Thursday, December 31, 2009

Keynes on British industrial history

I will leave aside Felix Salmon calling me “socially useless” (as a short seller) until I am in a position to reveal my pithy reply.  For the moment all I will confess to socially awkward and highly indulgent. 

In the highly indulgent vein I have just finished reading Tony Judt’s truly stunning history of Postwar Europe.*  Anyway – I thought I would leave you from a quote from Keynes – made at the end of the (Second World) War.

If by some sad geographical slip the American Air Force (it is too late now to hope for much from the enemy) were to destroy every factory on the North East coast and in Lancashire (at an hour when the directors were sitting there and no-one else) we should have nothing to fear.  How else are we to regain the exuberant inexperience which is necessary, it seems for success, I cannot surmise.

For the US Air Force read the policies of Margaret Thatcher, Tony Blair and – we can hope – the ensuing discrediting of all financial management. 




*This improves dramatically on the last bit of Mark Mazower’s equally stunning modern history.   

Wednesday, December 30, 2009

Kodak, Bill Gates and efficient markets

I am just back from my summer holidays on the New South Wales South Coast.  To my (mostly) Northern Hemisphere readers I should boast about warm water, perfect waves, beaches in national parks with only one or two pairs of footprints on them and no people, fish that seem to suicide on your lines, etc – but that would just be boring.

In the middle of every day – when the heat became too much and the surf had waterlogged me I read.  On my kindle of course.  And some books which I had never read I read happily made easy mostly by the kindle’s large font options.  One of those books was Alice Schroder’s too long but otherwise excellent biography of Warren Buffett.  There was plenty there – I just want to share a single throw-away observation.

Warren Buffett has a group of his best investing friends get together once a year.  He originally called it the Graham group in honour of his mentor Ben Graham who presented at the first annual meeting in 1968.  By 1991 the group had expanded somewhat to include not only the original fabulous stock pickers but some business luminaries who could help enlighten the group on the nitty-gritty of their industries.  One regular attendee was Bill Gates of Microsoft fame.  From here I will quote Alice Schroder:

After a while Buffett asked everyone to pick their favourite stock.

What about Kodak? asked Bill Ruane.  He looked back at Gates to see what he would say.

“Kodak is toast,” said Gates.

Nobody else in the Buffett Group knew that the internet and digital technology would make film cameras toast.  In 1991, even Kodak didn’t know it was toast.

Gates was right of course – and since 1991 Kodak has been a terrible stock – and I would have counted Bill Gate’s comments as “knowledge” in as much as a statement about markets and technology could be knowledge.  But it would be an awful long time before that “knowledge” would be reflected in stock prices.  Here is a graph of the stock price since 1 Jan 1990. 



If you had taken Gates to heart in 1991 and shorted the stock then for almost ten years you looked like toast.  If you sold the stock because of something Bill Gates said then you looked silly for six or more years unless you purchased something better.

Indeed if you had the “knowledge” probably the best thing to do with it was to use it just to avoid the photography sector altogether.  That would mean you might outperform the market – but that outperformance was slight.  [If avoiding that sort of catastrophe was your mechanism of making money you probably needed an enormous amount of “knowledge”.]

Anyway there is little question that if you understood the implications of digital photography in 1991 you were – at least on that item – the smartest guy in almost any room.  And it did not help you make (much) money.

The market could stay wrong for a very long time.  Maybe as long as some blinkered academics could continue to believe in strong versions of the efficient market hypothesis.



Thursday, December 10, 2009

When regulators can’t do math: gas pipeline edition

The Federal Regulatory Energy Commission (the FERC) is charged – amongst other things – with regulating the rate of return on interstate natural gas pipelines.  Rates on these pipelines are by-and-large regulated so as to achieve a targeted return on equity.

Quite of its own volition the FERC has called for a judicial review of on three Midwestern gas pipelines including Natural Gas Pipelines of America (NGPL).  In its last rate case (1996), NGPL’s target rate of return was set at 12 percent. 

This is a peculiar review because – unlike past reviews – the review was called by the Commission itself and without a complaint from any of the customers using the gas pipeline.  [Customers for gas pipelines tend to be large oil and gas companies or large utilities and are usually not shy about calling for a review when rates are out-of-line.]

The FERC has argued – from publicly available documents – that the returns on the NGPL are (just) over 24 percent – and hence (and these are their words) are “unjust and unreasonable”.  They use lots of emotive language and have petitioned a judicial review to get the rates cut.  You can find the full document here.   A good press summary is here

To put it bluntly the FERC stuffed up.  It simply got the math wrong because it does not understand rates of return and depreciation – a staggering oversight for a body charged with regulating pipelines.  Worse – on the math presented – the rates on the NGPL should be increased in order to allow for the FERC mandated 12 percent return. 

This is a pretty nasty allegation – so I need to explain the basic mathematics of regulated returns.  I will start with the simplest of models that I can.

The simplest pipeline model

Imagine a pipeline that cost $100 to build.  It lasts 2 years.  The regulators have to allow the pipeline to recover an amount (say $x per year) so that the present value of $x per year adds up to $100. 

Now $x has to be more than $50.  Why?  Because over 2 years the pipeline has to recover at least the $100 that it cost to construct.  Depreciation alone is $50 per year – and having the pipeline recover only $50 per year would mean it made no profit.

We could (naively) presume that because $100 is employed the pipeline needs to make $12 per year profit in order to get 12 percent return.  So we would set $x at $62.  That unfortunately gives us a little too much return – because – in the second year the pipeline only has $50 of capital employed (they have recovered $50 through depreciation).  You can do the math here (and you assume for simplification that the cash is all received at year end) then the $62 received after year one would be worth $55.36 discounted at 12 percent and the $62 received in year 2 would be worth $49.43.  Add those up and you get more than $100. 

I used the “goal seek” function on Excel to work out the required annual return on the pipeline under the simplifying assumption that the annual payment is received in two equal increments.  I have linked the original spreadsheet (to convince you that I have done this correctly). 




In this case note that the required cash flow each period is $59.17c.  You can discount this if you want by 1/1.12 in the first year (getting $52.80) and by that squared in the second year ($47.17) and lo – these numbers add up to $100.

Now here is the clinch – which is that we know – by initial assumption here – that the return on equity for this project over its life is exactly twelve percent. 

But what is the return on average equity in the second year? 

Return on average equity in the second year!

The cash return in the second year is $59.17 cents.  [It needs to be that every year to provide a 12 percent return on equity over the life of the project.]   The pipeline depreciates by $50 per year over its two year life.  So the measured profit during the second year is $9.17 (the return less depreciation).

Capital employed commenced the second year at $50 (being the cost less the $50 of accumulated depreciation).  It ended the second year at $0 – as the whole pipeline had been written off by then.  The average capital employed for the second year is thus $25.  Given the stated profit is $9.17 the return on average equity for the second year – as recorded – will be 36.7 percent. 

This return will be observed even though the return on the project over its life is only 12 percent. 

There is nothing sinister about an observed 36.7 percent – and more generally there is nothing “unjust and unreasonable” in the observed returns of 24 percent of the Natural Gas Pipeline of America.  These returns are simply a mathematical artefact of the allowed return on equity of 12 percent over the life of the pipeline.   The observed ROE of 24 percent does not warrant a rate case – it is as to be expected.  Indeed as the pipeline in question is more than half depreciated I would have been surprised if the observed ROE was below 24 percent – and the 24 percent ROE does not represent a problem or a failure of regulation. 

What we have here is a regulator who has failed to understand the basic math of the business which they are meant to be mathematically regulating.

The deskilling of American regulators

I am no longer surprised at the general deskilling of American regulators.  This post demonstrates that the regulator – whose job it is to regulate the rate of return on gas pipelines – has no idea at all of the basic high school mathematical implications of that regulation.  I am used to SEC officials who can’t read a balance sheet or can’t see the Madoff fraud when it is laid out in front of them.  But the rot spreads more widely.  We have bank regulators who were blind or stupid and now we have utility regulators who can’t do basic math. 

A more generalised formula for what should be the observed returns on a pipeline

Warning – seriously wonky – here I do the math to show what the observed ROE should be.  You don’t need to read this – just accept the regulator has their math shockingly wrong.  But here is a way of working out precisely how wrong!

Being a nerd I thought I would help the regulator out with their math – and indeed it is not too hard to derive a generalised formula for the right observed return on a pipeline.  But hey – why bother when Wikipedia does it for you?  Wikipedia gives the present value of a stream of n paymnets of value A as follows:



PV(A) is the present value of the stream of payments – which in this case should be the construction cost of the pipeline

i is the rate of return – which in the case of FERC should be the regulated rate of return (12 percent), and

A is the annual cash return on the project, and

n is the number of years over which the project receives its return (which should be the depreciable life of the pipeline – or in the above example 12 percent). 

Now I would never use a formula out of Wikipedia without checking it (which I did by derivation) but for my readers I thought I should just plug in the above example – where the cost of the pipeline is $100, the annual payment is $59.17, i is the usual 12 percent and n is two years.  Plug the following into your calculator – it checks out just fine:


Now we can rearrange this standard formula to determine A:




Now we can also work out what the year-end capital employed (E) in year j of n is.  That is trivial – it is






Income in any year (Y) is equal to the annual payment less than depreciation.  In the formula below I just assume that the original cost of the pipeline depreciates in a straight line over n years.




Now the FERC is really obsessed by the observed return on equity on the pipeline (in this case about 24 percent).  But lets work out what the observed return on equity should equal:




You can rearrange and simplify this equation any way you like – I can’t really be bothered – I am lazy.  But hey we now have enough to work out what the observed rate of return should be.  Assume that the initial cost of the pipeline is 1 (it would cancel from top and bottom of the above formula).  The depreciation in the FERC document for the pipeline is 50 years – so n is 50.  The pipeline originally cost $3.728 billion but has accumulated depreciation of $2.273 billion – so we are in 35 of 50 – so in the above formula j is 35.  We are going to allow the regulated rate of return – which is 12% – so i is 0.12.  Plug this in and we get the following:




Just to check that I am not wrong I have done the same in a spreadsheet – which I have linked hereBut the lesson is that the observed rate of return should be 33.47 percent even though the project actually only returns 12 percent over the life of the project. 

An observed rate of return on 24 percent – the rate that FERC is complaining about – is too low.

FERC is right of course – the tariffs on these gas pipelines are “unjust and unreasonable” – they unjust and unreasonably low.  On FERC’s own numbers they are not adequate to provide the lifetime 12 percent return on equity that FERC mandates.

What are the options here?

I guess the easiest options for the owners of the pipelines are to allow the FERC numbers as to depreciation and capital employed to go to the judge uncontested.  They do not seem out-of-kilt with reality.  They then should present the math straight (and there are plenty of mathematicians who will do a better job than me) and they should ask for a rate increase! 

I do not think the judge will have any problem giving it to them.  But it is not the public policy objective here – and we wound up in this spot because of the mathematical incompetence of the FERC.  It is time to stop the rot at the FERC.

Stopping the rot at FERC

And it should stop relatively quickly.  Barrack Obama appears to have appointed a competent man to be the head of the FERC.  Whilst Jon Wellinghoff may have spent most of his career as an attorney he has – according to his CV – an undergraduate degree in mathematics (University of Nevada 1971).  He should be more than capable of checking the math in this post. 

I have contacted his office and given him a copy of this post.  Jon Wellinghoff endorsed and press released the review of the rates for the various gas pipelines.  He is however more than capable of withdrawing his request for a review.  Indeed I think he has to before the FERC is made a laughing stock as the SEC was after Madoff.

I will happily announce when he has reacted appropriately. 





PS.  The pipelines who would have had their returns slashed under this review include Northern Natural – which is owned by Warren Buffett’s Berkshire Hathaway.  I have not received or asked for a consulting fee but Berkshire holders (many of whom are my readers) should be sending their thanks...

PPS.  I am serious about the deskilling of US regulators.  I have spent only a few hours thinking about the mathematics and accounting of rate of return regulation in my life – and I spotted and roughly quantified this error within five minutes.  Regulators who do this all day every day should simply not make mistakes like this.

Saturday, December 5, 2009

Gratuitous advertising time: The Nick Hempton band is playing in New York

The distinctly cooler Mr Hempton (my cousin Nick) is doing a gig (with his band) at Smalls Jazz Club Saturday night. Its 183 West 10th street – and it starts at 7.30.

He may not know much about the capital needs of regional banks – but – as one good newspaper review once said – he looks like a movie star and plays like Charlie Parker.

Thursday, December 3, 2009

Getting it wrong about getting it wrong about coffee

One of the joys of the blog is that I have several readers who are WAY smarter than me.  One pointed out that I did NOT get it wrong in my Peet’s short.  [To get the background you simply must read this post first.]

I thought that Peet’s was overpaying for a license to put their coffee in k-cups.  I was wrong.

But my smart reader thought that either

(a).  the license to put coffee in k-cups was written as expected (favourable to Green Mountain but unfavourable to Diedrich) – in which case Peet’s was overpaying for Diedrich or

(b).  the license was favourable to Diedrich – in which case you could bet that Green Mountain – a much richer company than Peet’s – would simply and massively overbid Peet’s to own Diedrich.

If Peet’s was overpaying for Diedrich then I was going to win on my short.

If Peet’s was not overpaying for Diedrich then they would wind up in a bidding war with Green Mountain – in which case I could cover at a profit anyway.

Now tell me why I did not short Peet’s big time when they bid for Diedrich?  Stupidity I guess.




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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.