Blue Sky - some notes and an agenda for ASIC

Blue Sky Alternative Investments Limited collapsed after a short-sellers report from Glaucus - a now-disbanded two person short-selling research shop.

Blue Sky managed many funds - a macro-futures fund, a big fund trading water rights, a venture capital fund - and the funds were sold to investors (mostly retail, some institutional).

Blue Sky claimed to have $3 billion under management on which they collected base and performance fees. They only had about 100 staff at peak.

And they went bust.

The official story - promoted by several members of Blue Sky Management - is that Blue Sky was a fine institution - but reliant on public trust - and it collapsed because of a misleading short-seller report. They think that the collapse of Blue Sky was akin to a run on a bank. Lies were sufficient to cause the demise of an otherwise sound institution.

This is not obvious from the accounts. And it assigns magical powers to short-sellers that I did not know I had. (I am a short-seller.)

I do not know what went on at Blue Sky beyond what is in the accounts - but just the accounts are fascinating enough.

Here is a quick run through them:

The Blue Sky 2014 Annual Report

Blue Sky was on its way to being a successful asset manager in 2014.

Here is the key section from the shareholder letter:

Assets under management had doubled from $350 million to $700 million. They bought “Investment Science” – an award winning fund manager.

They raised $60 million for a listed (and closed end) fund called Blue Sky Alternatives Access Fund. Those are wonderful for an asset manager because they produce fees that do not disappear. You do not “redeem” a listed fund, you simply sell it on the stock market.

Finally – and most importantly – they raised $35 million from the public which they were going to use for co-investment in their funds.

The profit and loss account is repeated below.

This P&L surprises me a little. The main expense of both asset managers I have worked for is staff. Asset management largely consists of desks and computers and lots of people. Analysts, compliance etc. But in this case employee benefit expense is only $8.5 million – and the biggest expense is “other expenses” detailed in Note 8. So it is worth thinking what they might be:

Some of these expenses I am familiar with. Fund establishment expenses for instance are ones that I have borne but never in that sort of quantity. That said Blue Sky ran many funds – so they are plausible. Blue Sky also managed investment property – but I have never seen the manager (rather than the funds) bear the costs associated with sales of that property. But I have personally borne expenses that would normally go in small funds as part of the cost of getting funds running. So I am happy to accept it.

That said – in 2014 Blue Sky is a fast-growing and profitable asset management firm that had raised $35 million in cash at parent company level which it invested in the funds it managed.

The 2015 Annual Report

Here is the core extract from the shareholder letter in the 2015 annual report. Funds under management had increased to $1.35 billion – roughly doubling. And profitability grew nicely. The underlying funds were performing well with approximately 15 percent annualised performance since inception.

The P&L account made progress too. Operating revenue is $58 million. For a fund manager this is an a very large revenue pile offset (again) by sundry other expenses.

Remember the core expense of a fund manager is people and the desks to put them in. $58 million in revenue should leave an awful lot of fat after that expense.

There wasn’t a huge cash raise this year – so the amount of co-investment in the Blue Sky managed funds was not large.

The 2016 annual report

2016 was very like 2014. The company raised money again to co-invest in funds. Here is an extract from the shareholders’ letter.

Note the critical detail here – the company raised $66.8 million in cash at the parent company. That cash was mostly left on the balance sheet that year though some was used for co-investment in the funds that Blue Sky managed (see discussion below).

The Chief Executive also noted that funds under management had grown to more than $2 billion and they were targeting $10 billion. Returns were of course good.

At the end of the year they held $35 million in investments in their own funds. These are itemised.

Note that a net $11 million dollars was invested in the funds during the year (16.5 million in additions, $5.1 million in disposals). 

Operating cash flows in the year were $13 million so the bulk of operating cash flows were invested in Blue Sky funds. Their past investments did well too.

But the core observation here is an organisation in rude health., It has $35 million in investments, and a cash balance over $60 million mostly raised in the secondary market. Revenue was about $60 million and staff expenses still modest.

The 2017 annual report

In 2017 Blue Sky went from strength to strength. Here is the key extract of the annual letter.

Things grew about 50 percent across the board – with fee earning assets now about $50 million. Here is the key part of the shareholder letter.

Revenue was over $70 million after share of operating profits from their investments and just shy of $70 million prior. As per usual much of the cash balance got poured into their funds as co-managed investments.

You can see this on the asset side of their balance sheet. Investments in retirement villages (which they operate) is $54 million. Investments in associates and joint ventures is another $51 million.

The retirement villages are the Aura village – but even that was doing well as they booked an increase in fair value.

We know these funds were eventually returned as Blue Sky sold the Aura projects. This was after the final 2018 annual report as per this press article.

https://www.theweeklysource.com.au/blue-sky-returns-686-5m-in-funds-including-for-three-aura-projects-to-investors/

The other investments were also moving along nicely. Here is the reconciliation:

You will note that this lists the specific investments. They are quite profitable (with $8 million of appreciation). Net additions were about $9 million (25 additions, 15.9 disposals). They were continuing to pour money into their investments. As their investments were profitable this seems a good thing.

The 2018 annual report (also the final annual report)

The 2018 annual report was written after the short-seller report – and the results had begun to fall apart. Here is the core part of the shareholder letter:

The Chairman described the year as Blue Sky's annus horribilis.

That said the financial position is pretty good because they raised $100 million in cash from shareholders just before the Glaucus short-seller report came out. This extract makes this clear:

There was no debt. They also state clearly they expect cash from the balance sheet to be “recycled”, that is they expect to cash some of their existing investments and to invest more.

The asset side of the balance sheet shows the deployment of all this cash (notably the cash they raised).

Note that the investment in retirement villages is now $112 million and the investment in associates is $46 million.

The retirement village reconciliation is below:

As of the 2018 annual report this investment was still doing well – they booked almost $5 million in unrealized gains. But they did pour in and capitalize $47 million of cash. That said this is $112 million invested in Aura – and as noted in the above press article this was largely returned to investors.

The investment in associates is also reconciled in the annual.

This time they made modest losses, booking 6 million in losses and partially reversing the prior year gains. They did however make net additions absorbing some more of the cash they raised.

The actual investments are listed too:

Presumably these investments were there at the end too.

What happened next?

There are no more annual reports from Blue Sky.

Blue Sky ran out of money and they took a further $50 million in cash from Oaktree.

They couldn’t meet the terms of the Oaktree loan and they were put in liquidation.

On their numbers they had a couple of billion of funds under management which presumably come with management fees of 1 percent or so. They had collectively raised almost $200 million in cash at the holding company (with equity offerings in 2014, 2016 and 2018) and they had $50 million in cash raised from Oaktree. And they had invested that money into funds that they said performed well.

And then they could not repay the money to Oaktree.

Three hypotheses

I have only three hypotheses to explain this situation.

Either

• a)     The cash raised was invested in funds that remained there when Oaktree put the firm into liquidation – and Oaktree wound up for $50 million with investments that had about $200 million in cost. Oaktree made out like bandits.
• b)    The cash raised and the accumulated profits were invested in Blue Sky funds – but that Blue Sky is such an atrocious investor that $200 million in investments at cost were not enough to repay Oaktree on liquidation or
• c)     The investments were never made – and were fictional from inception. The cash raised wasn’t invested. It was diverted for purposes unknown. And likely the profits that Blue Sky booked along the way were fictional.

The second explanation - the one that management lost all that money - is the most innocent of these. Loosing money is a pity, but it is not a crime. [That explanation is also difficult for Blue Sky management who wish to stay in the asset management business without a tarnished reputation.]

I do not have any access to Blue Sky's liquidation reports or internal accounts. But ASIC has been made aware of this analysis - and if by this time next year we have not seen an answer to where the $200 million raised went to then I will be disappointed.

I wrote this all out because I am a little off-put by the negative press that short-sellers have received here - even though - on the face of it it looks like a cool couple of hundred million (a quarter of a billion including the Oaktree loan) have just gone missing.

But at this point Blue Sky has gone to zero. It is not up to short-sellers to explain what really happened. That is up to Australia's corporate regulators.

This is a really important case for them.




John

Thinking aloud about bank margins - Part 2

Part 1 of this series laid out a bleak future for monetary policy and/or banks. As interest rates go down so do bank margins and there are limits on how far interest rates can be cut because eventually they take bank margins below levels adequate to cover losses or even below levels adequate to covering operating costs.

If this is right ultra-low interest rates are non-stimulative because they stress the bank sector causing the bank sector to tighten (not loosen) lending. Monetary policy hits a wall of non-effectiveness and ultimately bank bail-outs.

This is essentially the Raoul Pal view of the world. He sees no policy way out of the next recession -particularly in Europe - because if you don't cut rates you are stuffed and if you do cut rates you blow up the banks and you are stuffed anyway.

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As I said at the end of the last post I am not sure it is always so simple and/or so bleak. That is because ultimately there are two drivers of margins a weak one (Central Bank policy) and a strong one (the competitive landscape the banks face).

In Europe both of these are driving bank margins down for most but not all banks. But it doesn't need to be that way and more deft policy-makers have different options.

But to see why need to run you through a stylised history of banking margins.

Lloyds bank as the best bank in the world

Just over twenty one years ago The Economist wrote a glowing article about what was then a roll-up of British High Street banks. It was Lloyds TSB.

A glowing article about Lloyds seems peculiar now as the bank was bailed out in the crisis and has lurched from disaster to disaster ever since. But under the title of The Lloyds Money Machine the economist wrote the following:

... Lloyds TSB runs head-on into a problem that most other banks would envy: it simply earns too much money. By some estimates the bank is sitting on £3 billion more than it needs. It would gladly use this for acquisitions. But short of buying another big British bank and closing down hundreds of branches, which would almost certainly be blocked on competition grounds, it is difficult to imagine an acquisition that would be as profitable as Lloyds TSB's current business.

The bank had fat margins and was busy cutting costs. The article goes on:

Peter Ellwood, former boss of TSB and now group chief executive, believes that even without further acquisitions the bank can continue its impressive run by cutting more flab and by persuading its existing customers to buy more of its products. Costs have already been brought down to 52% of income, a low figure for such a large bank. Once Lloyds and TSB are allowed to merge, analysts at Dresdner Kleinwort Benson reckon, the bank could shut more than 800 branches without weakening its high-street coverage, thus saving up to £300m a year. Along with these savings will come proceeds from the sale of businesses that underperform. The bank is seeking to sell Black Horse, its estate-agency arm. Its small Latin American banking and consumer-finance network may follow.*

At the time Lloyds was the thirty-fifth biggest bank in the world by assets but the biggest by market capitalisation. It was hyper-profitable and traded at a svelte seven times book.

And then it all went horribly wrong. The bank took only a decade to be nationalised.

What went wrong was competition. At the time Lloyds revenue to risk weighted assets was 8 percent. This was the highest number I have ever seen on a major bank anywhere.

These fat margins attracted competition mostly in the form of Northern Rock and Fred Goodwin's Royal Bank of Scotland behemoth. These guys never saw a loan they didn't want to undercut. Revenue to risk weighted assets in British banks went down by 75 percent. If you do it as a percentage of assets revenue as a percentage of assets fell from over 5 to about 2.

The point of this is that this happened in a non-zero interest rate environment. Competition killed margins and excessive willingness to write loans meant that margins were destroyed just as credit losses ticked up. You can find a full set of Lloyds accounts from CapitalIQ downloaded here.

German (and Italian and Japanese) banking margins have been terrible as long as I have looked at banks. In both markets there was strong competition and a shortage of borrowers (at least relatively). Also in Germany there were aggressive Landesbanken who fulfilled the margin compressing role of RBS. It is kinda-nice when you fund yourself with a quasi German government guarantee. It is not nice to compete against someone who has a German government guarantee.

By contrast the oligopoly banks of Australia and Canada have made lots of money with a good economy despite being breathtakingly stupid. In banking - as in other industries - you make money out of market structure as much as anything.

Before everyone stuffed around with the definition of risk-weighted assets I used to compare revenue to risk-weighted assets by country. These are still roughly right in terms of profitability,

• The thinnest margin banks in the world were Japanese with revenue to risk weighted assets of about 1 percent.
• Then were the Germans and the Italians at about 2 percent
• The Americans were in the middle - between 4.5 and 5.5 percent with a single outlier - the most effective major bank at screwing their customers in America - and that was Wells Fargo. Wells Fargo was about 6 percent.
• Then there were the highly oligopolistic Canadians at 6-6.5 percent.
• Finally - the fattest margin banks in the world were Australians. And that was at 8 percent. 

Our friends at Lloyds went from 8 percent at the time of the article to something in the mid 2s now. The world wasn't quite turning Japanese - but maybe turning German.

But there are outliers - and some of them are surprising. The Irish Banks look in Ireland pretty darn profitable. The Scandinavian banks are alright too - despite (say) Swedish interest rates going negative before everyone else.

Even some French regional banks are okay.

And these banks are profitable even in a negative interest rate world.

Swedish banks faced negative rate early - and they came out kind of well.

If central bank policy is going to work the central bankers are going to need to learn from the banks that have maintained reasonable profitability in the face of negative rates. This may be the single most important lesson for central bankers in the next decade.

If I knew all the lessons I would tell you. I don't. I know several of the outlier banks but nailing down quite why they are outliers is hard. But I will look for you.

Till next time when I will have a look at the outlier-banks.





John

PS. Whilst for years I used revenue to risk weighted assets as a measure of profitability it doesn't work that well anymore because of changes in the definition of a risk weighted asset. For the next post I just intend on using revenue to total assets. It tells the story well enough.

*For the record the (retrospective) silliness of that Peter Ellwood quote didn't seem to hurt him later in his career. He got his knighthood somewhat later.

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:

-->

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