Tuesday, November 24, 2015

The Thing About Prediction

A recent book titled Superforecasters is making waves in the financial circle as expected. The book proposed that it is possible to predict the future, if a good team was in place, with teammates coming from very varied backgrounds and good training. Coincidentally, there had been a few occasions on this website where we discussed prediction and its ultimate futility. Today, we try to marry these concepts, hopefully coming away with a few key ideas for readers to ponder about.

I believe the first thing to know about prediction is to never trust any. Never trust anyone who claims that he can predict and never trust any prediction to be accurate. The business of investing is not to predict the future. The business of investing is to try earn a high expected return by thinking hard about what could happen. Using historical standards this translates to 8-10% return per year and one needs to do this over very long time frame while minimizing risks of losing money. 

The future, is inherently unpredictable and until it happens, it remains a set of probabilities. Pundits will forever say they can predict the future, but the truth is no one can. When the future happens, they would dig out what they have said in the past and then say, "See! I was right!". That's amateur. In today's post, we hope to get all readers to see past all these.

Let's illustrate with a few examples. Imagine we have a four sided dice and we roll it. For those who have never seen one, take a look at the picture below: these nicely shaped in pyramids with four possible outcomes are four sided dice used in old board games (at least that was the way I used them).

Four sided dice

There are four sides that give four outcomes. We can think of most futures as such, usually there are a few outcomes, one of them will turn out right. So if someone comes and predict the next role will be 4 or 2 (in the dice, it is the number at the bottom) and he turns out to be right, how much credit should he get? The whole world of finance and investing is essentially full of people guessing the next roll, then claiming they knew, they can read the future. Obviously it's not possible. It is only claiming glory in a game of chance after the fact. That's what we meant by "amateur". That's the first point we need to understand. The future is a set of probabilities.

Let's move on to another analogy: now it's four horse race. So now the probability is changing, in the previous dice, all the outcomes have the same 25% probability of occurring. In a horse race, there are champions, and dark horses. Say Horse 1 (Jedi Star) is the favourite, the chances of winning is 50%. Then Horse 2 (War Horse) and 3 (Force Horse) has 20% each and there is the Dark Horse (Dark Side), with only 10% chance of winning. Horse analysts spent careers analysing horses, trying to make predictions. Yes there is some skill involved, but still, luck is pretty dominant. Pundits in the financial world would, by and large, be more like these horse analysts. The skill element while present is elusive. This is very well discussed in a recent book by Michael Mauboussin called The Success Equation.

In some games, skill is very dominant, like baseball or tennis. But in others, skill and luck becomes equally powerful. It is possible for some horse analyst to be able to predict race results or for analysts to predict economic outcome? Yes, there are gurus out there can get some predictions quite right. How right? Well, about 60% of the time. There is still a lot of luck involved. This is the reality. The gurus out there get 6 out of 10 predictions right and 4 out of 10 wrong. Close of half the time, they are wrong. This 60% is the same number that appears over and over again. The best fund managers get 60% of their bets correct. The best basketball players gets 60% of their shots in the basket (or somewhere around the vicinity). Hollywood makes 6 blockbusters and 4 flops.

So, it is not about predicting.

Then what is it about? Well, it is about getting the probabilities right, getting the math of expected return to work, sizing the bet, understanding the reality better, accepting risks and the possible failure ie losing money. It is hardwork, like card counting, or trying your best to make a fun, touching, universally popular movie like the ones Disney Pixar produce. Each movie take years and thousands of man hours. And still, some of them flopped at the box office. In fact, it is very difficult to predict which movie will make it, according to Hollywood insiders.

This is what the game is about. Let's use a real investing example: our favourite shipping liner Neptune Orient Line or NOL in short. It has gone up 50% in the last three months. It was at a 10 year low at 80c and it shot all the way up to $1.2 or so. Some analysts got it right and they say, "See, NOL is worth a lot, now someone is willing to buy at a much higher price vs 80c." Was that foresight?

Let's turn back to clock to say a year ago, i.e. 2014. The shipping industry had boomed and busted primarily because of China. It went from a total shortage of ships to 30-40% over capacity in a span of 6-7 years. At the peak of the capacity shortage, customers all over world scrambled to get shipping lines to send their goods. It cost more than $2,000 to ship a container box (called TEU in the industry) across the globe. Shippers were super bullish, they started building more ships and bigger ships. They argued that the vintage of ships globally were too old. A lot would need to be scrapped. Hence there was a need to increase capacity by a lot.

Then the GFC came, and then China collapsed. These ships, which took 4-5 years to build, came out right at the point where demand was non-existent. Ships had no goods to ship. They decided to go slow steaming i.e. running at half the usual speed, to save fuel and also to reduce capacity. Shipment cost per TEU collapsed.  That was still not enough, they cancelled orders for ships that were built halfway. Then also scrapped all the old ships. Some shippers went bankrupted, even a large one was at risk. But still the over-capacity issue could not be solved.

NOL five year chart

NOL was right in the middle of it all. It was bleeding through the hull and struggling to stay afloat.  It was burning a billion dollars per year for the last few years. Its book value dropped from $1.5 in 2008 to 80c in 2014. They cancelled orders, cut costs to conserve cash and finally sold their logistics business to raise cash. To rub it in, it was rumoured that Temasek decided it would not save NOL after saving it so many times. So this was it. This was the moment of reckoning for our beloved shipping line.

So, what were the future options for NOL? Now we must understand we should not have the benefit of hindsight as we have now. At that point in time, we would need to try to paint the future in a few options. Here's what it might look like:

Option 1: Cut enough to pull through, TEU prices cannot remain below cost forever

Option 2: Raise money from other investors or the market

Option 3: Bankruptcy

Option 4: Find a strategic buyer

There could be more options, but let's put it at four. Next we have to assess the probabilities and also the return potential of each option. Now, since we won't have the luxury of having full time analysts working on these, the no.s would be pretty arbitrary. In a real process, each number would be debated and each return potential calculated and debated and re-calculated. That's real investing and real work. It would take man hours of analysis. Lots of mental workout. Again for simplicity, we would say that the price was 80c while we were doing this. Here's how the future could pan out, at that point in time:

Option 1: 30% probability, book value dropped by another 20%, share price hit 60c (-25% return)

Option 2: 40% probability, equity raised with 30% dilution, share price hit 50c (-37% return)

Option 3: 10% probability, bankruptcy, share price goes to zero (-100% return)

Option 4: 20% probability, strategic buyer buys it over at a slight premium, share price hit $1.2 (50% return)

So, working with these probabilities and return numbers, it would be clear that NOL had very poor expected return. It would be a negative 22% based on the above probabilities. In fact, we could play around with all the probabilities (and/or returns) and realized that most permutations gave poor expected returns except when we ascribed a 60% or higher probability that a strategic buyer buys it over.

So for those analysts who said they got it right, was it foresight? Or luck? Or something else? For the un-initiated, a rumoured bidding war between two strategic buyers came out for NOL which is why the stock is now up 50% from September. This was one of the future options that panned out. But it could well have been bankruptcy or more likely equity raising in the market with Temasek not supporting it. The future was always just a set of probabilities, what turned out to be the reality/future doesn't mean it should be. No one could have read the future.

As it stands now, it is still unclear how far have the negotiations moved. All bets could still be off because it is ultimately not very beneficial to buy over NOL. What could NOL provide that Maersk or CMA couldn't get? It doesn't need more ships nor crew nor customers (they have the same customers). It would just be a case of buying NOL over to shut it down so that there is one less competitor to disrupt prices. Does it make sense? Or would the buyer try to strike a deal with Temasek and Singapore to get preferential treatment at PSA terminals globally? Or what? It was not clear.

Hence it wouldn't be easy to ascribe a high probability that a strategic buyer would bail out the current NOL shareholders. But as it turned out, this is what caused the share to skyrocket. There would be pundits who would want to claim credit. But as astute investors, we should know better.

The thing about prediction is that it is not what we think it should be like following pundits and it is actually a lot of hard work thinking through everything. The term Superforecaster might well be a misnomer. Well, as Singaporeans, we still hope NOL gets saved though. Happy Thanksgiving! Cheers!

Friday, October 23, 2015

Pay Up for High ROIC! (Part 2)

Do read from the first post.

So does it make sense to pay 20x for 20% ROIC? The answer is YES! In fact, as a rule of thumb in Singapore's investment circle, we should pay one multiple point for 1% of ROIC. So if it's 20% ROIC, we can pay up to 20x and still get a good return. If it's 30% ROIC, then it's 30x. Here's the same table from the previous post showing a 15% ROIC business, let's call it Table 2.

Table 2

So as we can see, at Year 8, even if we value the business at just 10x its earnings per share or EPS, it is worth $30.6, which is more than twice the original price of $15 if we paid 15x for this 15% ROIC business. Now eight years might be a tad too long for most people on this planet, particularly finance people working on Wall Street, or for those of us who can't wait for 2 years for a new iPhone and go for the minor upgrade S version and be disappointed but for true blue value investors, this is the time horizon we are talking about. 

To test the rule of thumb, here's another table (below) showing how long it takes before we double our money using the same assumptions in Table 2. As we can see in the Table 3, testing the original rule of thumb of paying one multiple point for 1% of ROIC, it takes 6 to 8 years to double our money. In fact, if a business can generate sustainable ROIC of 50%, even paying 50x PE, it would only take 5 plus years to double our money. 

Table 3

But how do we know that this 50% ROIC is sustainable? Well, we don't. We can only base in on track record of both the business and its managers. As we discussed before, there are inherently good businesses: consumer related brands, razor-and-blade models, asset light and recurring revenue operations but as businesses grow, incremental return would diminish. For those of us who had scoured businesses across the globe for years, well ROIC of 50% doesn't sustain for too long. 

Hence while in theory it works, in reality, even if we see one or two years of 50% ROIC, it should be safe to assume that ROIC would normalize at some point. Alibaba illustrated this point well. It went public with ROIC at 50-100% which allowed its promoters to justify paying 50-100x for this world's #1 internet stock. ROIC then went on to normalize to around 10-20% today and we saw its share price fell from $100 to a low of $50 before rebounding to $72 today.

Alibaba's ROIC from Gurufocus

More importantly, business managers must stay really focused to reinvest all those earnings for us at higher than normal ROIC (normal means only 8-10% ROIC). Most business managers aren't able to do that. They would see all these cash being churned out and be tempted to use them to buy up low ROIC businesses. It's just too hard to sit there and see the cash pile up for most corporate CEOs. This is why it is way more difficult to find strong capital allocators. Especially so in today's world of short-termism. Even if the CEO did resist doing silly investments, he would be bombarded daily by hedge funds and bankers asking him to spend the money. It would take a zen master to be able to resist the Wall Street vortex of financial sorcery.

Hence, based on experience it is really difficult to find businesses with sustainable ROIC of more than 25%. If that is the case, we have to assume that most businesses would only be able to generate at best high teens ROIC over time. Then going by the rule of thumb, we should then be paying just high teens PE. In the past, I have advocated not buying anything at more than 20x PE. This is one of the criteria of an all-important checklist.

So pay up for high ROIC, but only to a limit - 20x!

Friday, October 16, 2015

Pay Up for High ROIC! (Part 1)

Part 2 is out!

In financial math, high ROIC or return on invested capital can justify almost any PE to buy. This is what this post strives to illustrate. Do read on, it's really important! Promise you won't waste your time. Invested capital simply accounts for all the capital that businesses need: equity and debt. ROE which stands for return on equity, does not take into account of debt. In the financial world, most people talk about ROE but essentially both ROIC and ROE are about how much we can get back by putting in $100.

The genesis of this post comes from:

Some businesses are inherently very strong and generates huge cashflows. For every $100 that we put into the business, we could be making $20. That's ROIC of 20%. One example could be the potato chips business. Raw materials are essentially potatoes and packaging materials which cost next to nothing and what matters is the ability to put it into shelves around the world, in the 7-11s, the Tescos and the mom-and-pop stores all across the planet. Well, this, my friends, is the business moat: global distribution networks that takes years, if not decades to build. The world's biggest potato chips maker had shown that ROIC of this business is pretty high. That's Frito Lay or Pepsico, the listed parent entity.

Don't we all love Frito Lay?

For simplicity let's assume that the potato chips firm can generate 20% ROIC (Pepsico does around 15%). We further assume that in Year 1, its earnings per share or EPS is $1. Because of it's ability to return 20%, this $1 will make $0.2 in Year 2 and together with the original ability to make $1, EPS in Year 2 is $1.2. As we can see, this is compounding at work, So Year 3 will be $1.44 and Year 10 EPS is a whopping $6.2. Assuming that we paid $20 for the EPS $1 in Year 1, ie paying up 20x PE, what is our return after 10 years? It's phenomenal! (All this math is in Table 1 below)

The original capital of $20 now generates $6.2 i.e. over 30% return, over the next decade, it will generate more than the original capital in one single year (Year 17 to be exact). If we assume that it trades at 10x PE at Year 10 (which is ridiculously cheap, remember we bought it at 20x PE), the stock will be worth $62 (ie more than double our original purchase price or around 7%pa using our rule of 72. In Year 17, when EPS is $22.2, more than two dollars higher than our purchase price, the same stock should be worth around $222 dollars at 10x PE. So, in a nutshell, what we bought at 20x PE became a ten bagger. Thanks to its ROIC!

Table 1

In Year 20, using the same methodology, the same stock will be worth $383 while generating almost twice the our original capital ($20) in  EPS (of $38) in a single year. This is why we pay up for high ROIC!

Saturday, September 26, 2015

Invert, always invert

This is a quote originally from Carl Jacobi, a German mathematician but has now been attributed to Charlie Munger, Vice-Chairman at Berkshire Hathaway, investing partner alongside Warren Buffett. Munger used this phrase so many times in so many of his books that value investing students would have to come across it sooner or later. 

Inversion is a technique used widely in math to solve problems by reversing the thinking to come to some kind of solution. In investing, Charlie encourages us to also always invert to see through issues that are not easy to do so conventionally. Today, we would like to discuss three topics about inversion and hopefully gain some insights about using this technique in the future.

Satoru Iwata, the late President of Nintendo was perhaps one of the most brilliant executor of inversion. Sadly he passed away this year before being able to steer Nintendo to greater heights after its successful launch of Wii some ten years ago. Not sure if most readers would remember, during 2004-2006 the gaming market was an epic battle of specs between Playstation and Xbox. Back then there was no mobile gaming, PC gaming was very niche and game consoles were the main devices that people played games with. Sega was dead after it lost out to Playstation and everyone thought that Nintendo would follow Sega.

Sony and Microsoft were well funded to develop game consoles that were going for higher quality graphics, faster controllers, more storage, customized computer chips to run these machines. Nintendo had neither the cash nor the resources to compete. Hence Mr Iwata decided to invert the problem. The problem was not about what core gamer wants, which was thought to be all of the above: graphics, speed, specs and all. The problem was how to get the non-gamers to play games.

Nintendo and all its cute characters!

The answer was the Wii. It had none of the graphics, nor speed, nor specs. It was cutesy Nintendo characters and the innovative wand controllers. It was about making game play much more accessible to non-gamers and it worked! Wii sold more than 100m units and Nintendo at its peak became the 3rd most valuable company in Japan. However the Wii also opened the market for casual mobile gaming as people caught on to how games should be made simple, addictive, fun and on the mobile phone which was in everyone's pocket all the time. Nintendo did not catch this mobile gaming trend fast enough and went into losses. But Iwata-san was quick to react and switched the firm to join the mobile bandwagon last year. Again by inverting the logic that Mario games should only be played on Nintendo devices.

Iwata-san did not live to see the fruits of his legacy as he succumbed to cancer that plagued him for two years. He worked till the final days of his life, giving all he had for the firm, for the shareholders and for Nintendo fans. Iwata-san has my full respect as an innovator who dared to invert mainstream logic and brought the firm to a soaring success never reached before and will likely be renewed with the direction that he set by moving into mobile gaming. Rest in peace, Iwata-san!

The second and third topic would be around TED videos that I watched recently that really opened my mind to issues that are really important. Do read on carefully! Before watching, I was pretty much thinking the same way as most people would, but the videos showed that by inverting, we get to enlightening solutions. The first one is on charity and the second one on happiness and work.

On charity, the consensus thinking, which was also my thinking is that charitable organizations should never aspire to pay its staff market compensation. They should also work with a low cost to donation ratio (like 10-20%) and spend very little on growth. But the speaker argued that all these were wrong and if we continue to think the way we did, we would never solve any of the world's biggest issues like poverty, cure for diseases or helping the disabled and the less advantaged.

The speaker gave powerful examples to illustrate these points. Most memorable being that a CEO of a charitable organization could only be expected to receive $80,000 a year while a CEO of say even a small SME would be paid $200,000 and an MBA graduate would be paid much more than that as they reach the peak of their careers. So these folks could donate half their income, seat on boards of charitable organizations to supervise the poor CEO and be recognized for doing good charity, enjoying fame, status on top of being rich. So who in the right mind, with the capabilities of a SME CEO or earning an MBA would want to be that CEO of a charitable organization and really do all that heavy duty stuff and yet get supervised by MBA grads?

Well, for those really interested, I strongly encourage you to watch the video:

The solution was really to invert and think big. For charity to really become a force to reckon with and solve the world's biggest problems, they have to be for profit corporations, not non-profit charitable organizations. This is inversion at its best!

The last issue that was interesting was related to happiness. The conventional thinking was that we think of happiness as a goal, as something to be achieved, as boxes that needed to be ticked. If we do this, we will be happy. If we go for that holiday, we would be happy. If we achieve that sales target, we would be happy. But the speaker opined that the inverse was what actually made much better sense. If we were happy, we would do this, and do it better. If we were happy, we can plan and enjoy that holiday much, much more. If we were happy, we would over-exceed the sales target by manifolds. Invert, always invert!

The key to happiness is not about goals and ticking boxes. It's to train our brains with the few simple things below:

1. Write down notes of gratitude for one thing and one person daily
2. Share a moment with our loved ones
3. Perform a random act of kindness
4. Exercise or engage in some physical activity: gardening or photography
5. Meditate or contemplate our day and update them in a journal

The talk below:

Time to invert and transform our lives!

Thursday, September 10, 2015

Cooling Off Day Post

While the global stock markets rocked in choppy waves of unprecedented volatility in the last two weeks, Singaporean investors were probably busy following the campaigns of the current elections. This round to me seemed less interesting vs the previous cycles where we saw various tumultuous sagas involving CCTVs, sweet young things vs sweet young things, Dr Chee shouting at PM Goh like a gangster, Cheng San GRC (for those of us old enough to remember). This round we pretty much got to get excited only about this Titanic poster below.

For the un-initiated, this was an argument using the analogy of cruise ships. PM Goh liken PAP as a solid cruise ship with a final destination while WP is a gambling cruise ship sailing to nowhere. To which Mr Low replied that perhaps the more apt example would be comparing Singapore to Titanic, which sank. PM Goh then replied Singapore had  been sailing for 50 years, while Titanic sank on its maiden voyage. Creative Singaporeans then created the poster. Who says we cannot innovate?

The Father of Value Investing, Benjamin Graham left this quote some 70-80 years ago: "The stock market is a voting machine in the short run but a weighing machine in the long run." Some things just don't change. We tend to vote with our hearts, not our minds. Hence we keep seeing actors, boxers, prominent people getting voted into government all over the world: Ronald Reagan, Manny Pacquiao, Arnold Schwarzenegger just to name a few. But what is really important in both elections and stock picking is really to see through the rhetorics and power acts to the essence and make rational choices. 

In investing, that's about understanding and then selecting really strong businesses and buying them at the right prices. It's an art that would take a lifetime to master. Yours truly is still working on it after 10 years. In tomorrow's polling, it's another kind of selection, akin to giving a Facebook "Like", obviously, much more important and with serious consequences. So give it a good hard analysis as we would when we analyze and look at stocks.

A weighing machine will not lie. It tells you where you were before and where you are now. Humans take about 20 years to grow from 2-4 kg at birth to an optimal 40-80kg. Well, a lot of us continue to grow laterally, exponentially, massively after that but that's another topic. :) Both gaining and losing weight significantly are not easy manoeuvres. Changes will take time to be reflected. Hence the analogy that the stock market is a weighing machine. Over the long run, great companies see their stock prices follow exponential curves, mediocre ones fall flat or slope downwards. Nations follow the same paths. 

Singapore's GDP growth follows an exponential curve

Singapore grew spectacularly in the last 50 years. It will be quite unlikely to repeat the same growth in the next 50 years. Nor do Singaporeans want that at the expense of lower quality of life. A lot of election topics revolved around the price we paid for our spectacular growth: foreign workers, MRT breakdowns, rising cost of living etc. But we do need to keep improving. Growth is the only way forward. It may not be economic GDP growth at 8% but we do need some form of growth: entrepreneurial or perhaps cultural or at the individual level (ie you and me) spiritual growth. 

Our decisions tomorrow would decide the growth trajectory over the next five years. Will it be giving up some GDP growth for better quality of life, or continuing GDP growth at all costs or poorer growth in all aspects? It will be our choices!

Sing First Sing First Sing Sing First! 

Thursday, August 27, 2015

This is just the beginning...

Market participants rode through one of the scariest financial roller-coasters in the past two weeks. In Singapore some stocks were down 7-8% in a single day, cumulatively losing 15-20% in one week. In the US, things were even more dramatic, some stocks when through 20% intra-day swings. Then today everything bounced, as if nothing happened. It was really quite unsettling. Most of us would be asking, "Why? Why? What happened? What now?". Sadly, at this juncture, there are no good answers. That was what happened during the first two weeks for the Lehman crisis.

Markets are a bit like earthquakes. Shifts in tectonic movements cause tension to build up and over time this would result in earthquakes or eruptions, usually once every 10 to 20 years, we see a mega earthquake around the same vicinity. There was Kobe in 1995, then Fukushima in 2011. In the financial markets, we see the same phenomenon. Tension builds up over time as investors feel comfortable and buy up everything, at high valuations until some catalysts trigger a major sell off.

It was said that the Global Financial Crisis (GFC) would be a trilogy. We saw the original crisis created when Lehman collapsed, which then shifted to Europe with the Greek saga and now coming to Asia with China. This pattern resulted because of the measures brought in to stabilize the system. When the GFC first occurred, Europe unleashed its liquidity to save the banks, the Greeks took advantage of that and over leveraged and its tragedy unfolded. Then China dumped 4 trillion RMB to save its economy and led to over-capacity in every form: ghost towns, roads to nowhere, idling steel plants, you name it. 

Now all the death stars are aligned, we just saw a crazy stock market boom in China from late 2014 to June 2015, US stocks were at all-time high valuations after months of rally and Europe started to feel euphoric again. Things are really ripe for a collapse. As usual, nobody saw this coming. Because the future is unpredictable. We simply cannot tell. But based on past experiences, we can guess what is more likely to happen. The guess today is this is just the beginning of a more major collapse.

Why so? The following chart might give us some clues. 

STI's Price, PE and Dividend Yield

The above is a chart of the STI from 2005. The price movement is in white and brown bars give the PE over the years and the purple bars show the dividend yield. So, it is now clear that even with the heart wrenching crash last week, STI's PE is still high at 12.5x compared to its own history and dividend is not at all attractive at 3.5%. Even when compared to the Greek crisis in 2011, when PE was 10x and dividend rose to 4.5% we cannot say we are close to that kind of level. 

Hence it is more likely that as the global markets continue to cough and sneeze, STI will see more bloodshed. We could be heading below 2,500 before there is any stabilization. I really don't think STI would revisit Lehman lows of 1,500 and dividend going to 7% given that the global economy is not at the brink of collapse as it was during Lehman. 

Those were crazy days, it was said that the world as we knew it would stop functioning. Fiat currencies would mean nothing and all the zeros in our bank accounts would literally mean zeros. Imagine life savings gone! Those with land or livestocks could be king because they could grow their own food or live off their animals. This is not a joke, take a moment to think about how the world could have changed.

Well, that didn't happen. But you can read about it in, "What Could Have Happened".

Now we see the alternative scenario playing out, the crisis had become a trilogy and this final installment is in front of us now. It is not a bad thing for the market to fall another 20-30%. It would be a great opportunity to buy those really great franchises we talked about and also to reconfigure our portfolios to better names. This is a rare chance in almost a decade. 

Again, this is not a prediction. All we are saying is that there is a high probability that the markets will have to fall another 20-30% before things are sorted out. But it could also well be that markets again shrug off the woes because the world central bankers decide to do another round of global QE (rather than raising interest rates in September as was talked about), and we see the tides rise again! That's low probability but to zero probability.

So buckle your seat belts, the ride is about to begin!

Wednesday, August 12, 2015

All-in costs, breakeven costs, cash costs

Analysts of deep cyclicals, industrials, commodities would be very familiar with these terms. These terms are invented by the financial industry to try to help analysts analyze real businesses from their desktops, in plush offices, hundreds or thousands of miles away from where the businesses actually took place. It bears little resemblance of how real ops managers actually thought about their costs or how businesses actually operated. 

All-in costs refer to all the costs that are needed to start and ramp up a business. Take the example of a gold mine, the all-in cost today for digging up an ounce of gold is supposedly $1,000. Today gold trades at $1,100 per ounce. So if gold falls below $1,000, then new gold production should stop since no one would spend $1,100 to dig something and then sell it for $1,000 right?

But wait, all in costs involved sunk cost like exploration, consulting fees, shared costs like HR, R&D and needless to say, actual operation costs like building the mine facilities, transportation etc. Maybe we shouldn't include some of these. What's important is the breakeven costs. This takes out the sunk and shared costs. Breakeven cost is the true operational expenses including depreciation, utilities, transportation etc. So maybe the true bottom for gold prices should be $600-800 per ounce, which is the estimated breakeven cost range.

Ok that made sense, which is why gold has not even come close to those levels in the last few years. But in another familiar highly cyclical industry close to home, we saw how prices crashed below breakeven costs: shipping. Shipping is a notoriously tough sector. Long time value investors would know to avoid these capital destructive firms. Let's take a look at the breakeven cost again.

While most of us would be familiar with container shipping, which is the bread and butter of our beloved national shipping company: Neptune Orient Lines or NOL, looking at the bulk Capesize shippers for shipping bulk commodities would serve to illustrate today's point better. There are 1,000+ Capesize ships globally shipping bulk commodities like iron ore and coal all over the world and the shipping rates of all these ships are calculated into an index called the Baltic Dry Index or BDI. The chart below from the Economist shows how the index traded over the last 10 years.

The infamous BDI index

During the heydays of 2006-08 the BDI traded at 10,000 levels, 2 digits higher than today's paltry 500. Back then it was impossible to fathom that BDI would fall to today's level. It is yet another manifestation how our primitive homo sapien minds worked (we really cannot think long term) and how unpredictable  the future really is. Just as it is today, can we imagine BDI would again go to 10,000 say 8 years from now?  

It is said that the breakeven cost to run a Capesize ship is about $30,000 per day. This breakeven cost would include depreciation of the ship (a huge part of the cost), the fuel, the crew and other miscellaneous including docking fees etc. This $30,000 per day translates to roughly 3,000 on the BDI and it does form a strong support over the last 10 years. Notice the support in 2005-06 and again the resistance/support in 2009-2010.

But in late 2010, the BDI broke the 3,000 low and fell all the way to 1,000. Nobody could figure out how could this happen. No business should operate below its breakeven cost. It means that for every single day the ship was out there, it was losing money. This is negative margin. It should not happen but it did! So analysts came up with another explanation: cash cost.

Cash cost refers to the cost that is needed to operate a business, on cash basis. This is serious. Breakeven cost has non-cash components like depreciation but cash cost means pure cash in and out. No business should operate below cash cost. So, back with the Capesize ships, the cash cost is estimated to be $15,000 per day, this is the money needed to pay the crew, to pay for fuel, all cash involved. So this should be the absolute bottom for spot prices. If prices fell below this, then all the ships should stop running. No company will burn cash to operate any business.

Then in 2015, the BDI broke 1,000. It fell to 500 and remained around there, a 30 year low. 500 on the BDI translated to just $5,000 per day. So theoretically, we can book a Capesize ship for $5,000 a day for some event, like a birthday party or a wedding! It's cheaper to host a wedding banquet on the ship vs in a Singapore hotel. For all that analysis, BDI broke the cash cost level and remained there.

What happened? 

Why did shippers operate below cash cost? Didn't they know that they are burning money every day? Yup they did, but that was not part of the equation the real business operators were working with. All-in costs, breakeven costs and cash costs exist only on spreadsheets. In the real business, Capesize ships have to run every day, it would take a few weeks just to reach anywhere and a few months to fully stop operations. Even worse, these ships were funded with credit. They could not be stopped even if revenue fell below whatever costs.

Stopping ships from running might trigger default and meant paying back the banks whatever loans that was used to finance buying the ships in the first place. So shipping co.s had to operate as long as revenue was not zero. ie as long as the BDI was not zero. Also there was always the hope element. Managers would always be hoping that things would turn. If they bled for just three months, maybe enough ships would be off the market and prices would turn up again. But since everyone thought the same, that didn't happen and BDI remained at 500. That was the reality. 

This is the same story for many, many cyclical industries. We saw that with semiconductors, with commodity prices and even crude oil. There was not such thing as breakeven cost level or cash cost level. The only true real level is zero and market forces determine when the rebound would be. In the end, the message is this: stay away from commodity businesses where companies do not have pricing power but take prices from spot markets. Buy strong businesses with great global franchises. These are the best bets that we could compound our money at above average growth rate over time.

Thursday, July 16, 2015

Grexit? THIS IS SPARTA!!!!

Five years and 3 bailouts later, it's amazing that the leaders in Europe haven't made any progress in this long and painful odyssey of pulling Greece out from hell. Everyone had their fair share of blame. The latest instalment this year from May-Jul 2015 started with Alexis Tsipras, the Greek PM who thought that he was King Leonidas, went to the negotiating table with the European Union  (EU) demanding money and yet promising no reforms. Essentially reminiscing the unforgettable scene from the comic based comical epic movie: 300, released in 2006. 

This is Sparta!

For the un-initiated, the scene was about how a Messenger from Persia came to negotiate with King Leonidas of Sparta, that if he was willing to be subjected to the rule of Persia and the god-king Xerxes, his country will be spared from bloodshed. King Leonidas refused to kowtow and bellowed the famous words, "THIS IS SPARTA!" and pushed the Messenger into a bottomless pit.

In the Greek tragedy unfolding today, we also see Tsipras shouting in a similar tone to his counterparts in EU. Essentially demanding respect and refusing to kowtow to the whims and fancies of the likes of modern-day aggressors. Sadly, Greece today is not Sparta. Greeks today have zero will to train hard to climb out of the bottomless pit of debt but chose instead to rely on its ridiculously generous government pension system to live on borrowed money indefinitely.

To give a flavour of the system's atrocities, Greek pensioners get to retire at 50, draw a monthly pension of roughly 2,000 Euros (c.S$3,500) per person per month for as long as they live. That's part of the reason why employment rate is 25%. Unsurprisingly, close to 3m Greeks out of a population of 11m lives on pension and the Greeks spend a whopping 20% of its GDP on pension. This is the highest ratio even the EU and perhaps even globally. Singapore spends like $20 on pension?

No wonder the rest of EU is upset that Tsipras has the cheek to come back and ask for more money while achieving nothing. And when he didn't get what he wanted, he started playing games with EU ultimately culminating to the scary referendum in his country. That was the same trick that his predecessor played. He was probably thinking if the Greek voted YES, then he could give in to Europe and be hailed as hero for keeping Greece in the Eurozone. If they voted NO, he would use that as a bargaining chip to maintain Greece's crazy pension on top of asking for the scale back of other tough austerity conditions imposed by the EU during previous bailouts.

Well, that didn't work. EU caught his bluff. Now, the Greeks voted NO, but the reforms just got harsher! Bcos Greece met it's match - Artemisia, in the form of Germany's female chancellor Merkel. This lady is ruthless. She humiliated Tsipras and Greece by forcing harsher conditions including securitizing Greek national assets, possibly including the kingdom of Sparta and the infamous bottomless pit at its townhall, in a $50bn fund for future payment in the event that Greece did not reform. This is akin to Singapore selling our Merlion to pay debts for 1MDB (oh yah, should be Petronas Towers). It was too much. Merkel became Europe's enemy overnight.

Artemisia, well... protrayed here not by Merkel but Eva

But the financial markets were just relieved that Grexit did not happen and the party continues, oblivious that this was just kicking the can down the road for another 2-3 years even if it passes through all the respective parliaments in the next few days (Greek passed theirs). The ordeal continues, Odysseus has yet to meet the Sirens. So we are now left hanging at the cliffhanger moment. Again. 

Can Greece muster enough will to reform after failing twice in five years? The odds are definitely against them. It's like giving a drug addict three years worth of drugs after which he must promise to quit. Will he really quit after three years? Yeah... right... So far, Greece had failed to live up to that promise. Despite all other alphabets of the original PIGS actually doing it (Portugal, Ireland and Spain). Grexit might really be the Hobson's option. In fact, Merkel and Tsipras fought it out last weekend (or as we would prefer Leonidas and Artemisia) and it nearly didn't come to this. The world would be very different today if Grexit was the conclusion last Monday.

Well, we might have that in 2018 and hopefully by then perhaps Europe would be ready for that. Sort out the laws for Grexit, get ready the printing machines for the new Drachma, humanitarian aids and supplies ready to help as the country implodes. It would be a sad day. A micro Great Depression just for the 11m Greeks. It would then really take Spartan philosophy to get the country back into shape.