ASIC does not have a reputation as an aggressive regulator so that they are monitoring the company going forward is the expected result.

But the ASIC report (available here) does give some insight into Afterpay.

Here are a few extracts:

First an example of underwriting:

Case study 1: Debts on top of further debts 

Vicki was in her early 20s and a mother to three preschool-aged children. She was unemployed but received Centrelink payments. 

Vicki had multiple payday loan debts totalling $4,000 and a $9,000 car loan. Vicki also had a $1,000 debt to Certegy Ezi-Pay that had been referred to a debt collector and several telecommunications and utility debts. 

Vicki explained that she then incurred a $740 debt to Afterpay to buy goods at a butcher and several clothing stores

Note that Afterpay is the last lender here and lent after a previous debt had been referred to a debt collector.

And another underwriting example:

Case study 3: Sold goods that the consumer didn’t need 

John received a carer’s pension. He was cold-called by a merchant who sold him a solar power system financed through Certegy Ezi-Pay. John said he did not have a job at the time and the salesperson said that he would write down John’s last job. 18 months later, he owed over $6,100. John also owed over $7,000 on a loan and $3,000 in other debt.

John said he started using Afterpay in early 2018 and now owes them $960. He said he doesn’t recall being asked about his expenses when he signed up for this arrangement.

Note again Afterpay is the last lender.

And another underwriting example:

Case study 4: No inquiries about the consumer’s financial position 

Ben was unemployed, received a disability support pension, and lived with his father who assisted him as a carer. Ben said he had a shopping addiction. 

Ben reported feeling overwhelmed with debt. He had a $5,000 credit card debt, and he was able to accrue a $1,500 debt with Afterpay, and a $1,000 debt with zipMoney.

In this case Afterpay lent after the consumer was clearly in trouble. But they may not have been the last lender.

Afterpay - the worst lender in the group

Afterpay is considered the gold standard in this sector. It has the most highly valued stock. I have asked several bulls and they all tell me how much better Afterpay is than the competition.

But ASIC have the numbers. Here is a graph of the percentage of Afterpay customers who incur a late fee versus the competition. It sure looks like Afterpay has the worst credit quality.

All I can say is that ASIC have helped out researching a controversial stock.





John