Rob McCreary

We have watched quite closely the first half financial performance of our portfolio of lower middle market companies. Almost all of them have benefitted from four trends that have accelerated in the pandemic:

            Business Travel Has Stopped

            Business Entertainment Has Been Curtailed

            Capital Expenditures Have Focused on Customer Experience

            Falling Energy Prices and Demand Have Relieved High Freight Costs

SG&A Savings Have Helped Bottom Line

The biggest change is business travel. For now, customers do not want new people on their premises and suppliers don’t want to risk either contamination from travel or quarantine under state rules. For most of our portfolio, virtual sales meetings using Zoom, Google Meet or Microsoft Teams are an effective substitute with existing customers, but have yet to be shown as effective new customer development tools.

The good news is revenue declines have been offset by sales, general and administrative changes, and significant freight reductions. Instead of dramatically reducing head count, other savings have kept bottom line budgets created in January mostly achievable based on performance through the first 6 months and trends for Q3 and Q4. A recent article in the WSJ dated June 15, “Business Travel Won’t Be Taking Off Soon Amid Coronavirus,” reported it the same way with a special emphasis on how CEO’s perceive it:

Andreas Fibig, chief executive officer of International Flavors & Fragrances, said he is planning for a permanent 30% to 50% reduction in business travel for his company because he says remote work has proven effective. While Mr. Fibig used to max out at 11 meetings a day, now he sometimes has 13 Zoom calls a day, plus an extra two hours to exercise, because he no longer has a commute.

Whisky & Tickets No Longer A Dominant Sales Tool

Another trend that has accelerated is the changing nature of business entertainment.  Big trade shows are on hold now, but will still make sense for many of our companies once or twice a year, as long as customers and suppliers can schedule 10 or more meetings a day. Golf trips, expensive dinners, marquee sporting events, and reward travel were already declining before Covid-19 because of time management.  It seems like customers would rather see you solving their problems than playing golf with you. Time management and family priorities make a ½ day experience rare. Even the traditional power lunch is giving way to quite popular virtual “lunch and learns” catered by Uber Eats or GrubHub. The restaurant industry is slumping according to Open Table and some parts of it may not come back for business:

Property, Plant and Equipment Expenditures Are Curtailed

Most of our companies’ capital expenditure budgets are based on really quick paybacks (12-18 months). When a major budget item is considered, it often is linked to the customer experience like an enterprise resource planning (ERP) system that lets customers enter and track orders or factory automation where savings can be shared with customers in exchange for long term contracts. Right now, there is plenty of production capacity in the industrial space and excess inventories are expensive in a leveraged business model.

Freight Costs Have Fallen by a Meaningful Amount

Collapsing oil prices and excess capacity for most freight companies have given companies which ship long distances a meaningful benefit. This change makes geography less of a business advantage for industries with high shipping costs. Here is a chart from the WSJ Daily Shot as of the mid April 2020. The freight depression has only worsened from that time based on the significant reduction in freight expenses our companies are seeing:

Face to Face Travel Model Will Be Challenged

I spoke with a friend who is the Global Director Of Industry Relations for a premium travel organization with thousands of customers and agents all over the world. She has found Covid-19 has broken what she calls the “hamster wheel of business entertainment relationships.” Business travel and entertainment budgets have been slashed and even if suppliers want to reward customers with traditional “whisky and tickets,” there will be no budget for this and even less interest from a new generation of business people who value customized experiences over traditions like a trip to The Masters or The Super Bowl. Her company has already replaced the holiday cocktail party with a kids party. It is extremely popular because of unique experiences.

Her company is global and she understands that her budgets will be spent on upgrading technology to link customers and agents, not reward travel. While this will be the short-term allocation of capital for her business as it recovers from a devastating cessation of travel, she wonders whether face to face relationship building, especially a new business relationship, can ever be successful in a virtual world. She also says destination travel contracts will be completely rewritten to allow flexible cancellations.

One emerging trend she thinks will be permanent is the substitution of individual choice for the old model of group rewards. All-expenses-paid group reward travel to Tahiti for big producers may cease to exist.

           

           

           

College friends are brutally honest. So, it came as no surprise to me in a Zoom cocktail chat with former classmates over the weekend there was some curiosity but even more suspicion, about Bitcoin’s recent price rises. Here is BTC’s chart over the two years from the May 6, 2020, “The Daily Shot”.

I called my classmate/ detractors “luddites” and assured them Bitcoin is highly relevant in the time of Coronavirus for the following reasons:

• Central Banks all over the world are running their printing presses at a rate everyone knows will result in “unpayable debt”.
• There is no difference between Bitcoin and any other currency—none of them is backed by anything tangible- just trust and confidence.
• Emerging countries who print money in their own currency, but owe creditors in a currency other than their own, like Argentina, Venezuela and Brazil, risk hyperinflation.
• Crony capitalism is destroying the full faith and credit pledge—it only seems to be working for a small group of insiders.
• Bitcoin is the easiest way to move capital out of a country anonymously.
• The blockchain on which BTC is based has never been manipulated by insiders or outsiders.
• The guardians of the blockchain are paid in Bitcoin.
• The pledge of scarcity is being fulfilled this month by the third “halvening”.

Central Banks Are Printing

According to Jeff Booth, author of “The Price of Tomorrow” (here is the YouTube link), the latest “C-19 Recession” reveals a current world economic order where central banks over the last 20 years have created $185 trillion of debt to support annual worldwide increases in GDP of $46 trillion. That is almost $5.00 of debt to produce $1.00 of GDP, and it seems like a bad trade-off, especially when the major winners are people who already have capital.

Bitcoin’s constitution limits the number of Bitcoin to $21 million. That number will be in circulation in 2140 after which no more Bitbcoin will be created. Right now, there are slightly more than $18.3 million in circulation and the pace at which they are being created will be “halved” on May 11, 2020 for the third time since Bitcoin was created.

No one person, group of people or external authority can change blockchain’s constitution unless a cartel is formed controlling more than 51% of the coins incirculation. So far there have been “forks” where groups have split off from Bitcoin ( like a new religion), by forming a new constitution around ideas like expanding the coins in circulation, but no one has taken control of Bitcoin. This is a risk and there are several large miner groups in China and one dominant dealer in the US..

The US Dollar and Bitcoin Are Not Backed by Anything

In 1971 the United States abandoned the gold standard under which 25% of all new issuances of money had to be backed by physical gold in the US Treasury. By abandoning the gold backing, Nixon ushered in a new era of central bank monetary policy. The US Dollar has held up as the world’s reserve currency since Bretton Woods in 1943 and there is no other currency that threatens the USD’s hegemony right now. But understand the USD is only as safe as people’s confidence in it.

This is exactly why Bitcoin will continue to compete with the USD. They both are based on confidence, but right now you can’t easily buy pizza with Bitcoin. This is not a flaw in BTC’s design- one BTC can be digitized to 0.00000001 (a “Satoshi”). Rather, the dollar is an accepted medium of exchange and is a better world currency than the Swiss Franc (low circulation), the Chinese renminbi (no transparency), or the Euro (weakest link member problem).

Capital Flight Urgency May Elevate BTC’s Standing

If you wanted to get capital out of China in 2017 when its government created strict “capital flight” restrictions, you literally risked your life unless you could be invisible and anonymous. These weren’t criminals hiding drug money. These were citizens and businesses in China using bitcoin to anonymously move capital to safer harbors. Similarly, if you are a citizen in Venezuela, Argentina or Brazil in 2020 experiencing the early innings of hyperinflation where their local currencies are in the process of being debased by 10x or more, you would find BTC to be a suitable alternative. It is more anonymous and portable than gold or silver. The 20-30% swings in the trading price of BTC which currently hinder its utility as a currency will likely be just fine with Venezuelians, Argentines and Brazilians when a loaf of bread costs rises from 20 cents to $1.40.

Peer to Peer Networks Are an Antidote to a Crony Kleptocracy

Increasingly, the central bank systems around the globe are built on a “who you know” or “who’s your lobbyist”. The winners are those who take huge risk with leveraged bets, but get bailed out every 10 years in a crony kleptocracy. To my knowledge there is no visibility of who benefited in March and April 2020, from the Fed’s latest round of monetizing private assets, including Exchange Traded Funds that had lost their value.

Under Bitcoin the currency is an open book that is verified with every transaction through the blockchain. There is a limited amount of BTC in circulation and no outside influence can debase the value of BTC by printing more. A world order based on a currency that cannot be manipulated for the benefit of a few will likely be much desired in coming years.

Scarcity Is Happening This Month With the Third Halving or “Halvening”

Effective May 11, Bitcoin is cutting in half the reward it pays its miners for validating the blockchain. This payment mechanism is the only method by which new BTC is put in circulation. According to the May 6, 2020, “The Daily Shot” here is the history of the first two “halvenings” and the prelude to the halvening set to occur on May 11:

Given the competing central bank regimen of unlimited “do whatever it takes” money printing, this built in restraint on the supply of Bitcoin may be viewed as unique.

No Panacea but Getting More Attractive Every Day

The future of Bitcoin is still pretty uncertain, but its relevance as digital gold and a transporter of wealth in capital flight situations is becoming more mainstream. If the central banks lose the wheel and world economies run off a cliff, Bitcoin may be in the mix as a strong replacement candidate for the next reserve currency.

One of the funniest and most memorable Saturday Night Live skits was John Belushi and The Olympia Restaurant. That New York diner provided customers with a full menu of food choices, but only  served “Cheeseburger; Pepsi no Coke; and no fries, chips.” Regular patrons like Gilda Radner just ordered the “usual”. Newer customers started with tuna salad plate, or grilled ham and cheese on wheat toast, but always ended up with Cheeseburger. There was an illusion of choices but, if you were hungry and wanted to eat, only Cheeseburgers were served.

US Capital Markets Are the Eighth Wonder of the Modern World

Throughout my investment life in America, we have had multiple markets and multiple market makers ranging from the OTC, NASDAQ, AMEX, NYSE for equities to a Bond Market handling Govies, Munis, Corporates, and Mortgages. Specialty traders handled commodities, options and derivatives. U.S. Capital markets are admired worldwide for their liquidity and predictability. While the Big Recession reinforced the flaw of counterparty risk in many of the derivative markets for Collateralized Loan Obligations and Mortgage Backed Securities, most capital markets have remained dependable because counterparties are well capitalized and have the skill to maneuver downturns.

Imagination Has Led to Amazing Product Innovations

Endless products have also been invented to package and repackage these primary asset classes. Miliken invented High Yield. Nate Most at Barclays first introduced the ETF, but John Bogle and Vanguard are credited with selling them to the masses. Henry B. R. Brown came up with a money market product called Reserve Fund that paid interest on the equivalent of bank deposits. In 1924, Massachusetts Investors Trust first introduced mutual funds to America.

By the beginning of the 21^st Century there was a full menu for the investor—Cheeseburger with Cheddar, Onions, Pickle and Mayo with fries and a Diet Coke backed up by a piece of pie and a cup of coffee. Unlike the Olympia Restaurant, you could even order eggs at lunch time.  

Trading markets survived Black Monday in 1987, the Telecom bust in 2001 and the Big Recession in 2008, but each crisis revealed increasing liquidity and counterparty risks.

First Inning for Modern Monetary Theory

As the first inning of Modern Monetary Theory (“MMT”), is playing out in April 2020 with the Fed still at bat after taking 4.0 trillion swings, it occurred to me the only end game is Cheeseburger, Cheeseburger, Cheeseburger.

For a two day period in late March 2020, the Fed underwrote money market liquidity, unclogged “plumbing problems” in the bond market, stopped the bloodbath in high yield, and monetized untradeable “drek” in every asset class. It even had enough pine tar to reverse the mother of all stock market crashes. Jerome Powell is the only batter, the only market maker. The guy on deck is wasting his time and should head back to the dugout to catch the latest episode of “Stranger Things”. He won’t bat for a long time.

Where this goes is like solving a multivariable equation, where your confidence in the assumptions behind any single variable is low—sorta like Covid-19 testing. However, the one thing we cannot dispute is investment outcomes for every asset class are now being managed, directly or indirectly, by the Fed.

Some smart money is sitting on their wallets because we now have a single market maker and it is pure speculation to guess who will be saved and who will be sacrificed. Why speculate in any of those markets or products when you can invest in the one product that will be monetized as long as Jerome Powell is still swinging the bat: US government debt. Many naysayers say the US Dollar will lose reserve currency status, or the government will declare a debt jubilee on its own bankrupt promises, but that is the second inning.

We are in the top of the first and Chairman Powell is the only batter in the line-up, and while he may be selling leftovers in the second inning, right now he is all cheeseburger, cheeseburger, cheeseburger.

The current safety net programs being offered by the Federal Reserve Bank are widespread. They include the Paycheck Protection Program (“PPP”) safety net of 8 weeks of payroll subsidy for companies that have existing Small Business Administration loans. They also include Fed purchases of a wide swath of debt instruments including collateralized loan obligations, mortgage backed securities, high yield bonds, and short term debt supporting repo markets.

For the first time in my memory the Fed is also buying original issuances of state and municipal debt, presumably from issuers who cannot raise capital right now to keep states and cities functioning.

The Fed is also backstopping money market funds and providing liquidity to debt and equity capital markets. As a result of this unprecedented debt creation, the Fed’s balance sheet is projected to grow to as much as $10 Trillion, but this is a moving target and I think it will be dramatically more.

This time, however, the program is already different than the playbook in 2008. PPP is set up as a forgivable loan from a bank to a borrower funded by The Fed. This is not a repayable loan from the Fed to a troubled bank like TARP or the Fed’s direct investments in 2009 in the equity of GM or AIG Insurance. This is free money to keep small business employers writing payroll checks and keeping their labor forces in tact for the “Huge” Resumption.

But the PPP program also allows 25% of the forgivable PPP loan to be used for non payroll expenses like rent and health insurance.   In addition, when the loan is forgiven there is no “forgiveness of indebtedness” income to the employer which would be the normal tax treatment.

So, the PPP program is a true debt jubilee for small business.

To my knowledge the PPP businesses are the first beneficiaries of what may become a more widespread Debt Jubilee.  

Is This the First Time There Has Been a Jubilee?

I am unaware of any other time in American economic history where the government abrogated a private contractual monetary relationship with the exception of 1933 when President Roosevelt  proposed to eliminate the so called “gold clause”, under the terms of which a holder of U.S. Treasury Bonds could elect to receive gold in lieu of paper money as payment at maturity of the bond. FDR’s elimination of the gold payment was challenged by creditors who wanted gold, not paper dollars.  Three disputes ended up in the Supreme Court after two lower courts declared the gold clause enforceable.

Fearing repudiation, FDR threatened to ignore the findings of the Supreme Court and even suggested changing the composition of the Supreme Court by adding 5-8 new justices. This may sound familiar because it is exactly what opponents of Neil Gorsuch and Brett Kavanaugh suggested after their nominations.

The Supreme Court in 1933 was saved when the justices voted 5-4 to permit FDR’s cancellation of the gold clause contracts. That legislation was rescinded 4 years later.

The only other time the US made a similar reversal was 1971 when President Nixon abandoned the gold standard by eliminating the backing of US dollars by a 25% gold deposit in the US Treasury.  The creation of US debt was constrained by requiring at least 25% of each new dollar of debt have a corresponding gold bullion deposit. There was also a promise to foreign creditors to pay off their debts for gold.

This resulted in more than 50% of America’s gold reserves being exported to foreign creditors.  Going off the gold standard set up the printing press of debt and set off a long recession in the United States where there was no confidence in the US dollar. It got so bad “Carter bonds”, where repayment was denominated in Swiss Francs, were the only way the US could raise capital in the mid 1970s.

The World Has Experienced Jubilees Before

My research on debt jubilees does not convince me they were widespread, but  The Washington Post sure thinks they were and also thinks we need one today.

In an article by Michael Hudson on March 21, 2020 The Post chronicled the debt jubilee history:

“The word “Jubilee” comes from the Hebrew word for “trumpet” — yobel. In Mosaic Law, it was blown every 50 years to signal the Year of the Lord, in which personal debts were to be canceled. The alternative, the prophet Isaiah warned, was for smallholders to forfeit their lands to creditors: “Woe to you who add house to house and join field to field till no space is left and you live alone in the land.” When Jesus delivered his first sermon, the Gospel of Luke describes him as unrolling the scroll of Isaiah and announcing that he had come to proclaim the Year of the Lord, the Jubilee Year.

Until recently, historians doubted that a debt jubilee would have been possible in practice, or that such proclamations could have been enforced. But Assyriologists have found that from the beginning of recorded history in the Near East, it was normal for new rulers to proclaim a debt amnesty upon taking the throne. Instead of blowing a trumpet, the ruler “raised the sacred torch” to signal the amnesty.

It is now understood that these rulers were not being utopian or idealistic in forgiving debts. The alternative would have been for debtors to fall into bondage. Kingdoms would have lost their labor force, since so many would be working off debts to their creditors. Many debtors would have run away (much as Greeks emigrated en masse after their recent debt crisis), and communities would have been prone to attack from without.“

The Post article also points to 1948 Germany when Reichmarks were exchanged for Deutchmarks and 90% of German debts, including war reparations, were forgiven. Here the US created a Jubilee by forgiving a foreign power’s debt in the name of national security.

The Jubilee May Be The Only Way To Preserve Social Order

The long debt cycle beginning in 1986 has smiled on people and institutions who have had access to credit, especially as the cost of debt capital has fallen from 15% in 1986 to 0% in 2020. It has also smiled on those who have used that credit irresponsibly, by giving them  “do-overs” in  2000 and 2008.

Meanwhile, a large swath of the population has been shut out of debt-based Disneyland. In fact, the Big Recession punished relatively responsible home buyers by enslaving them to unpayable mortgages while it provided bailouts to Wall Street and irresponsible banks that had profited from those toxic products.

This Time Has to Be Different

The right thing to preserve social order is sound the trumpets and forgive certain loans, and other unpayable obligations, but only for those people who are now eligible for all or a portion of the $1200 “helicopter money” being issued under The Cares Act.   If you don’t qualify for any portion of the $1200 checks (joint income with spouse above $200,000), and you have been too irresponsible to save from the largesse of cheap capital over the last 20 years, you should not be saved now.

In any event the new round of Fed tools will continue to include outright debt jubilees as well as “helicopter money” and other experimental programs spawned by modern monetary theory.

Buckle your seat belt and keep your fingers crossed.

As a society we have been moving at 80mph most of my adult life. There is endless stimulation from people, meetings, media, business, religion, socialization, travel, sports, entertainment, literature, the stock and bond markets, internet and iPhones.

Sometimes we are moving so fast we never have time to process what is happening. The only silver lining of Covid-19 is we now have nothing but time at home to process. One of my business partners sent me a really stimulating article from “The Marginal Revolution” by Tyler Cowen called “World 2.0.” The caption knocked me out:

“THERE ARE DECADES WHERE NOTHING HAPPENS, AND WEEKS WHERE DECADES HAPPEN”

The Author’s List of Then and Now

This is from a very able and perceptive correspondent:

World 1.0	World 2.0
110 successive months of job growth	10 million jobless claims in 2 weeks
10 year bull market across sectors	Winners and losers with extreme outcome inequality
Full employment	30% unemployment
Base rate thinking	First principles thinking
Physical	Digital
Office by default	Remote by default
Office for work	Office for connection, community, ecosystem, makerspaces
Suit, tie, wristwatch, business card	Good lighting, microphone, webcam, home office background
Commute + traffic jams	Home + family
Last mile	Only mile
Restaurants	Groceries + delivery
$4 toast	Sourdough starter
Walkscore	Speedtest
Cities	Internet
$100k for college	Not paying $100k for a webinar
City	Countryside
YIMBY	NIMBY
Internal issues	Exogenous shock
Lots of little problems	One big problem
Stupid bullshit	Actual issues
Too much technology	Too little technology
Complacency	Action
Years	Days
Policy	Capacity
Ideology	Competence
Assume some government competence	Assume zero government competence
Institutions	Ghost ships
WHO	Who?
Trusted institutions	Trusted people
Globalization	Decoupling
Just-in-time	Stockpile
Tail risk is kooky	Tail risk is mainstream
NATO	Asia
Boomers most powerful	Boomers most vulnerable
Productivity growth collapse	Economic collapse
Social services Democrat	UBI Communist
Propaganda	Propaganda
Deficit hawks	MMT
Corporate debt	Government debt
Techlash	Tech a pillar of civilization and lifeline to billions
Break up Amazon	Don’t break up Amazon!!!
Avoiding social issues	Avoiding layoffs
Sports	Esports
Phone is a cigarette	Phone is oxygen
Resource depletion	$20 oil, $0.75 watt solar, <$100/kwh batteries
Stasis	Change
Low volatility	High volatility
Design	Logistics
Extrovert	Introvert
Open	Closed
20th century	21st century

Coronavirus has also created several “forever” changes, foremost of which are changes we see right now to business interactions, education and our homes and family.

Modern Monetary Theory

The one change, however, that will alter our world more than the entire list taken together is the shift from fiscal responsibility to Modern Monetary Theory. Only recently did I get exposed to “MMT” for the first time in a series of articles about Ray Dalio and The End of the Debt Super-Cycle.

MMT’s main concept is governments can print money with impunity because they can never default in their own currency. The printing of money may lead to inflation, but MMT presupposes the ruling class will have restraint when inflationary risks are too high. Proponents are Bernie Sanders and Alexandria Ocasio-Cortez. Counting on restraint from them is like Trump using two syllable words or Biden completing a sentence.

The accounting is simple; the government’s deficit (debt creation) creates a private sector surplus thus unlocking the productive energy of the nation. Central banks have been doing this since 2008, but they have pretended it is short lived, and more importantly, reversible.

I have never believed in the printing press or helicopter money as a solution to an over levered economy. At best, these moves forestall panic selling and kick the can down the road. This is how Reuters summarized our predicament on April 6, 2020 in a post on Yahoo Finance.

“The ECB, Fed and Bank of Japan have a combined $14 trillion worth of assets on their balance sheet, largely bought since the financial crisis of 2008 to complement interest rates already stuck at zero or lower, Datastream data shows.

But so far, they had maintained that this so called “quantitative easing” (QE) was temporary and policy would one day go back to normal, with positive interest rates and lean balance sheets.

Not any more. All major central banks are now more or less openly talking about permanent QE, which would mean governments and companies, whose bonds have been bought by the central bank, could roll over that debt indefinitely.

The BOJ, for one, already owns 43% of Japan’s government debt, and the ECB did away with a cap on owning more than a third of any one euro zone country’s bonds.

Some economists are calling for even more extreme measures, such as cash handouts to all households, known in economic parlance as helicopter money, or debt cancellations, which were urged by former ECB President Mario Draghi.

Some forms of debt forbearance… may be needed—for instance by extinguishing private sector loans vacuumed by the central banks,” said Gilles Moec, chief economist at French insurer Axa.”

The Debt Jubilee is Coming

MMT is for sure the next big thing and its political ascendance is unstoppable. Whether it is the New Green Deal proposed by AOC, or forgiveness of student loans proposed by Bernie Sanders, Modern Monetary Theory will be cited as the “high-brow” rationale for allowing politicians to write unpayable checks against the world’s wealth.

There is another domino that has to fall, however and I think it is coming soon. I will write in my next blog about the debt jubilee and what it means for our monetary system.

In a recent conversation about asset allocation with an astute growth investor, I was surprised he dismissed the possibility of a socialist as President. He simply could not see that happening and, therefore, it could not serve as a reason for changing a traditional 60 percent equity/40 percent bond mix in a target allocation. He may be right about that risk, which was known, but what about something unknown like Covid-19?

I deeply respect smart money opinions, but I am a value investor and value investors are trained to expect the unexpected. At the heart of value investing is a conviction the future is unknowable. Whether it is a socialist in the White House, Covid-19, or Trump defeating Clinton, Brexit, or a Saudi oil price war, investing is merely “speculation” for guys like Howard Marks, Joel Greenblatt, Warren Buffet, Bruce Greenwald, and Seth Klarman, unless it has a margin of safety.

I have doubled down on reexamining the written word from the great value investors and I present them here because these guys have been on the sidelines, and mostly out of favor, for a long time. You won’t hear their names as thought leaders for 2020. Possibly, the threat of a global shut down in response to Covid-19 will refocus investors on risk associated with momentum investing?

Here are the books I have been reading:

• “The Essays of Warren Buffett” by Lawrence Cunningham
• “Value Investing: From Graham To Buffett and Beyond” by Bruce Greenwald
• “The Most Important Thing” by Howard Marks
• “Margin of Safety: Risk Averse Value Investing Strategies for The Thoughtful Investor” by Seth Klarman
• “The Little Book That Beats The Market” by Joel Greenblatt

In addition, I have read Jeremy Grantam, and have heard Jim Grant speak in Cleveland. Universally, all of these value investors channel Graham and Dodd and their most eloquent, modern day proponents: Warren Buffet and Charlie Munger.

Buffet Pearls of Wisdom

Here a few pearls of wisdom from Buffett …

Seth Klarman Sits On Cash

Seth Klarman is also one of my favorites. He manages a successful hedge fund called Baupost with $32 billion under management of which more than 30% is in cash. Here are a few of his insights from “Margin of Safety”:

• “The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose. Institutional investors, in particular, are usually evaluated—and therefore measure themselves—on the basis of relative performance compared to the market as a whole, to a relevant market sector, or to their peers.”
• “A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.“
• “Mark Twain said that there are two times in a man‘s life when he should not speculate: when he can‘t afford it and when he can. Because this is so, understanding the difference between investment and speculation is the first step in achieving investment success.”

Howard Marks Recommends Buying Cheap

Howard Marks is another one of my favorites. He manages Oaktree Capital Management in Los Angeles with $80 billion under management. Here are a few of his insights from his book “The Most Important Thing”:

• “Theory says high return is associated with high risk because the former exists for the latter to be compensated. But pragmatic value investors feel just the opposite: They believe high returns and low risk can be achieved simultaneously by buying things for less than they are worth. In the same way overpaying implies high risk and low returns”
• “Of all the possible routes to investment profit, buying cheap is clearly the most reliable. Even that, however, isn’t sure to work. You can be wrong about current value. Or events can come along that reduce value… Or the convergence of price and intrinsic value can take more time than you have; as John Maynard Keynes pointed out, ‘The market can remain irrational longer than you can remain solvent.’”
• “It seems to me the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on an analysis of a company’s current worth.”
• “To simplify (or oversimplify) all approaches to investing in company securities can be divided into two basic types: those based on company attributes called ‘fundamentals’, and those based on the price behavior of the securities themselves. In other words, an investor has two basic choices: gauge the security’s underlying intrinsic value and buy or sell when the price diverges from it, or base decisions purely on expectations regarding future price movements.”

Joel Greenblatt Has A Magic Formula

Finally, I read Joel Greenblatt’s book “The Little Book That Beat The Market.”  For less than $15, you can get access to Joel’s model portfolio based on his two-pronged approach to discovering undervalued stocks.

“Joel Greenblatt is an American academic, hedge fund manager, investor, and writer. He is a value investor, alumnus of the Wharton School of the University of Pennsylvania, and adjunct professor at the Columbia University Graduate School of Business. He runs Gotham Funds with his partner, Robert Goldstein”. (Source:Wikipedia).

Here are a few of his quips:

• “Choosing individual stocks without any idea of what you are looking for is like running through a dynamite factory with a burning match. You may live, but you are still an idiot.”
• “Figure out what something is worth and pay a lot less”
• “Remember it is the quality of your ideas, not the quantity that will result in big money.”
• “One way to create an attractive risk/reward situation is to limit downside risk severely by investing in situations that have a large margin of safety. The upside, while difficult to quantify, will usually take care of itself. In other words look down, not up, when you are making your initial investment decision. If you don’t lose money, most of the remaining alternatives are good ones.”

Reading About Value Is A Cathartic Exercise

This exercise has been cathartic for me. All of these brilliant value investors have been completely wrong about market returns for the last 5 years as they sold and held large pots of cash. But they must be right about risk because the stock market has recently lost almost 20 percent of its market value. Covid-19 and oil price wars are just a reminder about the future being unknowable. Invest with a margin of safety.

When we started our private equity firm 20 years ago, high net worth individuals and institutions were interested in the asset class for three big reasons:

• Outperformance versus the Stock Market
• Lack of Correlation to Publicly Traded Asset Classes
• Persistent Outperformance by Top Quartile Managers.

McKinsey & Company just released a report on Private Equity that suggests a fourth, equally compelling reason, to own PE. Growth opportunities in the public market are shrinking as the number of publicly held companies shrinks. According to Mr. Klempner, one of the authors of the McKinsey report, PE is the best way for institutional investors to be exposed to those growth opportunities. A recent article by Julie Segal writing for Institutional Investor explains the new attraction:

“The number of private equity-owned companies has doubled since 10 years ago, Klempner pointed out, and the number of publicly traded companies is half that of 20 years ago.  Institutions need to be in private equity if they want exposure to growth companies, regardless of whether they can pick the top managers.”

However, the institutional imperative comes at a price. As the institutional community seeks representation in this asset class, it drives up valuations based on a surplus of investable cash:

The disciplined managers still look for growth at a reasonable price and the value managers look for misunderstood stories but, more than ever, success in private equity investing will be about the quality of the managers.

Priced For Perfection and The Long Run

Given that leverage constitutes an ever-greater percentage of the capital structure, the margin for error in company selection is unusually high. If you make a mistake in the public markets you can usually get liquidity at a price. By design, the private equity model locks up your capital commitment for as long as 10 years. If you want to get out of the asset class you can try to sell to buyers in the so called “secondary market”, but the bids are usually at a steep discount to the stated annual valuation.

The McKinsey report shares my enthusiasm for the best managers, but laments how hard it is to know who they are. Many private equity firms have transitioned from founders and are known for their collective, not individual, reputations. It is virtually impossible to cherry pick only certain portfolio companies in your exposure unless you have a liberal co-investment option. Ms. Segal points out the dilemma:

“Although persistency of outperformance by PE firms has declined over time, making it harder to consistently predict winners, new academic research suggests that greater persistency may be found at the level of individual deal partners,” the report’s authors wrote. “In buyouts, the deal decision-maker is about four times as predictive as the PE firm in explaining differences in performance. However, the McKinsey report stressed that it is difficult for institutions to make funding decisions based on individuals.”

Good investors in any asset class are hard to find and even harder to discover when the industry has $ 2.0 trillion of money to invest and thousands of managers. Smaller firms with more transparency about which managers are creating the fund’s outperformance (alpha) may be a winning tactic. Unfortunately, institutional money is often concentrated in a few large funds at the top of the pyramid and only a few funds allow investors to “cherry pick” individual deals or managers.

I was waiting at a traffic light in Naples Florida, and a radio jingle about “going first class” with Marcus by Goldman Sachs captured my attention.  Goldman is selling savings accounts called “Marcus” to the masses and advertising on the radio????

This wasn’t the Goldman Sachs I remember. The feared counterparty no one wanted to trade against is now offering poor schlubs a chance to piggyback on Goldman’s vast reservoir of financial advantage, and maybe offering a toaster oven to the first 30 depositors?? This was too good to be true for the consumer. Clearly someone at Goldman had lost their money-making compass?

Then I remembered something I read in the Saturday edition of the WSJ about the FDIC voting 3-1 to suspend the Volker rule which was reenacted as part of Dodd Frank reforms in 2008. Was Goldman just looking for cheap funding for a new product line?

Banks Trading Is Good For America

That rule basically prohibits banks from using depositor funds to invest in proprietary trading, venture capital, hedge funds and private equity. After 2010 when the banks could no longer trade in stocks or bonds, liquidity in the bond market really suffered, but at least Goldman was not speculating with depositor funds guaranteed by the taxpayer. Banks had been a large source of trading liquidity, and bond trading was an important revenue source for banks. Letting banks trade again will be good for America.

It suddenly became crystal clear why Goldman Sachs is willing to borrow cheaply from the masses.

Goldman is now a bank. They became a bank in 2009 for many of the same reasons Jesse James robbed them – that’s where the money is.

When they accepted TARP in 2009, and agreed to be regulated as a bank most people saw an end to Goldie’s greed, hubris and arrogance. However, Matt Taibbi writing for The Rolling Stone in July 2009, saw it as another trap play of x’s and o’s from the timeless Goldman money making playbook. 

Tabbi’s article points out that Goldman became a commercial bank, borrowed $10 Billion in TARP from The US Treasury and repaid it one year later. In the interim it picked up some new financial tools reserved only for banks like the ability to borrow cheaply from the Fed in periods of market meltdown:

“The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They’ve been pulling this same stunt over and over since the 1920s — and now they’re preparing to do it again, creating what may be the biggest and most audacious bubble yet.”

Mr. Taibbi points out Goldman used the Big Recession to get rid of its fiercest rival, Lehman Bros, engineer TARP for AIG, which was Goldman’s largest counterparty in the CDO market, and as a result, collected $13 Billion from AIG that was essentially worthless had AIG failed and finally escaped regulatory scrutiny imposed on other banks by paying off TARP early.

This doesn’t seem like a humbled and repentant Goldman to me?

The Taibbi article is “must read” for anyone who is listening to Goldman’s radio adds about going first class with Marcus by Goldman Sachs by becoming a depositor. It is also a harbinger of the likely outcome of the Volker Rule debate.

Back To Self Reporting and Self Supervision

The Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency have already approved the changes to the Volcker rule. The Federal Reserve, Securities and Exchange Commission and Commodity Futures Trading Commission also have to approve them, and are expected to endorse the changes without any significant revisions. The most significant change relates to presumptions about the safety of proprietary trading. As I read the changes, large banks like Goldman and Morgan Stanley will once again police themselves rather than being subjected to proctological examinations by bank examiners. Are you kidding?

The proprietary trading profit center, Goldman’s wheelhouse, has risen from the ashes of the old Goldman partnership structure and has been reborn as a commercial bank getting its deposits from retail oriented radio ads. One thing for sure is this will be good for Goldman.

It might be smarter for Marcus depositors to own Goldman’s equity rather than being their counterparty. The yields are the same and there is a little more alignment?

A January 9, 2020, Wall Street Journal article by James Mackintosh entitled “Money Losing Stocks Mushroom Even As Stocks Hit New Highs” cautions about the high percentage of publicly traded stocks that show three years of losses but still are experiencing significant price appreciation. Here is a chart from his article showing smaller stocks are a large percentage of the sample:

It seemed impossible to me there could be such a large percentage of losers, but when your market cap cut off is only $10 million there will be a large number of venture companies.

Microcaps Are Soaring With Wax Wings

I have written before about checking small cap public market peers to see if PE valuations are appropriate. My latest check , however, showed a stunning disregard by investors for fundamentals among the smallest participants in the public market! This is a new development and the anomaly forced me to do my own research about what is happening.

I looked at all public companies trading on major US exchanges with revenues greater than $75 million, net income less than zero in the most recent fiscal year, and stock price appreciation greater than 15% since January 2017.   I was surprised that more than 1,652 companies had losses, and even more surprised that 20% of those losers still managed a 15% stock price increase since January 2, 2017!!!

I then asked the question whether indexing and consistent equity inflows could be responsible for the stock movements.

No Price Discovery – Just Momentum

From the sample of 320 companies I looked at 17 companies I know and examined a few of their fundamentals like revenue, EBIDTA, and net income over a 5-year period.   I also looked at the average daily trading volume over that 5-year period, and the change in the holders of the stock.

One of the companies, let’s call it Beta, a software provider, has Cleveland roots so I dug deeper to see what was happening to its stock.

It shows a little growth in revenue since 2016 (4.7% CAGR), negative EBITDA, and negative Net Income.   There are few analysts who follow the stock.   Nonetheless, its shares have appreciated from $10.83 to $26.23 over that 5-year period for an impressive 19.53% compounded annual return.. Those are competitive Private Equity returns for a 2016 vintage year. It would be like CapitalWorks buying a portfolio company with losses and then selling the same company 5 years later without having eliminated any of the losses, but still getting a return of 2.4x our original investment.

I then looked at Beta’s average daily trading volume over that 5-year period. The volume in March 2016 was 206,000 shares a day.   The average trading volume for the twelve months ended 9/30/19, was 652,000 shares, and during that period the largest increase in ownership was Blackrock which doubled its position.

Losers Become Winners With Index Momentum

I began to wonder whether the disconnected price appreciation was simply the persistent flow of capital into index funds which, in turn, deploy the capital into the proxy portfolio irrespective of financial performance? I was surprised Beta is a member of more than 350 separate “software and services” or “information technology” indexes. These indexes contain leaders like Google, Microsoft and Amazon and have more momentum than Bernie Sanders with millennials.

In fact, I found where a company has persistent losses there is strong correlation between trading volume and price appreciation. Passive investment vehicles like index funds don’t appear to be using any fundamentals to select their index components. This is a big difference from mutual funds selecting components on the basis of fundamentals. As a result many companies whose stock price would have withered with persistent losses find impressive returns for simply being included in an index with momentum.

What Happens When Flows Reverse?

I then wondered how these persistent losers would perform when the capital flows reversed? So I looked at the most recent mini crash in December 2018, when interest rates were spiking and the Fed was shrinking its balance sheet. Sure enough, my universe of losers had dramatic stock price reversals ranging from 10-35% over a matter of weeks.

I am just not confident the arbitrage mechanisms built into the index fund pricing model will work when investors are forced to look at component stock fundamentals rather than their momentum. The miracle of indexing may join Milliken junk bonds and Big Recession mortgage derivatives as just another set of Wall Street products gone awry? (Thanks to Adam Zybko for statistical analysis).

Mark Twain is credited with saying “History Does Not Repeat Itself, But It does Rhyme”.   So, as we enter year 2020, I looked for the last year in the United States history that repeated, and also the only other year in the Julian calendar which both repeats and also follows the first decade.

What I found about 1919, and also 1010, was quite interesting and supportive of Twain’s rhyming theory.

Research shows 1919, was near the end of the Progressive Era in the US where two constitutional amendments granted women the right to vote with the 18^th Amendment and, almost simultaneously, launched prohibition with the 20th Amendment. Even more amazing is more than 2/3rds of the states ratified the amendments. There was a clear consensus about progressive issues.

There were also many other similarities and differences:

1919	2019
Home grown anarchists repeatedly send bombs to politicians	Politicians bomb each other
New stock market off highs, but no crash yet	Stock market all time high

1919	2020
Communist party formed in USA	Socialist candidates thrive
Black Sox lose World Series on purpose	Houston steals signs in 2017 World Series
Babe Ruth sold to Yankees for $125,000	Gerit Cole gets $340 million over 10 years
Teddy Roosevelt dies; Woodrow Wilson has a stroke	Dems impeach Trump
Women get right to vote	LGBTQ rights protected
Ripleys “Believe It or Not” introduced as cartoon	“Believe It or Not Journalism” is a cartoon
Nation starts prohibition	Cannabis beer Is new
The Boston Molasses Disaster kills 21; warm winter	California wildfires kill 9; drought
US deports Illegal Immigrants	US deports Illegal Immigrants

The events for the 11^th century are a little more eclectic:

1010  AD                                                            

• The Nile River freezes over
• Atlas of China Containing 1,556 chapters and written over 39 years is completed
• Viking Explorer Karlsefni makes North American settlement
• Caliphate of Cordoba is defeated
• Beowulf is written anonymously
• Lady Muraski writes The Tale of Genji (in Japanese)
• Danish raiders pillage Canterbury; Archbishop taken prisoner; later killed/no ransom paid
• King AEthelerd (The “Unready”) tries to buy out Viking Raiders for Danegeld (48,000 lbs of silver)
• Pope Benedict VII succeeds Pope Sergius
• Sulayman ibn al-Hakam reconquers the Caliphate of Cordoba
• The Four Great Books of Song- the Song Dynasty Chinese Encyclopedia has 1000 volumes with 9.4 million Chinese characters
• Kaifeng, capital of China, becomes largest city in the world replacing Cordoba.
• Abu al-Qasim al Zahrawi writes a 30 part medical encyclopedia in Arabic

Going back has helped me to look forward. The middle eastern culture is still awaiting a successful caliphate. England still has leaders who are “Unready”. The USA is a temporary haven for capitalism, but the experiment is only 250 years old and shows signs of aging. China resumes a 3000 year upward trajectory interrupted by short pauses with communism as a political organization and socialism as a failed economic theory. The winter temperature in the Nile river is now 71 degrees.

With 2020 I have perfect insight- just what the numerologists predicted.

Financial literacy is a hot topic right now. It should be.

A large swath of the younger population in the United States could not pass a basic financial literacy test, much less debate the pros and cons of capitalism. In recognition of this deficiency, Barrons devoted a Special Report, “Kids and Money” in its December 2, issue to the topic of educating your children about finances.  

According to Barrons, “21% was the portion of wealth held by Baby Boomers in 1989, when their average age was 35. Millennials will control just 3% in 2023, when their average age is 35.”

No wonder Millennials are fascinated by wealth transfer promises from Bernie Sanders and Elizabeth Warren.  If you haven’t learned to save by the time you are 35, your future is highly dependent on those who have. That won’t be Millennials or the Gen Z group right behind them.

Here are a few more statistics about young America’s wealth gap.

• 36% of 23-38 year olds don’t have any emergency savings
• 36% of college students have more than $1000 in credit card debt
• 45% of 18 to 29 year olds have received financial help from their parents in the last 12 months.

In a recent article for Business Insider by Hillary Hoffower, entitled “ 70% of Millennials Say They Would Vote For A Socialist” there are alarming facts about the poor financial condition of the largest population group in the United States. High interest rate credit card debt is right at the top:

“Of those who were in credit-card debt, slightly more than half (54%) said they owed less than $5,000, and 24% said they owed $5,000 to $10,000. The remaining one-fourth said they owed significantly more – 9% owe $10,000 to $20,000, 4.5% owe $20,000 to $30,000, and 4.5% owe more than $30,000. Source Business Insider– Hillary Hoffower.

With average credit card rates exceeding 15%, a $5000 card balance costs $750 interest each year. If it is not paid off or down, the principal balance will be $10,000 in 5 years. I wonder how many young Americans understand the manacles of compound interest?

Enslaved By Student Loans

The younger generation has argued that they have been enslaved by student debt. This is true and it has remained so over many generations. Many Millennials and predecessor generations without the means to repay were underwritten by a political class who made “college for all” a birthright without regard to affordability. Millennials signed up by the millions. They now can’t pay. Politicians are suggesting forgiveness.

According to a 2019, study by credit agency Experian “The average student loan balance among Millennials, consumers between the ages of 23 and 38, was $34,504, an 8% increase from Q1 of 2018. Millennials are alone, however, in their ability to repay:

Capitalism is not working for the younger generation of Americans because a political class has advocated forgiveness, not accountability. To a generation that is used to participants’ trophies, safe spaces and immediate gratification, Capitalism will never be as appealing as a selfie on the beach. Mounting student loans may now be a pile of tinder for a socialist bonfire benefiting a permanent ruling political class.

Capitalism Must Be Taught

Capitalism has not been taught as an economic theory for a long time.  As governments provide an ever greater share of life, capitalism will fade as an abstraction. The cornucopia will stop providing.

Financial literacy is needed.  Like all good habits, saving and frugality must be taught. The destructive inevitability of debt needs to be understood. Foremost, socialism as failed political and economic theory is a now muzzled by colleges and teachers, many of which owe their own existence to the student loan program. Free speech must return to college campuses.

I taught my children capitalism. They are teaching their children, and I am cheerleading.  There are too few parents who understand the economic and political underpinning of a system that has made the USA unique in the history of the economic and political world. For the Holidays, buy a copy of Neale Godfrey’s 1996 book “Money Doesn’t Grow On Trees” and read it to your children or grandchildren.

Millennials won’t miss capitalism until they have a ruthless socialist master like Nicholas Madura in Venezuela.  By then compound interest and student loans will be the least of their worries.

When the Houston Astros aren’t allegedly stealing signs, doing advanced analytics, or deploying infielders like short fielders in slow pitch softball, they are obviously sniffing the air of change in the wage and hour world. Recent articles from The New York Times, Sports Illustrated, ESPN and Fan Graphs all confirm Major League Baseball is reorganizing its farm system.

Right now the 30 major league teams average 6 different minor league teams. Big organizations like the Yankees have 9-10. The bottom two rungs on the ladder are the Short Season A clubs and the Rookie League.

It looks like 42 Minor League teams from the Short Season A and Rookie Leagues will be disbanded when the MLB revises its Professional Baseball Agreement with minor league owners, possibly as early as 2020.  If your favorite team is the Mahoning Valley Scrappers, the Orem Owlz, the Idaho Falls Chukars, the Batavia Muckdogs or the Lowell Spinners, you will most likely not have a minor league team next Thanksgiving.   If, however, you are a fan of Triple A clubs like The Durham Bulls, or the Portland Sea Dogs your romance with minor league baseball can continue.

When you try to make sense of this abrupt reorganization, you can’t justify it on the basis of avoided costs which MLB cites as a prime motivator.

MLB pays the salaries of the players and coaches in the minor leagues, and it directs all matters of player development and deployment. The rest of the teams’ expenses are paid for by the minor league owners.   Here is an explanation from Mark Stanton who has written an exhaustive law review article for Villanova’s Law Review on the topic of wage and hour discrimination in the minor leagues entitled “Juuuusst A Bit Outside”:

“A player is only entitled to receive his monthly salary during the championship season, which, at its longest, is five months. Thus, minor leaguers are not paid for any of the work they are required by contract to perform outside of their regular season and playoff games, such as spring training, winter workouts, and instructional leagues. Due to the limited number of months in which players can receive a paycheck, plaintiffs estimate the majority of minor league players earn less than $7,500 annually. Therefore, given their annual income, minor league baseball players fall well below the federal poverty guidelines.”

Can This Really Be About The Money?

If my math is correct and you assume 25 players on each of the 42 disbanded teams, the annual avoided payroll cost for 1050 players for 5 months of service is only $7.875 million. As a benchmark, Major League Baseball spent almost $5.5 million on baseballs alone and Max Scherzer of the Washington Nationals made $42 million in 2019. Can this really be a money problem for Major League Owners?

While the MLB announcement talks about reallocating resources for minor league facilities and raising the pay for the 160 surviving teams, Major League Baseball has a recognized attendance problem and a youth interest problem. It has spent millions on slick marketing campaigns to promote the game like RBI- Reviving Baseball in Inner Cities. Why self-inflict a promotional black eye and trigger very real contingent obligations to bricks and mortar owners in disbanded communities, possibly in the hundreds of millions, when you are only saving slightly more than the yearly cost of Rawlings hardballs?

MLB Owners May Have Much More At Risk

Whenever something does not make sense to me, I always say “FOLLOW THE MONEY”.   In this case the real money at risk is when the world learns the MLB pays these 42 teams, and the rest of the minor leaguers about $3.75 per hour for a full year of work.  This is the average contractual wage based on contract responsibilities, and it is currently being challenged as a violation of Fair Labor Standards Laws as below Federal minimum wage and overtime rules.  That lawsuit (Senne V. The Commisioner of Major League Baseball), has been pending since 2014 and has been tied up in dilatory appeals by The Office of the Commissioner of Baseball.

Recently, a judge in California ruled that past and present minor leaguers in 3 big states (California, Arizona and Florida) could sue MLB as a single class for wage discrimination. This is many thousands of players suing for a wage adjustment.  Furthermore, in a separate but important decision, the NLRB just ruled that Northwestern football players are “employees” opening the pay issue for college sports.

No Sympathy For Fat Cats

 Against a backdrop of strident voices calling for income equality across the nation, it is a major PR problem for MLB to be paying the best left-handed pitcher on the Vermont Lake Monsters and the best hitter on the Billings Mustangs only $3.75per hour.

The legal pundits, including Mark Stanton, think the MLB can win the wage discrimination legal battle in the Senne litigation under a “seasonal employment exemption” for players on teams like The Tri-City Devils and the Chattanooga Lookouts, but a victory may further erode their anti-trust exemption and tarnish their promotional campaigns.

Furthermore, billionaires are getting little sympathy and MLB owners know it.  Having the “Squad” target fat cat owners and then having Elizabeth Warren do the math online for minor league fans is not welcomed.

The alleged sign stealers from Houston are smart, and they sense correctly that a $12-$15 minimum wage for all will become a Maginot Line of liberal politics. Billionaire owners will not be able to hide from pitch fork wielding wage zealots. The only way they can afford the 160 teams they want to keep under their anti-trust exemption is cut the contingent wage liability for 42 teams on the margin.

Not surprisingly, MLB is volunteering to raise wages and working conditions for all the minor leaguers who stay.

While the Thanksgiving mood may be a little muted in secondary markets for affiliates of the Reds(4 teams lost) and Kansas City (3 teams lost) it is a pumpkin pie “so what” for perennial contender like the Yankees, Astros Dodgers, Red Sox, Giants and Indians who will only shutter one affiliate.

While I am thankful for my Indians I feel regret for communities losing their cornerstone of entertainment and association. The Owlz, Muckdogs and Lookouts will be missed.

I have never been good at betting on NFL football.  Invariably, I am on the wrong side of picking the over/under or the winner, especially Superbowl games. I always thought it was my lack of information. So this season I entered two NFL football pools sponsored by a friend, and I was determined to do some research on ESPN every week.

The first pool is called “Pick ‘em/ Rank’em” where you pick the winner of every NFL game each week, and then assign a confidence level of 1 (think Browns) to 16 (think Patriots) to each pick. Since everyone has a bad week now and then, you get to throw out your two worst weekly totals.

The point spreads do not matter in “Pick ‘em/ Rank’em”,  other than showing the bookies’ confidence level. When the Patriots are playing the Miami Dolphins, for example, and the point spread is minus 17 for the Patriots it means the betting book is willing to give Miami a 17 point lead before the first kick-off. This was a no-brainer. Take the Patriots because the minus spread does not count – just the Patriots must win.

The second pool was even easier. It is called “Survivor”, and all you have to do is pick one and only one winner (without point spreads), each week.  The wrinkle is you cannot pick the same team twice.

So, after you have picked the Patriots, 49ers, Ravens, Kansas City, Green Bay, and New Orleans, you have to start thinking about Cleveland, Miami, Arizona and the Bengals. Luckily it takes two mistakes to be eliminated. How hard could this be with all the information I had at my fingertips?

“Pick ‘em/ Rank’em” has been a disaster. I am in 40^th place. “Survivor”, was even worse.   I was wrong for the second time after week 7, and was the 3^rd player out of 53 to be eliminated. Clearly, it was not me. I was not getting enough information in a timely fashion.

5G and Sensor Technology To The Rescue

But I am no quitter, so when I read the WSJ’s special report this week written by Sarah Krouse about the information surge coming to professional sports betting from 5G and sensors I was thrilled. According to Ms. Krouse the U.S.A is finally going to catch up with the Europeans, and I will have all the information I need to excel in some sort of betting opportunity:

“Faster 5G service will help connect more sensors within stadiums and bring much lower latency, which translates into more in-game betting opportunities, says Guru Gowrappan, chief executive officer of Verizon Media Group… In the U.K., more than 70% of all mobile sports bets are in-play or after the game has started, while sports betting in the U.S. has focused primarily on which team will win or lose, says Stephen Master, president of sports-business advisory firm Master Consulting.

U.S. sports are well positioned for in-game betting, he says, because games like baseball and football are less free-flowing than soccer. Every at-bat, drive or kickoff has an outcome on which to bet.”

Mound Ball Is My Only In-Game Betting Experience

Actually, the only in-game experience I have so far in my betting career is “mound ball”, where you bet beers on whether the defensive player in baseball holding the ball after the 3^rd out in any inning will roll the ball to the area designated as the “mound”, or whether it will roll off into the grass. I always fashioned myself as a mound ball savant and had several memorable hangovers to prove it.

Think of the thrill of having twenty mound ball games going simultaneously! 5G will make it possible. Unsolicited, the beer vendor in your aisle in Cleveland will pour you a beer in the 5th inning when you win the 3rd inning (time change) mound ball bet in Milwaukee. When you lose, the internet of things (IOT) will debit your Venmo account and credit a beer opponent in Boston who will get an unsolicited pour of Sam Adams.

The same opportunity will exist for bets on whether the Browns will be offside on a 4^th and 1 in the red zone, or whether Coach Kitchen’s heart rate will spike when Jarvis Landry is called for taunting on the first touchdown of the game.

With 5G and the IOT my betting opportunities will definitely abound. My sports betting record will probably continue to be like every Browns’ season except for mound ball where, happily, the beer hangovers will be like the Patriots.

There is always a large dose of wonder and a small amount of dread about travel to developing parts of the world. The electrical grid and connecting your devices usually mean at least 5 different connector models, none of which really work when you actually get to your destination. Cell service is spotty even if you have an international plan.

Then there is the Center For Disease Control (CDC), and the regimen of drugs for known diseases like Malaria and Typhoid as well as possible gastro intestinal challenges from water, fruits and vegetables. In some venues there are sanitary issues with open sewers and public toilets. Ultimately, your travel plans are sculpted by the weather, the people, the local politics, personal safety, natural beauty and quality of the experience.

An Interesting Opportunity

In researching Rwanda, Zambia, Zimbabwe and Botswana for a recent trip of a lifetime, I came across this interesting review of an emerging third world opportunity:

“The weather is superb. Endless sunny days with low humidity, pristine beaches, snow capped mountains and beautiful seasonal breezes. The gross domestic product is the 5^th largest in the world, and the diversity of climate supports agriculture and one of the largest wine industries in the world. Education is exceptional and many the best universities in the world are located here. The intellectual capital is enormous and the businesses headquartered here are renown for worldwide leadership in the digital revolution, social media, the movie industry and autonomous vehicles.

 Recently wide swaths of the parched land have been on fire, and there is endless environmentally protected “natural” deadwood to feed its continuous renewal. There is no reliable power grid because the dominant energy company has been bankrupted by litigation blaming it for setting the land on fire. Connecting your devices has become a challenge as the electrical grid shuts down.

One of the most famous cities in the world is headquartered here on the Pacific Ocean. It serves as a sanctuary for 6,000 homeless people who are protected and encouraged by $350 million of annual subsidies. The result is unsanitary conditions, open drug use and spent drug paraphernalia. The residents pick up after their dogs, but not their homeless.

Vagrancy, the grid and pop up fires mean this destination is a third world bargain. Bring your travel dollars and best sense of humor to California.”

We Chose Africa Over California

As compelling as this California opportunity seemed we chose Rwanda, Botswana and Zambia. It turned out to be wise.

These countries are also parched by their own drought, but they undertake endless “controlled burns” to stop spontaneous combustion which they blame for all of their fires. There is a rudimentary power grid but we never experienced any black outs. There was no sign of human waste in the streets and no evidence of drug paraphernalia either.

Capitalism and Hard Work Are Evident

Although their GDPs are respectively #141, #117 and #109, capitalist business models in these countries encourage hard work from dawn to dusk. While many families are devastated by HIV, their villages take care of their homeless orphans without subsidies from anyone. The tourism industry attracts the best and brightest people who make your stay enjoyable and memorable. Everyone speaks English as the preferred language and their vocabulary is startling. While poor and lacking resources, you can see the growth of civilization in Rwanda, Zambia and Botswana.

The young and ambitious citizens in Rwanda, Zambia and Botswana all want to come to America and will be happy to speak English as their first language.

Every year The World Series of Poker hosts the finals of the Texas hold ’em competition where the best poker players in the world compete for a multi-million-dollar purse.

Unlike most other poker hands, the players in Texas hold ’em get 2 down cards which they alone can see, and then 5 up cards, which can be used in every player’s hand.  Those up cards are turned over in 3 stages with betting on each turn. The turns are named for the betting drama they create; the first turn is 3 cards and is called the “flop”, the second turn is 1 card and is called the “turn”, and the final card is called the “river”.

Everyone Is Looking For “Tells” At The Poker Table

The skill of the players is a combination of reading the ‘tells” which is poker terminology for reading signs that opponents are holding winners, or bluffing, and the ability to calculate odds in their heads.   Most of the best players wear sunglasses because eyes provide the most reliable tells at the poker table.

The investment world today is like a Texas hold ’em tournament.  All parties have equal and instantaneous information.  Machine learning fueled by algorithms buttresses institutional traders and investors.  Like the flop, the turn, and the river, almost all investment professional insiders have perfect information. Even though they see their hands and counter-parties hands as well, the very best investors still look for the markets to give them a “tell”.

My Favorite Tell

I wrote a blog (You Know It Is A Market Top When???) in October of 2018, about companies borrowing money to buy back stock, and insiders selling into that liquidity as a sure “tell”. Insiders may not be prescient all the time, but that is the way I would bet if I only had only one piece of information.

Buffet’s Favorite Tell

A recent article in Market Watch “One Look At This And You Can Tell Why Warren Buffett Is Siting On An Unprecedented Pile of Cash”, talks about a reliable tell for the Wizard of Omaha:

“One reason may lie in this chart, a variant to what Buffett has described as the best single measure of where valuations stand at any given moment,” which was posted by Gary Evans of the Global Macro Monitor blog this week.”

Gary Evans Favorite Tell

Mr. Evans also has his own “tell”, which is the number of hourly earnings needed to buy the S&P500:

Another tell may be what is happening with bank debt and highly leveraged loans. The debacle in 2008 should have taught us the lesson that rating agencies are profit driven, and often short on rigorous credit analysis. When you are only betting your reputation, not your wallet, your credit opinion is for hire.  In fact, the real test is what owners of leveraged loans are doing.

Rating Agencies And Markets Diverge

According to a recent Article in Barron’s “The Riskiest Bank Loans Are Selling Off” by Alexandra Scaggs, the discount on leveraged bank loans (23%) is significantly higher than the 5.8% discount for the market’s lowest rated loans (CCC). The disconnect which may be another “tell”, is that at least 50% of the bank loans are supposed to have a significantly higher credit quality. Again, the market is saying something dramatically different than the rating agencies.

In any event, equity investors have seen the flop, the turn, and the river, and still are ignoring the “tells” and have pushed all their chips into the center of the poker table and declared they are “all in”, (which means they are betting it all). As Gary Evans puts it, “they are sustained by thematic delusions whether it is the magic of QE, artificial intelligence, or cessation of trade wars with China.”

Another of my favorite “tell” is when my brother, the landscape architect, starts giving me investment advice. In 2001, I sold everything when he told me a great strategy was “buy companies that have just split their stock- they always go up.” If you don’t have reliable family member or friend, you can probably count on Warren Buffet getting it mostly right.

In the movie “Terminator” machines with artificial intelligence provoke a nuclear holocaust with the objective of eliminating humanity. While they almost succeed, the future reveals a small, but determined, human resistance led by John Connor. In that future Connor is on the verge of eliminating the machines when they dispatch a cyborg assassin back in time to kill Sarah Connor, John’s mother.   Sarah Connor gets help from the future also when her son also sends a defender back to protect mom from the assassin cyborg, Arnold Schwarzenegger, assuring John’s birth and fulfillment of his destiny to save humanity.

In listening to the first season of a podcast about artificial intelligence called “Sleepwalkers” https://podcasts.apple.com/us/podcast/sleepwalkers/id1449757372 ,  I started wondering who from the future is coming back to protect us from the growing manipulation of algorithms and data mining by corporations and governments?

Stop Sleepwalking About Artificial Intelligence

“Sleepwalkers” serves as  a clarion call to the billions of people who have openly shared via social media their data, preferences, inclinations and personal secrets. This naïve pursuit of community, friends, recognition or self-alteration on Facebook , Instagram and Twitter and immediate gratification from Google and Amazon, may really be changing the social contract. The owners of the algorithms and the data may become a new ruling class.

Where that data is not shared because it is too sensitive, it has often been stolen. Recent examples are Target, Equifax, Facebook and now Capital One which is changing its slogan from “What’s in your Wallet to “Who’s in Your Wallet”. The upshot is the owners of the data and the algorithms to use it to predict or manipulate human behavior may be in a position where they know us better than we know ourselves.

You can test it by logging into Amazon. Amazon knows how you behave better than behavioral scientists like Kahneman and Tversky, and certainly can predict your inclinations better than you might predict yourself. For example, Amazon knows I will eventually buy two pairs of ASICS volleyball shoes if they first show the only one in inventory.

The “Sleepwalkers” series debunks the social assumption that humanity is really on top of the food chain and completely in charge of political systems, financial outcomes and self-determination by pointing to advances in artificial intelligence powered by data analytics.

Artificial Intelligence Is Already A Tool Of Repression

One of their episodes is devoted to China’s use of facial recognition to score model citizenship. Good citizens are allowed to travel and get good jobs, while bad citizens enjoy few freedoms. The worst among them (Tiannemen Square), are reprogrammed or simply eliminated. The facial recognition episode also asserts China’s belt and road policy of providing financial aid to emerging nations comes with a Faustian bargain. The puppet rulers of those nations have to allow facial recognition as a tool for citizenship conformity by which Beijing controls its burgeoning empire and puppet leaders with legions of cameras and algorithmic software scoring citizenship.

At its core, the uprisings in Hong Kong suggest a whole mass of humanity is not sleep walking about China’s intentions for imposing its repressive regime via its puppet leader in Hong Kong, Carrie Lam.

The Power of the Gods

Sleepwalkers Season 1 asks the question: Can you trust businesses and governments to make the right ethical decisions about using artificial intelligence when we have given them the lightning rods of Zeus? Mark Zuckerberg sort of looks like Zeus, and I would answer the trust question in the negative. The same would be true for Google and Amazon.

Needless to say, when you hear interviews on this podcast with senior executives from Google saying they will not permit their children to be on the internet at all because of manipulation and mind control you know you need your own cyborg.

Faustian Bargains in 2020?

While my personal opinion is the 2016 Presidential election was not influenced enough by social media to change the outcome, I have absolutely no confidence the 2020 presidential and congressional elections will not be manipulated by artificial intelligence to create the first devil’s bargain between the owners of artificial intelligence and consumer data and politicians all too willing to do anything to get elected. Maybe Facebook’s Libra gets approved if it will spread fake news or censor certain users?

I can envision Amazon giving double discounts to citizens who vote in certain states, Instagram generating fake pictures of candidates with a goat on election eve which they will then blame on the Russians and maybe even fake posts from Trump’s Twitter account.

Listen to ‘Sleepwalkers’ and wake up! Then start searching for your own cyborg not named Alexa or Siri. I am sure Elon Musk will be offering one soon.

There are only a few financial occurrences in my lifetime as confusing as negative interest rates.  In September 2015, I wrote a blog about living in a Bizarro World where everything is reversed ( https://capitalworks.net/i-am-living-in-a-bizarro-world/). Negative interest rates are just the latest Bizarro example where you have to pay more for a bond or bank deposit than you get back.

What does a negative interest rate really mean, and is it based on real relationships between lender and borrower or is it just another experiment by central banks to get savers to spend? It might also have something to do with crushing national debts and trade wars.  It could also be a huge source of profits for insiders who actually understand this unnatural occurrence.

The chart below explains how debt now carries an obligation by the lender of capital to pay the borrower (negative interest) for returning par value at some future date. Under this scenario a purchaser of a $100.00 par value nine year bond bearing interest at 2.5% will have to write a check for $138.70. The blue is acquired principal. The green is acquired interest. The red is the premium (negative interest) you pay to get the bond. The 2.5% bond becomes a 1.5% bond.

For me this is preposterous, and no individual borrower will knowingly do this, especially depositors at banks.  I think the only institutions doing this kind of trade now must be sovereign central banks and their vassal commercial banks who are either buying each others negative interest bonds or, worse yet, buying their own bonds (printing money). However, there is more than $15 Trillion of negative interest debt much of which has been created in the last 5 years, so maybe Europeans and Japanese investors really are panicking?

What About Real World Transactions?

Our friends at Wasmer Schroeder who are fixed income specialists confirm the negative interest world is not market driven but rather imposed by central banks either trying to depress their currencies or stimulate their economies by forcing banks to lend at low rates. So far, savers are not paying a penalty for their deposits at banks. Wasmer Schroeder also confirms the business world is not transacting at these rates. The creation of LIBOR Floor interest rates in many loan covenants is an indication that central banks can set interest rates below zero, but lenders won’t necessarily let interest rates fall below a healthy LIBOR minimum which now stands around 50bps.   

Macro Global Monitor, an investment newsletter, also sees it the same way:

“We expect Treasury auctions to get sloppier with the risk of some even failing.   That will send a real wake-up call to markets and the policymakers.   Zero price discovery in markets has ugly consequences, some of which, take a long time to be realized.”

Yes, Virginia,  there is a debt overhang.  And yes, Vice President Cheney, deficits will matter.”

“With repressed yields a sort of “rent control” problem arises, where there is a shortage of funds at the given fake or below market yield.   Just as the case with a shortage of housing when rents are held below their market rates.”

The Financial Times in an article by Keith Fray dated August 13, 2019, is equally astonished by this worldwide trend but does not confirm that real world transactions are taking place at policy rates:

“Bonds have sub-zero returns out to 15 years’ maturity in Japan, France, Sweden and Belgium, out to 20 years in Denmark, 30 years in Germany and the Netherlands and an astonishing 50 years in Switzerland. In the case of Germany, it has become the largest economy where its entire yield curve is trading below zero.”

This Won’t Work For Jamie Dimon

By charging banks a fee for depositing reserves at central banks the hope is banks (the real distributors of money), will encourage borrowing and investment in slow growing economies. This is evident in a Danish Bank offering the first negative interest mortgage where the borrower will pay back less than he borrows over the life of the mortgage. While it is hard to understand, the bank is still making money (avoiding cost) because it may be charged even more to keep that capital on reserve at the Danish Central Bank.

The analogy in the industrial world would be a relationship between a manufacturer and distributor where the manufacturer persistently charged the distributor more than the distributor could resell the manufacturer’s products. The distributor would instantly look for a new relationship with a manufacturer willing to supply a similar product line at a discount. Or he would find a new line of business.

Holding Cash or Bitcoin May Be Better

The relationship between central banks and their money distributors is a closed loop. There is only one source of manufactured money (central banks) and there is a limited, chartered universe of approved money distributors (banks). Banks derive their funding from depositors and the central banks. The real test of negative interest as a central bank policy tool will come when commercial banks charge a depositor a fee to store cash. It won’t take long for that depositor to realize holding cash under the mattress is better because at least in the U.S., it always is worth at least par.

In a negative interest world Bitcoin may also become the world’s preferred currency?

Central Banks Have Failed in Europe and Japan

Japan and Europe have led the way on this failed policy. According to an August 14 article in The Japan Times on the topic, the only apparent benefit has been the devaluation of currencies against the US Dollar and even that trade benefit has eroded for Japan:

“The impact on growth and inflation has been even more mixed.”

In the eurozone, average corporate borrowing costs slipped to 1.6 percent in June from 2.8 percent at the time the ECB adopted negative rates in June 2014. Although economic growth initially boomed, it is now close to stagnating, having increased just 0.2 percent quarter on quarter from April to June. Inflation, which the ECB wants to keep below but close to 2 percent, hit a 17-month low of 1.1 percent in July, missing the target since 2013.

The benefits have also been questionable in Japan, where years of heavy money-printing had already pushed rates near zero. Bank lending rates, which were at 0.80 percent when the BOJ adopted negative rates in January 2016, stood at 0.75 percent in June.

Japan’s economy grew a meager 0.4 percent quarter-on-quarter from April to June, slower than 0.7 percent in the first quarter of 2016. Annual core consumer inflation stood at 0.6 percent in June, remaining distant from the BOJ’s 2 percent target.”

For Me Negative Rates Are Deflationary

I don’t think negative rates will work. They are so Bizarro, they would frighten me into Bitcoin, or maybe even Facebook’s Libra. One thing is for sure I am not going to buy a house because someone is paying me to borrow mortgage money. It immediately makes me think the money isn’t worth anything which suggests I will wait and see what happens. This is DEFLATIONARY and it is every politician’s worse nightmare–wrong Bizarro answer for central banks desperate for INFLATION.

When convention is flipped on its head and investors are looking for their yield in the stock market and their long term capital appreciation in the bond market you know central banks may have lost control.

I did not appreciate Elon Musk until I read Ashlee Vance’s biography entitled “Elon Musk: Tesla, SpaceX and the Quest for a Fantastic Future”. The author is clearly a Musk advocate and he looks past Elon’s shenanigans to find a once in a century mind working from what he calls “First Principles” on important projects like privately funded space exploration and clean energy independence. First Principles are grounded in chemistry or physics like electrons are faster than internal combustion. Michael Barnard from Clean Technica explains the physics as follows:

“Teslas use electricity in batteries instead of physical fuel. Getting electrons from a battery to an electric motor is much faster than getting fuel from a gas tank to a piston. Electrons travel much faster along a wire than fuel does along a fuel line, and the electrons basically go straight to the place where they are needed, while the fuel goes through a fuel pump, then to a fuel injector, then is sprayed into a piston, and then is ignited, turning into force which drives the piston to finally create torque. “

Tesla and SpaceX are stunning endeavors. Tesla is often misunderstood as an automotive company, when at its core Tesla is really an energy storage company.  For Musk, SpaceX is more about propagating our species than it is about commercial pursuits like putting satellites in orbit and resupplying the space station. The implications of each endeavor are simply transformative.

Below is a graph predicting the crossover point where the cost of an electric vehicle will be less than an internal combustion vehicle. The second chart presents the predicted increase in battery storage capacity through 2025.

Not everyone agrees with this crossover timeline. In 2016 speaking in Oslo Tony Seba an educator, author, futurist and a disciple of disruptive energy technologies predicted a crossover in 2020 for electric vehicles. His speech is a little bit light on facts and dates but the general thesis is powerful (https://www.youtube.com/watch?v=2b3ttqYDwF0).

The span of disruption from energy storage is vast. The electric vehicle will obsolete the internal combustion engine because of the cost curve shown above, and when you consider a Tesla is really a computer on wheels with only 18 parts, new technologies like 5G will make vehicle maintenance continuous and cheap. Even if the internal combustion engine can tie the electric vehicle, cheaper maintenance, and environmental concerns will move the world to electric vehicles.

The losers are almost every vehicle company that does not have an EV strategy as well as the vast supply and service chain that supports them. Maybe the only old economy survivor will be the tire industry.

The Equity Markets Are Weighing Tesla

At a $41 Billion market cap the stock market is weighing Tesla. When you read equity research the analysts are all over the map on its future. It has $14 Billion of debt. It has great unit sales, but gross profit margins have been sacrificed for revenues. Cash flow is strong, but Tesla is underinvesting in growth capX. Manufacturing problems are hurting fulfillment of the order book. Most of the senior management team is jumping ship including the CFO and CTO. The CEO, Elon Musk, seems to have an emotional stability issue and, now, he is alone and completely in charge.

Tesla’s Financials Did Not Look Too Bad

Rather than listening to the rhetoric- remember there are a lot of competitors facing a blank wall of oblivion if Tesla succeeds – I just looked at the numbers. I was shocked that Tesla makes any money or for that matter any cash money, but it does. Granted its profit margins are low for a cutting edge, disruptive technology company (18-19%), but if I were Musk I would prioritize revenues over profits, especially when the electric vehicle has a huge post sale advantage in maintenance.

Tesla Has Two Years of Cash

Since I simply do not know enough “first principles” and cannot opine about the 16% annual reduction in the cost of battery storage technology predicted by Tony Seba, I don’t know if Musk can accelerate profitability by reducing battery costs just as his tax subsidy expires. I just know that I have seen much worse-including decades of marginal profitability from Amazon.

 People forget that AMZN had only $10.8 Billion of revenues and a gross margin of $2.45 Billion (22.6%) in 2006 and a small net income. Its market cap at the end of 2006 was $16.25 Billion. In 2018 the leverage of AMZN’s disruptive business model produced $232 Billion of revenues and $93 Billion of gross profit (40.2%). Its market cap is now $900 Billion. In 12 years, its market cap has multiplied 55 times.  Here are the two stock charts side by side.

After reading Vance’s biography you realize Elon Musk always seems to do his best when he is alone with his back to the wall.  Disrupting the world’s auto industry is like free soloing El Captain. There is no route, no rope, no slips and no going back.

Losing Talented People Is A New Thing For Musk

However, I am disturbed by talent migration. In his early endeavors at Space X and Tesla, Musk was able to recruit the best engineers in the world simply for the chance to transform the world. If talent is now leaving Tesla, it may be a signal that Tesla’s business model is in trouble. That probably means that the energy storage cost curve is not as steep as Musk’s first principles suggested. He doesn’t have the cash to wait for a 2025 crossover on the cost curve shown above. He needs it now.

An interesting investment idea may be to buy TSLA’s debt. They have issued mostly convertible debt, but there is a small private placement of straight debt. In a bankruptcy, the straight debt might vote as a separate class. If TSLA fails, the debt holders will become the equity holders without conversion and there are a number of investors who would be interested if you shed $41 Billion of market value.

Mark Zuckerberg would be one of the last people on the planet I would trust with my financial information, but obviously his Board of Directors must see it differently.

Facebook announced that it would introduce its own cryptocurrency called Libra tied to a market basket of world currencies and backed by real assets. A group of passive investors like MasterCard, Visa, PayPal, Uber, Spotify, Coinbase, VC firm Andreessen Horowitz and many others will capitalize a subsidiary of Facebook called Calibra with $1 Billion. Here is how Forbes describes Calibra:

“A centralized subsidiary of Facebook, that promises to act independently, Calibra ,is a wallet for all your Libra coins! Calibra will require (you guessed it!) KYC of all users. Calibra will be available as a stand-alone app, and integrate directly into your WhatsApp and Messenger App. The app is primarily meant for sending funds peer to peer, as well as paying for everyday transactions. The announcement is vague on the question of fees, but promises for them to be reasonable.“

What Forbes means by “KYC” is Know Your Customer which is a banking concept to prevent crooks and terrorists from laundering money through the US Banking System. This will require Libra users to divulge their financial information to Calibra (Facebook) just like Mastercard or Visa or your bank gets your financial info. Alternatively, Calibra will likely accept a bank transfer of currency to buy Libra.

Just recently Facebook introduced their own white paper explaining Libra which they promote as a “universal stablecoin”- an instrument impervious to the violent swings of markets in periods of doubt and uncertainty.

Seductive and Laudable Objectives

This white paper is seductive. The notion of a universal currency available to the masses (including a wide swath of the world population that is not within the banking system) is laudable. The Libra white paper presents a wonderful dream which Facebook with its 2.4 billion users across the world is well suited to sponsor. But I have enough reservations about the likelihood of more mercenary objectives that I prefer to call Libra “FakeBits or, if you like to rhyme, SuckerBits”.

Libra Is Just Another Payment Cartel

My first caution is the unbanked members of the Facebook community will probably find they have to open a bank account or deliver all their financial info to Facebook to get credit or swap their local currency for FakeBits. In countries with totalitarian, repressive regimes your financial anonymity is often life itself.  Facebook’s own white paper contrasts FakeBits to cryptocurrencies like BitCoin that operate outside the banking system. That is exactly BitCoin’s founding principle- don’t buy into a system where central banks can print money and control yours or where your anonymity as an ordinary citizen (not a crook) is existential.

There is also a fundamental difference between Bitcoin whose value is primary and not backed by anything other than users’ confidence and coin scarcity and Libra whose value is derivative and backed by a mountain of assets that may be highly leveraged. There is also the difference that the validators of bitcoin are paid in bitcoin while the owners of Libra are paid in a special Libra Token that is different than the Libra currency you will use to buy coffee. I am suspicious that the Libra Token may trade as a security thus giving owners a path to liquidity in hard currency?Finally, bitcoin is not owned by anyone while Libra is owned by a cartel of really wealthy interests.

It is true Bitcoin has had problems becoming a universal currency because of its volatility and costs of validating its blockchain, but I am much more comfortable with its model than Libra. Here is Bitcoin’s chart since inception. Notice how the Libra announcement has helped Bitcoin’s valuation:

Independence Will Be Assured By Switzerland

FakeBits will serve as the first commercial attempt at an internet or universal currency and Facebook with 2.4 billion users has the heft to make this market. Evidently there is a concern that, like its users’ data, Facebook will be tempted to monetize Libra’s financial info. Ostensibly, an independent Libra Foundation in Switzerland will assure secrecy and resolve other conflict of interest concerns.  At inception Facebook will control Libra Foundation but promises to transition control after 2019.  I will take the over bet on that promise because I can’t see Facebook’s Board allowing Switzerland to control its Calibra subsidiary.

Currency Volatility Will Be Muted By Owners’ Capital

The stablecoin will be pegged to a market basket of real currencies. Yikes- I can’t think of anything more unstable than real currencies. Nonetheless, The Reserve Fund will dedicate trading capital to buying and selling the tracking currencies to stabilize the peg.

The Big Recession convinced the founder of Bitcoin of the need for a worldwide currency that was not controlled or manipulated by central banks printing money or a small group of owners whose capital disappeared when the going got tough. One of Libra’s the biggest risks is lack of support by the ownership cartel for the underlying currencies in an economic meltdown. Even worse the owners may monetize the Libra Reserve Fund with leveraged dividends and destroy its capital base.

The Reserve Fund May Be Like Lehman Brothers- Thinly Capitalized

The group invited to make a $10million investment in Calibra is among the smartest money in the financial world. When the fog lifts on Calibra they are unlikely to have any real capital at risk. Their $10 mil contribution will likely be returned in profits in the first 12 months, if not before then from a loan against the business model. It is completely possible The Reserve Fund will be capitalized with borrowings from banks and lenders who will loan against the future cash flows of the payment processing model which will include transaction fees and float on Reserve Fund Assets. The numbers are staggering. The Economist suggests the Reserve Fund could hold more than a Trillion Dollars:

“What’s not to like? Mr Zuckerberg’s initiative, which has been cooking in Menlo Park for 18 months, has two problems (see article). First, it could disturb the stability of the financial system. America’s biggest bank, JPMorgan Chase, has 50m digital clients. Libra could easily have ten times that number. Were every Western depositor to move a tenth of their bank savings into Libras, its reserve fund would be worth over $2trn, making it a big force in bond markets. Banks that suddenly saw lots of deposits leave for Libras would be vulnerable to a panic over their solvency; they would also have to shrink their lending. And the prospect of huge sums flowing across borders will worry emerging countries with a fragile balance of payments.“

After All This Is Facebook’s Casino

Would you withdraw $100 from your bank account insured by FDIC and backed by the taxing power and full faith and credit of the United States to buy a poker chip with Marc Zuckerberg’s face on it? Recognize his casino will cash out your poker chip, if at all, when it pleases him and his investors and at a price that clears them of any financial responsibility. Watch the movie “The Big Short “and ask yourself why the mutts who bet correctly on a meltdown in the housing market could not get out of their winning trades? They held poker chips in someone else’s casino – in this case it is Zuckerberg’s casino.

I am sure Libra is just the same playbook. Buy SuckerBits at your risk.