Speaker 1: Hello, Odd Lots listeners, It's Tracy Allaway. Before we get
Speaker 1: to today's show, I have a bit of news. It's
Speaker 1: something I'm really excited about. Odd Lots is hosting its
Speaker 1: first ever live event on Thursday, September nine in New
Speaker 1: York City. Join me and Joe Wisenthal as we host
Speaker 1: an all star lineup of guests to talk about everything
Speaker 1: from white collar fraud to sovereign debt and much much more.
Speaker 1: This will be a group of new Odd Lots guests
Speaker 1: plus a few old favorites. Will also have live finance,
Speaker 1: the music, as well as drinks and just overall great conversation.
Speaker 1: Details of the lineup are going to come out very soon,
Speaker 1: so keep listening to add blots to learn how to
Speaker 1: sign up to see us live on Thursday September in NYC.
Speaker 1: Joe and I both hope to see you there. Hello
Speaker 1: and welcome to another episode of the Odd Lots podcast.
Speaker 1: I'm Tracy Alloway. My co host Joe Wisenthal is away
Speaker 1: this week. I happened to be on a work trip
Speaker 1: to Australia. I've never been before. It's fascinating. I have
Speaker 1: big plans to meet a koala, but beyond that I
Speaker 1: also happened to be in the country for a momentous
Speaker 1: historic occasion, which is the benchmark Australian bond deald dipping
Speaker 1: below one percent for the first time. I was also
Speaker 1: there when the Reserve Bank of New Zealand opted to
Speaker 1: cut rates by fifty basis points, which was something that
Speaker 1: shocked the market. And just a couple of hours later
Speaker 1: we had rate cuts from the Central Bank of India
Speaker 1: and also the Central Bank of Thailand as well. So
Speaker 1: clearly we are in another cycle of fresh monetary easing.
Speaker 1: And along with these lower yields and interest rates around
Speaker 1: the world come lower bank stocks. Bank valuations are trading
Speaker 1: at historic lows, partly because of concern about bank's ability
Speaker 1: to make profits on lending when rates are this low.
Speaker 1: And who better to talk about all of this than
Speaker 1: John Hampton of Bronte Capital, someone who's been writing about
Speaker 1: the financial markets for a very long time on his
Speaker 1: blog and also invests in them through a long and
Speaker 1: short hedge fund. John, it's so nice to meet you
Speaker 1: in person. Finally, thank you. I'm a little a bit
Speaker 1: in ore of that requirement to speak about it generally
Speaker 1: because I like to speak about these things rather specifically.
Speaker 1: Um I started my career in financial markets as a
Speaker 1: bank analyst. So once upon a time I read more
Speaker 1: or less every bank account for every major bank in
Speaker 1: the world, and along the way I decided that they
Speaker 1: largely not very good businesses. There are exceptions. There are
Speaker 1: extremely good oligopolies in some countries Canada, Australia, Scandinavia. There
Speaker 1: are a few banks that have large captive businesses that
Speaker 1: should be very cheap to run. The trust banks come out.
Speaker 1: But as a general rule, most banks are not very
Speaker 1: good businesses, but they mask themselves as pretty good businesses
Speaker 1: most of the time. How do they do that Well, Firstly,
Speaker 1: they're very powerful because they have access to large amounts
Speaker 1: of money, and being powerful means that you just get
Speaker 1: a lot of press. Journalists seem to be too interested
Speaker 1: in bankers. The world seems to be too interested in bankers.
Speaker 1: The second reason is that you can deceive yourself for
Speaker 1: a very long time running a bank. Banks are quintessentially
Speaker 1: estimate machines. And thirdly, every now and again they really
Speaker 1: are very profitable. We're looking at the moment it banks
Speaker 1: across the world except in the United States, basically at
Speaker 1: thirty yellows a lot of the European banks. And it's
Speaker 1: not just Deutscher thirty year lows. If you look at
Speaker 1: sock Jan it's at a thirty year low. If you
Speaker 1: look at credit agricol ubs, the English banks, they're all
Speaker 1: at thirty year lows. And I live in a world
Speaker 1: of extremely expensive stocks, and so suddenly I feel like
Speaker 1: I want to be a bank analyst to give just
Speaker 1: because you know, these things look cheap. So I've been
Speaker 1: puzzling myself a bit about bank margins for a while.
Speaker 1: Now I'm going to lead you back to an article
Speaker 1: that was appeared in The Economist on January and the
Speaker 1: article is just comical when you read it now. It's
Speaker 1: called the Lloyd's Money Machine. And at the time, Lloyd's TSP,
Speaker 1: as it then was, was the thirty five biggest bank
Speaker 1: in the world by assets and the biggest bank in
Speaker 1: the world by market cap. Ten years later Lloyd's was
Speaker 1: essentially UK government property. But this was it wasn't ordinary profitable,
Speaker 1: it was ferociously profitable. To pick an example, if you
Speaker 1: look at the banks in the world at the moment
Speaker 1: and do say revenue to risk weighted assets, you see
Speaker 1: the Japanese banks at the lowest end and revenue is
Speaker 1: sub one percent of risk weighted assets. Then there are
Speaker 1: the German and Italian banks, and the English banks get
Speaker 1: up to about two and a bit descent. And the
Speaker 1: English banks are in the order that you would expect,
Speaker 1: with Royal Bank of Scotland being the thinnest and Barclays
Speaker 1: being the fattest margin and the margin actually just matches
Speaker 1: the stock prices, right, And then sitting in the middle
Speaker 1: is sort of these American banks at about four and
Speaker 1: a half five percent, and then with an outlier, and
Speaker 1: the outlier is the one you'd expect, which is the
Speaker 1: most revenue focused retail bank in America, the one it
Speaker 1: would do anything to, including steal from you, to get
Speaker 1: more revenue, and that's which is just the fattest margin bank,
Speaker 1: and at about the same sort of revenue to risk
Speaker 1: weighted assets you see the Canadian banks is about six percent.
Speaker 1: And then the fattest margin banks in the world are
Speaker 1: the ones that speak in my accent, right, and it's
Speaker 1: just this really good oligopolic. But if I go back
Speaker 1: to this article, Lloyd's revenue to risk weighted assets at
Speaker 1: that time was eight c Lloyd's in the UK made
Speaker 1: more money than the Australian banks do now. It was
Speaker 1: just astonishingly profitable. And over the next ten years, English
Speaker 1: bank margins went down, and then they went down a
Speaker 1: little bit more, and then they went down a little
Speaker 1: bit more, and eventually you had the wonderful institution called
Speaker 1: Northern Rock which was the protagonist in all of this.
Speaker 1: And Northern Rock ran mortgages at about sixty bits of
Speaker 1: margin and about twenty five bits of cost, and eventually
Speaker 1: they got down to twenty bits of knit margin leave
Speaker 1: at sixty times to produce an eighteen centirow it. But
Speaker 1: they managed to do this in a low but positive
Speaker 1: interest rate environment. I understand why English bank margins collapsed
Speaker 1: and why Lloyd's collapsed in the answer was, well, there
Speaker 1: was a large whack of competition. The banks will blame
Speaker 1: it on new regulation, right and the fact they have
Speaker 1: to hold more capital and they can't eke out that
Speaker 1: much money per capital plus low interest rates predated that, right.
Speaker 1: This was pre crisis lloyd Lloyd's was ferociously profitable in
Speaker 1: its revenue to risk weighted assets was north of eight
Speaker 1: by two thousand and eight. It's revenue to risk weighted
Speaker 1: assets was sub you're talking the beginning of two thousand.
Speaker 1: It that night after September two, two thousand and eight,
Speaker 1: it was subject. And the problem is that when your
Speaker 1: revenue to risk weighted assets went down that far, even
Speaker 1: small credit losses blew you up. Right Now, the beauty
Speaker 1: of the American banking system was that the revenue to
Speaker 1: risk weighted assets never went below about four and a half.
Speaker 1: During the crisis, there was the banking sector had three
Speaker 1: thirty billion, I think was the number of pre tax
Speaker 1: pre provision income. And if you've got a trillion dollars
Speaker 1: of losses, you can write that off over three years,
Speaker 1: and as long as you can extend and pretend enough,
Speaker 1: you never actually go sub profitable. And they raised a
Speaker 1: lot of money, and they sort of came through the
Speaker 1: English banks didn't have enough revenue, and the German banks
Speaker 1: spectacularly didn't have enough revenue, right because that the German
Speaker 1: banks are the thinnest in the world. But all of
Speaker 1: this margin collapse happened in a positive interest rate environment. Recently,
Speaker 1: the most interesting thing I've seen is by a guy
Speaker 1: called Shannon mcgonachy who runs a fund for Horseman Capital
Speaker 1: and japan focused fund. He's an Australian. I've never heard
Speaker 1: of him before this interview, but he was running through
Speaker 1: Japanese regional banks, which are the lowest margin banks in
Speaker 1: the world. And he says, and I haven't verified the number,
Speaker 1: but I believe him because it sort of matches my
Speaker 1: on the ground observations that the average interest rate achieved
Speaker 1: on a new loan in a Japanese regional bank this
Speaker 1: year so far has been sixty eight basis points, and
Speaker 1: it costs more than sixty eight basis points to administer
Speaker 1: the bank. You've got to have branches, you've gotta have staff, etcetera,
Speaker 1: and so on increment on current business. The Japanese banks
Speaker 1: are loss making before credit losses. They don't even need
Speaker 1: a credit loss to lose money, right If they have
Speaker 1: credit losses, that's just extroduced to the capital destruction that
Speaker 1: it doesn't show in their accounts and Lorea's and is
Speaker 1: that they have a bunch of reason the ways of
Speaker 1: turning capital gains into interest income, the most obvious of
Speaker 1: which is that they've held a lot of jgbs because
Speaker 1: they have loan deposit ratios of sort of point six
Speaker 1: point seven they've held a huge number of jgbs. As
Speaker 1: rates have come down, they've got huge capital gains. They've
Speaker 1: been clipping those capital gains all the time and calling
Speaker 1: it interest income, so they look like they're marginally profitable
Speaker 1: at the moment that they're in fact marginally loss making
Speaker 1: before credit losses. So instead of making money on actually
Speaker 1: extending loans to customers or corporates in the way that
Speaker 1: they used to, they're making most of their money through
Speaker 1: asset price increases that then get booked as interest income
Speaker 1: that will run out, and then they will make losses
Speaker 1: on extending lines. His simple view is there's no price
Speaker 1: that you can buy these at their point to book,
Speaker 1: and that's a value trap. So is the banking business
Speaker 1: just broken at interest rates that low. That's what is
Speaker 1: clearly the case in Japan, and is what the market
Speaker 1: is telling you about the big mega banks in Europe.
Speaker 1: The flip side is that you know there are banks
Speaker 1: in Europe in oligo baalistic markets that are still got
Speaker 1: fairly fat margins which have also come down. So you know,
Speaker 1: if I'm going to beat myself up the stock on
Speaker 1: the portfolio, the two stocks that I own that have
Speaker 1: bugged me. Most have been Spensker Hundle's Bank, which is
Speaker 1: a very well run, highly oligobalistic Swedish bank, and Allied
Speaker 1: Irish and Allied Irish is a less well run but
Speaker 1: even more oligo ballistic Irish bank. And Irish banking margins
Speaker 1: are very nice right there, about the same as US
Speaker 1: banking margins. They're not as rich as Australian banking margins,
Speaker 1: but there are many times you know a big French
Speaker 1: or a big German bank, or even a big English
Speaker 1: bank yet that they're still drowned to trading. At point
Speaker 1: six book, I'm trying to work out why I'm wrong.
Speaker 1: We've we've had a demonstration of margins collapsing even in
Speaker 1: a positive interest rate environment, and that's called English banks.
Speaker 1: And we have a demonstration of margins completely and utterly
Speaker 1: collapsing in a negative interest rate environment, and that's good
Speaker 1: in Japanese regional banks. And I'm wondering whether I'm just
Speaker 1: insane or not. But that's my little frustration at the moment. Well,
Speaker 1: so how would you explain it? Then? Is the is
Speaker 1: the market wrong? That would seem to be the simple explanation.
Speaker 1: Every time I've been confident that the market is wrong,
Speaker 1: it tends to beat me in the head I think
Speaker 1: it's wrong. I rang up Shannon mcgonicky after this, and
Speaker 1: I tried to go through right just because I wanted
Speaker 1: to work out whether any of the margin collapse that
Speaker 1: and the methods of hiding it that he could see
Speaker 1: in Japan we're applicable to my Irish banks. And the
Speaker 1: answer was no. But that doesn't mean that I'm not wrong.
Speaker 1: I am enough of a stock picker to know I
Speaker 1: can be wrong any day of the week, and believe
Speaker 1: me the moment I think I'm wrong, And if any
Speaker 1: of your dear listeners will tell me why, then I'll sell.
Speaker 1: These positions. Are not allergic to them, but they are
Speaker 1: very tempting. And the reason they're very tempting is that
Speaker 1: almost everywhere you look in this world, particularly in North America,
Speaker 1: you see assets at extreme prices. Right that we have
Speaker 1: a situation where the market really does believe that low
Speaker 1: interest rates are here here to stay, and that economies
Speaker 1: are relatively are going to be relatively weak. So things
Speaker 1: that have highly deterministic cash flows that you can value
Speaker 1: off the low interest rates are priced at very high levels.
Speaker 1: My favorite example of this is Visa. Visa trades that
Speaker 1: last time I looked at seventeen times revenue. I think
Speaker 1: the markets down a bit this week, so it might
Speaker 1: be only sixteen times revenue or fifteen times revenues. Yeah,
Speaker 1: there's a famous quote from Scott McNally at the end
Speaker 1: of the It's one of the quotes that I almost
Speaker 1: pin on my wall at the end of the of
Speaker 1: the tech bubble, which said that, you know, at the
Speaker 1: height of the tech bubble, Sun was trading at ten
Speaker 1: times revenue, And dear readers, what were you thinking, you know,
Speaker 1: at ten times revenue. In order to get a ten
Speaker 1: percent return, I've got to return a hundred percent of
Speaker 1: revenue to you in cash, which means that I don't
Speaker 1: have any staff, which is kind of hard when you're
Speaker 1: running a tech company and they don't have any inputs,
Speaker 1: which is kind of hard when you're selling computer boxes.
Speaker 1: And I don't pay any taxes, which is kind of illegal.
Speaker 1: And that I can maintain all the revenue without any
Speaker 1: R and D expense, which seems a little improbable. What
Speaker 1: were you thinking that ten times revenue was the sort
Speaker 1: of number that said this is insane. Now Here, I
Speaker 1: have Visa, which is a very fat margin business. I'll
Speaker 1: admit it's a very fat march in business, trading at
Speaker 1: sixteen or seventeen times revenue, and yeah, it's got two
Speaker 1: thirds margin. Half half of Visa's revenue drops to the
Speaker 1: P and L, and all of that is spent on
Speaker 1: either dividends or buybacks. It's an incredibly cash generative machine.
Speaker 1: But it is one point seven times the price that
Speaker 1: Scott McNelly said was insane. Is the difference between now
Speaker 1: and past markets That in past markets, valuations used to
Speaker 1: be self limiting. At some point someone would go, you
Speaker 1: know what, the stock is far too expensive and I'm
Speaker 1: not going to buy it. Whereas now because so so
Speaker 1: much of the profit that you make by investing is
Speaker 1: basically momentum and a price increase. No, nothing, that's just
Speaker 1: got to be wrong. Nothing is as as expensive as
Speaker 1: the worst as second tier tech stocks were during the
Speaker 1: tech bubble. If you go have a look at the
Speaker 1: biggest five or six tech names during the tech bubble,
Speaker 1: and you brought them now and you held them to now,
Speaker 1: you've actually made an acceptable return. If you went and
Speaker 1: looked at names twenty to thirty in March two thousand
Speaker 1: and you held them to now the result is an unbelievable,
Speaker 1: spectacular wipeout. Right, there are names that were hugely important
Speaker 1: then that don't mean anything to you now, Like I
Speaker 1: two Technologies. There was a period where the too hottest
Speaker 1: tech names in the world, where I too Technology and
Speaker 1: JDS Uniphase and I two Technologies had a market cap
Speaker 1: of two hundred and twenty billion and j D s
Speaker 1: Uniphase was to eighty billion. Now, the various parts of
Speaker 1: j DS you are still available and if you actually
Speaker 1: add them up, there's probably went to your thirty billion
Speaker 1: market kept there, so it's not the complete insane way about.
Speaker 1: I think I two Technologies were sold at the end
Speaker 1: for seven million. If you go back to the second
Speaker 1: tier tech names, they were just insane, right, That is,
Speaker 1: if you actually had revenue, like Cisco. Cisco was one
Speaker 1: of the first ones to break, and the reason it
Speaker 1: was one of the first ones to break is that
Speaker 1: it actually had revenue and it told you the world
Speaker 1: wasn't quite as good as you thought, and so they
Speaker 1: stop went down a lot. Right, There was that period
Speaker 1: where profits were about you in a really good bubble.
Speaker 1: Profits are a bad idea because then you have a
Speaker 1: fantasy about it. But the tech bubble got to the
Speaker 1: point where revenue was a bad idea, right, because then
Speaker 1: you'd have a fantasy. You couldn't write what you really
Speaker 1: wanted to measure with something like eyeballs, potential growth, potential growth,
Speaker 1: And if you bought the stuff that was the second tier,
Speaker 1: then the wipeout was far more spectacular. That was much
Speaker 1: more overvalued than anything i'm seeing now. That said, all
Speaker 1: the old economy was priced at seven or eight times earnings.
Speaker 1: There the years two thousand to say two thousand and
Speaker 1: six were the years in which the naive champion bearded
Speaker 1: self righteous value investorout the FORMT. I know a few
Speaker 1: of them. I'm sorry, the bearded self righteous value investor.
Speaker 1: Is that their official name? No, but that's what they are.
Speaker 1: You see them. They were they're just cheap and they
Speaker 1: liked buy cheap stocks, right, and they're very obsessed by
Speaker 1: pe ratios. Several of them owned things that looked cheap,
Speaker 1: like Jase Bank and right. They also wear cheap suits.
Speaker 1: They'd like to be buffet acolytes, and they all meet
Speaker 1: up at the Berkshire Meeting. I've been been to this
Speaker 1: Berkshire meeting. Several of these people are my friends. Right,
Speaker 1: they're almost the cliche of they start with the valuation
Speaker 1: and they'd buy almost any old economy stock at seven
Speaker 1: or eight times earnings, and for the next five to
Speaker 1: seven years they just did wonderful, right, They outperformed like crazy.
Speaker 1: And a lot of the things that they owned were
Speaker 1: cheap and bad. So the same people often. You know,
Speaker 1: if I take a look at long Leaf, which is
Speaker 1: a fairly decent, well known mutual fund, I don't think
Speaker 1: they have beards, but it falls into the same camp.
Speaker 1: Long Leaf owned a whole lot of things that look
Speaker 1: cheap and went to zero, right, the sort of general
Speaker 1: motors stuff, and you know, sometimes cheap as cheap for
Speaker 1: a reason. But at that time, the whole old economy
Speaker 1: was cheap, and if you just bought the old economy,
Speaker 1: you did really well. And you know, some of the
Speaker 1: misvaluations in were crazy. You go have a look at
Speaker 1: the New York Times or any other newspaper. And newspapers
Speaker 1: hit their highest valuation ever in two thousands, just as
Speaker 1: their business model was about to dismantle. And I actually
Speaker 1: asked somebody at one stage, a sort of check analyst,
Speaker 1: why all these newspapers were valued so highly. And the
Speaker 1: answer came back, looking at me weirdly, is it? Well,
Speaker 1: they have websites, don't they? People look at their websites. Right,
Speaker 1: There were tech plates at that time because they all
Speaker 1: of them were going big on the internet in some
Speaker 1: way or each other. The overvaluation this time is not
Speaker 1: as bad as that time. It's just broader. Right in
Speaker 1: that time, if you just did the naive thing and
Speaker 1: bought the ten times earnings or nine times earnings old
Speaker 1: economy stocks including there, I say at Wells Fargo, you
Speaker 1: just did fabulous, right. And the most naive, self righteous
Speaker 1: value investor, the one that seems to think that any
Speaker 1: growth stock is risky but value stocks are not, right,
Speaker 1: did great guns for five kids? Mhm this time? You
Speaker 1: know I want to be a self righteous beard and
Speaker 1: value investor, I really do. But the only things that
Speaker 1: look cheap, thanks, And I've just given you you know
Speaker 1: my angst feeling about them, my own two banks. I
Speaker 1: also earn a little slither of a company called Power
Speaker 1: Corps Corporation of Canada. None of this I've ever disclosed.
Speaker 1: For that they they look really cheap, and I don't
Speaker 1: think they're problematic. The problem with cheek stocks is cheap
Speaker 1: stocks are often problematic, and you can get yourself very trapped,
Speaker 1: as every beard and value investor is once discovered. Okay,
Speaker 1: so talk to me about how you actually go about
Speaker 1: selecting companies in an environment of ultra low interest rates
Speaker 1: as we've discussed, but also generally broad high expensive valuations.
Speaker 1: Actually I tend not to start with the valuation at
Speaker 1: all my general view, as I start with the business.
Speaker 1: And there are some business models that you just want
Speaker 1: to own at some stage. The best business model in
Speaker 1: the world is will develop global scale, will share the
Speaker 1: better scale scale with their consumers. And it's also the
Speaker 1: hardest business model in the world twine, especially as a
Speaker 1: hit as a bearded value investor. And the reason is well,
Speaker 1: the iconic example is, of course Amazon. But if you
Speaker 1: look at Amazon in two thousand and two, it just
Speaker 1: sold books, It made small losses, it was growing very fast,
Speaker 1: and if Jeff Bezos had told you where he was going,
Speaker 1: he would have sounded insane. Right now, it wasn't in
Speaker 1: Jeff Bezos's interest to tell you where he was going,
Speaker 1: because if he told you, he sounded insane. People and
Speaker 1: to some weirdo out there, they might think, oh my god,
Speaker 1: I want to get there too, and so he'd induced competition.
Speaker 1: If you're Jeff Bezos in two thousand and two, the
Speaker 1: job is to grow as fast as possible, subject to
Speaker 1: the constraint you don't run out of cash, and you
Speaker 1: want to get big before or your competition get there.
Speaker 1: And the problem with that from a value investors perspective
Speaker 1: is the optimal profitability is zero. So what you have
Speaker 1: to do is buy a high growth, zero profit company
Speaker 1: that doesn't tell you what it's directions. This is the
Speaker 1: hardest thing in the world to do, but I'm always
Speaker 1: on the lookout. Right. Problem is I don't have any
Speaker 1: right um that that. Well, I have a few, but
Speaker 1: I don't want to talk about them. And the other
Speaker 1: thing is if I told you what I thought about
Speaker 1: them might sound insane. The other thing is that if
Speaker 1: they don't not go in that direction, I want to
Speaker 1: sell them before the d rate. So it's not in
Speaker 1: my interest to tell anybody for the same reasons it
Speaker 1: wasn't in Jeff bezos Is interest to tell anybody. The
Speaker 1: second sort of model that I look at all the
Speaker 1: time is what we call the trifecta. If you are
Speaker 1: a small but important part of the big thing, you're consumable,
Speaker 1: and you have a high switching cost, you make a
Speaker 1: packet of money. The problem with these trifectors, and I'll
Speaker 1: give you a nice example, is an English one called
Speaker 1: Crowda right, which we own and Croda makes active ingredients
Speaker 1: for cosmetics. It does a lot of other things, but
Speaker 1: the original ingredient product was active ingredients for cosmetics. It
Speaker 1: turns out there are recipes almost every face cream that
Speaker 1: can answer the medical question visibly reduces the appearance of wrinkles,
Speaker 1: has it in it ingredients that are extracted from war Greace.
Speaker 1: Now there are Egyptian recipes for war Greace makeups or cosmetics.
Speaker 1: And they were stuck, and so the woman would put
Speaker 1: this really smelly face cream on and sleep somewhere a
Speaker 1: long way away from her husband. Helena Rubinstein, you may
Speaker 1: not know, was in Australia. She grew up in sheep
Speaker 1: Country and western Victoria, and she originally started making cosmetics
Speaker 1: from Greece. She extracted from sheep sheep sheds in Australia.
Speaker 1: It also all stunk. The first company that pulled out
Speaker 1: the active ingredient was Croda, which was a little company
Speaker 1: in Ghoule, East Lancashire and sheep Country in the north
Speaker 1: of England. And you will know the name of it.
Speaker 1: It's Landlord, but there's about seventy derivatives of Lanoline and
Speaker 1: Landeline is the basis of the modern face cream industry
Speaker 1: because it made a face cream that worked and instink.
Speaker 1: Now Crowda has a fairly high switching cost. Sheep do
Speaker 1: things that are nasty. They walk through paddocks which have
Speaker 1: herbicides and pesticides in them, and if you are not careful,
Speaker 1: you'll get her decides and pesticides into the face cream.
Speaker 1: And a sort of bad day for a Lorreal brand
Speaker 1: manager might be um recalling your product because it has
Speaker 1: pesticides in it. So if you're the Loreal brand manager,
Speaker 1: you want to be really sure of the provenance of
Speaker 1: your supply chain. Croda buys almost all the war grease
Speaker 1: from all the sheep in Australia, in New Zealand, ad
Speaker 1: buys it in China and it's small batch processes that
Speaker 1: and it does the chaos monkey type testing where it
Speaker 1: puts contaminants in it to make sure that the tests
Speaker 1: final the contaminated batches as well, right, so that it
Speaker 1: knows and it's never had a product recall, and it's
Speaker 1: testing procedures are extremely rigorous. And if the question is
Speaker 1: do you pay twenty five cents for the commodity one
Speaker 1: or fifty cents for the crowd for the Croda ingredient
Speaker 1: in your fifty loreal face cream, it's a no brainer
Speaker 1: for the lore L brand. Actually, they're going to buy
Speaker 1: the Croda product problem for a potential. Right, So you
Speaker 1: have a small part of the big thing. It's the
Speaker 1: critical ingredient. It has lots and lots of pricing power
Speaker 1: because the brand manager doesn't want to change. The other
Speaker 1: thing is the brand that it's selling to is an
Speaker 1: incredibly fat margin product. So when you're selling a fat
Speaker 1: margin ingredient to a fat margin product company, you just
Speaker 1: sort of make double margin. And Crowder maybe the best
Speaker 1: chemical company I've ever seen. I start with a model
Speaker 1: like that. The only problem is that Crowder also trades
Speaker 1: at five times revenue, and revenue is not growing very fast.
Speaker 1: And it is a chemical company, right, It's not quite
Speaker 1: the ten times revenue that Sun was at the height
Speaker 1: of the dot com bubble, but it ain't evaluation that
Speaker 1: should make you comfortable. Now, the way we choose stocks
Speaker 1: hasn't changed, which is that we start with the business model. Right.
Speaker 1: I'm not interested in owning a bank, but I am
Speaker 1: interested in earning a bank in an oligobalistic market, right
Speaker 1: because there's something that it's got. I'm not interested in
Speaker 1: owning a modity chemical company, but I am interested in
Speaker 1: owning a specially chemical company that has something that makes
Speaker 1: you not want to change to the competitor. We start
Speaker 1: with that, and then we go to the valuation. And
Speaker 1: the problem is at the moment that every time I
Speaker 1: go to the valuation, I start getting this slight queasy
Speaker 1: feeling in my stomach. I used to get uncomfortable buying
Speaker 1: specialty chemical companies at two and a half times EV
Speaker 1: to sales, and I now get uncomfortable buying them at
Speaker 1: four times EV to sales. Specialty chemicals is an area
Speaker 1: that I know a lot about, and I can't find
Speaker 1: anyone that I like that's trading it less than four
Speaker 1: times EV to sales. And this is true of business
Speaker 1: after business in the area that I have genuine expertise.
Speaker 1: Now I know that there must be some cheap sector
Speaker 1: out there, but it's not one that I have expertise
Speaker 1: in except for banks, and banks are a scared one
Speaker 1: because with banks, when you're wrong, you're really, really, really wrong.
Speaker 1: If if I go back to that article in The
Speaker 1: Economist which basically described Lloyd's as having the problem of
Speaker 1: just generating way too much capital and making way too
Speaker 1: much profit. And it had so much profit that it
Speaker 1: didn't know what to do with door right, and so
Speaker 1: it was buying back stock or giving it to shareholders
Speaker 1: in huge gobs. If you told me that ten years
Speaker 1: later that bank would be bankrupt, it would not have
Speaker 1: believed you. If I'm wrong about Crowder, it's going to
Speaker 1: d rate by half. If I'm wrong about a bank,
Speaker 1: I'm going to get a big fat zero. The other
Speaker 1: thing is that changes the risk management. You know, there's
Speaker 1: a Warren Buffett saying that if you liked at ten dollars,
Speaker 1: you should really love it at six dollars, so you
Speaker 1: should buy more. And every Harry faced value investor does that, right,
Speaker 1: That is they buy on the way down the As
Speaker 1: a famous photo of poor Tutor Jones, there's a young guy,
Speaker 1: he's a trader, and in the back of his picture
Speaker 1: is that it's just stenciled on a piece of paper
Speaker 1: hanging crooked in the office is the phrase loses average losers.
Speaker 1: And at one end of the world you have Warren
Speaker 1: Buffett that says, if you loved it at ten dollars,
Speaker 1: you should be buying more at six. And at the
Speaker 1: other end you have poor Tutor Jones saying loses average losers,
Speaker 1: and they're both right. In times, Harry chested value Harry
Speaker 1: faced value. Investors also Harry chested Ones get themselves into
Speaker 1: trouble by doubling down and doubling down and doubling down again.
Speaker 1: The most famous example, of course, is Bill Miller, who
Speaker 1: doubled down on a I G many times to bankruptcy. Right,
Speaker 1: and Bill Miller had a record where he outperformed the
Speaker 1: S and P I think for eighteen straight years and
Speaker 1: then gave back all the excess performance in one Right now,
Speaker 1: I don't want to be building You're right, John, you
Speaker 1: mentioned buy backs, yes, And I want to ask you
Speaker 1: about this because it does feel like at a time
Speaker 1: when there is ample liquidity in the system and people
Speaker 1: talk about money essentially being free, and at the same
Speaker 1: time you have sluggish global economic growth, you do see
Speaker 1: a lot of companies doing buy backs or raising dividends
Speaker 1: because they don't know what else to do with their money. Apparently, well,
Speaker 1: not knowing what else to do with your money is
Speaker 1: actually the sort of half of the course for really
Speaker 1: good companies. And you know, if you have a look
Speaker 1: at Crowda, it's roes whatever it is, it's a very
Speaker 1: big number. It's return on assets is enormous, but it
Speaker 1: can't grow. So what's to do with its money? That
Speaker 1: does an acquisition or and it in the dividend or
Speaker 1: buy back. It is very rare that you find a
Speaker 1: really good business with really fast growth prospects. Right. So,
Speaker 1: in fact, historically the companies that I liked by generally
Speaker 1: generate excess cash and they generally return it collectively. The
Speaker 1: markets insane at this If you look at aggregate buy
Speaker 1: backs over the last thirty years, buy backs are highest
Speaker 1: when the markets high and their lowest when the markets low.
Speaker 1: The stock market went into net issuance mode during the
Speaker 1: GFC when the stock market was at its all time low,
Speaker 1: and at the moment it's at all time record buy
Speaker 1: back levels. So whilst they like companies that do buy backs,
Speaker 1: I'm quite aware that on average, buy backs are done
Speaker 1: very badly, and they're done badly by some of the
Speaker 1: companies I like as well. At this time, I'd be
Speaker 1: very jauned us about a company that's incurring debt buy backstock,
Speaker 1: because you know you could have done that a lot
Speaker 1: more rationally a while back. I have examples of companies
Speaker 1: that have brought backstock beautifully over the years. If you
Speaker 1: have a look at the tobacco companies, the tobacco companies
Speaker 1: for years and years and years traded at a very
Speaker 1: sharp discount because people thought tobacco was a bad idea.
Speaker 1: They're right. Tobacco sales have the number of Americans smoking
Speaker 1: has halved over twenty five years, and Philip Morris is
Speaker 1: like a ten x or fifteen x, some big number.
Speaker 1: And the reason essentially is that they got some pricing
Speaker 1: power and they brought back lots of stock at cheap prices, right,
Speaker 1: And that works all day. At the other end, you
Speaker 1: have a company which was very admired once and made
Speaker 1: the mistake of buying back a hundred and thirty billion
Speaker 1: dollars of stock over a decade and a half. Who
Speaker 1: is that General Electric? Of course, had General Electric only
Speaker 1: bought back a hundred billion dollars of stock, not a
Speaker 1: hundred and thirty. We wouldn't be having this discussion about
Speaker 1: General Electric. It would still be a perfectly okay company.
Speaker 1: It would certainly would be a less good company that was,
Speaker 1: And it's clearly made missteps along the way, the biggest
Speaker 1: of which is probably buying Alston. But you know, you
Speaker 1: can argue about what the missteps are. One of the missteps,
Speaker 1: for instance, is selling all the brands. And once upon
Speaker 1: a time there was a g appliance in every household
Speaker 1: pretty well in the Western world, and that was a
Speaker 1: pretty good branding exercise. And now those g appliances don't exist,
Speaker 1: and they just got rid of them because they were
Speaker 1: low margin businesses. But to got rid of mind ship.
Speaker 1: There are all sorts of little mistakes that they made
Speaker 1: along the way, but the biggest mistake by far was
Speaker 1: they just brought back way too much stock. Right, and
Speaker 1: G is my poster child for a company that has
Speaker 1: impaled itself on stock by backs. And you can go
Speaker 1: back to that tree and I've got it. It's a
Speaker 1: wonderful document. The three and activists pitch for G when
Speaker 1: G was about thirty dollars a share. Essentially, the pitch
Speaker 1: was the same as every other activist pitch, which is
Speaker 1: that they should leave her up and by even more stock. Right. Well,
Speaker 1: had they followed that advice, G would now be a
Speaker 1: big fat round zero. G is your poster child or
Speaker 1: bad buy backs. I've got a longish list of companies
Speaker 1: that have brought themselves back to a balance sheet which
Speaker 1: I would consider single B, and often they're often they're
Speaker 1: rated single bit. If you go back through long periods
Speaker 1: of history, the ten year cumulative default rate for companies
Speaker 1: rated double B is about thirty. The ten year cumulative
Speaker 1: default rate the company's rated single B is about and
Speaker 1: you know the rating agent, and I'm going to get
Speaker 1: the exact words here. The rating agency definitions are kind
Speaker 1: of interesting. It's investment grade if under the wide range
Speaker 1: of circumstances it's going to repay. It's junk or double
Speaker 1: B if there are reasonably likely circumstances in which it
Speaker 1: won't repay you. In other words, you'll get repaid if
Speaker 1: something doesn't go wrong. The CS they invert that, which is,
Speaker 1: under the wide range of circumstances you won't get repaid,
Speaker 1: and that the shorthand is you will get repaid if
Speaker 1: things go right, and the credit market is almost always
Speaker 1: open at the triple B level. When the credit market
Speaker 1: closes at the triple B level, the economy has very
Speaker 1: real and very sudden problems. The credit market is sometimes
Speaker 1: open historically at the double B level, and it's almost
Speaker 1: never open at the triple C level. This cycle, I
Speaker 1: have seen triple cs issue debt many times and single
Speaker 1: bs issued debt a lot. Now, the maths of it historically,
Speaker 1: and again these are very rough numbers because the junk
Speaker 1: debt people will probably laugh at my naivity here, But
Speaker 1: the maths of it is that triple bees used to
Speaker 1: trade at about three hundred basis points spread over treasuries,
Speaker 1: So you've got paid three hundred three ten basis points
Speaker 1: a year for holding it, but you had at cumulative
Speaker 1: default over ten years, so you'd lose three and a
Speaker 1: half percent of than a year, but you'd get a
Speaker 1: recovery on that. So the cost of it of earning
Speaker 1: the junk debt in credit was about one point seven
Speaker 1: percent a year, and you've got about three percent a year,
Speaker 1: so that there's one point three percent carry for owning
Speaker 1: junk debt. That's a reward on a diversified portfolio. It
Speaker 1: makes some sense as a banker. You got to the
Speaker 1: point here where looking just at historic numbers, that carry
Speaker 1: went to zero. This is of course irrational because the
Speaker 1: defaults all happen at the wrong time. If you held
Speaker 1: triple B double B is for a very long time,
Speaker 1: you've got that one point seven percent on average, but
Speaker 1: you've got all your defaults selectively in two thousand and
Speaker 1: two and two thousand and nine. Cash in two thousand
Speaker 1: and two and two thousand and nine is worth more
Speaker 1: than cash in two thousand and six and two thousand
Speaker 1: and nineteen because you can turn that cash into money
Speaker 1: into the market at very low valuations. Right, So whilst
Speaker 1: you've got a premium over a very large periods, the
Speaker 1: premium wasn't well timed. You really want to make money
Speaker 1: at bear markets, so you can use that money to
Speaker 1: buy things. It's really important. One of the problems with
Speaker 1: businesses that lose money in bad times is that they
Speaker 1: lose money at the wrong time. Liquidation businesses, by contrast,
Speaker 1: make money at the wrong time. So you know, the
Speaker 1: extreme version of that is Charlie Manger's company, the Dow
Speaker 1: News Wire, and it publishes bankruptcy notes. It's a legal
Speaker 1: public share that you and Charlie owns. Charlie Manger, not Birkshire,
Speaker 1: own's a very large amount of the company. And Charlie
Speaker 1: is the chairman of the board and he has an
Speaker 1: annual meeting where all the hairy jested value investors go
Speaker 1: and hairy faced value investors go and they all listened
Speaker 1: to Charlie and Charlie dolls them out wisdom. But the
Speaker 1: real trick with that company is it makes okay money
Speaker 1: over a cycle, but it makes it all when bankruptcies art. Right,
Speaker 1: it's like a hedge for the macro economy. Yeah, but
Speaker 1: then you've got Charlie Manger as your investor. So they
Speaker 1: made a whole lot of money when the when the
Speaker 1: markets were really low, and Charlie went and bought things
Speaker 1: with it, right, And in fact, if you go look
Speaker 1: at it, it brought almost all of its Wells Fargo
Speaker 1: on a single day, one day from the absolute bottom
Speaker 1: of the Wells Fargo stock price. And the real trick
Speaker 1: to that business is not only does it make money
Speaker 1: at the right time, but you have a really wise
Speaker 1: guy who invests money at the right time. Right the
Speaker 1: dollar doesn't care much how you make it. It cares
Speaker 1: like crazy when you make it. So talk to me
Speaker 1: about excesses in the debt market, which you just described,
Speaker 1: and how that impacts the stock market which you invest in.
Speaker 1: And I'm thinking of one of your most famous calls here,
Speaker 1: which would be Valiant. Valiant was a series of opaque accounts.
Speaker 1: It had all the famous adjusted earnings, and you could
Speaker 1: not work rationally from the adjusted earnings back together. You
Speaker 1: just had to trust them on that. The other thing
Speaker 1: about Valiant was that it was trading at ten times sales,
Speaker 1: and it was buying companies at ten times sales. And
Speaker 1: ten time sales is my favorite magical number. You really
Speaker 1: really need to be good to justify ten times sales.
Speaker 1: That Scott McNally quote is just burned into me. You
Speaker 1: had this thing trading at ten times sales, buying things
Speaker 1: at ten times sales with accounts that made no sense.
Speaker 1: The first thing we did was we tried very hard
Speaker 1: to reconcile the adjustedy adjusted a bit the number to
Speaker 1: their bit the number, and we found instances where they
Speaker 1: were like, there's no if saw butts about this. The
Speaker 1: first one we found was a trivial one. It was
Speaker 1: the Galderma Royalty. They had bought a business essentially from
Speaker 1: Nestle from Memory and they were selling stuff that goes
Speaker 1: in women's lips to make their lips puppier. But every
Speaker 1: dollar of sale they had to send five five cents
Speaker 1: of that just a small amount back to Nestle because
Speaker 1: they owed them a royalty. When they are working their
Speaker 1: adjusted A bit throughout, they didn't include that. Now it's
Speaker 1: an expense. Every dollar you sell you have to send
Speaker 1: five cents back. If you sell extra dollar, you have
Speaker 1: to send five cents back. Now they capitalize their estimated
Speaker 1: value of that and amatize and excluded it from their
Speaker 1: adjusted dedicta. Right. Then we found another one that was
Speaker 1: like that, and another one that was like that. Can
Speaker 1: I ask you on this point though, because whenever I
Speaker 1: have a conversation about adjusted earnings, what some people will
Speaker 1: say is, well, what does it matter because you have
Speaker 1: the gap numbers there anywhere? Valiant wasn't making gap profits right.
Speaker 1: In fact, I always feel like pulling them up right now.
Speaker 1: But the first gap profit that Valiant made was after
Speaker 1: it blew up, and in fact it was it was
Speaker 1: writing off deferred tax liabilities and writing off earnouts right,
Speaker 1: there were no gap profits. Without adjusted earnings, Valiant looked
Speaker 1: unprofitable and would have been judged as such by the market.
Speaker 1: There are times that adjusted earnings make sense. I'll go
Speaker 1: right back to the very beginning of my stock picking career.
Speaker 1: This was a very very much bearded value investor thing
Speaker 1: that a twenty two year old might think about. There
Speaker 1: was a company in Australia called Byron, and Byron invented
Speaker 1: the process for making synthetic emeralds, which is in fact
Speaker 1: that these things have turned up to be kind of useful.
Speaker 1: If you could make them large enough, you might make
Speaker 1: a set synthetic sapphire as a screen from mobile phone,
Speaker 1: which would make a sort of unscratchable screen. Um. They
Speaker 1: are used for the nose cone of cruise missiles, and
Speaker 1: the reason that their work is they're extremely hard and
Speaker 1: abrasive and the military doesn't care what they pay for them.
Speaker 1: But you can run the guidance system through the nose
Speaker 1: cone of the missile, so you can see through it
Speaker 1: without putting. You know, it's a sort of unbreakable window
Speaker 1: on a missile that's going extremely fast. But these were
Speaker 1: originally jewels, and I can only remember the numbers in
Speaker 1: price push in per share, but they'd spent about a
Speaker 1: dollar eighty per share building this whopping big plant, and
Speaker 1: they were amortizing the plant off, which was about twenty
Speaker 1: cents a share a year. They had these enormous projections
Speaker 1: for how much money they were going to make about
Speaker 1: selling these synthetic sapphires, and that didn't work out that way. Firstly,
Speaker 1: the Russians copied the plants, so you could buy synthetic
Speaker 1: sapphires from other places, and the military establishment copied the plants,
Speaker 1: and they also started selling synthetic sapphires. And then women
Speaker 1: started looking down their nose at synthetic sapphires anyway, and
Speaker 1: so you didn't get a big price premium for them,
Speaker 1: even though they were flawless. You've got a discount for them.
Speaker 1: In fact, a sort of flawed natural sapphire traded at
Speaker 1: a premium to a flawless, beautiful synthetic one. So the
Speaker 1: company never was never going to recover. In fact, it
Speaker 1: was going to lose money. But it was making about
Speaker 1: eight cents a share of operating cash flow, offset by
Speaker 1: the admortization of this plant, So I was declaring losses,
Speaker 1: but it had built up about twenty cents a share
Speaker 1: of cash. After all, the debt was trading at twenty
Speaker 1: cents and was making seven cents of cash flow a year.
Speaker 1: Was going to make losses forever now, the beau. The
Speaker 1: first adjustment was just adjust out the depreciation because it
Speaker 1: was a plant that I didn't pay for. I was
Speaker 1: paying twenty cents a share. The people who paid for
Speaker 1: the plant paid a dollar radia ship from my perspective
Speaker 1: of the earnings for seven cents a share right for
Speaker 1: the next ten years. And that's roughly how it turned out,
Speaker 1: except some rich guy bought control of the company and
Speaker 1: diverted the cash flows for his own years. But there
Speaker 1: was a perfect instance where I should ignore the gap accounts, right,
Speaker 1: and I should just look at what's really going on.
Speaker 1: And the world is full of those instances, right, But
Speaker 1: it's also full of people who, like Valiant, will ask
Speaker 1: you to ignore the Galderma Royalty. Now, the Galderma Royalty
Speaker 1: absolutely patently obvious that you shouldn't ignore it. And you know,
Speaker 1: when you're late in a ball market and people are
Speaker 1: hyping things, they'll ask you to ignore the most silly things. Ever,
Speaker 1: Byron was the example of a company which was loss
Speaker 1: making as far as the eye could see and was
Speaker 1: still worth a lot of money. So what would you
Speaker 1: And this is probably going to be the last question,
Speaker 1: but what would be your one piece of advice for
Speaker 1: people who have to put money to work in the
Speaker 1: market right now? With all this going on, you're asking
Speaker 1: someone that's finding extremely easy to find shorts at the
Speaker 1: moment and extremely hard to find longs. How I invest
Speaker 1: long at the moment? This is not an easy question.
Speaker 1: If you go back to the height of the tech bubble,
Speaker 1: if you've bought the top ten five names and you
Speaker 1: held them to now, you did okay. If you bought
Speaker 1: names five, you did terrible. It feels bad to pay
Speaker 1: a big price for quality, but in retrospect it's worse
Speaker 1: to pay an even bigger price for a junk. Right,
Speaker 1: So my gut reaction is probably leave half of the
Speaker 1: money to do something else with right, and in some
Speaker 1: sense rebalance A sixty forty portfolio would be a reasonable
Speaker 1: assumption and actually pay out for quality, because I think
Speaker 1: you'll not, because you do better paying up for quality,
Speaker 1: but you'll probably lose less, which is as you know,
Speaker 1: and you know over very long periods of time. My
Speaker 1: guess is the quality stocks will still produce returns that
Speaker 1: are adequate. If your idea of adequate is low single digit. Well,
Speaker 1: on that happy note, John Hampton, Franti Capital, thank you
Speaker 1: so much for being on offline. Thank you for having
Speaker 1: this has been a special edition of the Odd Thoughts
Speaker 1: Podcast down Under. You can follow me Tracy Alloway at
Speaker 1: Tracy Alloway on Twitter. You can also follow my co host,
Speaker 1: Joe Wisenthal at The Stalwart and you can follow our
Speaker 1: guest for the episode on Twitter, Mr John Hampton at
Speaker 1: John Underscore Hampton. You can also follow his blog Bronti
Speaker 1: Capital dot blogspot dot com. You should also follow our
Speaker 1: producer Laura Carlson at Laura M. Carlson, and you should
Speaker 1: follow all of Bloomberg Podcasts at podcast on Twitter, st