Economy & Forecasts

Happy Holidays to you and yours!

Here’s a small post before the holiday festivities.

Enjoy!

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I care about the economy, as most people do. I want the economy to grow. A growing economy means more jobs and higher salaries. More money in people’s pockets means more people can afford a home. Profitable businesses can re-invest in their growth and hire more people. Higher tax receipts mean the government can spend more on education, healthcare, and infrastructure. A good economy brings prosperity and raises the standard of living for everyone. That’s the wealth creation process. Or to put it plainly, “growing the pie” so you can have a bigger slice.

However, when it comes to investing, people are fixated on the economy. They tend to rely on forecasts to make investment decisions. This is extremely difficult. You have to get a couple of things right. You have to 1) Correctly predict an event, 2) Correctly structure the investment, 3) Correctly time the market, and 4) Correctly understand its implications and the chain of events.

Making predictions is the easy part. Calling a recession is easy. Pointing out that high-interest rates will lead to higher defaults is easy. Claiming that a company is overvalued because of the lack of growth is easy. Identifying that large deficit spending leads to inflation is easy. But getting the timing right, and the depth of the outcome, that’s tough.

And if you don’t structure your investment properly, that can be costly. Let’s say you found the perfect short candidate, you then have to find and borrow the shares to short. That can be expensive. Or instead, you buy put options. That comes with a specific target price and expiry dates. Again you have to be great at market timing. Remember, John Maynard Keynes gave us this warning: “The market can stay irrational longer than you can stay solvent.”

Worse, you nailed a prediction but the market went the other way because you misunderstood its implications. Even worse, you made a prescient call on a company’s sluggish fundamentals, and despite the lackluster results you watched the stock rally. It happens all the time. The market doesn’t care about your brilliant analysis. The market doesn’t owe you an explanation.

When you place money on a prediction, what ends up happening is that you become so obsessed with the outcome that you lose sight of what you are supposed to do: buying incredible businesses at a reasonable price and holding them for a long time. Even if it’s a little bit of money, the “bet” consumes your energy and time. It’s a distraction. The opportunity cost can be high because you could be doing something else with that money.

Let me dig deeper. Investing on predictions is a mistake. First, acting on predictions means you are deviating from your financial plan and sound disciplined investing. Second, nobody can accurately answer these questions: What’s the GDP forecast for next year? Will there be a recession? Will the economy have a soft or hard landing? Where will interest rates be next year? Will the central bank cut or raise rates at the next meeting? How many rate cuts are priced in for next year? The unemployment rate? Will inflation be within the central bank’s target? Where will the S&P 500 close? Nobody gets this right or the full extent of the implications. And putting money on the outcome is gambling, not investing.

Forecasters get a lot of attention. Their financial bite sounds good on TV. It drives headlines. But they are wrong, all the time. Nobody knows what the future holds. Matter of fact, where are the experts that correctly predicted the current state of the economy you are in? The strong consensus of the past couple of years was proved entirely wrong. It was a done deal that we were supposed to be in a recession right now. Nope, the economy is still strong. Just look at interest rates. No economists last year called the current level of interest rates. Sure, once in a while an economist will nail a prediction. If you predict 13 of the last 5 recessions, you will eventually be right.

I don’t ignore the economy and macro stuff. I quite enjoyed it. I read the news. I stay informed. I have an idea of the state of the economy. Understanding how an economy works is important and useful. But I’m not obsessed with it. I’m aware that I could be 110% wrong. And more importantly, I don’t make investment decisions based on economic forecasts. I never sold a stock because some economists think the GDP will shrink next quarter.

The economy is like the weather. People always try to predict it. Here’s what you need to understand: Some days it will be cloudy. Some days it will rain. On other days there will be a hurricane. Then it will be sunny. That’s the economy. Earnings will go up and down. Inflation will go up and down. Interest rates will go up and down. The market will gyrate up and down. The economy will grow and retract. Once you understand that, there’s a better approach.

Instead of calling for a direct event, prepare for possibilities and probabilities. Focus on companies that are prepared for everything. Since guessing is unreliable, it’s probably better to invest in a company that can withstand a recession. Or even better, companies that can roar out of a recession stronger.

The position you are in when you enter a recession will largely determine how you come out of it. Why invest in a company that would fall like a house of cards at the first sign of distress? Or a company that constantly needs external capital to stay in operation. What happens when that money source dries up? Would you rather enter a recession holding Berkshire Hathaway, a company in a position to get great deals because certain businesses are desperate for money, or a company that’s vulnerable to an economic contraction? Isn’t it preferable to hold companies that could perform well across all environments?

Nobody wishes for a recession. Recessions are terrible. The economy contracts and people can lose their jobs and their homes. Recessions happen. Does that mean you shouldn’t be invested in a recession? If you invest for the very long term, you will live through many economic cycles. I stayed invested through many cycles and I benefited. It’s not easy. A bear market is a fraught experience. But staying invested is superior to the alternative, which is getting in and out of the market. Long-term investors that stay the course, and can withstand the storm, are eventually able to reap the rewards.

Recessions can offer investment opportunities. It’s during these fearful times that you can buy high-quality companies at reasonable prices. If an asset is out of fashion, it means it’s cheap. What are they? Typical criteria to look for are a solid balance sheet and a steady business. They generate strong cash flows, maybe they pay a dividend, and their business is recession-resilient. Too simple? Well, how does a business go out of business? It dies because it runs out of cash. As a start, make sure your investment doesn’t run out of cash. When researching a particular company, go back in time and find out how it fared in the last recession. That should give you an idea of the character of the business.

A great investment shouldn’t be different during a recession or not. Some might disagree with that statement. Some said that during a downturn, you should seek “safe-haven” or “defensive” investments. And during a bull market, you should invest in growth. I take issue with that reasoning. It’s not necessarily wrong, but it’s flawed. Let’s say the consensus calls for a recession, well it’s probably too late to buy those “defensive” investments because the recession is price-in (e.g. “everybody now is the time to buy gold”). If you overpay for an asset, it loses its defensiveness and you are taking more risk.

Of course, when you invest in a business, you are dealing with the future. And when you deal with the future, you have to make certain assumptions. You have to determine future cash flows and how the business will evolve. You will likely be off. That’s why you should apply a large enough margin of safety. To protect yourself from unforeseen things and misjudgment. Unforeseen circumstances are part of life, aren’t they? A margin of safety can take many forms, like paying a discount to those future cash flows or making sure there are enough assets backing your investment.

At the end of the day, recession or not, the goal is to buy excellent businesses that generate growing free cash flow at a reasonable price and hold them for a long time. That’s the approach I recommend if you want better performance. It’s a better approach than calling direct events and marketing timing. If economists are so great at forecasting, why ain’t they rich?

Gold

“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head”. – Warren Buffett

Gold deserves its own post because it’s such a unique asset. It’s nice and shiny. We all want more of it. I happened to be in the vault of the Federal Reserve of New York once (the one that gets robbed in the movie Die Hard III) where they stash gold bars from governments from all over the world (my idea of fun in NY). I can’t explain the powerful feeling of having one of these 27.5-lb bars in your hand, but it’s really nice. But no, I’m not writing to reminisce about my past gold exploration. When it comes to investing, gold is a different story. There are many ways to think about gold. 

There’s gold, the physical shiny metal. It makes nice jewelry. Everybody likes gold. It’s beautiful. It’s timeless. It’s universal. It’s inert. It doesn’t chemically react. That natural perpetuity is what gives it permanence. If I could take a time machine and go back two thousand years, my gold would buy me some nice things. It’s safe to say that the lust for gold will be there in the future too. People have pursued gold for centuries. Medieval alchemists tried to turn metals such as lead into gold. People have killed each other for it. Scrooge McDuck has a money vault full of gold where he dives in. It makes people dream. And it makes spouses happy.

There’s gold, the industrial input. Because of its inherent properties, some gold is used in certain industrial processes. Gold conducts electricity and does not tarnish. There’s a little bit of gold inside the iPhone. Gold is used for cosmetic purposes, like in teeth (it doesn’t rust and I’ve seen it in music videos).

There’s gold, the lingos that central banks stash in their vaults. Central banks use gold to diversify their reserves. Central banks hold a lot of the gold ever mined. Gold can back a currency that is subject to swings in value. Gold carries no credit or counterparty risks, it serves as a source of trust in a country.

There’s gold, the money. Money can take many forms. Monetary systems evolve. In ancient times we used cowry shells. In a more recent time paper currency was backed by a reserve of gold and silver. Maybe in the future, we will use some blockchain cryptocurrency thing where you can program money.

There’s gold, the obsession. Some people are nuts about gold. They are called “gold bugs”. They are die-hard believers in gold. They advocate buying gold against an anticipated collapse in the currency or the world. They are all gloom and doom. They have cult-like behavior and none of it is grounded in rational behavior. They have a distorted view of the world and they believe it. That strong belief is what makes them very convincing. Gold bugs say that you should hold gold in case the “world goes to hell”. The parameters of what that means are quite large, but if it’s related to surviving, I lean towards guns, gas, food, and water. With that gold will come your way.

And there’s gold, the investment. Gold is often touted as a “safe haven”. A safe haven is where investors stash their assets when share prices crash, economies collapse, or when inflation wipes out a currency. A safe haven is supposed to preserve its owner’s capital. Safe havens are supposed to hold their value when nothing else is. Other safe-haven assets could be physical things like land, real estate, art, or other precious metals. You can print money, but not gold, or land.

Gold has been prized as a store of value for millennia. But can it be trusted? At the time of writing, the year is 2023, and saying we live in a period of uncertainty is a bit of an understatement. It’s the gold bug dream environment. The one where you park your assets in gold. The ingredients are there. We have a war in Europe. We have nuclear threats from Russia. Iran is getting nukes. China is challenging the world order. The Middle East is blowing up. The economy might fall off a cliff. We have massive environmental problems. We have energy issues. Governments are running massive deficits financed by printing way too much money which leads to inflation and higher national debt which needs to be financed with more borrowed money. I could go on.

I might be overdramatic for effect but according to the gold bug’s doomsday checklist, it sounds like there’s never been a better time to buy gold. If I were a betting man, everything is lining up for gold to skyrocket in price and the dollar to crash. But nope. It’s that easy. Despite the apocalyptic atmosphere gold price is down 22% in 2022 and is barely flat for 2023 so far. And the dollar is up. What else do you need for gold to perform? That’s what I mean by “can it be trusted?”

Yes, gold makes nice jewelry and looks impressive in a vault. But it has its inconveniences. It doesn’t have an income stream. It doesn’t pay interest. It’s hard to value. It’s hard to use for everyday spending (it’s heavy and unsafe to carry around). You need a couple of guards if you are a baller. You need a safe to store it. You need insurance. Gold doesn’t always perform when it’s supposed to (like in moments of high inflation and crisis). Over long periods, gold has been a poor asset to own.

Gold at Work

I’m not dismissing gold, or other precious metals by extension. I have seen gold at work. When I was abroad in emerging countries like Cambodia and Vietnam, many locals kept their assets in gold, other precious metals, or US dollars. There’s also the increased use of crypto-currencies, a gold proxy for some. 

There a several reasons for this. First, the last thing you want is to stash your capital in local currency that is eaten away by high inflation. Or worse, at the risk of being confiscated by the government. That’s fast-tracking yourself to poverty. Second, you risk having your emerging market currency not being recognized. As in nobody wants it. Try showing up at your local bank branch with a bag full of Cambodian Riel notes, you will be welcome with a recycle bin. Or try using rubles outside of Russia. You might say it’s not fair, but turn the table around, do you want somebody to hand you a bag of Cambodian paper or US bills? Do you want to take the counter-party risk? I didn’t think. But gold is universal. You don’t have to explain what it is. Nobody turns down gold. And last, some countries have capital control in place, making it harder to move your money internationally. 

That’s gold at work. I don’t blame them. I would have done the same thing as them if I was in their shoes.

Fiat and the US Dollar

The subject of fiat currencies comes up when you talk about gold. Fiat currencies have major flaws. High inflation can erase a fortune very quickly. Inflation is brutal on purchasing power. We all heard the story of what grandpa could buy with $1 in his youth. Governments constantly renege on their paper promises. Economies are mismanaged. Some default. Some redefaults. Some are invaded. But there’s one currency that’s king: that’s the US dollar. Why?

Because the US dollar is the world’s reserve currency. The US possesses unique strengths. It has the strongest economy and the greatest capital markets giving the US an edge on global capital flow. Everybody loves the greenback. For those who are saying that the US dollar is worthless, I don’t see any of them throwing it in the trash.

Sustaining the achievement of world reserve currency status will be a challenge. One day the dollar’s position as the world’s reserve currency could be lost. It happened to other currencies in the past. I don’t know what form of payment we will use one hundred years from now. But today the US dollar is what makes the world go round. Despite the massive deficits and the money printing, the world relies on the full faith and credit of America’s Treasury Department (so far they pay their debt). Sure, we can trash the US and their “worthless” paper, but I don’t see anybody turning down a US$20 bill.

Inflation is a major issue if you are holding cash. That dollar loses value over time. But despite what you read, stashing all your cash in gold is not a sound strategy. A better solution to inflation is to buy assets that grow and produce income, like companies with pricing power. Companies with pricing power have the competitive advantage of protecting their margins and passing on increased costs to customers. Maybe the company has a great brand, lacks competition, or simply has inelastic demand like gas and cigarettes.

Here’s a story to make my point. You probably never heard of  Ronald Wayne. He’s the little-known third co-founder of Apple, with Steve Wozniak and Steve Jobs. The Steves were kids in their 20s when Apple was founded in 1976 and Ronald, almost twice their age, acted as the “adult” in the room. After twelve days he bailed and sold his 10% stake for $800 and used it to buy gold. In a 2014 Bloomberg article, Wayne said that his savings have been in gold for 40 years and live off of his Social Security checks. At the time of writing, Apple is a $2.4 trillion company. A 10% stake would have made him one of the richest men in the world. As for his gold stake, I’m going to be generous and estimate he doubled his money.

I can see the pushback. Obviously, I cherry-picked the example just to prove my point and hindsight is 20/20. It’s never that easy. I could easily have gone the other where his $800 equity position became a zero. Gold does have shiny moments, like in the 1970s. In 1971 gold traded at US$35. By the end of that decade, gold touched US$850. That’s a 2,300 percent gain in the 1970s.

Gold in your Portfolio

Part of gold’s attraction comes down to personal preference. Some have strong feelings about it, others less so. For some, the gold investment shows up in jewelry, others in mining stocks or royalty companies.

The elevator pitch on gold is “If the financial system collapses, well you still have your physical gold.” First, that’s a crappy elevator ride. Second, if the financial system collapses, we might have larger problems than the price of stocks. But I get the point. You want assets that are not correlated or linked to the financial systems.

Gold has drawbacks:

• No matter what price you forecast, it’s going to be wrong.
• Gold is volatile. You are betting that the price will go up. Gold is shiny and beautiful but it doesn’t guarantee high returns.
• But what’s the intrinsic value of gold? Nobody knows. How do you know it’s not $500/oz or $3000/oz? 
• Part of what drives the price of gold is fear. It tries to play the role of a ‘safe-haven’.
• If you are seeking income from your investments you might find gold less attractive since it doesn’t generate income. 
• Investing in gold means allocating funds away from other potentially lucrative investment opportunities. 
• And gold doesn’t always shine when it’s supposed to.

Gold does have a spot in your portfolio. Gold has been considered a reliable store of value for thousands of years. Gold is intended to serve as a potential hedge against adverse markets. It has a low correlation to the business cycle and other asset classes. It should play a stabilizer role. If you have some gold you can put it to work in very distressed environments and convert it to the ownership of enterprises on very advantageous terms. Gold has survived the test of time. And there’s one gold.

On that, I will you this Charlie Munger quote:

“I don’t have the slightest interest in gold. I like understanding what works and what doesn’t in human systems. To me that’s not optional; that’s a moral obligation. If you’re capable of understanding the world, you have a moral obligation to become rational. And I don’t see how you become rational hoarding gold. Even if it works you’re a jerk.”

Buybacks – Blame the Governance, Not the Tool

There’s nothing inherently wrong with buybacks and returning capital to shareholders. But can buybacks be abused? Of course. Like anything else. But it’s a governance problem. It’s not because the tool is wrong. Share buybacks is a board decision. Directors have to approve the buyback. Management decides the level and timing of share buybacks. The key question is “Is the board fulfilling their fiduciary duty in acting in the best interest of the corporation?” Or are they acting in their own self-interest?

One legitimate criticism of buybacks is that companies tend to be bad market timers. They reduce buybacks when their stock is suffering and boost them when the stock is riding high. Lumen Technology comes to mind. In 2021 Lumen spent $1 billion buying back shares around $12 but when the stock was traded at $2 two years later, the buybacks totally stalled. With that approach, Lumen destroyed a lot of value. Henry Singleton did the opposite: Buy low, sell high.

Another governance problem is using buybacks as a tool for financial shenanigans. Keep an eye on executives using buybacks to boost their compensation. If part of management compensation is linked to growing EPS, it’s one area I would for potential buyback abuse. Buyback shares and boost EPS. Boost EPS and you boost the share price. Boost the share price and you boost the value of management’s stock options. Another financial shenanigans game is using buybacks to hit quarterly EPS. Short-termism is the enemy of long-termism.

While there is nothing wrong with returning capital to shareholders and boosting the stock price. Buybacks should be used only if other uses of capital have been optimized and the share price is undervalued. Sometimes it’s obvious that the buybacks are excessive. Sometimes it’s not. I would look for if the board has adopted a capital allocation framework. It brings capital allocation discipline. It should be part of a broader long-term strategy. And look at past decisions to see if it’s been respected and their impact. It should give you enough clues on whether they are disciplined or wasteful.

But as I mentioned, the problem is not the tool, it’s a governance issue. Directors should fulfill their fiduciary duty and focus on the economics. When buybacks are misused, it’s a loss for society because all the stakeholder loses.

Berkshire Hathaway and Fairfax AGM

A couple weeks ago I attended the Berkshire Hathaway AGM and the Fairfax AGM back in April. I’ve documented some of my past trips (here, here, here, and here ). And the Internet is full of reviews of people who have been. Every time the experience is similar and different.

It took me a while to get this post going. A month actually. I was wondering what can I write about the meeting that hasn’t been written? What is there to say that hasn’t been said?

Regarding Berkshire Hathaway (BRK), the substance of the meeting has been decorticated and analyzed. I won’t rehash what has been said. However I will touch on two points: 1) Buffett provided the closest thing to earning guidance. He expects earnings to be down. 2) Some people said that Buffett, the ever optimist, had a pessimistic tone. In a sense it was true and uncharacteristic of Buffett. But I think what he said has been misquoted through the doomsday clickbait. What’s been overlooked is that he also said that if you believe in what made this country great, you will do fine too. He’s always reiterating that it doesn’t make sense to bet against America. He repeated multiple times that the USA is where he would choose to be a newborn.

Regarding the Fairfax AGM, it was a good meeting. It’s similar to BRK, but on a smaller scale. It was good to participate in various events and reseeing friends that I haven’t seen in a long time. Like the BRK AGM, over the years an ecosystem has been built around the Fairfax AGM. 

Instead of repeating what has been said about the BRK AGM, I’ll touch on a couple observations. Little things that don’t necessarily get covered.

“The Meeting is Online”

When I tell people that I’m going to Omaha for the BRK AGM, some have to remind me that the meeting is online. Thank you for the reminder. I’m not in Omaha by mistake. Usually the comment is made by someone who has never been. I understand the intent. But we all know that a Zoom meeting is not the same as a physical one. If you have been to Omaha, well you know.

If you have seen your favorite artist perform live, you know it’s not the same as streaming their music.

Going to Omaha for the AGM is not the point. It’s bigger than the meeting. I can catch the meeting later on Youtube here, which I do for parts of it.

So why go?

If you are a serious investor, or a student of investing, and you want to improve, I highly suggest you attend at least once.

But the biggest reason is The People.

It’s about the people. The events. The networking. To see friends and make new ones. There are people from all over the world. There are not many occasions where I can talk shop with people from China, Singapore, Europe etc…

There’s a massive intangible impact. I came back with a bunch of investment opportunities. Ideas. Stuff to work on. And hopefully I’m smarter and better.

Investing is a little bit of a lone wolf endeavor. It’s a lonely quest. Yeah, I meet and talk to other investors. But not everyone. You just can’t. In Omaha, it feels like everyone is there. 

During my 4 days in Omaha,  I had a bunch of meetings, but you need to leave some space for happenstance. You never know who you are going to meet.

I ran into Jim Pattison, the Canadian billionaire. Here’s a  good Globe and Mail article on him. There’s a little of a story here, but to make to short, I bought him an ice cream. 

This lucky billionaire got an ice cream from me

Diversity of the Crowd

The BRK AGM has been dubbed the “Woodstock for Capitalists”.

It carries its name well.

It’s not just a value investing fest. There’s all kinds of investors. Venture capitalists, quant people, students, day traders, whatever style, you name it, it’s there. You have Buffett/Munger fan boys. You have people who are curious that have no investments. You also have investment managers and different businesses promoting their own funds/business with various events.

I even stumbled in an Oracle meeting. 

Oracle: “Are you with Oracle?” 

Me: Oracle? No. Why is Oracle here?

Oracle: “We are meeting executives from BRK businesses…”

So on top of the various kinds of investors, and BRK executives, you have sales people targeting them.

Exhibition Hall

I was a little disappointed with the exhibition hall this year. If you like shopping, then you would love it. But I don’t care much for the shopping, or massive line ups. What I like about the exhibition hall is meeting the managers of the various businesses and picking their brains. I used to do that during the BRK meeting. I would go to the exhibition floor when it was quiet and just talk to the managers.

In past years, I felt a balance between shopping and business information booths. You could walk around and learn about some of the businesses BRK owned, both small and big. This year, shopping dominated. The stores, like See’s Candy, took a lot of space. And they were all packed. Overcrowded. Even during the AGM.

The show stealer this year were Squishmallows, a business that came with the Alleghany acquisition. These things sold like warm bread.

Squishmallow throne

Security

A notable change since I started going in 2015 is security. In 2015 I didn’t see any. I’m sure there were some, but I didn’t notice it. You could walk right into the exhibition hall. Buffett and Bill Gates would walk around in the crowd. Those days are over. 

Now security is tight. Buffett doesn’t roam around in the exhibition hall visiting businesses and meeting investors (I’m sure age is a factor too). You and your belongings get screened when you walk in. There’s a lot of armed security and cops with AR 15. Snipers in the rafter during the AGM. Unfortunately that’s the new normal.

The BRK AGM has always attracted a crowd of protestors. It’s a blend of groups and they have gotten more zealous over time. Ranging from NetJets pilots demanding higher wages to pro-life protesters, conspiracy theorists, and environmentalists. Looks, it’s fine. I don’t have a beef with any groups. You can believe in whatever you want. They are allowed to be there protesting. It’s a free country. It’s your right. But why are you screaming at people? In some cases insulting them. Here’s a tip: If you are trying to get somebody to your side, screaming at them won’t help (I’m not talking about the Netjet pilots here). I talked to a NetJet pilot at the picket line. Nice fella but doesn’t seem to be convinced in his cause.

I remember you could just ignore them. Now, some of them are yelling at you. I’m not trying to misportrait or scare you or anything. It’s a minority of people. It’s just an observation. This year they changed how you wait in line for the meeting so you don’t have to be yelled at.

Uber

Uber ride from the airport: “You’re from Canada! Do you know Bret Hart?”

It can be expensive getting around Omaha during BRK AGM. Fares fluctuate a lot. But there’s also the hidden fees. Maybe I’m not using it right, but I only see the full fare later once I’m billed.

Despite that, it’s still a superior offer to taxis. I had a great chat with the drivers and they are a great source of local intel.

Cinco de Mayo

Mexican Independence day. It’s the first time I notice it, but that Mexican holiday became a major party in the USA. I just can’t get my head around a bunch of Midwesterners celebrating a Mexican holiday. Maybe it’s like a new St-Patrick day.

“You coming out for Cinco de Mayo?”

Do we need another excuse to drink?

Stock Pitch

I attended a “stock pitch” event. It was informal (no slides). Everyone had to bring an idea to share and discuss. I won’t go over all of them, but let’s just say that there were a lot of global micro caps that I never heard of. As the event went on, it felt like the market cap of these companies kept getting smaller and smaller. Somebody pitched a $2 million market cap company. I said I have a smaller one, a small bank called First Republic, and it’s a zero. 

The Bank Thing Part II

“I just lost half my money to this banking thing.” – Sharon Stone (Twitter)

This is Part II of the Bank Thing. You can read Part I here.

In The Bank Thing, Part I, I peeled layers of the onion and tried to explain in a simple way how this banking mess got started. A lot happened really fast. In this post, I will give an overview and comments on banks, bail-outs and bail-ins, deposits insurance, moral hazards, the Federal Reserve, DeFi and on why you should care. I’ll try to keep it brief and simple.

Banks are Different Animals

Banks are not like a traditional business. A traditional business manufactures goods and provides services. A typical balance sheet consists of inventory, receivables, plants, equipment, payables on the left side of the balance sheet (you also have intangibles and goodwill but let’s keep it simple), and on the right side the liabilities and equity that funded the assets.

A bank is a different business. A bank doesn’t make anything. If anything, they manufacture financial products like mortgages and certificates of deposits. At its core a bank is where demand and supply for capital meets. You have excess cash? You can park it at the bank and get interest. Need money? You go to the bank and pay interest.

A bank is in the business of providing capital to businesses that provide goods and services and to individuals that want to buy a home and a car. The money the banks loans out comes from the deposits. Deposits are a liability for a bank and its money they owe to depositors. On the asset side, you have loans and investments that are funded by the deposits. As I explained in the last post, banks want to maximize profits. They do this by making long duration loans that earn the most interest, and short-term deposits that pay the least amount of interest. This approach maximizes your net interest margins. However, maximizing these two items can lead to serious trouble. You run into a problem called asset-liability mismatch because you finance your loans with short-term money that can disappear. And if you don’t manage that risk very well it can kill your bank. How you manage your assets and liabilities is one of the most important jobs a bank has.

Banks are important. Banks are an economic pillar. It helps capital move between savers and borrowers. It provides the blood flow of the economy. A sound banking system is important to a healthy economy. That’s why when a bank collapses, it’s not to be taken lightly. There’s a potential contagion effect. It can cause enormous economic damage. And depending on the bank size, the counterparty risk can be immense. A small problem can turn into a big one very quickly. Think of the domino effect. Your bank fails and you don’t have access to your money, then you can’t make payroll, pay suppliers and your mortgage. And as a result, they default on their obligations and so on. A bank failure can be the spark that starts a wildfire. Some banks are so massive that if they fail they create a massive blackhole that takes everything down with them, like in 2008. They are called “too big to fail.”

A healthy banking system is built on confidence. Confidence is the currency of banks. That’s what we have right now, a crisis of confidence. If people don’t trust putting their money in the bank, or worse, they start pulling it out en masse, you are potentially faced with an economy on the brink of falling into a tailspin. The litmus test is: can you sleep at night?

If you are a finance person, you know that these few lines don’t fully capture the complexities and nuances of a working bank. I just wanted to lay the groundwork to make sure we have a basic understanding.

What Do I Care?

You might wonder what do I care if the market is down? Or a bank or two fails? You might say “I don’t own stocks”, or “I don’t have money in that bank”, none of this affects me. Maybe my point didn’t get across in the previous paragraph. Sure, the failure of SVB doesn’t affect you directly, but it impacts you indirectly more than you think.

There are many ways I could go about this. History is a great teacher. I think a brief summary of the Great Depression can provide some answers to the question “why should you care?” I feel that the circumstances that led to the 1929 stock market crash are similar to the speculative boom of the last couple years we just experienced. Mark Twain said that “History never repeats itself, but it does often rhyme.” Just so we are clear, I’m not predicting a financial crash and an economic depression. I’m making a point on bank failure and its impact.

In 1929 the stock market crashed and the Great Depression began. It is estimated that less than 2% of American households had money in the market. It wasn’t like today where the average person can get started with $500 and buys an ETF. Back then you had to deal with a stock broker, and to have a broker you needed to be wealthy, and to be wealthy you needed a lot of money. Let’s work with the idea that 90%+ of the population wasn’t involved in the stock market, why would they care about a market crash? So it’s October 1929, the stock market crashed, everyone is poor and waiting in line for bread. Long story short, during the period commonly known as the Roaring 20s, were good times. People borrowed money and speculated. Assets prices were going up, which fueled more borrowing and more speculation, which further pushed assets prices up, and so. Eventually the good times, indulgence and rosy outlook weren’t sustainable and the whole party came crashing down. 

When the value of these assets collapsed, loans went bad, which caused banks to suffer significant losses and fail. And here’s the kicker (more a kick in the nuts): There was no deposit insurance. That means your money disappeared when a bank failed. Back then a lot of thoughts went into which bank you pick to park your money because bank failure was a frequent thing. The way you usually picked a bank was to find out where the rich kept their money at. If it was good for them, it should be good enough for you. And if that bank ran into trouble, you better hope there’s other rich people to bail it out.

To recap, we had the stock market crash, you had bank runs and failures, stores and factories shut down, massive unemployment and poor people looking for bread everywhere. The crash had a major impact not just on Wall Street but on everyone across the world. Everything is interconnected.

If you are a history person, you know that these few lines don’t fully capture the complexities and nuances of the Great Depression. The Great Depression is still a source of intense academic debate. My point is if there’s a bank run somewhere, it can come to a branch near you, and by then it might be too late.

No News is Good News

There’s a lesson in mass psychology here.

When you have to come out and try to reassure investors and depositors, it normally backfires. The intention is good and sincere. The reaction and result are sincerely not. It raises questions like “why do you feel like having the need to tell us that?”, and suspicion like “is there something wrong with my deposits?” 

In the last couple weeks we have seen a lot of banks releasing press releases saying “don’t worry, everything is fine.” I don’t have data on this, but I’m willing to bet that the banks that didn’t make an announcement are doing much better than the ones that tried to reassure the public.

You want to spook investors? Tell them not to worry. If you want people to be calm, just keep it “business as usual.” And the worst you can do is Tweet “There’s no line-up outside the bank right now.” (I’m not saying a bank did that but I wouldn’t be surprised.)

Everytime a bank CEO comes out and says his bank is fine, the stock plunges. Just stop talking about it. Last week, out of the blue, the Charles Schwad CEO comes out and does an interview with the WSJ, saying the firm is fine, and the front page headline is: “Charles Schwab Says It Could Ride Out a Deposit Flight”. The reaction: The stock (SCHW) is down almost 6% while the market is up.

The whole episode reminds me of the letter Credit Suisse released last October trying to reassure employees and investors about the health of his bank. The stock plunged 20%.

Imagine if you told your wife out of the blue “Honey I just wanted to let you know that I’m not cheating on you.” Your intentions are good. Her reaction won’t be. She’s going to be like “why do you feel the need to tell me that?” Congrats on planting seeds of doubt in her mind.

I think politicians understand this psychological trick better than business people. In politics, one of the responsibilities of a leader is to make his citizens feel safe. A country like the US probably faces constant terrorist threats, jihadist beheaders, missiles pointing at them and what not (balloons?). Have you heard about it? Except for that ridiculous balloun episode, nope. People go on with their lives. The President doesn’t come out saying “hey guess what, we stopped a couple plane hi-jacking, it’s safe to fly!”

In a weird twisted sense, let them fool you into thinking that everything is fine.

Deposits Insurance & Moral Hazards

A lot of people are arguing whether or not non-insured deposits should be made whole. The argument goes something like “they made a mistake and they should assume it, it’s not the government’s role to always step in and save everyone from their mistakes.” This is what’s happening with the non-insured depositors of SVB and Signature Bank. The Treasury and the Federal Reserve announced that they guaranteed the deposits above $250k in a move to stop the panic.

At the center of the debate are moral hazards, even if they are justified. Should market forces wash away poorly managed institutions? If the Fed/Gov always come to the rescue, there’s a cost. It creates a moral hazard. By creating expectations that the Fed will come to the rescue, it encourages banks to take risky behavior. We are privatizing the gains, socializing the losses. All we are doing is repeating the mistakes of the past. And for depositors, there’s not much reason to discriminate between good and bad banks. Should people take responsibility for monitoring the financial health of their banks?

You can debate all you want, but during a bank run, here’s what will happen if uninsured depositors lose their money. There will be a run on every bank and some of these institutions will be on their knees. The economy collapses like a house of cards. Now you are faced with a “big” problem. Do you really want to run that test? That’s what you are faced with.

I think it’s important to protect the depositors. Maybe make the bank pay more for deposit insurance or raise the protection to a level that makes sense because $250k is too low. I understand the arguments, the pros and cons. The free market guy inside of me is asking questions. Entrepreneur/Shark Tank/Billionaire Mark Cuban has a thread on Twitter that explains how a business with $2.5 million in monthly payroll and overheads would need 10 banks to just make sure their money is insured. 

A couple SVB thoughts. 1. 250k is too low. It's insane that a small company with say 2.5m in payables and payroll at the end of the month should be "prudent" and split their cash across 10 banks in case of a run. The fees and admin would be crazy. But great for banks

— Mark Cuban (@mcuban) March 11, 2023

Take the depositors. It’s unrealistic to expect depositors to do the work that a bank equity analyst does when picking a bank. Depositors are not bank risk managers. Depositors are not going to calculate common equity tier 1 ratio and liquidity reserves. Depositors shouldn’t be on the hook for the mistake of the bank’s bond portfolio manager. Have you looked at the financial statements of banks? These things are black boxes. SVB was on the list of Forbes’ best banks 2 days before it went under and rating agencies didn’t have an issue with SVB. Before the collapse, SVB’s CEO was at a conference talking about how he likes to ride his bike. It was business as usual until it wasn’t.

The fight shouldn’t be on whether deposits should be insured or not. Banks pay for insurance for that. I think the better question is “how do we prevent getting there in the first place?” If we are faced with a bank, that means there were underlying problems in the first place. Shouldn’t we address the underlying issues before they become a systemic problem? This is a regulatory problem. Banks need strict regulations. Regulators need to make the system safer. Banks are too important to the system. Canada hasn’t had a bank failure in over 100 years. Canadian banks are boring. Maybe there are lessons there.

Bailouts or Bail-Ins?

It needless to say that bailouts are not popular. The public has no appetite for another banking bailout. The Great Financial Crisis of 2008-2009 is not too far in the rearview mirror. Images of bankers getting bonuses while millions of people lost their homes and savings are still fresh. All these years later, politicians are still paying the price. No politicians want the label “we saved the bankers”.

The 2008 bailouts were a necessary evil. And it could have been done without protecting the bankers. I don’t want to rehash everything that happened but the reason why things are messy is because rules are made in a hurry on a weekend to make sure the world still exists on Monday. And we are still doing that.

The point is that after 2008, rules were put in place to make sure that the government doesn’t step in to save the banks. I don’t know if they are called rules, but the idea was that the solution to a banking crisis has to come from the private sector, more specifically: the banking sector. They have to fix their own mess. That would be referred to as a bail-in.

The government can play a role, and should, since it’s in the public’s interest, to prevent a banking crisis from becoming systemic, because we could all pay the price.The government’s role would be to set the conditions in place to make sure the banking system is sound. Regulators should focus on reforms that solidify the banking sector, which prevents figuring out a solution on the fly during the weekend that opens the door to clumsy interventions.

Right now I think they are on the right track with guaranteeing deposits and facilitating talks between banks. There’s no taxpayer money at work because the banks are using their bonds as collateral to get funding that guarantees the deposits. Executives and owners (investors) are not protected. But the solution is stricter regulations to make the system safer. It shouldn’t get to this in the first place.

Federal Reserve

I don’t want to get into whether the Federal Reserve is the good guy or the bad guy? Or the money creation process (yes it’s created out of thin air but there’s side effects like inflation). Any topic on the Federal Reserve will lead you towards a deep rabbit hole of conspiracy theories. I’m just going to quickly cover its broad role.

The Federal Reserve was initially created to address these banking panics. The Federal Reserve was created after a severe banking panic in 1907 that resulted in bank runs that wreaked havoc on the financial system. Bank runs were a regular thing with disastrous consequences. The Federal Reserve is not perfect and they make mistakes. But I wouldn’t want their job.

The Federal Reserve has two jobs. The first one is regulating the supply of money, that is monetary policy. That has a huge influence on people’s lives. Setting the price of money influences credit card balance, car loans, mortgages, how much to invest and save. Their second role is maintaining confidence in the financial system. Like we saw with the collapse of SVB, or when the economy was shut down in March 2020. The Federal Reserve has been created to serve as a lender of last resort.

DeFi

Just a quick comment on decentralized finance (DeFi). I’m far from an expert on the topic, but isn’t DeFi’s time to shine? For something that’s been labeled the future of finance, how come it’s not stepping up? Bitcoin was created after the financial crisis of 2008 because of the frustration and lack of trust of the financial sector. Wasn’t the whole thing built on the idea that banks sucks? I’m not trying to be judgmental. I have an open mind. I’m curious about it. If somebody wants to explain it to me that would be great.

Summary

I just hope you come away with a better understanding of the bank thing.

Thank you for reading,

Brian

The Bank Thing

“There’s an old saying: Whenever the FED hits the brakes, someone goes through the windshield. You just never know who it’s going to be.” – Michael Feroli, Chief Economist at J.P. Morgan, NYT

Bank failures are suddenly the topic du jour.

As you might have heard by now, the financial markets and banking system are roiled after the sudden failure of SVB Financial Group’s Silicon Valley Bank (SVB). The 2nd largest bank failure in history almost seemed to come out of nowhere and it happened really fast. What just happened is rate; closing without being insolvent (no credit issue, but deposit flight.) SBV, the 16th largest bank at the time, embraced the start-up culture of its namesake locale; move fast, disrupt and break things.

The collapse of SVB brought flashbacks of 2008: “Are we really going through this again?”, “Didn’t we have rail guards in place to make sure it never happens again?” Waking up to not knowing if you will access your money is not a great start to your day. The better safe than sorry mentality prevailed. It was “Don’t ask questions. Just withdraw the money now.” 

On an individual basis, moving your money to a safer bank is a prudent choice. On a collective basis, it’s crashing down the financial system. What we have is a crisis of confidence. The problem with bank runs is that they become a self fulfilling prophecy. As more people withdraw cash, the likelihood of default increases, triggering further withdrawals.

Confidence is the main currency of banking. Without it, there’s no financial system. You need to have 100% certitude that your money is going to be there when you wake up.

Following the collapse of SVB, two other banks followed SVB into receivership: Silvergate Bank and Signature Bank. A deep analysis of the three banks reveals that the common denominator among the failed banks is that their name all began with the letters “SI”. If your bank doesn’t start with the letters “SI”, your deposits are fine.

A lot has happened really fast. I always wonder why it takes a crisis to learn firsthand about banks? Probably because 1) It’s more fun to watch paint dry, and 2) when things are going well, why bother?

How did we get to this? I’m going to try to peel off the layers of the onion without getting too deep into the arcane accounting details of banking. Here are fair questions to ask at this point.

How did SVB collapse last Friday?

It was a bank run. Depositors rush to withdraw their money. SBV didn’t have enough cash on hand to cover their withdrawal. It failed.

Look, imagine you are a bank, and all your friends and family loan you money (deposits) because you said you would keep it safe and pay out interest. You take that money and make long-term loans with it. But tomorrow morning, your friends and family read on Twitter that their deposits might be in trouble. Panicking, they all rush back to you demanding their money back. Guess what? You don’t have it. Guess what? You are in trouble. Guess what? You don’t want to find out.

Why did depositors run on the bank?

A panic started in group chats and social media that their deposits were in danger of disapearing. Some highly influential financial personalities said that depositors should withdraw their money right away or risk losing it. It went viral and compounded the problem. You don’t need to go wait in line anymore to get your cash. You can transfer money with the app. Too many people did that and killed the bank in the process.

Why did the depositors panic? 

SVB suffered a $1.8 billion loss and attempted to address its liquidity problem by selling equity. The move backfired. SVB’s share started going down. A red flag was raised. Depositors got spooked who rushed to withdraw their money before the situation got worse.

I don’t have credits.

How did SVB lose $1.8 billion?

The short answer: SVB took a $1.8 billion loss trying to rebalance its underperforming $21 billion debt portfolio. To address the problem, SVB said it planned to raise $2 billion in equity, but never got to complete it. Depositors saw the capital raise as a sign of trouble, the word spread, and it was a downward spiral after that.

The longer answer provides some background. There are two main factors behind the loss. The first factor is that many of SVB’s deposits were held by startups. When interest rates were low during the pandemic, SVB received a massive amount of deposits. SVB grew a lot really fast. Most startups have all their money in one bank. And most of the deposits (93%), anything over $250k, were uninsured. Now that these startups (SBV’s clients) are facing headwinds and burning cash (going through deposits), SBV experienced an increase in withdrawals from depositors. But this doesn’t cover the $1.8 billion loss and the mistake SBV made.

The second factor covers the main reason for the loss and the mistake SBV made. Generally a bank goes under because of credit risk; too many loans going bad, like during the Great Financial Crisis (GFC) when baristas defaulted on their mortgages en masse. But that wasn’t the case here. SVB didn’t have a credit problem (for now). Even with borrowers repaying their loans as promised, SVB’s problem was it’s structure (balance sheet mismanagement). SBV was a victim of forgetting an old banking 101 lesson: Asset-liability matching.

What’s this Asset-Liability Mismatch thing?

For a broader more complete explanation, I’ll refer you to Prof. Sanjoy Sircar’s article in BW BusinessWorld. But here’s a summary:

The asset-liability mismatch is when the bank has to pay a short-term liability (deposits) for which it is undergoing a long-term asset (loans/investments). A balance sheet has assets and liabilities. Banks accept deposits (liabilities) and offer loans (assets). In addition to loans, securities portfolios also compose bank assets. When a bank makes long-term loans by using money raised from short-term sources like deposits, it exposes itself to risk.

The incentive to take short-term funds to make longer-term loans is profit. When you use cheaper short-term funds to give out long-term loans, then it increases profits because the short-term sources of money are cheaper than the long-term sources of money.

The risk is that the depositors may demand their money back anytime. In such a situation, the bank may not have the funds to do so, as they are all locked up in long-term loans or invested in securities that are underwater. This is the scenario which has played out many times in the past, more recently at SVB.

How did the Asset-Liability Mismatch play out at SVB?

Banks acquire funds through short term deposits while they lend them for longer maturities.

After the initial rush of deposits during the pandemic, SVB couldn’t loan all of it. SBV invested depositors’ funds in long-term bonds and mortgage-backed securities (MBS), at the top of the market. The reason they did that is for higher yield. The yield on the bond portfolio was 1.7%. 

Of course operating in a zero interest rate environment has its challenges, but buying debt out 10 years to squeeze out another 50 or 60 basis points. You just don’t do it. This led to an asset/liability mismatch and trouble.

We know what happened next. The Federal Reserve increased interest rates to combat inflation, the value of their bonds and MBS portfolio cratered, taking SVB with it.

As Prof. Sanjoy Sircar explain, large banks manage the asset-liability mismatch risk by having a large, diversified base of depositors whose funds stay inside the bank for longer terms. We call those deposits “sticky” (you could argue that deposits are less sticky now because of mobile banking, with a simple click you can transfer your funds out).

Sticky deposits provide large banks with cheaper money and keep rolling it over and over again (it stays at the bank). This rolling-over of deposits provides an opportunity to the bank to give long-term loans at a lower cost and in turn, increase its profits.

SVB has one type of depositors: startups that need their deposits because they are in a downcycle. It wasn’t sticky enough.

Imagine a large wave of deposits coming in, and then washes out. That’s what happened to SBV. Tons of money came in fast and left fast.

Another issue that SBV was facing, and all banks, is the inverted yield curve. 

What’s this Inverted Yield Curve thing?

Normally long-term sources of funds are costlier than short-term sources. A 30-year loan is more expensive than a 1-year loan because of the duration risk (it’s a riskier loan). Sounds logical so far.

But right now the world is upside down. The short-term interest rates are higher than long-term interest rates. Right now, the payments on shorter term Treasury bonds exceed the interest paid on longer term bonds. A 1-year Treasury has a yield of 4.4% and a 30-year Treasury has a yield of 3.6%. The result is an inverted yield curve. An inverted yield curve points to trouble. It indicates the likelihood of the economy slipping into recession is high.

An inverted yield curve is a sign that wider financial conditions are not so easy, presenting banks with a far more challenging economic and financial environment. When your cost of funding exceeds the rate of return, that’s not good.

This is an issue for banks because their deposits (liabilities) can cost more than their loans/securities (assets). SBV had short-term liabilities, or deposits, which it financed with long-term bonds and MBS. The yield on the bond portfolio was 1.7%. The borrowing rate was 4.5%, which is the amount they pay depositors, exceeding the return on assets. The yield curve was upside down and they didn’t know how to deal with it. 

Are all banks in trouble?

No.

To be fair, at the moment all banks have the “unrealized loss issue” with their securities portfolio. The number being floated around is $620 billion unrealized losses on their securities portfolio according to the FDIC, underscoring the hit from rising interest rates. But it’s only a real “issue” if you have to sell and realize a loss. If you hold the securities to maturity, you get your capital back (no loss realized and you get to re-invest). SBV didn’t have a choice because deposit outflows forced their hand to sell at a loss.

Plus, this is a different kind of crisis. Regional banks aren’t in the spotlight because of mountains of troubled loans; their immediate problem is deposit outflows, and replacing those deposits with expensive funding.

Should I be worried about my deposits?

No.

The Fed, FDIC, and U.S. Treasury said that all depositors (insured and uninsured) will be made whole.

Should bank investors be worried?

Depositors can sleep at night. For investors that’s a different story. The bank you are invested in is probably fine, but it’s the reaction from clients and shareholders causing it to blow up. 

Should you be worried? Yes and no. It depends. Should you be worried about the banking system’s stability? Yes. Even though the banking system remains sound, it comes with a question mark. Are all the banks in trouble? No. The big worry is a risk of contagion that brings everything down with it.

We have a two-tier system: The big banks where it is always safe to deposit and do business, and everyone else.

The big banks, like Bank of America and JPMorgan Chase of this world, are fine. They will benefit from the crisis. Deposits from smaller institutions are flowing to them and their cost of capital is likely going down. It’s a case of where the strong gets stronger and the weak gets weaker.

Regional banks are in a different bucket. Their deposits are often concentrated. The key issue is not loan defaults but potentially significant deposit outflows can leave a bank in a tough spot.

The other issue banks have to deal with is their held-to-maturity (HTM) portfolio of securities. If the deposit outlook is fine, securities can be HTM at par without realizing losses (threatening core equity, but you get your capital back at maturity). Most scenarios point to the core equity ratio getting wiped out if HTM losses are realized. But that’s the key question. What’s the likelihood that happens? Very low in my opinion. These HTM securities can be held to maturity if the bank doesn’t need to raise cash.

It’s not easy to assess how banks will fare out. You have to make a lot of assumptions. Banks are a little bit of a black box. What’s the deposit outflow? What’s the impact of higher funding cost? The pressure on their loan portfolios? The government’s potential role in quelling a more significant crisis? The theoretical capital impact of an immediate liquidation of a bank’s entire investment securities portfolio? What happens to core equity when deposits leaves and investments are liquidated at a loss?

The government has taken measures to make sure deposits are fine (at the moment there are mixed reports on future bank failure but that seems to be the idea). Their goal is to restore confidence in the system and to prevent further bank runs.

Summary

We are not out of the woods. Further bumps in the road should be expected.

Overall, I believe solvency fears on banks are overdone. The problem is when a wave of panic hits, it’s hard to gauge the impact. Because we are currently in panic mode. Fundamentals don’t matter. Fear is the dominant emotion. Confidence needs to be restored. Investors can earn significant returns here by leaning into the fear and buying the bloodbath. But if you play with fire, you can get burned.

Hope this article provides a better understand of what’s happening.

RIP – Silicon Valley Bank – 1983-2023

Forbes on March 6. On March 10 SVB didn’t exist. How fast things can change in a few days. https://www.forbes.com/lists/americas-best-banks

*Update: As I was writing this, the FDIC shut down the bank. The FDIC seized the bank. The FDIC will be able to sell off assets and return money to insured depositors. When there’s a crisis of confidence things can move very quickly. I kept the original text to show how quickly things can change in a few hours. It was the US’s 16th largest bank and the second-largest bank failure in US history.

Silicon Valley Bank has been around for four decades. It was founded in 1983 over a poker game. Monday it might not exist. If SVB fails to raise capital, which I believe won’t go through, it might have to sell itself in a fire sale.

SVB’s is mostly focused on tech and venture investments. Well it’s in the name right? In an era of low interest rates and easy money, SVB was killing it. But the ingredients that made it successful are gone. VC firms have been less willing to fund start-ups—a problem for SVB, which gets deposits from VC-backed start-ups that were earlier flush with cash. Now that money is gone.

As interest rates have risen, many banks have become more profitable because the spreads between what they earn on loans and what they pay for funding has widened. The metric is called the Net Interest Margin, or NIM. With SVB, the NIM has been squeezed. Interest rates have increased, boosting the cost of the deposits the bank uses to fund loans.

SVB’s trouble came after the bank sold bonds worth $21 billion from its portfolio for a $1.8b loss following a decline in deposits. Deposits are a low cost source of funding for banks. As that dries up, banks are forced to turn to their securities portfolio to raise capital but with bond prices down, the banks are selling those securities at a loss. Prices of fixed-income securities such as bonds fall as interest rates go up. SVB rushed to sell off its low-interest bonds, with an inverted yield curve, in which it costs more to borrow short-term money than long-term, creating headwinds for those that are borrowing short-term and lending long. SVB’s portfolio was yielding an average 1.79%, far below the current 10-year Treasury yield of around 4% and 2-year T-Bill at 4.6%.

It wasn’t supposed to go down that way. What started as a portfolio restructure exercise and capital raise turned into a financial market bloodbath, and ultimately the end of Silicon Valley Bank.

Long story short, SVB bought long duration assets for almost no incremental yield pickup. Normally banks would not be taking big duration bets with deposits. What happened here is that banking deposits are siphoned off (liquidity) and bond portfolios collapse on duration exposure.

SVB might be an outlier in this case. I think most banks have access to ample liquidity. Yes, other banks have underwater bond portfolios as well, but they generally have lots of retail deposits, which are much less rate-sensitive than SVB’s deposits. Banks are big investors in bonds because they need lots of safe places to park their cash. In February, the FDIC said US banks had unrealized losses of more than $620 billion on securities, underscoring the hit from rising interest rates. The key is not selling them. If you have to sell, you will be realizing a loss. At maturity you can reinvest at higher rates. SBV didn’t have a choice because deposit outflows forced their hand. Too many customers tap their deposits at once and created a vicious cycle.

Banks on Providing “Confidence”

When you have to tell investors “to stay calm”, like the CEO of SBV did yesterday, that’s ‘bank speak’ for “run for your life.” Remember a couple months ago when Credit Suisse CEO released an out of the blue letter basically saying “hey everything is okay, don’t worry…” well the stock tanked on that reassuring. A solid bank is a solid bank. They don’t do a circus of “please trust us”. Imagine if you told your wife out of the blue “honey I just wanted to let you know that I’m not cheating on you”, she’s going to be like “why do you feel the need to tell me that?” Do you think she’s going to feel better with that in her head?

Contagion Risk? A Plus for Big Banks

SVB set off alarm bells. The easy-cash era is over. Its impact is only just starting to be felt. The SVB collapse is a sign of pain coming from the end of the easy money era. High interest rates removes the froth from the system. Weak stuff got blown up during a storm. “Garbage” stocks and crypto were the first to go. According to good old SVB, between the fourth quarters of 2021 and 2022, the average value of recently listed tech stocks in America dropped by 63%.

Is SVB the first domino to fall? Maybe. If you are an under-capitalized bank, you might be in trouble. SVB swallowed hefty losses on its bond portfolio to meet deposit redemption requests. Other ‘questionable’ banks will face the same deposit withdrawal pressure, have to sell bonds at a lost, and will have to raise capital at a hefty price. Or worse.

If too many customers tap their deposits at once, a bank run can ensure or trigger sector contagion. SVB had a singular funding base, which made life difficult for it when start-up companies ran out of easy cash. The country’s largest banks, though, have more diverse funding sources, broader business models, have a lot of capital, are much better managed in regards to risk, have a lot of oversight from regulators, which should help insulate them from SVB’s problems.

This can be a plus for the stronger banks since smaller and less capitalized banks might see customers pulling out their money and move them to stronger, better banks. The weak gets weaker and the stronger gets stronger. This will also lower the cost of capital of the stronger banks.

Contagion can happens in many forms. Cracks starts showings in one place, then spreads to other places, and eventually takes everything down. We saw that scenario in 2008. I don’t think we are there. Banks are much better capitalized. We have better systems in place. Better risk management. If there’s a major liquidity crisis, the Fed is ready.

The bigger problem at the moment is fear, and fear spreads faster than a virus, and fear makes people irrational, and that can cause major damage, like we saw with SVB.

ChatGPT & DALL-E 2

It took a while but I managed to get an account. You have to be patient at times because the servers are maxed out. ChatGPT and its sister product DALL-E 2 is amazing and scary at the same time. As in any new technology, comments range from acclamation to criticism. Where do we go from here? Love it or hate it, the genie is out of the bottle. The beast is out. There’s no turning back. We have to adapt and learn how to live with it.

Quick primer. What is ChatGPT & DALL-E 2? They are text-to-image generators that let you type in almost any phrase and get an image or some kind of smart answer. Go check it out. I can spend 5 minutes writing what it’s about, or you can go try it yourself. The “wow” factor is in playing with it, not reading what it is, just like it’s more fun to drive a car than looking at a picture of it. This thing is an assistant, a doctor, a lawyer, a coach, a co-chef, an artist, and an advisor of all sorts. It’s not perfect and it make mistakes, but I’m not perfect either.

A fat American baby eating candies and floating in space.

Both products are creations of OpenAI (wiki). OpenAI is now a for-profit organization. It started as a non-profit in 2015. It was funded by Elon Musk, Peter Thiel, Sam Altman and others. The business is currently run by Altman. Musk resigned from his board seat in 2018. OpenAI is now backed by Microsoft. The partnership with Microsoft allowed them access to the computing resources it needed to train and improve its artificial intelligence algorithms. Microsoft now wants to incorporate the OpenAI tools in its products. More on this later.

For decades, we’ve been hearing about how AI is going to change how we interact with the world. We see AI in action, mostly in the background, when we use Netflix, our email, when we shop on Amazon. But I think this is the first time we actually use it to create something. It’s the first time most of us recognize it in action. Almost every time I put in a prompt and see what’s returned I’m amazed, entertained and scared, all three combined. 

It had that “feel.” The first time I used the Internet. I knew. I just knew that it was a game changer. Not exactly how, but I knew that it wasn’t just a trend. There was no going back. It’s hilarious to write this, but at the time many experts didn’t think the Internet would live last, or work. I’m serious. Look it up. Or what about when the iPhone came out. You knew it was a game changer. 

Clip from the a 1995 article in Newsweek, Why the Web Won’t Be Nirvana

First thoughts on ChatGPT: “Wow this is crazy amazing, and…..Is anybody ever going to do work anymore? Who wants to write papers?”

The technology is fun but full of potential unknowns. And there’s this whole question of ethics (I’ve seen called an “ethical fiasco”). I grew up watching Terminator. My brain wasn’t shaped into thinking about a rosy future about AI robots. What if down the lane the robot overrides its programming and becomes independent? It’s not helping that I’m watching Westworld. In a sense, you can argue that the machines have already won and they didn’t have to fire a shot. We are on our cell phones all the time. 

Back to ChatGPT/DALL-E. New game changing technology creates opportunities and lots of incertitude. There’s no going back. What does it mean for your job? If you are an artist, this is a nightmare. I mean the thing is cranking out poems. If you are not an artist, like me, this is awesome because I don’t have to learn how to use the Adobe slate of products. If you are a copyright lawyer, this is a goldmine. But I’m also worried about what it means for my career in the future. I’ve seen ChatGPT being used for legal advice and it’s not bad.

The current version of ChatGPT is 3.5.  It’s embryonic right now (beta). ChatGPT is more than a flash in the pan. We are in the first inning. It will need to scale. But as it develops, as it races to build it so that it could fully mirror the intelligence and capabilities of humans, who knows what we are getting into.

ChatGPT 4.0 will come out this spring and I heard it will be a massive improvement. And you know this will have 5.0, 6.0….10.0….

And you know the competition, like Google, and mainly Google, is not just sitting around doing nothing. A NYT article reported last month that ChatGPT’s launch triggered Google’s management to declare a “code red” internally (so they had a meeting).

Got it somewhere on Twitter

Search Engine War 2.0

I remember the search engine war of the 90s-early 00s, when you could choose between Altavista, Yahoo, Excite, Goto, AskJeeves, and many others? Well Google won (duh). Like crushed it. It now has a monopoly on search. Google killed all the search engines. Who’s in 2nd place? Bing? Nobody says “Let me Bing this up.”

I like Google and its slate of products. It works fine. But maybe it’s time for a little competition. A little shake up, a little pressure, a little there’s something big coming in the rearview mirror called ChatGPT. When you are in 1st place for 20+ years, you can get complacent. It’s just what happens. Google did introduce LaMDA, a rival AI chatbot.

Microsoft, with its Bing search engine, is going all in. Microsoft said it’s expanding access to OpenAI tools. DALL-E 2, ChatGPT, and other AI-powered software will soon become available to Azure OpenAI customers.

It’s early and Google is safe, for now. But as the AI industry takes off, there will likely be a battle between Microsoft and Google. Search engine are a high fixed cost businesses. Once you built the infrastructure, it’s all about scale. Right now, a product like ChatGPT is very computationally intensive. It cost ChatGPT “pennies” per query. Every search is burning cash. It wouldn’t cost or hurt Microsoft much to integrate ChatGPT to Bing because it’s much smaller. But for Google that’s a different story. Search users are very profitable. Deploying ChatGPT like feature (AI tools like Large Language Model (LLM)) is going to be very expensive and eat in their margins, and that’s just to keep market share. And I’m not sure ad revenue would be more profitable (less if you lose market share).

So, at the moment, the economics of deploying LLM isn’t quite there yet. It’s one thing to demo it. It’s another to try to integrate it deeply in a system with billions of request a day. Think of the cost and the latency. Those are two major bottlenecks I read that cost would need to go down at least 10x, or more, before it starts making sense. It will take some time.

Don’t fight the tide, swim with it

AI is a massive wave. Don’t fight the tide. Swim with it. Jobs and lives will be disrupted. Nothing is static forever. You need to adapt. As for artists, maybe it is a chance to use and adopt new tools. Just like they did with the PC, photoshop, and the Internet. Any new technology can be seen as a threat at first. The PC didn’t kill the artist. It probably made the artist better. Lawyers will be better. Doctors will be better. 

Fighting this won’t help. You have to embrace it. Remember when MP3s came out? It did kill the CD industry. But it didn’t kill music. MP3s disrupted music. Some artists were fighting it. In the end who won? The companies that adopted MP3s (Apple/iTunes), artists and the consumers. More music is being created than ever. More music is being consumed than ever.

ChatGPT is a deflationary force in an inflationary economy. What it means for productivity, competitiveness, efficiency is incalculable. Every organization in every industry will need to infuse this sort of AI technology in every business process and function so they can do more with less. It’s what I believe will make the difference between organizations that adopt changes and those that get left behind. There is an opportunity to apply technology to make a real difference has never been greater. You get to leapfrog. Imagine if you have nothing in the middle of nowhere, but you have access to this tool, it’s powerful. It will empower the people at the bottom. It will allow them to achieve more.

I’m not saying I like it. I’m not pro or anti AI. It’s just is. Just like I don’t hate or love steel. I do my have concerns. There’s a lot of incertitude. But that’s mostly because we don’t understand it. There are already books published by ChatGPT. I’m not sure what to make out of that. You don’t have to buy it. You don’t have to read it.

Or maybe this won’t age well, like the Newsweek article above. I’m just trying to be optimistic.

A bowl of soup that looks like a monster, knitted out of wool.

2022 Predictions Review

2022 

That was one hell of a year. And not in the “it was totally rad” sense of hell. No, actually it was hell in the sense of hell. Or maybe not. My year was actually all right considering everything that is going on. I shouldn’t complain. Pain is relative. My country wasn’t invaded by Russians. I didn’t lose money in FTX. I’m not in an Iranian jail for breaking the dress code. I didn’t die from Covid. Will Smith didn’t slap me on national TV while hosting the Oscar. The FBI didn’t raid my house for classified documents. I didn’t waste $44 billion on Twitter. I didn’t get ban from Twitter. And despite a tough year in the market, my portfolio didn’t lose as much as the market. I remain optimistic. In chaos and disorders, there are opportunities. The attitude and mindset you bring when you approach a problem matters. You can decide to be a victim or not. That’s a choice.

Let’s go back to my 2022 predictions. First, let me say straight up that it’s a fool’s errand to predict anything. I knew that and I know that. But I thought it would be fun to try and see how it held. It’s the time of the year where you get to read about “experts” predictions. I read some stuff, try to stay informed and all of that. But did you ever notice how they never go over their past predictions? But I will go over mine and let’s see how embarrassing it is.

Second, I remember spending maybe 5 minutes making predictions, because I figured it was a total crap shoot.

Third, I had to go back to my 2022 post because I didn’t remember what I predicted.

The first thing that jumped at me was the date of the post. February 22, 2022. Two days before Russia invaded Ukraine. More on that war prediction at the end.

Source: Me last year. And I just noticed a typo.

Let’s review,

S&P 500 2022 prediction: Target: 4500

Wrong. Really wrong. The S&P finished at 3832. I was off almost 15%. In hindsight, it was a very stupid prediction knowing that 1) interest rates were going up and 2) the S&P just had a massive 26% return in 2021, and 16% in 2020 based on massive stimulus that was going away. Looks like I wasn’t the only one that’s wrong: The 2022 consensus for the S&P 500 was 4,800 at year end 2022.

Interest Rate 2022 prediction: Interest Rate, 5 rate hikes max. The 10-year T-Bill will finish at 2.5%.

Wrong. 7 rate hikes and the T-bill finished at 3.8%. The Federal fund rate is at 4.25%.

Inflation 2022 prediction: Inflation will come down in the 2nd half.

I’m giving myself a “W” for that one. I nailed the trend. But the inflation number is higher than I expected.

Oil 2022 prediction: The classic safe answer of “between $50 to $100 per barrel”. The narrative is that market dynamics will keep pushing prices higher, well above current levels around ~$93 a barrel. I’m going to go against the grain on this one.

This one makes me laugh. It’s a win that doesn’t feel like a win. The WTI ended the year at $73. Yeah I took the contrarian bet, but the journey! I feel like Apollo in Rocky I. Yes Apollo won, but it didn’t feel like a win. 12 rounds and a beating for the win. Oil hit a peak of $123 a barrel and analysts said that it was only the beginning. And yes energy was the only sector that performed well in 2022, and oil is 50% off its peak and trading at a 52-week low. 

Gold 2022 prediction: Gold will finish the year below $2000/oz. Why? The central bank will raise interest rates and “restore” a little bit of trust in the dollar.

Win. Gold finished at $1800/oz. Goldman Sachs called for a $2500/oz by the end of 2022. I crushed Goldman Sachs. I don’t know how to value gold. It was a lucky guess. With everything that’s going on in the world, war, inflation, and the money printing, I don’t know why gold is not higher.

Cathie Wood 2022 prediction: More carnage for ARK

Nailed it. The ARK Innovation ETF was down -69% (-80% at peak). I tried to remember why I made a prediction on Cathie Wood, or why would I even care. I wrote:

As a valuation professional it’s frustrating to watch. People have invested their retirement money and their kids’ education money in her ETFs.

Look I don’t like to see somebody losing money. It can happen to anybody. But there’s a little bit of “I told you so” in ARK’s debacle. We have seen this tape played many times in the past. Her MO is concentrated investments in companies with neat ideas and zero earnings, with astronomic valuations (if they can be measured at all). This is a recipe for disaster because 1) when companies don’t live up to their prospects (e.g. Peloton, Roku…) and  2) when rates rise, and they will, it will hurt the present value of future cash flow. And all of Wood’s investments rely on the future profits in years to come.

At the end of the day valuation matters. Fundamentals matter. Cash flow matters. Profit matters.

I still stand behind that statement.

Russia-Ukraine War 2022 Prediction: Russia won’t do a full invasion of Ukraine. The cost is too high. Instead it will support the separatist regions and will never stop harassing Ukraine through different means (cyberwar, coup, rigged election, propaganda etc…). (Update, a few hours after writing the previous lines Russia sent troops in the breakaway regions of Ukraine. I still don’t think a full invasion will happen.)

Really wrong with brutal timing. And not like I would had I wish Russia invaded just to be right. I still can’t believe Russia invaded. Nobody gave Ukraine a chance. Russia was so confident that the first wave of troops arrived with dress uniforms ready for a victory parade and without nearly enough food. The Ukrainians stood and fought. The Ukrainians have proven themselves.

Record: 4 wins, 3 wrong. It’s not bad. Because I didn’t remember what I predicted, I thought going in that it was would have been a disaster.

As for 2023, I may or may not make predictions. Not because I’m afraid to be wrong. But because I had fun last year making them. It’s impossible to predict the future. But you can plan for it.

We will see.

SA Interview: Investing With A Margin Of Safety With Brian Langis

I was interviewed by Seeking Alpha Pro. I think it’s only available to PRO subscribers but I’m not too sure. Maybe you can read some of it or get limited free access. I know some people without PRO were able to read.

Here’s a preview. There are 9 questions total, the first two are below. Full interview.

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Summary

• Brian Langis is an investor and a Chartered Business Valuator (CBV). He manages Cape May Capital, a private investment company, and specializes in business valuation.
• How to build a margin of safety, key questions to answer in the research process and how to identify catalysts are topics discussed.
• Brian Langis shares a long thesis on Spectrum Brands, Lumen Technologies, Stella-Jones, Haleon, Activision-Blizzard and Primaris Real Estate Investment Trust.

Feature interview

Brian Langis is an investor and a Chartered Business Valuator (“CBV”). He manages Cape May Capital, a private investment company, and specializes in business valuation. He has been publishing articles on Seeking Alpha for almost ten years. You can learn more about Brian at brianlangis.com and on Twitter @absolut_brian. We discussed best practices for a SOTP valuation analysis, the opportunity in stocks that “fell off the orbit” and an under the radar company that should benefit from a key demographic trend.

Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?

Brian Langis: When I look at a new business for the first time, I go straight to the balance sheet. I do a quick read of the balance sheet. By just reading the balance sheet you can learn a lot about a business without actually knowing anything about it. I can tell if it has enough money to pay the bills for the next 12 months. It’s akin to doing a blood test on a stranger. You can learn a lot about a person’s health without ever talking to them.

A quick read of the balance sheet tells me right away if it’s a company that’s worth spending more time on. It tells me how much cash, assets and debt is behind the business. The retained earning line is a number that reflects what happened in the past. You get a feel if this business can stand on its own or not. If the balance sheet doesn’t feel right, I don’t waste time.

The reason I look at the balance sheet first is because I have scars from some of my early days of investing as a teen when I got in trouble with penny stocks. I had no clue what a balance sheet was and that was an expensive lesson. So balance sheet first. It accomplishes two things: 1) It’s time well spent. For 5 minutes it prevents me from wasting my time and 2) It potentially keeps me out of trouble.

Then I look at the statement of cash flow. I like to see how the cash flow moves around. I want to see if it’s generating free cash flow. I want to see if it’s growing and sustainable. I want to see what they do with their FCF. I reject most companies that cannot show enough cash income to care for growth and expansion, capital returns, without resort to continual new financing (there are few exceptions). The statement of cash flow gives you a good idea of their capital allocation strategy.

And then I look at the income statement. I try to answer simple questions like 1) Is it growing? 2) How are the margins? 3) Is it profitable?

Then you piece all of it together. I want to be able to see the cash flow flowing through the business. All I am doing is getting a “feel” for the business. If it feels good, it might warrant that I spend more time on it. If not, or it’s too complicated, I move on.

There’s some classic value investing to my approach. I’m buying a business. That’s the mindset. It’s important that I understand the business. It’s important I understand how it makes money and what it does with it. I try to visualize the cash from the sale, to the expenses, and to the bottom line. If I can’t, I move on.

There’s a test that I need to pass. I try to answer key questions like 1) Would I like to own the whole business? 2) How would I feel about holding it for a really long time, like 10 years? 3) How much would I pay for the whole business? The purpose of the test is to get me in the right mindset when I analyze the business. This forces me to focus on the fundamental drivers of the business and think long-term. It helps you avoid costly errors.

As for the rest of the process,

1. I want companies that are profitable, FCF generators with decent return on capital.
2. I want great management. It’s a point I used to overlook. For the past couple years it has taken more importance in the process. Business is about people. If it’s not about the people, then what is it about? I’m looking for a business that is run with honest talented managers that think and act like owners. That’s very important.
3. I’m looking for capital allocation discipline. What are the reinvestment opportunities? A great business takes money in, invests it, and turns it into more money.
4. Valuation. Can I get the business at a fair price? I want a business that is trading at a significant discount to its intrinsic value. At the end of the day, I’m counting cash and I need to make a decision on how much to pay for it.

When it comes to opportunities, I don’t discriminate. I’m not restricted by sector or asset class. I’ve a pretty wide hunting ground. An opportunity is an opportunity, why would I care if it’s bonds, stocks, or real estate? The only restrictions are things outside my circle of competence. All you want is getting more than you paid for. You are looking for the mismatch between price and value. You often find it where nobody is looking. And if nobody is looking it’s because it’s generally hated. And if it’s hated it might present opportunities for bargains.

SA: How do you identify catalysts, and more importantly, how do you tell if they are priced in already or not? What is the difference between a hard and soft catalyst, and which one is better and why?

Brian Langis: Value investors like me like to focus on fundamentals, come up with a value, and say “look I’m getting all that other stuff for free.” And you know what happens? It stays that way forever. Because the perceived value is trapped.

A catalyst is anything that can lead to a drastic change in a stock’s current price trend. It could be good or bad (i.e. buyout, bankruptcy). You are looking for an event or action. Identifying an asset that’s undervalued or not recognized by the market probably won’t lead to much. The market will discount it until action is taken to unlock that value. Otherwise it will most likely stay trapped. Basically you try to take advantage of companies undergoing change.

As for the question “how do you tell if the catalysts are priced in?”, the catalyst investing practice is mostly geared towards undervalued situations.

If a stock is trading on a high multiple basis, it’s hard to tell if any potential catalyst is already priced in. You can assume it is. Let’s say you identify a catalyst that you think the market has ignored, what’s the upside if the stock is overvalued? Unless it’s a massive catalyst, the upside is likely to be marginal. In situations where valuation is overstretched, it is safer to avoid.

As for companies that are perceived to be undervalued, I work with what the market gives me. I reverse engineer the stock price. I try to answer the question “What is the market saying?” The price is the collective view of the market. I might use a reverse DCF. A traditional DCF forecast cash flows to determine value. A reverse DCF starts with the end, the stock price, and works backward. You try to estimate the level of expected performance embedded in the current stock price. For a company with many different assets and businesses, a Sum-of-The-Parts (“SOTP”) approach can help. You are looking for mismatches, a gap between price and value.

Not all catalysts are equal. I don’t know if there’s a preset definition of a hard and soft catalyst (I didn’t find any). Below is my own spin on the meaning:

Soft catalysts are more internal. It could be a change of management, a new strategy, a new product, cost cutting, better execution, hidden or misvalued assets, unique intangibles, key people, tax losses. It could be real estate or excess land just sitting there. For example MSG Entertainment has unused air rights/development rights that could be unlocked. Or a company that’s net cash and it’s just sitting in the bank account doing nothing. That will be discounted by the market. Soft catalysts can have a wider range of outcomes and may be more nuanced in nature.

Hard catalyst is more of an external event. It could be a company getting sold, carved out, a spin-off, an asset sale. It’s very specific. I don’t know if hard catalysts are better, but they are easier to value. A hard catalyst has a more defined outcome and timeline (i.e.merger, spinoff). We know what is getting sold, for how much, and we have a timeline. So they are easier to work with.

For the rest of the interview click here.