When I started this blog I promised to explore the negatives in my stock positions at least in part because it forced me to think clearly. We have a small position in Microsoft - and there is news today which lays out precisely how crushed a company Mr Softee has become. That news comes from - of all places - Verizon.
The new hot mobile phone operating system is linux-based with overlay system developed by Google called Android. It is open source and phone makers (HTC, Samsung and even Motorola) can take this system and incorporate it in their phone and not pay a penny. At first glance it is hard to see how Google makes a dime out of this operating systems.
At second glance it is not. The way people (especially the young and especially in developing countries) are interacting to the internet is through their phone. There are plenty of opportunities. With an Android system it is likely that will be with the Googleplex. Google - if you haven't noticed - is making plenty of revenue opportunities - and Android is part of the key to catching them.
Bill Gurley nailed it with possibly the best blog post I have read in the past year on any topic - where he described Google's business model as the "less than free" model - where Google will pay people to use their operating system provided they link the end-customer into the Googleplex.
Of course since anyone can modify the Android system anyone can compete with Google by modifying android and linking into their cloud services. We could have the Yahoo mobile phone that links you to Yahoo search and Yahoo maps and Yahoo mail. Or for that matter we could even have the Microsoft Android phone.
No wait - we do have the Microsoft Android phone - courtesy of Verizon. Verizon has just launched a very-high-powered Samsung phone that runs Android. Google has been disabled - and everything is linked to Microsoft. To quote Gizmodo:
Verizon, unfortunately, is also what ruins the phone. Or, rather, what it's forced Samsung to do to the phone, which you could sum up in a word: Bing. Bing is the default—and only—search engine on the Fascinate. A Google Android phone. In the search widget, in the browser, when you press the search button. Bing. No, you can't change it. There's no setting for it, and the Google Search widget that you can snag from the Market is blocked (or at least very carefully hidden). Being unwittingly forced into Verizon and Bing's conjugal relationship is infuriating on its own, but the implementation also feels like the sloppy hack that it is. The co-branded Bing/Verizon portal that an in-browser search takes you to is ripped from the circa-2005 dumbphone-approved "internet," while the Bing Maps app that it pushes you toward is vastly inferior to Google Maps (no multitouch, Latitude, etc.). To be clear, Bing itself is fine. This implementation of it is not.
Now presumably Microsoft paid Verizon handsomely for this. And that lays reveals precisely how bare the Microsoft business model has become. Microsoft is in the business of selling operating systems. Almost all other businesses are extras or adjacencies. They were once thought to have a "monopoly" on operating systems and were taken to task by the Justice Department.
Well Justice was wrong. Flat wrong. Microsoft is now paying telephone companies to use somebody else's operating system - a total business inversion - and one that lays out just how much BS was in Justice's argument. Ouch.
But worse - Gizmodo argues that Microsoft ruined this phone. So now Microsoft is paying phone companies to use other people's operating systems and even then they can't get the customers to like them.
Microsoft is darn cheap - even breathtakingly cheap. But boy is this a dramatically weakened business.
Warren Buffett describes certain types of business competition as a bit like standing on tippy-toes at a concert-in-the-park. His particular story was in the textile industry of Berkshire Hathaway’s origin - management would come in and sell him on a (very expensive) new set of machinery which would improve productivity by say 30 percent - and hence have a very high incremental return.
He would - after much arguing - agree to put in the machinery. The same decision was made by every other textile mill in the country. The marginal cost of producing textiles thus falls - and competition ensures that the price falls. The machines thus raise productivity but do not raise profits - indeed shareholder returns [cash flows after compulsory (re)investment] fall. Consumers benefit (which is the joy of competition) but from the textile mill owner’s point of view it would have been better had they just collectively sat on their collective backsides. He likens this to standing at the concert in the park - individually rational perchance - but it is still better if everyone just uses their gluteal muscles.
I feel the same about bank capital ratios. In the UK banks were allowed to lever themselves to a silly extent (similar over-leverage occurs in their life insurance companies). Overleverage as a policy was the defining character of Northern Rock.
Individually it makes sense for banks to lever up. However competition was intense - and collectively it was insane. Northern Rock was levered 60 times or so - but to mortgages that were really thin margin. Their spreads were about 40bps. (I wrote my impression of Northern Rock down here...)
What I suspect is happening is all the banks are standing on tippy-toes. It is individually rational - collectively insane because competition kills the benefit of all that extra leverage. Margins in the UK - the most over-levered market on the planet - fell further than anywhere else.
Of course competition was good for borrowers - at least for a while. Lower spreads meant cheaper finance - but not dramatically cheaper. Spreads of 150bps on mortgages levered 15 times is about as profitable as spreads of 40bps levered 60 times. Competition might drive spreads down by 110bps - at the risk to the whole banking system.
Its bad for the shareholders in the end because the banks get their excessive ROE on a smaller amount of capital at much greater risk than in the safely - and excessively capitalized - regulated environment.
I mention this because of my perverse view that re-regulation - opposed by most bankers - might be surprisingly good for banks over the long run.
The real winners and losers of deregulation
Competition - I argue - removed any real benefit of deregulation for bank shareholders. (The benefits for bank management created by the sudden need to cope with this brave-new-world however were obvious. They saw the opportunity and need to grow to maintain ROEs - and they lent with gay-abandon - taking all sorts of fees, commissions and bonuses along the way...)
The benefit for borrowers of competition however were dissipated in higher home prices and hence larger mortgages. The real winners were people selling homes - not people buying them. Even quite modest houses became valuable - and the elderly (the classic group moving to less expensive homes) did quite well. I haven't heard the expression "old and poor" quite as much as I used to. More generally you can see the relatively affluence of the elderly in the sell-the-home and go cruising set. Carnival Cruises was - for a very long time - a better stock than you might ever have imagined.
The other supposed beneficiary was suffering an illusion. Plenty of people - especially in their children’s teenage years - had an-in-the-end-illusory wealth effect - where they thought their home was worth much more than it was - and felt confidence in spending some of that money - or in saving less for their retirement - because after all they could downsize and they might inherit part of Grandma’s (housing) fortune.
Net-net the losers out of excessive bank leverage were (a) the shareholders because they got lower spreads and took more risk, (b) taxpayers because they partly bore the risk and (c) younger home buyers because they got royally-rogered by the elderly people they bought from.
I am waiting for some bank management - particularly a stronger incumbent - to see it that way and advocate sweeping bank re-regulation which will (a) reduce taxpayer risk (b) increase spreads and (c) reduce leverage. This will allow the strong incumbent to earn a good ROE at little risk on a lot more capital and will make the bank's shares a surprisingly good investment.
I doubt I am going to see it. These are the sort of @&$?! who stand up on their tippy-toes in front of you at Opera in the Park.
John
PS. Thanks for the many comments on the gold post. My inbox is also filled so if I do not answer all of your emails it is because they are so numerous. (I read them all though!)
We live in a strange world - the 10 year US Treasury is trading with a 2.63 percent yield. The market is presuming that there will not be much inflation in those ten years. However if there is deflation (as per Japan) then the 10 year will wind up being a very good investment (see my blog post on Japanese bond yields from the perspective of a Japanese household).
At the same time gold is appreciating very sharply - from $950 per oz to $1250 in the past year - and from $800 two years ago or $450 five years ago. On the face of it the gold price is predicting inflation.
Try as I may - I can't see any reason why both those prices are correct. I have long held the view that prices are mostly sort-of-rational - and that finding patent contradictions in pricing should be rare - because - if you can find them - there is usually a way to make money from them. But this looks wrong.
So either there is a theoretical way in which both these prices can be correct or even my weak version of the efficient market hypothesis is spectacularly wrong. But finding the way in which both these prices are correct is taxing my ingenuity.
My first question thus is can anyone tell me why these prices could possibly be consistent? Is there a rational reason why the bond market is pricing low inflation and the gold market seemingly pricing high inflation? Does anybody have the ingenious world view in which both these prices are correct?
The second question is more mercenary. If this really is as irrational as it looks what is the trade? What is the set of transactions I can place in financial markets which should make me money? My gut reaction - being a short-seller - is to short both the long bond and gold - but there are some awful tail-risks with that trade. For instance suppose money becomes suddenly near worthless - a Zimbabwe outcome. Then the gold price goes to the moon - and I have to return it - so I lose badly. And the bonds were a wonderful short in that I just made a lot of dollars - but the dollars are suddenly alas also worthless - they don't solve my problem of being short gold.
I have just read Daniel Amman’s excellent biography of Marc Rich - the oil trader notoriously pardoned by Bill Clinton. I don’t want to get into the politics and ethics of the pardon other than to note that few things in it are black-and-white when you finished reading the book.
But the way Marc Rich made his money is fascinating and says a lot about the current re-regulation debate.
Marc Rich exploited price fixing/import/export controls to make simply unbelievable profits trading oil. Marc Rich & Co (the Swiss vehicle) was started with just over $1 million in capital and a couple of years later was making in excess of $200 million in profit. This level of profitability exceeds - by far - any other trading operation I have ever seen - and was probably the most profitable trading operation in history. Marc Rich & Co (since renamed Glencore) is possibly the most valuable business in Switzerland within the lifetime of its founder.
A typical Marc Rich & Co trade involved Iran (under the Shah), Israel, Communist Albania and Fascist Spain. The Shah needed a path to export oil probably produced in excess of OPEC quotas and one which was unaudited and hence could be skimmed to support the Shah’s personal fortune. Israel - a pariah state in the Middle East - wanted oil. Spain had rising oil demand and limited foreign currency but was happy to buy oil (slightly) on the cheap. Spain however did not recognise Israel and hence would not buy oil from Israel - so it needed to be washed through a third country. Albania openly traded with both Israel and Spain. Oh, and there is an old oil pipeline which goes from Iran through Israel to the sea.
So what is the deal? The Shah sells his non-quota oil down the pipeline through Israel and skims his take of the proceeds. Israel skim their take of the oil. Someone doing lading and unlading in Albania gets their take and hence make it - from the Spanish perspective - Albanian, not Israeli oil. The Spanish ask few questions. The margins are mouth-watering - and they all come from giving people what they really want rather than what they say they want. We know what the Shah wanted (folding stuff). We know what Israel wanted (oil). We know what Spain wanted (cheap oil). Who cares that Spain was publicly spouting anti-Israel rhetoric. [Similar trades allowed South Africa to break the anti-Apartheid trade embargoes.]
It also helped that Marc Rich & Co was a (highly) multilingual firm. Rich is fluent in Spanish (it is the language he talks to his children in). He speaks English, German, Yiddish and presumably Hebrew. His business partner (Pincus Green - pardoned the same day as Rich) speaks Farsi amongst many other languages. They could do this deal because they could negotiate it and - deep in their heart they hold the Ayn Rand view that trade is a moral virtue and hence they do not need to be concerned with other morality. [The only line that matters is the law - and then it might not be the law of his adopted country - Switzerland - rather than the United States where he was resident.]
And when the Shah fell? Oh well - Pincus Green - an American Jewish businessman - gets on the plane to Iran and does a similar deal with the Mullahs - who - despite their rhetoric will sell oil down a pipeline through Israel - and will allow Israel to skim their take. Trading through the American embargo - well that is just another instance of getting around restrictions and profiting (very) handsomely. [Rich would argue that the trades were done by the Swiss company which was not subject to the American restrictions.]
The regulatory regime for domestic American oil was also perverse. Old oil (meaning wells drilled before the first oil crisis) received one price. New oil (wells drilled after the crisis) received a higher price. Squeeze oil (oil that was extracted from wells that ran less than 10 barrels per day) received a higher price still. The oil could be chemically identical and the price difference over $20 per barrel. Obviously a trader with a method (any method) of changing the oil source could make a fortune. Again I am not commenting on legality or morality. That was just plain fact. Ayn Rand applies - you give a value and you receive a value.
What all this regulation did was that it allowed people to make simply grotesque profits by thwarting regulation. The regulation thus worked less well and it was socially unfair. Pincus Green was good at negotiating in Farsi. He was astoundingly brave going to Iran immediately after the Shah fell. He was good at organising shipping. He worked really hard - but he did not invent something that changed the world and he wound up a billionaire. Traders make money by intermediating real business solutions - but these were real business solutions to problems made by legislation. Bad regulation, moral indignation about “trading with the enemy” or “trading with Israel” or with racists in South Africa made people with Ayn Rand morals exceedingly wealthy because you could arbitrage your way around any of these regulations.
If you read the Marc Rich book you will understand why lots of people who were generally left-of-center became ardent deregulation advocates. Plenty written by Krugman look like it advocates deregulation. (Not convinced: see his review of Laura Tyson’s book on trade theory in Pop Internationalism. Indeed see most of Pop Internationalism as favorably reviewed by - of all people - the Cato institute.)
Crank forward to the current crisis: what we see are the problems of deregulation and complexity. We see traders and investment bankers who get rich - not as rich as Marc Rich and Pincus Green - but still frighteningly rich. And they get there by taking risks that are ultimately absorbed by taxpayers or mutual fund holders (particularly taxpayers). We see agency problems everywhere - where management enrich themselves at the expense of others - and they do so by capturing upside but (in part) socializing the downside. Regulation in this case is about controlling agency problems - about stopping people privatizing the profit and socializing the losses.
A plea
As a plea then I want a debate about the right form of regulation - a regulation that controls agency problems but does not allow arbitrage opportunities to people with “Ayn Rand morals”.
We are not going to get that from the current Tea Party Republicans. They simply argue that regulation (they say but do not mean all regulation) impinges on “freedom” (something that is clearly a good but hard to define). However many of the same people want planning regulations to ban a mosque in downtown New York because it is an insult to the victims of 9/11 (and banning mosques is not a restriction on “freedom”).
If that is the level of debate we are not going to get good re-regulation - we are just going to get pandering to whichever lobby group manages to garner most support. And that is a real risk because we will leave agency problems in place (they benefit the rich and powerful) and we will introduce the same sort of (dumb) regulation that made Marc Rich and Pincus Green astoundingly wealthy. That sort of regulation also benefits the rich and powerful - especially those with “Ayn Rand morals”. [The rich and powerful - if you have not noticed - are good lobbyists. Unless we are careful many amongst them will get their way.]
I don’t know how to do this well - but I thought I would state the obvious. The most obvious things that need regulation are things with a government guarantee (implicit or explicit). If you have an implicit guarantee (as we now know almost all large financial institutions have) then regulation really matters. If there are large agency problems (small shareholders, large management) then regulation should be deliberately biased to put power in the hands of shareholders not managers (eg banning staggered board elections).
Likewise other agency problems should be strongly policed and the regulation should be of the form that allows that policing. When Elliot Spitzer found that Marsh - a large insurance broker - was participating in bid rigging against schools buying insurance that was shocking - and is precisely the sort of thing in financial markets that should be policed strongly. But it took Elliot considerable effort to find and prove his case. The rules should be established so that sort of behaviour is really difficult to hide.
And I do not think that I need to explain to anyone how much mortgage brokers contributed to the crisis by (a) deliberately misleading borrowers about conditions on their mortgage and (b) participating in the faking of borrowers income/assets/education level when they on-sold the loans to Wall Street. Agency problems were at the core of the crisis.
On the other side if there is no agency problem then deregulation should remain the order of the day. Trade restrictions create arbitrageurs - and the arbitrageurs ensure the trade restrictions don’t work anyway.
There are obviously going to be extensions to this rough rule - and this post is really to garner discussion. But for a start I expect agents who benefit from their agency (and the abuse of their agency) to join the Tea Party.
It is difficult to get policy right. And when and if the policy is got right we are in for a very long fight to implement it.
The main market for virtualization is not desktop computers - it is servers. Rackspace for instance is really a business running virtual private servers.
Rackspace claim 99.99 percent availability - but it did stuff up once and upset Michell Maulkin and Justin Timberlake. That was a small failing (and I would not worry too much about either of those people being upset). But more to the point - the failing was less than 20 minutes.
We however at Bronte have a server (an old Dell box!) connected to the net via a DSL modem and the vagaries of Telstra (possibly the OECDs worst incumbent phone company). My business website is down. Worse - my @brontecapital.com (that is business) emails are bouncing...
The problem is - you guessed it - Telstra.
One advantage of a virtual server in the "cloud" is that it can be mirrored in jurisdictions other than my own and hence removes the Telstra risk. Telstra risk is a serious problem in Australia.
The cloud may be an online offer - but it is almost certainly a superior product. And to anybody whose email bounced... sorry.
Over time we will give up on in-house information technology and move entirely into the clouds.
And if you are a Hewlett Packard shareholder you should think that through. The cloud is ultimately cheaper, allows you to outsource (or remove) your IT staff and offers superior execution. That is wonderful for many - but for the incumbent midrange server maker having a competitor that is superior in every way looks - well - ugly.
I have just done a huge amount of work on virtualization (see the recent "geek" posts here and here and here and the post on Dell). I worked out where Dell was going on virtualization and understood that HPQ was likely to play "catch-up". (This surprised me - I was stunned how far Dell had travelled.)
I understood the 3Par acquisition - and knew that HPQ was also lacking in this area and thought that Dell was (cleverly) leaving Hewlett Packard strategically challenged. I also put a small short on HPQ because of this.
So - having got all that way it never occurred to me Hewlett Packard would overbid Dell for 3Par.
Going long 3Par was an easy bet. Its downside was protected by Dell's cash bid (which would completed as the deal was important to Dell and Dell could finance it with cash on balance sheet). The upside was an overbid by HPQ. It was a bet with very nice risk-return characteristics.
And I did not do it.
Politely that is "lack of execution" - but I should stop making excuses. One word for that one: dumb.
I have already been asked by email what the Australian election result means and what will result from it. At this point I do not know – and frankly nor does anybody else. However I hope – and removing my politics from this – to give a quick handbook for someone with almost no knowledge of Australian politics. So please forgive me starting very basic.
What you need to form government
Australian politics is based on a “Westminister system”. That is – like the UK – to become a national leader you first need to elected a local representative in the “house”. This representation is in single-member seats. To become the national leader (the Prime Minister) you need to control the votes of a majority of the members of the House. Normally this happens through tight “party affiliation”. When you elect a member you know which party they belong to – and so you are really voting – indirectly and by convention – for a Prime Minister.
There are 150 members of the house – so 75 members for both sides would be a tie. You need 76 members under tight control to form a majority government.
A short summary of the political parties
I need this to explain roughly where the political parties sit. The main conservative party in Australia is (strangely) called the Liberals. There is a second conservative party called the Nationals. It is generally impossible for the Liberals to form government without an alliance with the Nationals – and so the conservative parties are generally known as “the Coalition”.
The Nationals are a strange and declining beast. They started life as “the Country Party” and their affiliation was Agrarian Socialist and (highly) socially conservative. The most famous of all Country Party politicians (Black Jack McEwan) was also probably the most economically interventionist politician Australia has ever had. The reason that the Nationals are declining is largely demographic change. Australia is becoming more urbanized as the average size of farms increases and agriculture becomes more of a “scale game”. Secondly the coastal seats are having huge demographic change as Sydney and Melbourne voters are moving to the coast either for lifestyle reasons or retirement. (“Sea change” is a big demographic trend in Australia.)
Like in America, conservative politics is an amalgam of economic conservatives and social conservatives. In America the social conservatives are the dominant voting block within the conservative party. In Australia it is more balanced.
The main non-conservative force is the Labor Party – a party which grew out of the (declining) unions and – is to some extent – still beholden to the unions. In the dim-distant past Labor party officials used to refer to each other as “comrades”. They continued to do it ironically well into the 1980s because it infuriated the right wing members. Now they just call each other friends (which is itself ironic). This is the party of factionalized power and voting blocks. Other than ensuring a remaining power base for union officials it has been difficult for many years to say what the party stands for other than a pragmatic approach to gaining and holding power.
Mostly to the left of the Labor party is the Greens. The Greens are hard-line on environmental issues (mostly), mostly very left-wing on straight economic issues and mostly extremely liberal on social issues. The Green policy summary for this election are (a) not just have an emission trading scheme for carbon but tax the polluters into the bargain, (b) make the miners pay the full-undiscounted original mining tax, and (c) legalize gay marriage.
The classic dividing line between the Greens and the Labor party is logging of high conservation value forests. The Greens are hard-line opposed. The Labor party is (mostly) inclined to take the position of the (unionized) forestry workers. They can irregularly (say once per 20 years) take a power-pragmatic position to align with the Greens in exchange for Green preferences in urban areas.
If you are mostly economically conservative, mostly socially liberal and fairly hard line on environmental issues there is simply no single party to belong to or vote for in that you will disagree with their positioning on something.
The balance elected last night
There are many “seats” (meaning positions in the “house”) that will come within a couple of hundred votes so final results will not be known for a while. However the split is likely to be 73 Coalition, 72 Labor, 4 independents and a Green. Three of the independents started their career with the National Party – so the most likely outcome is that they will support the Coalition on matters of confidence and we will get a Coalition minority government. But that assumes (as I would not) that the independents are a stable block.
The three conservative independents are very different beasts indeed. Firstly Bob Katter – representing an electorate in remote far north Queensland – is an old-fashioned National Party politician – and split from the Nationals over differences on economic policy and social policy. He is more interventionist on economic policy and more conservative on social policy than the Coalition. Indeed his positions are so strong they are almost a caricature of old-fashioned National Party values. The expression – not necessarily unkindly - is that he is as “mad as a Katter”. This advert is representative of the man.
Do look at this video. I cannot imagine any other politician advertising himself as the right guy when there are crocodiles on the loose or cattle have gone astray.
Rob Oakeshott by contrast represents a coastal electorate much closer to Sydney. He is an economic conservative and social liberal. His split with the Nationals is because his socially liberal values did not fit in.
My only involvement with him (or more precisely his office) came about because of Astarra. He represents a coastal electorate with many retirees and some victims and he is the only politician who has taken up the issue. Rob Oakeshott is likely to be friendly with Bob Katter – but on many issues they are a long way apart. I can’t imagine myself ever voting National – but I have to confess to liking Oakeshott a lot of the time – and I suspect I would like the man (though I have never met him).
I do not know anything about Tony Windsor (the third conservative independent) except that his electorate is more mainstream National Party territory – and it is likely the man is closer to the National Party than either of the other two conservative independents.
The Green is – as far as I can tell – a typical Green – he won a safe Labor seat taking extremely socially liberal positions in a socially liberal inner-urban electorate.
The remaining independent victory was a total surprise. He is the only minor Australian politician I would expect any of my non-Australian readers to know. The name is Andrew Wilkie – and I would describe him as a centrist with a white-hot fierce moral integrity that could easily be confused for self-righteousness. He started his career in the military and was educated at Duntroon (the Australian equivalent of West Point). He rose rapidly to Colonel and along the way joined the Liberal Party. He left to be an analyst at ASIO – the Australian equivalent of the CIA. He famously and publicly resigned when he felt the intelligence about Iraqi weapons of mass destruction was being doctored for political reasons. His resignation was global news. He later stood as a Green against the incumbent Prime Minister in the 2004 election. He moved to Tasmania and stood as an independent against the Greens in a Labor stronghold seat and he has probably won.
Summary
I do not know whether a stable alliance can be made of these people – but the Coalition plus three originally conservative independents makes one think the most likely outcome is a Coalition government. However it will be very hard to keep Bob Katter in the tent simply because he is so extreme on so many issues. If the issue-of-the-day however is one where the government is more socially liberal than Katter (ie most people on most issues) then perhaps they can make up the numbers with either Wilkie or the Green.
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