Sunday, May 29, 2011

Letter to a client

Mike*, our foundation client and a dear friend, sent us a really bearish broker note as if John Hempton - a shortseller by inclination - needed to get more bearish. He was adjusting his portfolio accordingly. We won't be.

Here - with a few corrections and expansions - is my reply:

Dear Mike 
The bear case always sounds intellectually more convincing than the bull case. And it is in this broker note too. Intellectual sounding and convincing. 
But America is still an amazingly innovative country, humans are ingenious and most of the imbalances will sort themselves out. Big cap equities are cheap relative to almost all other assets (especially relative to small cap equities, cash and bonds and to many assets such as commercial property that require leverage). Cash yields almost minus 3 percent after inflation and less post tax. Bonds are scary as hell and yield minus 1% after tax and inflation. 
Big though difficult-to-run companies are at low teens multiples.  Great franchises are at mid-teens multiples.  Tesco (UK) which is a truly great franchise - is at a 14 PE ratio. And the Pound is historically cheap. WalMart and Target - both slightly less good franchises - are at 12 times. The difficult parts of Silicon Valley (eg HP) are well under 10 times PE ratios (and we feel no need to own that one). The less difficult parts of Silicon Valley (Google for instance) are at a high teens PE ratio once you take out the excess cash. We own that. 
Own equities.  Don't kid yourself.  Mega-cap equities are generationally cheap compared to other assets - and certainly compared to the cash/bond/levered asset complex. 
Just don't be blind about it. The places that there have been high returns (Asia, small caps, smaller resource companies) are riddled with fraud. Twenty five years of deregulation and the high levels of innovation mean we have high and rising levels of stock fraud. Fortunately there is much less fraud risk in mega-caps. 
Don't own Australia or the iron-ore-coal-steel complex. It has run too far and has been too easy to make money. Too many stupid/aggressive/greedy people are doing too much expansion. Some of these people are stupid - but they have made much more money than you or me so they must be right!
I can find dozens of reasons to be bearish - but I look at it dispassionately and I am bullish on big caps, and bullish on America. The problems will sort themselves out and the American exceptionalism (decent institutions, free enough markets and a willingness to take risks) will work their magic again. 
Anything that takes you out of real assets (businesses and property that generate real cash flow) and puts you into nominal assets is - with a ten year time-frame - a bad idea. (And why is your personal account any shorter dated than that?) 
Just don't get greedy by buying things you do not understand: you will be ripped off. The underlying fraud level is as high as I have ever seen it.
Oh, and we are also bullish on France and Germany. Old Europe has manufacturing and production power of enormous levels. (Remember what they produced to fight wars? Their productive capacity is very high and Americans have forgotten that. They do engineering as well as anybody. And Germany no longer has a restrictive monetary policy to crush its consumer market.) 
Also the French are in that lovely position of having convinced newly rich Asians that they are the arbiters of good taste. There are few higher ROE businesses. France has played Asia better than America.
We can see plenty of reasons to be bearish - but just the frauds makes our portfolio short enough. Indeed we are plenty short and likely to remain so until I can't find frauds with ease.
Beyond that, there is a lot of pessimism around. It has got to be time to be bullish. We certainly do not desire being 125 percent net long or hyper-aggressive like that - but we will take steps to become incrementally longer. We are if anything too short.


*Mike is not his real name.

PS. I want to stress again that my cheap mega-cap equities are relative to other things a rich guy might own - such as small cap equities, bonds, cash, commercial property or gold. There are ways cash could be a better investment - hard deflation. Long bonds are probably the best investment in that environment. I do not see that happening (though I did think it a possibility 18 months ago). Equities were generationally cheap in absolute terms March 2009. I was buying but nowhere near enough - and indeed we carried some losing shorts through the second six months of 2009.


Ross Thompson said...

Hi John,

I have discussed how equities may potentially provide better after tax real returns than cash and bonds on my blog. Please see:

Michael R said...

"The problems will sort themselves out and the American exceptionalism (decent institutions, free enough markets and a willingness to take risks) will work their magic again."

I disappointed, John, to see you addressing the macro political economy with *exactly* the sort of homespun sententia that you would deem risible if applied to some skanky small-cap reverse merger du jour.

Reading your letter to your client, literally dozens of objections spring to mind, but I'll limit myself here to just two of the most salient.

First of which, you write: "Cash yields almost minus 3 percent after inflation and less post tax. Bonds are scary as hell and yield minus 1% after tax and inflation. Big though difficult-to-run companies are at low teens multiples."

If you focus on the narrow problem of how to optimally allocate a portfolio of assets to maximize returns, then, yes, you're probably right. In a hypothetical (and unfortunately not entirely implausible) environment where real yield on cash is -6%, real yield on bonds is -3%, and real yield on big-cap blue-chip retailers is 0%, you could look at your call, pat yourself on your portfolio-management back, and give yourself a good "Attaboy! Job well done."

The aviation safety industry calls this "controlled flight into terrain". Pilots get so narrowly absorbed in the professional and technical details of being pilots, that they don't notice the looming mountain until too late, if ever.

Just as an example, consider the wider social, political and economic implications if the trillions of dollars of defined-benefit pension obligations floating around no longer had any credible path to the 8% AAA returns they require for viability?

Which brings me to point two (and if you're clever and thoughtful, you'll grasp the segue).

You write: "Twenty five years of deregulation and the high levels of innovation mean we have high and rising levels of stock fraud."

Yes, deregulation and innovation. These were undertaken on basis of falsifiable claims derived from theoretical arguments put forward by known actors. Claims such as, for instance, that the market could allocate capital and manage risk more effectively than regulators, that economic growth would increase with regulation, etc.

These claims failed spectacularly. Only luck, and some creative (unsanctioned, unauthorized, and quite possibly illegal) last-ditch back-room shuffling about of 9-figure piles of cash and guarantees prevented a complete collapse of the entire global financial system.

The S&P 500 has now clawed its way back to where it was 12 years ago.

And what was the consequence of such clear, monumental, and irrefutable failure of the claims originally made in support of deregulation?

Three things mostly: 1) The exact people responsible for making the original, now failed claims have been given greater power and authority; 2) the theoretical underpinnings backing the claims have been studiously unexamined in light of new evidence; 3) all attempts to incorporate into policy and regulation safeguards against recurrence, all have been efficiently extinguished.

Economists call this "regulatory capture". This is the mother of all regulatory capture, unprecedented on a real or nominal basis in human history.

Other than vague sententia ("decent institutions, free enough markets and a willingness to take risks"), we are given no basis whatsoever for belief that the darkest nightmares of September 2008 won't return for real next time, and soon.

We are all clapping as hard as we can, "we believe in free markets, we believe in free markets" hoping and fully expecting to revive the fairy.

But there is nothing there on the intellectual balance sheet to support such a belief. And nobody wants to talk about that.

Michael R said...

And in that context, I think it's rather reckless to be calling anything "generationally cheap". That presumes a level of intragenerational certainty unsupported in evidence.

John Hempton said...

I knew people would be bothered by this. But I look at American corporations - and they make stuff, do stuff, earn money. Demand in US is hardly at a cyclical peak - and retailers are 12 times earnings.

That is an 8 percent yield and my guess is that the yield is going up.

Also it is inflation protected to some degree.

By contrast bonds have a 2 percent yield.

This is generational difference.

If you are a rich guy (and most my clients are fairly wealthy) the issue is that you have to to own something.

If it is cash or mainstream American equities - that is easy.


John Hempton said...


All fair comment. We were sent a benchmark bearish piece. It felt wrong.

Would I rather own equities than bonds?

That is easy. Megacap equities. Most of them look like they are in business making money.

So would I rather be short or long as a rule?

Answer Long.

Do I think we can do better - you bet. You know our position - it is long megacaps, short small cap frauds. Done global.

We think that makes sense.

John Hempton said...

Michael R - send me an email.


Anonymous said...

I'm a little surprised that:

1. You believe that the GBP will not continue to decline. Britain is a mess, and I don't understand what they have left to export.

2. You seem to believe that the governments will continue to control interest rates and be able to hold them down. I would be willing to bet the contrary--and at that point, equities might not look so appealing.

Having said that, your main point--that large cap is undervalued with respect to small caps and bonds--seems sound enough (indeed, it seems obvious). Private equity is really distorting valuations at the moment. It's bizarre that so few peope seem to be aware of this--I haven't read a single story in Bloomberg, FT, Economist, or WSJ that really analyses this.

Anonymous said...

American exceptionalism again? Come on, surely you don't
subscribe to that BS. A few centuries ago I subscribed to Greek exceptionalism and look where they are....

Brooks said...

John, You made the comment/blog entry ~6 months ago (give or take...) that it wasn't the right time to be bearish on Australia....

In the past month, WestPac and other banks down ~10-15%.....

Is now the time?

Brooks, American in West OZ

John Hempton said...

Yeah I do subscribe to the view that America was one of the first places to get a decent democracy going and to get decent institutions and to let it run.

Decent institutions are part of the story - and there has been a sustained political effort to make some American institutions dysfunctional. (Politicizing the congressional budget office was one - surely politicizing the basic numbers is bad news...)

Also there seems to have been a lapse in your judgement (I am not an American) as to the appropriate function of state/police.

The things that made America great are being diluted.

I for instance have no opinion about the legality of this demonstration

But there is NO QUESTION that there is a police/state over-reaction.

If they ain't hurting anyone its best to leave them alone. Indeed that sort of freedom (leaving people to do what they want if they are not hurting anyone) is part of what made America great.

I have no problem whatsoever about regulating pollution for instance. Polluters hurt other people - take away their free air, their climate etc.

But it is really really hard to see what was the hurt in that case.

That said - America is still a fine place.

Zorro said...

yes you have own something but the problems are hardly over...Fisher, Schumpeter, Minsky point to the kind of debt conditions we are still experiencing as unsustainable...debt relative to income is still at historical inflection points...its hardly stable or sustainable....muni and sovereign debt is in crisis....China is overheated and is probably due a significant set back......your fraud adventures are probably a bell weather yes what to own?

Stuff where the fundamentals will continue through the ups and downs of the next few years....the presidential cycle will probably keep things alive for a while.....commodities like copper and oil are likely safer than say iron ore and care and aged care to fit the demographics trends....and a fairly big allocation of cash for when things get sense is your making a short - medium term forecast...

Australian banks topped a few months ago, RE in Australia is ready for a cyclic set back, if china sneezes then the best place to be is probably in the US and USD or areas where fundamentals continue to be strong in a set back

you do have to put it somehwere and preferably you dont want to have to move it around to much either

craig t

Anonymous said...

American exceptionalism is not what you subscribe to I suspect, given that exceptionalism really refers to the bizarre belief that America does things better because.... It's America. Given that they are not much good at fiscal management and regulation, they can't sell Agricultural products without massive subsidies, they build crap cars and they can't even provide basic health care for all it's hard to believe they are anything but mediocre. Now if you want to talk about Australian exceptionalism......

Anonymous said...

>> they can't sell Agricultural products without massive subsidies<<

This is outright false. Few countries would be able to compete with America if no country were subsidised.

With all the bears I'm seeing, maybe I should be a bit more bullish...

Anonymous said...

Australia out competes the US in agriculture without $50 billion in subsidies a year, as a matter of fact $ 0.

Anonymous said...

The following might be of interest:

It is a comparison between projected returns of the major classes of investment based on historical and present data.

But What do I Know? said...

We're in the "digusted" phase with large-cap equities--if you continue to make comments like this on your excellent and influential blog we'll never get to the "loathing" phase.

One small caveat: there are also large-caps out there who aren't earning their dividends and face rising pension costs--make sure you do your homework. . .

Anonymous said...

For the semantics police out there who don't seem to want to discuss the crux of the post (mega caps relative valuation) -

American exceptionalism was never inteneded to convey or imply a superiority to other nations or people. It flows from the fact that we were a nation born out of a rebellion against the political and economic tenets of the ancien regime and in victory, founded a nation that incorporated all the tenets of modern democracies and republics - Lockean social contract, separation of powers among branches of government, and Voltaire's distrust of theocracy (religious power within the State) while preserving religious toleration. All of these we in the West take for granted now, but were mostly newfangled and untried in practice at the time. The culture that these institutions fostered led to many qualities that, for better or worse, characterize the America of today. Tocqueville captures much of this culture, present and future, in his classic Democracy in America. Thus, the notion of exepctionalism is about the cultural uniqueness that our founding, beliefs, and institutions foster.

This concept is no different from China's "Middle Kingdom" or an Arabic Caliphate. And you don't get the sneering when you hear Aussies talk about "God's country".

Re: mega caps, I would tend to agree with two caveats: first, as Sherlock holmes said, 'there is nothing more deceptive than an obvious fact', and I still have not seen a satisfactory explanation as to why they are so cheap given interest rates and level of S&P. Second, stock picking among mega caps will be just as important as it is for small caps, I suspect there are value traps lurking out there since many of the megacaps will not be able to compound at 8% forever, especially when many are priced above book value in the first place. Many will run off into obsolescence like Eastman Kodak and Textron of past big caps, so why pay over book value then?

yoyodyne said...

'Claims such as, for instance, that the market could allocate capital and manage risk more effectively than regulators...

These claims failed spectacularly. '

This is without a doubt the dumbest comment ever on this blog.

stocksystm said...

Nice letter overall Mr. Hempton.

Regarding "American exceptionalism" I have to make my comment from the peanut gallery. Warren Buffett always likes to go on and on about what a great country this is and how it will overcome any obstacle placed in front of it. Buffett basically stole my Clayton Homes stock, but that's another story. To me he's just another greedy old man who craves attention for some reason. Therefore his reasoning is suspect.

Back on task. America was fortunate to have some wise forefathers who set up a very good form of government. However, along the way its been hi-jacked by some very powerful big money interests. This has resulted in a plutocracy instead of the magical democracy most believe we live in.

Americans have been indoctrinated in the belief that they are special and God's chosen ones. However, if you drive on our roads you'll find this isn't the case. America is filled with lots of stupid people. Example: I've found that nearly 100% of U.S. drivers will not use their turn signal when facing you indicating their intent at an intersection leaving you to wait to actually see if they are moving forward or turning (note: I haven't done the statistics for other countries, but I may).

This notion that America is wonderful and replete with virtuous citizens was smashed in the period 2005-2008 when millions made up income to buy houses they couldn't afford who were accommodated by our financial institutions whose upper echelons deserve pay in the tens of millions of dollars. We all know how that ended. Of course, there are those that will say the bubble was a worldwide phenomenon and even worse in some other countries. But Americans weren't so special that they couldn't see through the obvious fraud inherent in a 2+ standard deviation event.

One of the things Americans do seem special at is devising ways to borrow money without having to pay it back. So we veer off into the netherworld of future Greek type tragedies and there doesn't seem to be anyone up to the task of setting us on the right course. Because things will sort themselves out and we are very special.

PSC said...

America is filled with lots of stupid people.

Maybe true.

But it doesn't matter.

America is full of reasonably practical entrepreneurs who give new ideas a go. Many of them are stupid - both the entrepreneurs and the ideas. But that doesn't matter.

Where America wins is if you stand up in many countries and say "I have a good idea", you get shot down for trying. In America at least people give you a go.

And they'll listen to your fourth or fifth idea even if the first few are ordinary. Which is in itself a form of stupidity.

I'm not an American btw.

Laban said...

The other risk factor for the US economy is demography and mass immigration from south of the border. The Latino population now stands at 50m - up 43% in ten years.

The US almost by definition was a nation of immigrants, but until 30 years ago this was combined with strong pressures towards integration and Americanisation - the "Melting Pot". These pressures - for example the pressure to speak English - no longer exist, and California, long the most advanced state, is slowly taking on the characteristics of its southern neighbour - including corruption and lawlessness. White Americans, generally net taxpayers, are leaving the state and being replaced by net tax recipients - one reason why the CA budget is shot.

Human beings are not interchangeable units of production*. Culture is vitally important, as the differences between the Edinburgh of Adam Smith and the Western Isles of MacDonald of Clanranald attest. IMHO red lights are flashing all over the cultural dashboard of the USA.

(* or the standard of living in Tajikistan might be closer to that of Switzerland, also landlocked, mountainous and with a <10m population)

Anonymous said...

Wow Laban thanks for coming out. Comparing Tajikistan and Switzerland? Really?

Please do not sully this forum with your racism.

Laban said...

Wow, anonymous, thank you for coming out as "synaptically challenged".

Culture is not race and vice versa, although they can be associated. The great asset of the US was the way they integrated many different cultures over the last hundred and fifty years. It's giving up on that which is a bad cultural (and therefore economic) indicator, although sheer numbers do make integration more of a challenge.

Still, addressing an argument takes time and thought. Shouting 'racist' absolves you of the need to take either.

Btw, "anonymous", what's YOUR take on the US future?

EconomistDuNord said...

JH said: "there is a lot of pessimism around. It has got to be time to be bullish."

That's about the most inane thing I've read in weeks. That's like saying, "a lot of people expect it to rain, so it must be going to be sunny".

In case you hadn't noticed, equities have run very high very fast over the last many months. The Dow (megacap stocks, btw) is up 80% since March 2009. Why? Because there's nowhere else to put your money.

Sounds to me like there's a lot of optimism around.

Equity investors could get KILLED if bond yields rise as a result of the end of QE2, the US congress making asses of themselves playing with the debt ceiling, or any other related cause. Especially in this economic environment where we're rapidly closing in on stall speed.

Zorro said...

You have to watch ideas like "rich people have to put their money somewhere", you are very good on the balance sheets of companies and less knowledgeable about economic cycles. Your OCD to look at all factors fails when you look at economic indicators, look at the debt then read Fisher, Minksy, Schumpeter, Roubini , Keen

Anonymous said...

Any thoughts on Tesco following its profit warning?

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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.