Hookers that still cost too much – some comments on the IMF and Latvia

This blog was early on giving a public cry on the Latvian economy.  I have the Latvian crisis to thank for a lot of my readership – it was about 50 per day until I wrote a post about the looming economic crisis in the Baltics – and illustrated the lack of competitiveness of the Baltic economy by talking about the price of prostitutes.  That single post raised my readership by over 1000 percent - and it has risen - albeit more slowly - ever since.  The post even warranted my first mention in the mainstream media – in the Estonian business press.

I guess it was subject matter.  With some cynicism I suggested that sex tourism was the main Latvian export – and if you wanted to know about the domestic competitiveness then you should look at the price of prostitutes.  The technocratic economists want to talk about “real effective exchange rates” and I just want to talk about the cost of getting laid.  Will the insanely clever PhD students out there (Claus you know I am talking about you) try to model that.  

Anyway if you really are interested in this I suggest you read the original post here…  It is (my opinion) one of the best posts on this blog – so I hope you will not think I am wasting your time.  

That said – the situation was that the Scandinavian banks – most notably Swedbank – had been funding the Latvian (and other Baltic) current account.  This was a fixed exchange rate but in an uncompetitive economy that was not accompanied by the monetary crunch that the theory would suggest because the Scandy banks (especially Swedbank) were acting as the Latvian central bank and borrowing in Euro and lending in Lats.  Locals told me that much of the lending was in Euro not Lats but the effect was the same.  The Latvian current account deficit was sustainable as long as Swedbank was guaranteeing it – and Swedbank kept its credibility.

Unfortunately in a financial crisis – and with management as inept as Swedbank – it is rather tricky to maintain credibility.  When trust in Swedbank eroded either (a) the Lat was about to get devalued massively – smashing up Swedbank either on currency risk or by making it impossible for Latvians to repay their Euro debt or (b) monetary policy – being a fixed exchange rate and an uncompetitive economy was about to re-assert itself and cause a great-depression level event in Latvia.  When Swedbank could not sterlise the current account deficit the Latvian central bank would be forced to do it causing a monetary crunch of massive proportions.

I argued that the other Baltic states were more sustainable than Latvia – Estonia being bad and Lithuania being about as unsustainable as the United States.

Well – if you haven’t been following events – they are playing out rather like my blog post.  Latvia has required an IMF bailout.  Estonia is in a rather nasty recession.  Lithuania is muddling on.  The order predicted in my original post.  

But – not in the scenario of the original post – the IMF has not required a devaluation of the Lat.  Apparently the pressure from the Scandinavian banks was large – and the Scandy governments (presumably political play-things of their banks) are large contributors to the bailout.  They have chosen a bailout with huge domestic contraction but a fixed peg.  The last time the IMF tried that was Argentina and it was eventually a disaster with the peso peg being abandoned anyway.  

There are plenty of raised eyebrows about the decision to keep the peg (see Krugman for instance) but the political economy is obvious…

First – abandonment of the peg is the most rapid way of showing the insolvency of the Scandy banks – and the Scandinavian governments are big contributors to the bailouts and – seemingly – political pawns of their banks.  

The second reason for not abandoning the peg in Latvia is that it would take about 15 seconds to decide the peg is doomed in Estonia as well – and maybe – because a trilogy is three tragedies performed in quick succession – in Lithuania as well.  

Anyway several people I admire (most notably a Fistful of Euros, Alpha Sources and also Krugman) have pointed out the obvious – that the monetary contraction that will happen will result in much lost production and loan failures anyway.  The monetary contraction however comes from the loss of credibility of the real Latvian Central Bank – Swedbank.  Once a real central bank has to give out its foreign exchange it will cause a crunch of gargantuan proportions.  

So – score this for Bronte Capital.  I admit my failures on this blog – and it is Christmas so I should indulge my successes.

As for how the bailout will work – I am with Edward Hugh of Fistful of Euros.  It is Argentina mark 2.  

And do I need evidence?  Well I have spent 15 minutes searching around on the web – and the prostitutes still cost too much (though their price seems to be declining).  If someone with first-hand experience wants to correct me then pop something (anonymously if you wish) in the comments.  

John Hempton

I have resisted pouring more scorn on the totally inept Swedbank – but I should remind people that they purchased a bank in the Ukraine early last year for USD735 million.  The bank had only 10 million of earnings – and most the 735 million was debt assumed.

They did this just in time for economic output to fall as much in the Ukraine as it did in the Great Depression in the US.  

Next time Swedbank management wants to blow half a billion I have a bridge to sell them in Sydney.  Their title will be just as good as their claim on the Ukraine!

This wouldn’t matter – but Swedbank was funding the Ukrainian current account deficit as well as the Latvian one – and when they stop the crash will be rather nasty. 

I blame the one child policy: explaining the brokers part II

This is going to look very tangential – but I know someone who is a demographer. And just as I think everything in the world comes down to banks (because that is what I understand) he think that everything in the world comes down to demographics.

He has a better chance of being right than me.

And the biggest thing going on demographically in the world is the one-child policy.

Asian style industrialisation and current account deficits

Pretty well every Asian tiger economy has gone into large current account deficit whilst it industrialises. Savings rates may have been 20-25 percent of GDP but the investment rates were higher. The high levels of current account deficits have left those countries vulnerable to current account crises – and they got their crisis in 1997.

China is different. The investment rate is higher in China then elsewhere. Chinese statistics are abnormally patchy – but Chinese investment may have got has high as 40 percent of GDP. (You can see this in the performance of various capital equipment exporters in the West.)

And yet China never managed to get a current account deficit. That is really strange.

We have investment of 40% of GDP and a large current account surplus. This means that the average Chinese person is saving maybe 46 percent of their income. Now once when I had a very high income I saved that much. But we have poor people saving half their income.

I ran this idea past a Chinese friend of mine (now resolutely middle class). He remembers his family saving money furiously whilst he was hungry for lack of food.

Question: what is it that makes them save so much?

Answer: fear.

In most poor jurisdictions there is a simple method of saving for old age. Have six kids. They will have a few each and if you survive there will be lots of grandkids trained to respect their elders who will look after you.

This does not work in China. Indeed if everyone has only one child there will potentially be four grandparents per grandchild. You can’t expect to get supported.

In most developed countries people trust the system to look after them. Mutual funds are well developed, there is often a social security savings net, and a lot of people (perhaps falsely) expect to sell their house and live in clover.

But in China you can’t trust that either. So you save. And save. And save…

Chinese families save because they have a gun at their head. They save an amount that is almost incomprehensible by Western standards.

I point this all out because there is a lot about excessive spending in the west (and the spending has been excessive). But for all this excessive spending there has to be an area with excessive savings. Japan has it. Petrodollars have it – but the big incremental excess savings of the last five years has been China.

And for that I blame the one child policy.

I am going to give Mr Bernanke a plug here. Before the crisis started Ben used to talk about excess savings in the world. He figured the bad lending in the US happened not because people were venal or stupid in the US – but that there was just an endless supply of investable funds because the world had excess savings.

I think he was right. Go look at a Japanese bank now and you still see excess savings. We discovered that we can’t lend them endlessly in America without substantial credit losses. But that doesn’t mean the excess savings aren’t there.

It is a strange reversal to blame bad lending on the people in China who wanted to take no risk with their savings – but it is the reversal that interfluidity made in one of the best blog posts of recent times. It’s a reversal I believe in too.

My thesis - which will be expanded in future posts is that the brokers have become the intermediaries between this endless demand for products to save in (China, Petrodollars etc) and the endless willingness of the profligate in the West to spend. What they do is - through their trading, their securitisation and through other things they turn the complex financial instruments of the West (mostly but not entirely debt) into vanilla instruments that the Chinese and petrodollars want to buy.

How they did that intermediation will be the subject of the next couple of posts – but it begins to explain why they got so big. This is the biggest demographic feature of the world and the brokers made themselves front-and-centre. (They may not have even understood what they were doing - but that is also subject of another post.)

Indeed how they did it altogether and its implications are for later in this series.

John Hempton

Deflation and bank bailouts in Japan

Given what is happening with Fannie Mae at the moment I should share a little of the history of non-US bank bail outs. I will start with Japan and later do Scandinavia.

Japan was an unusual bank collapse. It happened despite excess savings in the system. This is really strange. Most bank collapses happen when there is a lending binge that drives excess or investment or consumption and with a current account deficit. (See for instance Korea – where there was excess investment or Argentina where there was excess consumption.)

Japanese banks always had (at least collectively) sufficient deposits. [See my post on 77 Bank to see just how much excess deposits they now have.]

But the Japanese banks lent very badly indeed. Part of this lending was to the "Zombie companies" but most was on property. The formalised golf-club membership exchange in Japan at one stage was worth a good multiple of the entire Australian stock exchange (including giants such as BHP and Conzinc Rio Australia). Golf club memberships were of course a pure-play method of speculating on land.

But you need to notice that the Japanese bank collapse looked very different from what is going on in America now. The Japanese bank collapse was not a collapse of funding – it was a collapse of asset values and solvency. [Exceptions noted.]

American financial institutions are now having wholesale funding runs (or finding wholesale funding is unavailable which amounts to the same thing). Japanese financial institutions did not need wholesale funding (most had deposits) and hence by-and-large did not have runs. [There were some institutions such as the long-term-credit banks and similar institutions which had wholesale funding – they were effectively nationalised.]

Many Japanese regional banks (Nishi Nippon for example) were breathtakingly insolvent at the height of the crisis but they remained liquid because they had plenty of deposits. Because they remained liquid they never actually failed.

The zero interest rate policy

Insolvent but liquid banks are the key to understanding Japanese interest rate policy. There are several prominent macroeconomists in America (led notably by Krugman but joined by Bernanke) who argue that the zero interest rate policy was insufficiently expansionary – and that monetary policy should have been eased until it induced inflation. In theory this could be done by flying a helicopter over Tokyo throwing out freshly printed 5 thousand yen notes. Indeed it was in a speech about Japan that Bernanke uttered the famous helicopter line.

The BOJ always thought this policy was “risky”. Krugman’s response was that it was less risky that the endless government deficits Japan ran. Krugman missed the point – the question was who was inflation risky for? My answer: the banks.

A hypothetical insolvent bank

Imagine a hypothetical insolvent bank. Suppose the bank has 90 in funding, 10 in “stated equity” and “stated” 100 in assets. [I have left the currency blank because this could be 100s of billions of yen or billions of dollars.]

And suppose that the assets are not really 100 but 70 good and 30 bad - and everyone knows about the bad assets.

Then the bank “really” has 70 in assets, 90 in funding and minus 20 in equity. This is a realistic picture of insolvent Japan in 1994.

If the bank was in a current account deficit country like America, Australia, New Zealand or the UK there would be an immediate problem. In a wholesale funded market the 90 in funding would be say 60 of deposits and 30 of wholesale funds – and the wholesale funding would leave. The bank would go insolvent quite rapidly (see Northern Rock which was very reliant on wholesale funding).

But in Japan the 90 in funding was all deposits and was sticky. The funding never left and the bank continued quite nicely. Capital market discipline was not imposed – and the hypothetical bank could pretend there was no problem for many years. Banks fold when they go illiquid - not when they go insolvent. No liquidity problem means no crisis.

But the problem is still real. Over time insolvency may turn into illiquidity.

Now suppose that (and this is a gross simplification) that the spread between deposit rates was 2%. But rates could either be 10 and 12 percent or 0 and 2 percent.

If the rates were 10% and 12% the 90 of funding would cost 9 per year. The 70 of “real” assets would yield 8.4 per year. The bank would be cash flow negative. Anything that is cash flow negative for long enough goes illiquid eventually. The insolvency problem would turn into a liquidity problem.

Now suppose the rates were 0% and 2%. The 90 in funding is free. The 70 in assets yields 1.4%. The same banks is cash flow positive in a low interest rate environment. If they are cash flow positive for 15 years the bank will fully recapitalise.

• Summary: zero interest rates were critical to bank recapitalisation in Japan.

The reason why the BOJ rejected the Krugman/Bernanke line was that it was risky to the banks and the BOJ (and the MOF) are totally captured by their bank constituency. It was risky not to the economy but to banks. [Note the practice of amakudari translated as “descent from heaven” where former government officials get to be CEO of banks late in their career.]

Why this form of bailout won’t happen in America

In America it is the wholesale funded institutions that are in the most trouble. Think Bear Stearns, Lehman, Fannie, Freddie.

They are in diabolical trouble.

The funding is leaving them. It does not matter whether rates are 0 or 10 – the funding is still going.

America will look far more like Scandinavia than Japan. Scandinavia was a funding crisis. The posts by Naked Capitalism and others suggesting that Japan’s wasted decade will be the new normal are just plan wrong.

Implications

I still have not worked out what side of the inflation/deflation divide I am. But the people that point to Japan as a likely outcome miss a point. Japan chose deflation because the alternative was nationalising the banks.

America does not have that choice. The American institutions are wholesale funded and hence will nationalised or fail if the wholesale funding disappears.

Nationalisation can be inflationary if it involves printing. The date the Federal Reserve is not printing – but Helicopter Ben has made clear that in Japan the BOJ should have printed. And the institutional imperative to stop him printing will not be present in America.

Yesterday's post: a short version

I was discussing yesterday's post with a hedge fund manager (HFM) who gives that useful (and false) impression of being not too bright.

I starting explaining the Swedbank thing to him. You could tell he was only half listening.

Until I got to the statistics for Latvia. His ears pricked up when I said the current account deficit was well over 20 percent of GDP.

HFM: "Who are they stealing that from?"

BC: "Swedbank"

HFM: "So why didn't you say so?"

---

Well there is a reason that I didn't say so - which is that you wouldn't believe me if I posted the short hand. But what a 2o percent current account deficit means is that the AVERAGE PERSON spends 20% more than they earn.

This is of course impossible unless they are not going to repay it.

Borrowing without intention or ability to repay is the economic (but not moral) equivalent of stealing... and it doesn't matter what currency that borrowing is in...

This "theft" is so large that Swedbank is nearly insolvent.

And Swedbank management are steadfast in their belief that nothing is fundamentally wrong. Well they would say that, wouldn't they...

Newsflash: Spain looks dicey

If it were not for Fannie Mae and Freddie Mac going insolvent this would be the biggest financial story in the world today.

Spain can’t sell its sovereign debt reported here and here. The spreads of Spanish bonds of German Bunds is still small - so this is a warning shot. But it is a shot that rings very loudly at Bronte Capital.

Background

Spain is a current account deficit country with large wholesale financed banks. If you can’t sell Spanish sovereign debt the you shouldn’t be able to sell Spanish (mortgage) covered bonds. Moreover it is a current account deficit country with a permanently fixed currency (it gave up the Peseta and joined the Eurozone).

A while back the most liquid bank stock in the world wasn’t Citigroup or JP Morgan – it was Santander. The second most liquid bank stock in the world was BBVA. These are giants.

They are highly dependent on wholesale funding. If they can't raise wholesale funds they will come close to failing - and Spain will wind up in a horrid recession.

And it is very hard for the Spanish government to bail the mega Spanish Banks out because the Spanish government can’t print Euros. (Being unable to print a fixed currency is part of a model for bank collapse I will deal with in some future posts.)

If the Spanish can’t bail out their own banks I guess the Bundesbank (I mean European Central Bank) can – but that would be a call on German taxpayers to bail out the Spanish.

Of course the Eurozone could collapse. Spain can then go back to its old ways printing pesetas.

Alternatively this could all wash over by next week. But the implications of the Spanish pulling sovereign debt auctions are pretty horrible. Even if the spreads remain under 50bps.

Watch this space...

The arithmetic of bank solvency – part 1

This is a post driven by Krugman’s many debates on  bank profitability.  In particular, a post from Krugman – about why banks are suddenly profitable – and the debates it engendered amongst my friends is the origin of this post.  Long-time readers of my blog will know I have explored these ideas before.

First observation: at zero interest rates almost any bank can recapitalize and become solvent if it has enough time. 

Imagine a bank which has 100 in assets and 90 in liabilities.  Shareholder equity is 10. The only problem with this bank is that 30 percent of its assets are actually worthless and will never yield a penny.  [This is considerably worse than any major US bank got or for that matter any major Japanese bank in their crisis.]

Now what the bank really has is 70 in assets, 90 in liabilities and a shareholder deficit of 20.  However that is not what is shown in their accounts – they are playing the game of “extend and pretend”.

Now suppose the cost of borrowing is 0 percent and the yield on the assets is 2 percent.  [We will ignore operating costs here though we could reintroduce them and make the spread wider.]

This bank will earn 1.4 in interest (2 percent of 70) and pay 0 in funding cost (0 percent of 90).  It will be cash-flow-positive to the tune of 1.4 per annum and in will slowly recapitalize.  Moreover provided it can maintain even the existing level of funding it will be cash-flow-positive and will have no liquidity event.  (It does however need to be protected from runs by a credible government guarantee.)

Now lets put the same bank in a high interest rate environment.  Assume funding costs are 10 percent and loans yield 12 percent.

In this case the bank earns 8.4 per year in interest (12 percent of 70) and pays 9 per year in funding (10 percent of 90).  The same bank with the same spread is cash flow negative.  

This is an important observation – because – absent another wave of credit losses – a marginally insolvent bank with a government guarantee will certainly recapitalize over time provided its funding costs are pinned somewhere near zero.  The pinning of the funding costs near zero is not a subsidy (except in-as-much-as the government guarantee is a subsidy).  Both these banks have the same spread and have the same profitability.  The answer depends criticially on whether you can pin the funding to a low interest rate. 

Banks and sovereign solvency

All banks more or less anywhere get their finances entwined with the finances of the sovereign.  No sovereign will (or in my opinion should) allow a mass run on banks but they can only stop such a run if their own credit is good.  But this link between sovereign solvency and bank-system solvency means that bank funding costs at a minimum are bounded at the lower end by sovereign borrowing costs.

It was pretty clear in the crisis where the US Sovereign borrowing costs were pinned.  I barely cared whether BofA was solvent when I purchased it (but I was pretty sure it was).  I cared that the US government was going to pin its funding costs.  Buying BofA at low single digits was – in the end – a bet on US Government solvency.

On the same token Spanish banks may go the way of Greek banks.  They can’t control their funding costs because the Spanish sovereign cannot control their funding costs.  The idea that European sovereigns can default is now front-and-center.  And the Spanish banks can’t control that either.

Extend-and-pretend (what Felix Salmon crudely deigned to be the Hempton plan) worked well in America.  It won’t work in Spain because you can’t pin rates at zero even with a government guarantee.  The scale of financial restraint needed to solve this problem is enormous.  But the alternatives are worse.

 

 

 

John

Follow up to the small cap post - and some notes on SuperValu

My blog post suggesting that small-cap stocks were mostly to be avoided roused the animosity of many readers. The problem was that many of my readers see themselves as value investors. A surprising number run small funds and my post was an attack on their world view.

Their logic is that it is impossible for a small fund manager to add value by analysing Hewlett Packard*, Vodafone*, Google* or Total* but by being small and diligent and nimble they can add value by picking small caps. They tell themselves (and possibly their clients) this story every day - it brings meaning to their life. They can add value. By saying just avoid small caps I was asserting that their rationalizations were bullsh-t. No wonder they bristled.

My restrictions were somewhat limited - I was only wanting to avoid buying small caps where the possibility of a go-private transaction was underpinning the price. In other words small caps in safe jurisdictions with good balance sheets and open registers were mostly to be avoided. Private equity mostly can not or will not buy financial institutions (with rare exceptions such as JCFlowers) - and there is some value in smaller financials. Likewise some companies that are already so levered that a debt-financed private equity bid is impossible are potentially interesting. Some German two-class-of-shares mid-caps are also interesting. But even these are at best partial exceptions to my rule of small caps being relatively expensive.

Still the rationalizations of the small cap value managers reminded of Woody Allen's zinger about rationalizations being more important than sex. "When was the last time you went 24 hours without a rationalization?"

Most of the comments posted wound up revolving around SuperValu - the grocer that owns Albertsons and others and which has been distressed and whose stock price reflects that distress.

One of my readers points out just how cheap it looks relative to potential. He figures the pain (and there has been considerable pain) is more or less over and the stock should race. Without a lot of work I can't even express an opinion on that.

But I will note that the first question when analysing a business is "what will they look like in three, five, ten years". Warren Buffett tells us that when he buys businesses he likes to look out decades. I am a little more flighty than that (and I can always dump the stock) so I tend to look 3-5 years out. Call it the "Wayne Gretzky school of value investing" - look at where the puck is going to be and ask if it is cheap against that.

And when you look out three to five years the biggest determinant of how they will look is what the competition will do to them.

Whatever: on this metric SuperValu is difficult. The grocery market is not growing much in aggregate in the US except through food inflation. And the competition at the bottom end is fierce. I would rather wrestle grizzly bears than compete head-to-head with Walmart. And at the top end the competition is also evil. (The Wholefoods store in Chicago where I irregularly shop is very nice. Certainly nicer than the average Albertsons.)

Sales are going backwards. That does not look like it is going to change - although plausibly the rate of decline may drop. This unquestionably a difficult story where a strained company is fighting with superior competitors. When small caps are cheap (and they do get there fairly regularly) there is no need to take on difficult stories. When to find value you need to go headlong into difficult stories then you are probably deluding yourself about there being value there in any general sense (although there may be value in specific instances).

The focus on SuperValu (a truly difficult story) was confirmatory of my view that on-average small caps are particularly difficult at the moment. [I should note however that SuperValu is something that would not appeal to most debt-funded private equity shops. The company is shockingly levered - and my general restriction against small-caps does not apply here.]

Metrics

I have a few metrics I think about with grocers. The main one is EV (meaning market cap plus debt) to sales. My rough rule of thumb is that an EV to sales of under 0.25 is outright cheap (and only seen either when the whole market is distressed or an individual company is distressed). You have to have a very high quality company to want to pay more than 0.5 times sales. These numbers have to be adjusted for retailers that own much of their property (Walmart, Tesco).

The logic is as follows: grocery retailing is a 5 percent margin business give or take a bit. $100 of sales at an EV to sales of 0.5 is $50 of EV. That $50 of EV would have $5 of operating profit associated with it (5 percent margin on $100 of sales). Now imagine the company had no debt and thus no interest bill. Take out tax at 30 percent and you have $3.50 in after tax earnings. That is for $50 of EV (which in this case is $50 in market cap). The price earnings ratio would be just over 16.6.

To pay more than 0.5 times sales you have to argue that unlevered this company is worth more than 17 times earnings. That is possible if there is a lot of growth potential or the margins are sustainably fat. But 0.5 times sales is a price above which I need to be finding rationalizations to maintain my interest.

When non-distressed grocers with solid market positions trade at 0.25 percent of sales (which is very rarely) they are half that price which is cheap by most measures.

Here is the last quarterly balance sheet for SVU:

	December 3, 2011				February 26, 2011
		(Unaudited)
ASSETS
Current assets
Cash and cash equivalents		$	196			$	172
Receivables, net			747				743
Inventories			2,616				2,270
Other current assets			226				235
Total current assets			3,785				3,420
Property, plant and equipment, net			6,226				6,604
Goodwill			1,306				1,984
Intangible assets, net			887				1,170
Other assets			581				580
Total assets		$	12,785			$	13,758
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable and accrued liabilities		$	2,720			$	2,661
Current maturities of long-term debt and capital lease obligations			396				403
Other current liabilities			643				722
Total current liabilities			3,759				3,786
Long-term debt and capital lease obligations			6,203				6,348
Other liabilities			2,078				2,284
Commitments and contingencies
Stockholders’ equity
Common stock, $1.00 par value: 400 shares authorized; 230 shares issued			230				230
Capital in excess of par value			2,860				2,855
Accumulated other comprehensive loss			(379	)			(446	)
Retained deficit			(1,450	)			(778	)
Treasury stock, at cost, 18 and 18 shares, respectively			(516	)			(521	)
Total stockholders’ equity			745				1,340
Total liabilities and stockholders’ equity		$	12,785			$	13,758

The last SuperValu balance sheet had $396 million of short term maturities and $6.2 billion in long term debt. There is a couple of hundred million in cash - which is such a minimal number I am going to ignore it. (There is 200 thousand dollars cash per store - a number that looks small relative to obvious cash needs including just balances in the till.)

$6.5 billion in debt give or take a little. The market cap is 1.35 billion according to Yahoo! EV is thus 7.8 billion. Last year sales were something like 37 billion (and on a very steep decline of about 10 percent per annum). This year they will be something like 35 billion. EV to sales is just over 0.2 - and will be probably close 0.25 when (and if) they can stabilize sales. This is the bottom end of my EV to sales range but is not an outright distress type figure. Given most this EV is debt I would not be much interested in the debt at par (even though it yields 8 percent). That seems like not much upside and in distress this retailer is going to be worth less than 0.25 times sales.

If perchance the debt were to trade at 70c - implying an EV to sales in the mid-teens - then I might get interested in the debt.

The equity is another issue - one I address below.

My second metric for retailers is how much of a lean they are taking on suppliers. Grocers sell stuff fast - many sell their stuff faster than they pay the suppliers meaning they get free funding from them. If they get into trouble (or they want the cheap finance) they let their supplier obligations blow out. I wrote a post once about an Australian wholesaler (Davids Holdings) which let its supplier obligations blow out and nearly went bust. Not nice.

A rough rule of thumb is as follows. Most suppliers give you 30 day terms. If your payables are more than 30 days of sales you are taking a lean on your suppliers. If you take too big a lean they start getting stroppy and ask for cash-on-delivery or letters of credit or the like. Too much of a lean is pretty tightly defined: most grocers have payables of about 35 days of sales.

In the above table payables are 2.7 billion. That is less than a month of sales - SuperValu is clean on this measure. However note that the accounts payable have gone up as sales have gone down. Whilst the level is not a sign of distress the direction is not good (the reduction of debt is not as impressive as it looks).

Finally - and this is the measure that most bugs me - inventory turn is falling. Inventory is up year on year. Sales are down. For a grocer this is unremittingly bad news. Not only are they using capital less efficiently (getting less aggregate margin per square foot for instance) but slowly and surely the store is turning into one of those places you shop only if you like your groceries pre-packaged and just a touch stale.

Whatever - on the numbers as given this is not that cheap relative to EV and the metrics are going the wrong direction.

You could add - and one of my readers did - that the company is underspending on stores. Tired old stores with slow inventory turns and stale product - that is not the way to take on Whole Foods. And unless you are going to shave margins to nothing it is hardly a way to take on Walmart.

If I had to make a bet on this my guess is that it will have to restructure in some form. This might be a sale (for debt reduction) of a large part of the business or it may be Chapter 11. Whatever - this is not easy and not an obvious value stock.

Would I short the stock?

There is a big short interest in the stock. I think the company is probably going to continue to have a rough time. I am a short seller. The obvious question is "would I short the stock?"

Here the answer is surprisingly no. The company in aggregate is not cheap (EV to sales is going to wind up somewhere near 25 percent) but the equity is cheap. Why? Well if things go right (and things always can go right) and the company gets say 100bps more margin - then the stock looks staggeringly cheap.

There are 35 billion in sales. 1 percent margin increase is 350 million per annum. That is very meaningful relative to a market cap of $1.3 billion. Add in a big short interest and the stock could be very strong.

The leverage that makes this whole thing problematic works both ways. If the management can right this ship the stock could be a big winner.

Have the management done a good job

My bullish commentator thinks the management have done a good job. As far as I can tell he is right. They have shrunk the business (a lot), paid off a lot of debt, and it appears been pretty straight-up-and-down about it. I am a little irked by the falling turnover (it will make the product stale) but that might just be the hand they were dealt.

I have not done a lot of work. I have not walked around these stores. I have not done any apple-freshness tests. But on the numbers I see no reason to believe management have not been pretty good.

That is a blessing and a curse. Good management will be necessary to salvage this situation. But if these stores have been well managed then getting a new broom in can't save the situation. You have to play the cards that are dealt.

Summary

If SuperValu is proof that there is value easily detectable in companies under $5 billion in market cap then - frankly - I think I will take my large caps.

I would not be long this without tangible on-the-ground evidence (from surveying up to 30 stores in different locations) that this really has turned around. Because at the moment this does not pass the Wayne Gretsky test of value. In five years it looks really really bad.

And I would not be short it either with that leverage without a decent understanding of their day-to-day liquidity and just how short-dated the situation is.

This one belongs in the too-hard basket. And half a day is wasted looking at another stock that ultimately I don't care about.



John


*For disclosure purposes we were once short Hewlett Packard but have covered, we are long Vodafone and Google - two of our biggest positions, and we were once long Total but have sold.

Memo to Jeffrey Immelt – if you are going to lie you have to do it more convincingly than this

• GE sold its mortgage insurance business before the crisis broke.  That was high quality risk aversion.

• They sold their bond insurer (FGIC) to a combination of private equity and PMI Inc.  I figure the private equity buyers are hurting – PMI trading at less than a dollar surely is.  Again this is the mark of superlative judgement.

• I know the guys who run the Australian mortgage business.  They started cutting back risk very early.  The staff who used to get paid on volume are very unhappy indeed because – well – as credit standards tightened volume dropped.  Another mark of superlative judgement.

• They sold their life reinsurance business to Swiss Re.  I suspect Swiss Re is hurting - and indeed Swissy had to sell a big stake in itself to Warren Buffett - I suspect to partly cover those losses.

• They sold their P&C reinsurance business as well.  That is probably doing OK – but it carries a long tail risk.

• They sold their long term care insurance business.  That player – now part of Genworth – is the best company in the world in one of the worst businesses in the world.  The risks were high.
  

GE Finance in other words cut back on risk.  A lot of risk.  Mostly the right risks.  And they cut back on risk early – before the crisis hit – when they got good prices for rubbery assets.

I have argued at times that Immelt is the best CEO in the world for that. I even owned the stock for some of the fall in the price (though I have not owned it for a while). 

It was an article of faith for me that when you see consistent bad behaviour by a bank or an insurance company in one area it is usually rife.  You can’t know everything in a bank balance sheet.  Not even the CEO and CFO have a hope of that.  

Symmetrically if you see consistent good behaviour then you can guess that the good behaviour pervades the book.

When analysing a financial all you can judge is the culture – and if the culture was cleverly cutting risk in areas you knew really well it was probably cutting risk everywhere else.  

GE looked pretty good to me.  The behaviour exhibited was smart and consistent.

The problem

In finance you make profits in normal times by carrying risk.  The more risk you carry generally the higher your "normal time" profits are.

If you cut risk – as GE did – then your "normal time" profits will fall.  GE Capital profits did not fall as they cut all that risk.  That was very strange.

There is no question that GE fudged its results a little bit in order to keep reported profit momentum when actual profits were falling.  Gradient Analytics did a solid report on GE showing how they had systematically stripped reserves in many businesses.  

The bears travelled from the analysis of fudged accounts to guessing (and it can only be a guess) that GE must be full of toxic assets.  

I thought the negative reports were overly bearish.  I watched what they did more than I watched the accounts and what they did told me they were very good.  

The summary was that they were doing the right thing and their profits were falling for good reasons – and they were lying about the profit fall.  

Normally I have the view that a company that lies about its earnings in small ways has a lot to hide – there never been only one cockroach – but I was desperately impressed at the big-picture things that GE was doing.  To the accounting junkies GE was diabolical – because they lied.  To them sanctity of accounts is the true mark of quality of a business.  I am a little less pure than that – but maybe I should listen more.  I went long GE in the thirties.

Now my buy case for GE depended on them being a capital equipment exporter with costs in US dollars and with Asia growing like crazy.  This was the decoupling fantasy that cost a lot of investors (including me in this instance) some pretty coin.  As the world now knows China fell into the economic abyss sometime in the third or fourth quarter of last year and the upside case for GE (capital equipment sales) collapsed.  I sold for a bad loss – but it would have been a worse loss had I held.  

Anyway it is not true that GE kept cutting back risk.  They took a few too many risks in commercial property and even Immelt admits problems in UK mortgages.  The risk de-jour though is that they tied themselves up in Eastern Europe – and until very recently they were boasting about as a presentation show made in September last year shows.  (That presentation seems to have disappeared from their website).

Still according to Immelt’s letter GE Capital made $9 billion last year.

Sorry – I do not believe it.  Indeed the claim is comical.  Here from GE’s recently released annual report is a table of non performers and reserves.

In almost every financial company reserves have had to rise faster than non-performers over the past year.  Why?  Well consider how a non-performer becomes loss.  We will do it in the case of a mortgage:

1. The customer stops paying full interest.  They do this because they have had a hiccup in their business or life that is temporary or semi-permanent.  If they are an electrician and fell of a ladder you can bet that once their broken leg is healed the non-performing loan will again perform.  But if they are an auto worker who loses their job they might not get another one for a year or two.  You are probably going to foreclose.  The chance of a non performer defaulting goes up with unemployment.
   
   
2. Then once the loan defaults you need to sell the property.  If you haven’t noticed the loss given default has gone up sharply.  

In summary the chance of a non-performer turning into a loss has increased sharply so the ratio of reserves to non-performers should go up sharply.

What if I told you that the reverse was true at GE.   In many of the lines of business reserve coverage went down – often down sharply.  Not great.  Not even plausible.

Real GE profits

The funny thing is that it never needed to be this way.  GE was still – even on my adjusted numbers – profitable last year.  I have seen some bear-case estimates of the loss on the ground in various GE businesses and they look high to me.  These are guys who estimate losses by looking at accounts – and the losses GE will take are – in my view – substantially less than market because – on the ground – I have seen them operating in a lower-risk manner than their competitors.  

The problem of course is you do not know.  Summary: mostly good behaviour – bad accounts.  Sure I have heard some instances of bad behaviour – but they are thinner on the ground than the good things.  

Jeffrey Immelt in his letter says that he takes responsibility for the loss of reputation of GE.  If that were an operational responsibility he would resign.

And on the basis of his accouting he should.  

But I am not calling for his resignation.  On the risk management described at the top of this blog post he remains possibly the best CEO in the space - and he is way better than any obvious replacement.

GE as a parallel for America

Speaking as an outsider I have to agree - America at its best is a wonderful place.  It is amazingly productive.  The degree of specialisation of people and the cities they live in is wondrous.  The innovation is jaw-dropping and it has changed the world.  

Silicon Valley is a wonder of the modern world.  But so are half a dozen fecund places in America.

So is General Electric.

America has plenty to recommend it - and if I did not love Australia so much you would see me on the plane yesterday.

But the accounting sucks.  It sucked when the broker certified the taxi driver's income at $350 thousand for the purpose of the no-doc loan and it sucks when Immelt certifies the reserves in GE's accounts.  

It sucked when the Bush administration regularly and systemically misestimated the US budget deficit and it sucked when the SEC went after truth-telling short sellers rather than easily provable frauds by powerful people.  

But beyond all that accounting when the mess is cleaned up the good stuff about America will probably still be there.  

Will GE will still be there?  Well I think it will probably will - but without a huge run through the accounts and without your lie-detector running full blast - well it is very difficult to know.

I am trying to do the work.  But hell - this one is really hard.  Six Sigma precision - that I cannot deliver.

John

Disclosure: no position but leaning long.

We are not close to being Swedish yet

Nouriel Roubini has a newspaper article that says we are all Swedish now. I wish it were true. We are nowhere near being Swedish.

This is an investment blog – so – in tradition of investment blogs I am going to start with a stock chart.

This is a chart of a bank – I have removed the currency and the name of the bank.

The bank could be any bank that (nearly) collapsed in 1992 and recovered. It could be Citigroup or a small property exposed regional (such as North Fork). But it isn’t.

It is Skandinaviska Enskilda Banken, a Swedish bank which – at least in those days – was more upmarket and had a large corporate loan exposure.

It was in deep trouble. It was involved in a government support process which – had they failed various tests – would have wound up in nationalisation. The market truly believed that it would be nationalised. The only thing that kept it liquid was the implicit support that if it failed certain capital tests (weak tests because buffers were reasonably used by that time) then it would be nationalised.

It didn’t fail the tests. It got some private money. And the stock went to the races. The stock was a 20 bagger in 18 months. The bank however was implicitly supported by a process that could end in nationalisation. (That is it was solvent and would have been illiquid if not for implicit government support. It was a crisis - but a crisis alone was not enough reason to nationalise a Swedish bank.)

Here is another chart – this one is Svenska Handelsbanken – one of the better managed banks in the world. It too was loss making at the height of the crisis – and it had elevated losses for several years.

This bank did not even apply to be enrolled in the government support program (though it did consider it). It decided (with some justification) that it would get by fine. However the bank sure looked done for.

Swedish bank nationalisation wasn’t done by a traditional Swedish semi-socialist government. It was done by a centre-right reformist government for whom nationalisation was anathema.

They developed processes which were certain and which some adventurous money could recapitalise the banks under clear rules. The process respected private capital.

Banks that were deemed to require capital had to raise it – if they couldn’t they were fed capital by government. If they required too much capital the government wound up owning them. But there were defined rules and a process.

This is how it is – with certain rules and a process not every American bank is going to die - and possibly some or most of the big six will survive. Some will live – and they will prosper. Nationalisation with process leads to 20 baggers. Oh, and zeros - 100 percent losses.

But we are here in limbo. The nationalisation meme has taken hold – and nationalisation of some banks will happen. America is a current account deficit country – and almost all American banks need wholesale funding. There is none of that since the Lehman/WaMu week – and there will not be substantial wholesale funding until the rules are clear. All banks will fail in that environment.

The faster we come out with a good process – one which has nationalisation as one (but not the only) possible outcome then banks will continue to fail. And ad-hoc decisions will be made to bail them out or confiscate them. And we will be no wiser. And no closer to a solution.

Investing and nationalisation

Equity investors should not fear the nationalisation meme. It happened in Sweden and two of the banks were 20 baggers. Svenska Handlesbanken was a 50 bagger to peak (and it still trading well above 100 kroner).

The “all banks are insolvent” idea is simply not true – and it is not going to help you make money forever (though it will work until a process is found). But – hey – while there are no rules – it all a crap shoot. We own no American bank common equities at Bronte. Short a few.

Waiting, hoping… hoping we really can become Swedish. You make the real money on the long side...

John

A post script is required. SEB – which was an OK – but not great bank – got itself entangled in the Baltic mess. It is not quite as exposed as Swedbank – but it is not pretty. The stock is down from 250 to 50.

SvenskaHandelsbank has operations in the Baltic. Here is their Estonian page. But the exposures are substantially less large and the stock is one of the better performing European banks. Hey – best bank last cycle – best bank this cycle. A solid culture is the only way to run a bank.

A second postcript - in the comments it is noted that (a) the Swedish Kroner devalued sharply giving Sweden a strong competitive edge, and (b) the rest of the world could buy the Swedish product. It is much harder with a synchronised world downturn. No argument from me there.

Global diversification – an Australian perspective

There is a post by Dennis P. Quinn   Hans-Joachim Voth – good Finance professors both of them – on why international diversification does not seem to deliver the benefits that were expected.  They argue that globalisation has made everything more correlated. 

I think they are spectacularly wrong.

Obviously the good Professors are not Icelandic.  Iceland really has almost totally melted down – and if you were Icelandic but have global assets you have done just fine thank you very much.  In Kroner you might be up 500 percent even if your foreign assets were not that good.  Having an even small percentage of your wealth diversified globally has saved your sorry and cold Icelandic backside…

I enjoy all those mathematical models that suggest that if it is correlated it is not diversified.  But day-to-day correlation is not where it is at.  What you really want is “uncorrelated in a crisis”.  International diversification is pretty good at that.  Iceland has had a crisis – but New Zealand for instance – a country often paired with Iceland looks OK for now.

Now I am going to give you an Australian perspective.  Felix Salmon points us to a Merrill Lynch report that suggests on measures like current account deficit, short term funding requirements etc (all the things that obsess me) that Australia is the riskiest country in the world.  Latvia obviously is not a country according to Merrill Lynch – but they are more or less right.  Australia really is risky.  It has an American style spending habit, a property boom that allows me to go to Sausalito and think the houses are inexpensive (they are compared to Bronte).  And it has an economy highly dependent on a small number of commodity exports.  (Iron ore and China looks like a risk to me.) 

In other words Australia could do an Iceland.  I don’t think it will – Australia has a few advantages which include a government that has fiscal credibility and very low debt levels, a banking system that is relatively small to GDP (at least compared to Iceland), and the minerals that China needs (and will need more of one day). 

But Australia is not riskless.  The risks whilst small are very real.  And if you are a well-to-do Australian and you are not diversified at least 20 percent globally you are doing yourself no favours.  Those with self-managed superannuation funds should pay heed.

If you are an Australian and you diversify globally but swap the currency back to Australian dollars (as one well known retail fund manager does) you are also failing to diversify.  The main advantage of diversification internationally is that it removes the country specific catastrophe risk and swapping the currency back is simply insane.  Indeed an Australian retail international fund that wants to swap all the currency back is putting marketing ahead of client asset protection and is – in my view – almost criminally negligent.  Just think how an Icelandic international fund would look if it had swapped its currency exposure back to Kroner!  They would be a wipe-out because they would have to sell their valuable international assets to meet their obligations to deliver valuable foreign currency for worthless Kroner. 

But what is good for an Icelandic person or an Australian (some global diversification fully accepting currency risk) is good for an American too.  The US is bigger and more stable than Iceland or even Australia – but it is not riskless.  There remains a small chance that somehow the US will become a fascist dictatorship.  The chance I suspect is smaller after last Tuesday – and might be vanishingly small anyway – but it is not zero.  There are plenty of things that can go wrong. 

And there is a small chance that the US could go to pot in ways that I can’t envisage.  And in that case international positions would not be entirely correlated.  The US might take some of Europe down with it – but China and Australia might be OK.  A little international diversification would be great for Americans too.

The dear Professors have this wrong.  International stocks are correlated but not entirely and not in extrema.  Rich people in small Latin American countries know this.  Maybe the good Professors should too.

 

 

John Hempton