Wednesday, 14 June 2017

Modigliani-Miller, Warren Buffett, gravity and US equity valuations

Given the high levels of debt, the world's main central banks can't afford to rise interest rates dramatically over the coming 10 years. Thus, 10-year government bond yields in the US, EU and Japan will reach maximum 2%. If we add a 2% equity risk premium - historically rather low but justified by the low equity market volatility that is supposedly here to stay - we end up with equities being fairly priced at an earnings yield of 4%. A P/E of 25x.

This is the standard explanation many give to justify that equity markets, starting with the US, are currently far from overvalued. Then again, what do we know about the relationship between debt levels and the cost of equity (i.e. the equity risk premium)?

We know, from the Modigliani-Miller theorem, that a firm's capital structure has no impact on its valuation. Contrary to what many argue, the increase in a company's level of (low cost) debt vs. (high cost) equity - an increase in leverage - doesn't lead to a meaningful reduction in the average cost of capital. The reason is straightforward: an increase in leverage by increasing the company's insolvency risk leads to an increase in the company's cost of equity (the equity risk premium goes up). The increase in the cost of equity in turn fully offsets the lower cost of debt, resulting in an unchanged average cost of capital. As changes in the capital structure don't have any impact in a company's operating free cash-flow generation potential, it follows that a change in a firm's capital structure doesn't have any impact on its fair value. There is only one minor caveat: given that interest payments are tax deductible, an increase in leverage leads to a minor change in the average cost of capital via the debt tax shield (e.g. if (i) 50% of the firm's capital structure is made up of debt, (ii) the corporate tax rate is 25% and (iii) the average cost of debt is 4%, the average cost of capital is.......0.5% lower vs. a capital structure with zero debt and 100% equity. Only 0.5% lower!). But even then there is a limit to the benefits of leverage: at some point (dependent on the cyclicality of the underlying business) further increases in leverage lead to an increase in the risk of insolvency and cost of equity that starts to offset the tax shield advantage. Keeping adding debt once that point is reached starts to increase the average cost of capital instead of slightly reducing it.

By the way, that the capital structure has no meaningful impact on a firm's average cost of capital and valuation is one of the few things on which Warren Buffett, Charlie Munger and financial academics agree on. So we better take it seriously.

With this is mind, where does the world economic system stands now? This is how the world's debt levels have evolved since the year 2000 (courtesy of MGI - McKinsey Global Institute):


The world economy is today more leveraged than it was in 2007. This must surely mean that the aggregate risk of insolvency is today greater than it was back then. And knowing what happened in 2008, it is reasonable to conclude that the resulting increase in the cost of equity more than offset any tax shield advantage from the additional debt the system accumulated in the meantime. So, the risk-adjusted average cost of capital should be higher today than it was in 2007.

What does this mean to valuations in the world's leading equity market, the US? Assuming, very optimistically, that (i) today's average cost of capital is only 10%, (ii) the US economy will grow at 5% nominally per annum in perpetuity (2.5% real growth + 2.5% inflation) and (iii) companies' average dividend pay-out is 75%, US equities would be fairly valued at a P/E of 15x (with a pay-out of 65% the fair value P/E would be 13x).

The S&P 500 is currently trading at a cyclical-adjusted P/E of 29.9x, trailing P/E of 24.1x and 1-year forward looking P/E of 19.0x. If this is fairly valued, what is overvalued?

And remember: gravity does exist. In financial markets too. It's just that it is not Newton's gravitational principles that rule financial markets - it's Wile E. Coyote's: markets can deviate from fair value for a long time, but eventually the power of gravity takes over.


Tuesday, 16 May 2017

Macron(omics) missing piece - a private sector-based Eurozone transfer union: the core-periphery FDI bridge

The Eurozone suffers from a structural economic problem. An imbalance: a centre traditionally running current account surpluses, a periphery traditionally running current account deficits. Admittedly, the peripheral countries' current accounts are now balanced but as unemployment keeps falling it is difficult to see how this won't translate into a rise in imports and current account deficits resurfacing again. The classic response to address such imbalances is via the creation of an EU transfer union. In theory, it would make sense.

But theory is not always very practical: it is almost impossible to gain political support at the EZ's national level to transfer taxpayers money from the centre to the periphery. However, doing nothing is not an option either. And this begs the question: what to do? The answer: create a centre-periphery FDI bridge. The idea's rational being reasonably straightforward:

Problem: Peripheral countries (Spain, Portugal, Greece) have traditionally (i.e. since WWII) run current account deficits - the resulting accumulation of foreign debt leading sooner or later to an inevitable “sudden stop”, financial and economic crisis. Just like in 2009/2010. 

Solution: These countries need to broaden substantially their export base and implement an export-driven growth strategy. The way to do it in an effective and reasonably timely manner (5-10 years) is by attracting massive amounts of foreign direct investment (FDI): that the Siemens, L'Oréals, Googles of the world set up production/service units in the countries (or expand the already existing ones) to serve (mostly) clients abroad. For it to happen structural reforms at the national level are needed – no doubt. But it will not be enough. The European Union has to create a mechanism that incentivises the flow of private capital (simply said “Germany’s excess savings”) from the centre to the periphery to finance the FDI projects. This should comprise:

- tax incentives, e.g. FDI projects not paying corporate tax for the first 10 years;

- a pan-EZ legal & institutional framework, e.g. FDI courts at EU level investors could resort to in case of legal issues arising with their projects. Thus overcoming the potential lack of trust in the national legal frameworks & judicial systems.

In short: create special economic zones in the EU periphery offering investors a highly attractive and reliable fiscal, legal and financial return framework

Result: A win-win situation - the periphery expands its export base and generates strong export-based sustainable growth; the centre can invest its surplus in economically sustainable projects at an attractive rate of return (instead of investing in US-subprime or Spanish overvalued, excessively supplied, real estate assets as in the pre-2008 period). 

Cutting a long story short, the centre-periphery FDI bridge is an incentive mechanisms at the EZ level to channel private sector monies from the surplus centre to the deficit periphery, to finance FDI projects in the latter. It is both politically more feasible and economically more efficient / sustainable than creating a classic transfer union.

Combined with (i) a limited common EZ budget (managed by an EZ finance minister) to finance investment projects across the EZ, (ii) evolving the ESM into a fully-fledged European Monetary Fund for crisis resolution situations, (iii) full implementation of bank bail-in mechanisms and completion of EZ's banking union, the FDI core-periphery bridge would complete Eurozone's required institutional framework and make it a sustainable and prosperous economic construct. The Euro would definitely become a success story.

Emmanuel, are you reading? Thanks to you, we - the Erasmus generation - are in charge now. Let's make Europe great. Again.




Monday, 20 February 2017

Hard-core Brexiteers' investor sentiment: Germany is stupid enough to let the Euro collapse...


Germany's current account surplus is estimated to have reached 8.6% of GDP in 2016 (Source: Ifo Institut).

The Deutsche Mark (DM) was Germany’s currency from 1948 to 1999. How often did Germany in the DM period have a current account surplus of 8.6% of GDP? Zero. How often a current account surplus of 5% of GDP? Zero. The highest current account surplus ever recorded during the DM period was approx. 4% in two years in the 1980s. During the rest of the time, Germany’s current account surplus always peaked in the range of 2%-2.5% of GDP. This includes the years of Germany’s economic miracle in the 1950s and 1960. Check it out for yourself:
 


Source: Bloomberg

[Please note: chart only depicts Germany's current account balance data from 1970 to 2015. Full data from 1950 to 2015 for Germany's trade balance can be found under German Trade Balance 1950-2015 and for Germany's GDP under German GDP 1950-2015 - data source for both links: German Statistisches Bundesamt. To calculate the German current account balance please take into account that 1%-2% of GDP have to be subtracted from the trade balance. Reason: Germany's current transfers are negative (EU net transfers accounting for approx. 0.6% of German GDP + monies transferred by migrants living in Germany to their countries of origin more than offsetting Germany's positive income balance)]
 
Is today’s German 8.6%-of-GDP current account surplus sustainable? No. During the DM period it would have been swiftly eliminated before it even came into existence via an appreciation of the DM (r-e-m-e-m-b-e-r: with the exception of two years in the 1980s, the German current account surplus never surpassed the 2%-2.5% mark during the over 50 years long DM-period). With the Euro, this market-based adjustment mechanism ceased to exit. What to do? There are two options:

  1. Break up the Euro and return to national currencies in today’s Eurozone
  2. Put in place a transfer mechanisms from Eurozone’s surplus to deficit countries via the public and/or private sector
What are advantages and disadvantages of option 1 for Germany?

The only advantage of Option 1 I can see is the lack of need for economic co-ordination among Eurozone member states, which can often be painful. A veritable pain-in-the-neck. I can see, however, many disadvantages both cyclical and structural.

Let’s start with the cyclical: Germany would undergo a recession - then again, who cares? Many young well educated citizens from EZ’s periphery would head back home - one of the best performing asset classes in Germany over the past 5-6 years has been real estate. A fall in real estate prices would be unavoidable. There is no asset class where the average investor is as leveraged as real estate. What would that mean for the German financial system? Bail-ins or bail-outs - do we start to care now?

On the structural side: how many decades would the resentment and lack of trust between Germany and France last following France’s crash-out of the Euro? Could the EU survive a break-up of the Euro? If not, what would the end of the EU's single market mean for the German economy? With 80 million inhabitants and a Eur 3.1tn GDP, Germany is Europe’s heavyweight. It accounts for roughly 1% of the world’s population and 4.5% of the global GDP - how much weight would stand-alone Germany have in the world (the US accounts for 24% of global GDP, China 15%, the EU 23%, the EU ex-UK 19.5%)? How much influence would stand-alone Germany have in forming and shaping international treaties and world trade agreements? Could NATO be a credible tightly knit military alliance with no underlying mutual trust among its core European members?

By choosing option (2) Germany would agree to transfer a large part of its current account surpluses to the Eurozone periphery. In return it would continue to have the full benefits of the existence of the Euro and a stable, sustainable and prosperous European Union. Given that Germany’s giant current account surpluses wouldn’t exist without the Euro, Germany would give up something it wouldn’t have anyway in return for having something extremely valuable and tangible. This is the closest you will ever get to a free lunch: get great value in return for giving up de facto nothing.

We can discuss if in the end Germany will push for an Eurozone-wide public sector based transfer mechanism between surplus and deficit countries (Eurobonds and an Eurozone finance ministry). Or a private sector based one, i.e., create incentives at the Eurozone level to incentivise massive amounts of foreign direct investment (FDI) in the periphery financed with German private sector surpluses – the periphery widens its export base and German investors obtain attractive returns for their savings (my favourite option). Or if Germany simply starts to spend more via a mix of public investments with a positive impact on the economy’s supply side (infrastructure, education…) and larger pay rises, which would increase German imports. Or if Germany will push for a combination of all these (the most likely option).

But saying that Germany, in the end, will let the Euro break up is saying that the country’s top-decision makers are economic and political illiterate. And absolutely stupid. Or that they are not intelligent enough to convey the message of the Euro’s and European Union’s importance and extremely high benefits for the country to German voters. Meaning: they are really stupid. Or that the vast majority of the German public wouldn’t understand the message. Meaning: the Germans overall are really stupid. Or that the German political system would not comply with article 23 of the country’s constitution. Meaning: German top decision-makers are not only stupid – they cannot even read. And on top of it, Germany’s political and judicial institutions are a fraud.

No, no, boys and girls. No, no, hard-core Brexiteers. I know that it is unpopular to say it these days, and I’m sorry to disappoint you, but the Euro will not collapse. In Germany’s wisdom and quality institutional framework you should trust. Even if you don't like it.

Wednesday, 7 December 2016

Monte dei Paschi di Siena - parliamo deutschiano?

Matteo Renzi was defeated in Sunday's Italian constitutional referendum and quickly resigned as Italian prime-minister. The Italian banking sector, led by Monte dei Paschi di Sienna (MPS), became more than ever front and center of investors' and press' speculations.

One day, MPS will collapse, trigger a new Eurozone banking & financial crisis and the break-up of the Euro. The next day, it will be bailed-out by the Italian government and its shares (and bonds) are a screaming buy. This is all an excellent reflection of markets' and financial press' "action bias": be busy all the time even if it achieves nothing.

What about looking at the numbers and regulatory framework first and express opinions later, guys? Not very popular in the post-fact world in which we are now living? Let's be unpopular then:

1. According to the EU's Bank Recovery and Resolution Directive (BRRD), that entered fully into force in January 2016, national governments cannot recapitalise a bank before a bail-in of an amount equal to at least 8% of the bank's total liabilities including bank's own funds (capital) has taken place. Meaning: we're basically talking about 8% of total assets. In the case of MPS, that means a bail-in of an amount of approx. EUR 12.8bn;

2. MPS' total equity is approx. EUR 9bn; junior bonds face value amounts to approx. EUR 5bn, of which approx. EUR 3bn is held by retail investors. Bailing-in retail investors is politically untenable. The challenge then is to treat all junior bondholders equally while avoiding bailing in retail investors. And the elegant solution would be to define a bail-in free face value amount of EUR 100k per bondholder - everyone would be treated equally while MPS 40k retail junior bondholders were de-facto excluded from the bail-in. This would leave EUR 2bn of junior bonds to be bailed in. Not enough. MPS needs at least EUR 5bn of additional equity. On top of it, bailing in all shareholders and junior bondholders only amounts to EUR 11bn, almost EUR 2bn short of what is needed for a state participation in the recap efforts. What to do?

3.  The straightforward answer would be to bail in senior bondholders as well. But it's probably not a good idea many will argue: MPS senior bonds are currently trading at close to 100% of face value. Senior bondholders are not expecting to bear any losses in the MPS recap process. If a bail-in of senior bondholders did occur scared investors would drop senior bonds of other Italian (and non-italian) banks, leading to massive contagion and a collapse of the Italian financial sector. Whatever one thinks of this line of argument, the good news is that a bail-in of senior bondholders is not a pre-condition for the Italian government to participate in the recapitalisation of MPS. The reason is article 32 (4.d) of the BRRD.

According to this article "extraordinary public financial support" is allowed "in order to remedy a serious disturbance in the economy of a member state and preserve financial stability". It is the so-called precautionary recapitalisation and considered a case of state aid. In case of state aid a bail-in is still required before the Italian government can participate in MPS' recap. But the degree of burden sharing is lower: only shareholders and junior bondholders are required to participate in it (see points 15, 40 and 41 of European Commission's Banking Communication from August 2013).

Will the Italian government invoke BRRD's article 32 (4.d)? You bet it will.

What are the implications? On the one hand, MPS will survive. An Italian fully fledged banking crisis will be avoided. The Euro will not break up. On the other hand, MPS shareholders will be wiped out.

Investors buying MPS banking shares expecting a giant Christmas present from the EU/Italian authorities should think again. And MPS senior bonds currently trading at close to par, and yielding 3% to 5%, are not a prime example of an investment with a spectacularly positive asymmetric risk-return profile.

To reach all these conclusions you only need to understand what makes the EU great: a combination of German rule-based institutions with embedded Italian flexibility. Learn deutschiano and you will be just fine.

Monday, 31 October 2016

Hillary, Donald and Investment Management

Based on current betting odds and Nate Silver's fivethirtyeight polls analysis (link here), the probability of Trump winning the US Presidential election is only around 25%. With such favourable odds, the easy conclusion would be: let's go long on US (and global) equities and secure the 1-week 3-5% celebration rally that will tend to follow Hillary Clinton's victory.

But it would be too easy. And bad decision making.

Investing is not really about the probability of success vs. failure. It is not even about expected values and expected returns. It is all about assessing the consequences of failure. Binary outcomes and risk-return asymmetry.

In this case, we have a binary outcome: 0 - Hillary Clinton wins; 1 - Donald Trump wins. If Hillary wins the US equity market's upside is arguably 3-5% over a 1-week period; if Donald wins the downside is possibly 10-15% over the same period. Do you really want to be exposed to a binary outcome were you can win 3-5% if things go your way at the risk of losing 10-15% if they go against you? This is an highly unfavourable asymmetrical risk-return profile. The negative consequences of failure way outweighing the positive consequences of success. Thus, the sensible answer can only be no.

The more academic types among us could always argue that if the potential upside is 5% and the downside is 10% (after all you can exit before the losses reach 15%), with the currently implied 75% probability of Hillary winning the election, the expected 1-week return of building a long exposure to US equities the day before the results are announced is 1.25%. All nice and dandy. However, we should never forget that a 75% ex-ante probability of success can easily become a 100% ex-post probability of failure; a 1.25% ex-ante expected return become a 10% ex-post loss. And that in the age of "the rage against the establishment", the polls' - and implied probabilities - accuracy is not what it used to be.

Wouldn't actually a short position in US equities have a much more attractive risk-return profile ahead of the election than a long one? Yes, it would. Then again, if Trump wins there is enough time to make money with equities. 

Don't be too greedy. Think binary. Think negative asymmetrical risk-return profile. And stay away from the US (and global) equity markets ahead of the US election day.

Monday, 12 September 2016

Richard Koo, please mind the gap: the Eurozone is not Japan

Richard Koo is well known for his balance sheet recession analytical framework (here a link for one of his most recent and detailed presentations: Richard Koo at May 2016's Acatis Conference in Frankfurt).

His analysis points to the fact that once a debt fuelled asset bubble bursts, leaving the private sector in a highly indebted and over-leveraged position (with many individuals and corporates in negative equity territory), monetary policy becomes ineffective. Following the implementation of a highly expansionary monetary policy, private households and corporates will take advantage of very low interest rates to repay down their debt burden faster. Not to consume more. Not even to maintain their consumption at pre-asset bubble burst's levels. The private sector unavoidably retrenches.


In such an environment, the only way to avoid an economic depression is to combine an expansionary monetary policy with an expansionary fiscal policy: the government has to step in, run large deficits and increase public spending. This is what the Japanese government has been doing following the burst of the country's real estate and stock market bubbles in 1989. Once the private sector has completed its deleveraging process, and monetary policy becomes effective again, the government can then revert to a normal fiscal policy and the central bank normalise monetary policy.

 

So far, so good. Richard Koo's analysis is insightful and his recommended expansionary fiscal policy sensible. For Japan.

But does it really make sense to apply the expansionary fiscal policy strategy to the Eurozone over the coming years as he proposes? At first sight, it does. After all, the Eurozone, on aggregate, suffers from the "Japanese disease": an over-leveraged, over-extended private sector in parts of the periphery that needs to de-leverage; national governments that need to step in and spend more to offset the private sector's retrenchment. However, once you look at things into more detail the picture changes. And you realise that Richard Koo's Eurozone analysis overlooks a few things. Namely:

 
1. And this is fundamentally true for any balance sheet recession scenario (Japan included) - if you have a private sector balance sheet whose left side is suddenly smaller than the liabilities on the right side (as a result of the burst of a debt fuelled asset bubble), you have two ways to correct the problem of negative equity. One is by inflating the left side via an ultra-expansionary monetary policy while slowly reducing the liabilities on the right side - this is part of Richard Koo's proposed strategy. But contrary to what Richard Koo argues it is not the only feasible strategy available. There is another option: to radically and swiftly shrink the liabilities on the right side via debt restructuring and haircuts. This will lead to massive impairments in the banking sector and arguably the financial sector cannot be let implode. But that doesn't imply bail-outs and debt transfers from private investors to the taxpayer. All what is needed are bail-ins. Bank shareholders and debt-holders, who freely decided to invest in bank shares and bonds, bear the pain as would investors in any other private firm in a similar situation. There will be massive turmoil in financial markets while this process is ongoing but once it is finished financial markets' will recover quickly. And with private debt restructured and a swift de-leveraging process having occurred, monetary policy will be effective again. No need for ZIRP, no need for QE. No potentially dangerous financial, economic and political distortions as a result of an ultra-expansionary, unconventional and highly experimental monetary policy. Ok, I know, the Eurozone has descended way into unconventional monetary policy territory by now. But just making the point that there are alternatives to the path followed by ECB & Co. And endorsed by Richard Koo.

 
2. Japan is a fiscal union with a current account surplus. The latter means that it is not dependent from external financing - Japan's private sector savings are directly or indirectly (via pension funds or private bank purchases) financing the country's large public deficits. The Eurozone is a multi-sovereign state entity. Not a fiscal union. The EU's peripheral countries, which according to Richard Koo should implement an expansionary fiscal policy, have just about reached a balanced current account after many decades running current account deficits. An expansionary fiscal policy would unavoidably generate current account deficits again. Meaning: widening fiscal deficits in the periphery would have to be financed by international investors. How many would be ready to do it? And for how long? With fiscal and current account deficits ballooning again, a sovereign credit rating downgrade to non-investment grade and a sudden-stop in international financing would likely occur sooner rather than later. An expansionary fiscal policy strategy in the periphery is not really a sustainable option;

 
3. The Eurozone is structurally an economic unbalanced entity, with the core running historically current account surpluses and large parts of the periphery current account deficits. The adjustment process that the peripheral countries pursued over the past seven years to balance their current accounts was an uneven one: only 1/3 of the current account adjustment is explained by an increase in the countries' exports; 2/3 is due to a fall in imports - the reflection of economies operating way under full capacity and with high levels of unemployment. Having large parts of the periphery mired in a state of semi-economic depression is not a sustainable option either - the Eurozone would fall apart. So, what to do? The peripheral countries (think Spain, Portugal, Greece) need to return to high economic growth. But it has to be an export-led growth. Not one led by increased public spending. On the other hand, the Eurozone's core countries are awash in savings and in need of attractive investment opportunities to deploy them (think German pension funds). This makes it easy to create a win-win situation for both sides.

 
How? Simple: the peripheral countries need to attract massive amounts of foreign direct investment (FDI) to significantly expand their export base, create jobs and generate sustainable growth; these FDI projects in turn can be financed by the surplus countries's savings - international companies can issue Euro denominated bonds to finance their investment projects in the Eurozone periphery, which can be bought by the savers from the Eurozone's core (yes, the German pension funds). Surely a more compelling investment opportunity than US subprime real estate and overvalued Spanish real estate in the past or Eurozone government bonds today.

 
What needs to be done for a FDI-led growth strategy to pan out in the Eurozone periphery? To attract massive amounts of FDI (i) the peripheral countries have to continue to implement structural reforms to become an attractive location for international firms; (ii) the European Union needs to support them by creating incentive mechanisms for international firms to locate some of their operations in the countries (e.g. by classifying these countries as "special EU investment zones", which would offer, among others, exceptional tax advantages to investors for a 10-year period); (iii) on top of it, the European Union needs to finance a yield top-up on Euro bonds issued by international firms to finance their investment projects in the periphery. Thus creating an appealing investment proposition to channel the savings from the core to the periphery via financing of FDI projects.

 
After seven years of an economic structural adjustment process in the periphery carried out with varying degrees of conviction across the different countries, it is time for the European Union to start thinking about incentive mechanisms to support massive amounts of FDI to flow to the Eurozone periphery financed by the core's high savings. Thus creating a win-win situation for both sides. This has to be the EU authorities' top economic priority. Not an expansionary fiscal policy in the region. Remember: short-term fixes cannot, and will not, solve long lasting structural problems. Only buy time to fix them. 

Boys and girls, dear Eurozone leaders: it's fixing time.



Monday, 6 June 2016

The German economic trinity is easy to agree with

“It’s impossible to agree with a German economist. They don’t get it.” How often did we hear this kind of statement over the past five years?

Implied is that Germans are so much detail obsessed that they miss the big picture. To be fair, Germans are indeed obsessed with detail. They are the engineering nation, aren’t they?

Then again, they are also a nation of philosophers, who almost by definition are big picture thinkers. And when it comes to economics, philosophers are indeed what German are. Big picture thinkers in search of sound economic principles (not surprisingly, in Germany econometrics is normally not a mandatory subject in an economics degree programme and the overall level of mandatory math courses is quite shallow).

The German economic model itself is the result of a big picture approach to problem solving. It goes like this: reality is far too complex and unpredictable to be mathematically modelled with great detail. So, let’s focus on what we know and put in place some principles that if followed will guarantee the achievement of sustainable economic prosperity. The result is the German economic principles trinity.

Principle one: a fully independent central bank whose only mandate is price stability

Why? Because…..

….the only way to increase a country’s economic living standards sustainably over time is by increasing productivity. The way to increase productivity is by continuously investing in education, training on the job, innovation and technology (increase a country’s human and physical capital). How can we force companies to continuously re-invest part of their profits in training, innovation, technology instead of paying out bigger dividends to shareholders? By putting them continuously under competitive pressure. How do we do that? By having a stable currency.

If we devalue whenever there is a loss of competitiveness relative to foreign competitors, local companies won’t make a great effort in investing in training, innovation and technology. Why should they? When in trouble, they know that a currency devaluation will bail them out and restore their competitiveness. However, if a regular currency devaluation is not an option – and on top of it currency devaluations do happen regularly in countries where some of their competitors are based – they know that the only chance they have to remain competitive is by continuously investing in their human capital and technology.

How can we make sure, that politicians do not resort to regular currency devaluations? Simple: by ringfencing monetary policy from their interference (politicians are not allowed to access the “printing press”). This is achieved by creating a fully independent central bank, whose only mandate is to keep price stability and thus a stable currency. In addition, such a fully independent central bank will over time make the “promise” of a stable currency credible by committing to it. This credibility will lead to lower interest rates (with no risk of recurrent devaluations, international investors will ask for an ever lower interest rate risk premium to lend money to local issuers – government and corporates). Lower interest rates will reduce the cost of financing for the local government and companies. Making in turn massive investments in human and physical capital more feasible. Thus, companies have the pressure to continuously invest in human capital & technology and the financial means to do so.

In short, principle number one intents to set in motion a virtuous sequence of events: fully independent central bank whose only mandate is to keep price stability ---> stable currency---> put companies under permanent high competitive pressure----> forcing them to permanent high investment in human capital, innovation and technology ---> increase in productivity ----> sustainable increase in citizens’ living standards

Principle two: a balanced current account (or a current account surplus)

How do we know if the country is staying internationally competitive? By monitoring the current account balance. If the current account is balanced or in surplus nothing needs to be done. Everything is under control. If the current account swings consistently into deficit, something is not working. Structural reforms are needed to improve the countries competitiveness (think about Schroeder’s Agenda 2010)

Principle three: solid & solvent public accounts at all time

No matter how well the economy is run, there will always be recessions, unexpected disruptive events, negative external shocks that adversely impact the economy. In such situations, decisive government intervention is needed to stabilise it. In order for the government to be able to act forcefully, and run large public deficits in times of economic crisis, it has to have available fiscal space at inception of a crisis. It has to be solvent and public debt low when the crisis hits. Putting it differently, to run large deficits when the going gets tough, the government has to run a reasonably balanced budget in good times.

Finally, principles two and three combined also mean that the economic authorities don’t have to worry much about private debt levels. If the current account is at least balanced and the government is running a small deficit (in good times) it follows that the private sector (families and corporates) is running a surplus. So, either it is not accumulating debt or the debt is backed by assets denominated in the same currency as the debt - which makes dealing with situation of overleverage, and its impact on the financial system, much easier.

If you look at the Eurozone crisis from the perspective of the German economic trinity principle, you quickly understand why Germans insist so much on structural reforms in the peripheral countries. Since the second world war, Spain, Portugal and Greece have run current account deficits the vast majority of the time – making them dependent on external financing. Such external imbalances will eventually trigger a “sudden stop” in international financing and a financial crisis. They way out of this structural weakness is to expand the countries’ export base. This in turn can only be realistically achieved by attracting massive amounts of foreign direct investment. How to do it? By doing structural reforms that make the countries’ attractive to foreign direct investors (the Siemens, the Sanofis, the Googles, the deutsche Mittelstand & Co of the world).

So the question is: should we waste our energy and intellect in building ever more complex and elegant mathematical models instead of focusing on what we know about economics and keep things simple? The German answer is “Nein”. That’s surely not something so difficult to agree with, is it?


Sunday, 24 April 2016

Value Investing in a nutshell

As an entrenched value investor, I'm often asked to explain quickly and in simple terms what value investing is all about. And I'm always afraid of failing spectacularly in the task.

The difficulty doesn't lie however in the investing philosophy's extraordinary complexity. The opposite is the case: the value investing's principles are truly so simple and powerful that I'm always afraid to introduce complexity where there is none.

So, what is value investing? It is investing in companies that comply with the combination of 3 plus 5 principles:

Three qualitative principles:
1. Simple, understandable business models

2. Businesses with an intrinsic durable competitive advantage ("moat")

3. Talented management team, with high ethical standards, whose interests are aligned with those of the shareholders

Five quantitative principles:
a. Follow the cash: sustainably cash-flow generative businesses

b. Businesses whose return on capital employed is sustainably above the cost of capital (reflects the existence of a moat). For the overwhelming majority of investors this would be enough as an indicator of the existence of a moat. But it is not. If a business benefits from a moat, you should expect it not only to successfully defend its market share but actually to increase it over time. Meaning: you should expect to see a (10-year) track-record of continuos sales and (cash) earnings growth. If you are facing a business whose return on capital is above its cost of capital but whose sales and (cash) earnings are on a downward trend, it may rather signal a declining business. Whith no moat. And where a return on capital still above the cost of capital is a legacy feature that will tend to disappear over time (think Nokia or Blackberry two years after their sales started to decline)

c. Bridge to the future: sound capital structure (low debt levels) and liquidity position

d. No accounting shenanigans (reflects management team with high ethical standards)

e. Margin of safety: the company is trading at a discount of at least 30% to its conservatively estimated fair value

You may find my explanation too long and wordy. In that case, worry not:

Charlie Munger is alive, well, and kicking. In YouTube.


After listening to Charlie Munger you will understand why Leonardo da Vinci once said that "simplicity is the ultimate sophistication".

Monday, 21 March 2016

Helicopter money: great minds think alike. And they don't change

Would the FED and the ECB allow financial markets, and especially equity markets, to suffer a massive fall? Or would they, if deemed necessary to avoid such an outcome, extend QE and start to buy equities at some point? Could they resort to helicopter money and e.g. deposit, on a non-refundable basis, ten thousand euros / US dollars on each Eurozone / US citizen's bank account (possibly conditional to the money being used to pay down debt)?

Normally, to gain a deep understanding of reality - how the economic system works and things are likely to play out - you have to quantify it. Occasionally, however, you can gain the required understanding by analysing the top decision-makers' intellectual framework, background and the incentives guiding them. Let's do the latter to answer the questions above.

Who were/are the main top decision-makers in the post-2008 financial crisis world? Where do they come from? What's their intellectual background? The main decision-makers were/are: Ben Bernanke, Mario Draghi, Mervyn King, Olivier Blanchard, Larry Summers. The "PR department & fan club" cheering publicly their actions was/is led by Paul Krugman, Joe Stiglitz, Jeffrey Sachs.

All of them did their PhD studies in the same city and University in the 1970s. With the exception of Joe Stiglitz and Mervyn King. Stiglitz is a bit older than the others and finished his PhD at the end of the 1960s. In the same city and University. So, not an exception after all. Mervyn King studied in Cambridge, UK. And came later to the city and University for a 2-year tenure as visiting professor. During his time there he shared an office with the then assistant professor.....Ben Bernanke - so, not an exception after all either. Mario Draghi, by the way, was the first Italian to obtain a PhD from the University in question.

The University's economics faculty had 4 intellectual giants: Samuelson & Solow, who shared one office, and Dornbusch & Stanley Fischer, who shared another office. Samuelson is Larry Summers uncle. 

The University is the MIT (note: Larry Summers, who did is BA at MIT, and Jeffrey Sachs were PhD students at Harvard. But the MIT had an open door policy allowing Harvard PhD student to attend lectures. Summers and Sachs did just that. And Dornbusch's lectures with many of the students-turned-policy-makers-and-or-international-VIPs are legendary)

Cutting a long story short, if you know what the 1970s MIT's view of the world - and how to deal with financial crisis - is, you will understand the boys-turned-central bankers approach to the financial crisis to date and what they are likely to do in the future. This begs the question: what was 1970s MIT's analytical approach to problem solving and resulting view of the world? Answer: MIT's analytical style was based on developing simple and concrete mathematical models directed at answering important and relevant questions. I fully identify with this style - you don't analyse and try to find solutions for a complex reality by building models that are even more complex than the reality you are trying to analyse. You keep the models simple by identifying what are the key variables impacting the dynamics of the problem at stake and modelling accordingly (even because if you have a model with 20 variables most of them will be correlated and therefore redundant). 

However, once you get into this simple-model-analytical-framework mindset you risk being captured by it and think that for every economic problem there is a simple and straightforward solution at hand to solve it. As policy maker you will then tend to become too interventionist in areas you shouldn't and don't let the system correct its excesses. This is what happened in the post-2008 financial crisis world. Instead of focusing on the right side of the balance sheets and incentivising painful debt restructuring measures, balance sheet repair and debt-to-equity swaps in an over-leveraged economic system (starting with the banking sector), policy makers focused on the left side of the balance sheets and in reflating asset prices. Misallocation of resources is the result and we all will have to bear the consequences of it at some point down the road.

Are policy makers likely to change their crisis resolution approach, start to focus on the balance sheets' right side and on supply side / structural reforms (which arguably include public investment in human capital and infrastructure)? Very unlikely. People don't change - especially when it comes to their over many decades developed intellectual framework. The top decision-makers would have to be replaced for a radical change in economic and central bank policy to take place.

One could now argues that a major replacement already took place: Ben Bernanke is not the FED's Chairmain anymore. But that's irrelevant. Janet Yellen is intellectually very close to Ben Bernanke. And the current number 2 at the Fed, appointed de facto by Yellen, is....Stanley Fischer. Yellen, by the way, is married to George Akerlof - Nobel Prize winner and PhD from.....the MIT.

Do I need to say more?