Monday, November 9, 2009

The Investment Case for Zimbabwe & Other Links

The ultimate risk asset: These days investors and market commentators who believe the US is on course to hyperinflation are not necessarily on the fringe. While most people discount the probability of such a disastrous fate for the dollar and our beloved country, the money printing actions of the Fed and the enormous fiscal deficits are prompting people to at least examine the implications of runaway inflation. During such discussions and analysis, the precedential situations in Zimbabwe and/or Weimar Germany are often highlighted as just about the worst case scenario. Personally, despite my general bearishness about the sustainability of US prosperity and global influence, it is hard for me to believe that the economic situation will deteriorate far enough to produce hyperinflation. But for those who disagree and are trying to find a place to park your money before is it debased completely, Ambrose Evans-Pritchard of the Telegraph has just the place for you. Why hold US dollars that will only lose more and more purchasing power when you can invest in the future of none other than the infamous Zimbabwe? That’s right folks, Zimbabwe is back. In this environment where the size of the return is perfectly correlated with the amount of risk (with no limit to the potential appreciation as long as you are willing to accept more risk), there could be no better place for yield hungry investors to speculate on:

"The fundamental change is that we have stopped printing money to cover our deficit," said Tendai Biti, the MDC's finance minister, who shrugs off death threats.

The hyperinflation crisis has in a sense solved itself. The Zimbabwe dollar faded away as the army and then everybody else refused to accept it. The US dollar is now the coin of daily life. Prices have been stable for months. "Forget about a local currency," said Mr Biti.

Zimbabwe's central bank – an arm of state terror under Zanu PF enforcer Gideon Gono – has lost its cash cow. It is no longer able to skim profits from exchange rate arbitrage. The bank has allegedly been involved in the illicit selling of smuggled diamonds from the Marange field (seized illegally).

Harare's stock exchange is humming again. Volume has increased 20-fold, all now in US dollars…They say that Africa is the leveraged way to play China. If so, Zimbabwe is the leveraged way to play Africa. For brave investors, it is the ultimate rebound story.

Damn. Well there goes that idea. The Zimbabwe dollar is dead and now US dollars are the only currency accepted. Now if the dollar gets completely debased they may have to go back to the local currency. Apparently there is no way for Zimbabwe to escape hyperinflation.

The race to a sovereign default: Continuing on the topic of extremely severe but remote outcomes, this week Martin Hutchinson of The Prudent Bear tackles the question of which of these three major countries—US, Japan, or Britain—is most likely to default on its debt first. After reading the comments from Simon Johnson last week regarding Japan, I spent the weekend in Las Vegas betting on a Japanese default. Obviously the chances of a default are relatively small and it is likely that policy changes will be implemented well before there is an imminent risk. However, Hutchinson makes a compelling case for Britain as sort of the dark horse in this dubious race to the bottom:

The worst budget balance of the three deficit countries is in Britain, where the forecast budget deficit for calendar 2009 is a staggering 14.5% of GDP. Furthermore, the Bank of England has been slightly more irresponsible in its financing mechanisms than even the Federal Reserve, leaving interest rates above zero but funding fully one third of public spending through direct money creation. Governor Mervyn King has a reputation in the world's chancelleries as a conservative man of economic understanding. He doesn't really deserve it, having been one of the 364 lunatic economists who signed a round-robin to Margaret Thatcher in 1981 denouncing her economic policies just as they were on the point of magnificently working, pulling Britain back from what seemed inevitable catastrophic decline. King's quiet manner may be more reassuring to skeptics than the arrogance of "Helicopter Ben" Bernanke, but the reality of his policies is little sounder and the economic situation facing him is distinctly worse.

Britain has two additional problems not shared by the United States and Japan. First, its economy is in distinctly worse shape. Growth was negative in the third quarter of 2009, unlike the modest positive growth in the U.S. and the sharp uptick in Japan. Moreover, whereas U.S. house prices are now at a reasonable level, in terms of incomes (albeit still perhaps 10% above their eventual bottom), Britain's house prices are still grossly inflated, possibly in London even double their appropriate level in terms of income. The financial services business in Britain is a larger part of the overall economy than in the U.S. and the absurd exemption from tax for foreigners has brought a huge disparity between the few foreigners at the top of the City of London and the unfortunate locals toiling for mere mortal rewards. A recent story that the housing market for London homes priced above $5 million British pounds was being reflated by Goldman Sachs bonuses indicates the problem, and suggests that the further deflation needed in U.K. housing will have a major and unpleasant economic effect.

A second British problem not shared by the U.S. is its excessive reliance on financial services. As detailed in previous columns, this sector has roughly doubled in the last 30 years as a share of both British and U.S. GDP. In addition, the sector's vulnerability to a restoration of a properly tight monetary policy has been enormously increased through its addiction to trading revenue. The U.S. has many other ways of making a living if its financial services sector shrinks and New York is only a modest part of the overall economy. Britain is horribly over-dependent on financial services, and the painful if salutary effects of London costs being pushed down to national levels by a lengthy recession are less likely to be counterbalanced by exuberant growth elsewhere.

If this analysis is correct, Britain is facing many of the same challenges that I think will hamper growth and prosperity in the US, but on an even larger scale. Crippling budget deficit? Check. More room for housing prices to decline? Check. An outsized financial services industry that has become a drain on the entire economy? Check. Continued quantitative easing as even the US is beginning to ease off? Check. An economy that doesn’t produce anything and that relies on rent seeking? Check. Ladies and gentlemen, I think we may have a new contender in our midst!

Breaking news: The US financial sector is too large and may not contribute to growth: If the events of the past 2 years haven’t made the accuracy of these previous statements obvious and even intuitive, in a recent article Justin Fox highlights some data that backs up what most of us already know is true. Fox is the author of The Myth of the Rational Market, a book that attempts to further debunk the efficient markets hypothesis and promotes the idea that irrationality explained by behavioral finance is likely a better predictor of market fluctuations. I haven’t read the book yet, but for any of you who share my disdain for the efficient markets and the rational actor theories, I have heard it is very good. In any case, in this recent piece in Time Magazine, Fox cites a study done by Thomas Philippon of NYU Stern that calls into question Lloyd Blankfein’s contention that gigantic financial firms contribute to growth:

If there were a simple correlation between financial-sector growth and economic growth, Philippon reasons, finance's share of the economy would stay constant. But when he examined data back to 1860, he found that finance's share of GDP varied widely. It ballooned in the late 19th century, shrank, ballooned again in the 1920s, shrank and stayed low for decades, then began to grow again in the 1970s, reaching unprecedented levels earlier this decade. The measure Philippon uses is the economic value added of the financial sector as a percentage of GDP, which was at about 4% in the 1960s and hit almost 8% in 2006. An easier-to-understand metric — financial-sector profits as a share of overall corporate profits — followed an even more dramatic trajectory, from 12% in the mid-1960s to almost 41% in 2002.

The 1960s were by most measures the best decade ever for growth and widening prosperity in the U.S.; the past decade has been a bust. Yet the financial sector was relatively tiny in the 1960s and huge in the 2000s. Could this mean that good times for finance are bad for the rest of us? Philippon says it isn't that simple. The 1990s, for example, were good for both Wall Street and Main Street. His theory, which fits the historical evidence well, is that the financial sector's share of the economy should increase when there are fast-growing companies needing outside funding, like railroads in the late 19th century, manufacturers in the 1920s and tech firms in the 1990s. If financing wasn't in great demand in the booming 1960s, perhaps that was a warning sign of stagnation to come rather than evidence of the uselessness of financiers.

Over the past decade, though, reality took a detour from Philippon's theory. Corporate America's need for outside financing fell, but the financial sector refused to shrink; it pumped out ever riskier products until the system nearly collapsed. Why the refusal? Maybe the pay was too good. Philippon and the University of Virginia's Ariell Reshef have found that, starting in the mid-1980s, financial-sector paychecks began to outstrip those for jobs in other sectors demanding similar skills and education levels. Since the late 1990s, Philippon and Reshef estimate, 30% to 50% of financial-sector pay has amounted to what economists call rents — windfalls that serve no economic purpose. They may even hurt the economy by pulling highly skilled workers out of other, potentially more productive fields.

In other words, according to Philippon there is no clear evidence that the size of the financial sector has anything to do with GDP growth. In fact, high wages and bonuses as well as the stature associated with being a banker may have been enough to steal workers away from other, more productive industries. That is on top of the fact that the size, concentration, and interconnectedness of the financial system as a whole ALMOST BROUGHT DOWN THE ENTIRE GLOBAL ECONOMY. Sorry, I just wanted to make sure you hadn’t forgotten this somewhat trivial fact. Now that Goldman is making $100M a day trading, bonus payments are going to set new records this year and bank stocks have risen from the ashes, it is easy to overlook the fact that the financial sector is even more concentrated now and appears to be more focused on rent seeking and fee extraction that ever before. I guess the point of all of this is that when a banker comes to you saying that the entire world will end unless his firm is bailed out, you should remember that there is no guarantee we would all not be better off without such a company in existence.

Buffett paid what for BNI? It’s amazing how many Buffett haters come out of the woodwork whenever he makes a major investment. Recently people have harped on the fact that many of the companies Buffett has invested in (both of late and in the past)—Goldman Sachs, GE, Wells Fargo, American Express—have received some form of government bailout of subsidy. Apparently, they view this as a sort of an unfair handout to Buffett and Berkshire. Maybe he saw the writing on the wall that the government would step in to stabilize the stock and financial markets and thus made a very prudent investment. Those Goldman warrants sure look nice right now, huh? Look, I am not a Buffett apologist. He is a shrewd investor with an unsurpassed track record who uses his position, influence and stature with the media to obtain better deals and further his financial interests. In other words, he is a capitalist through and through. Such people used to be revered and admired. Now, even people who give billions to charity are criticized as if they were banksters.

It is within this backdrop that the naysayers have once again emerged to criticize the large premium paid for Burlington North (BNI). According to these geniuses The Oracle no longer follows the principles of value investing and has overpaid for BNI. I know for a fact that the first assumption is patently false. As for the second, only time will tell if the price was too rich. However, I think people should remember a few things before they prematurely pass judgment. First, with over $20B in cash on the balance sheet, Berkshire has to do large deals if it wants an acquisition to have any meaningful impact. As a result, Buffett has admitted that it will be harder for BRK to generate the returns it has in the past. Big deals are not cheap and sometimes the control premium is substantial. Further, despite Buffett’s initial training with Ben Graham, since he shut down his partnership all those years ago he has focused on buying great companies at a fair price as opposed to fair or bad companies at a great price. I happen to believe that BNI is a great company, but maybe not for the reasons you automatically assume. I thought Simon Johnson of The Baseline Scenario explains the long term positive secular story that may end up justifying the price (and reminds me of when Buffett bought Coca Cola) as well as anyone:

Buffett’s big investment in railroads looks like a shrewd way to bet on growth in emerging markets – which is where most incremental demand for US raw materials and grain comes from. It’s also a polite way to bet against the dollar or, even more politely, on an appreciation of the renminbi.

When China finally gives way to market pressure and appreciates 20-30 percent, their commodity purchases will go through the roof. You can add more land, improve yields, or change the crop mix of choice (as relative prices move), but it all has to run through Mr. Buffett’s railroad.

Of course, Buffett is nicely hedged against dollar inflation – this would likely feed into higher inflation around the world, and commodities will also become more appealing.

And Mr. Buffett is really betting against the more technology intensive, labor intensive, and industrial based part of our economy. If that were to do well, the dollar would strengthen and resources would be pulled out of the commodity sector – the more “modern” part of our production is not now commodity-intensive…

By betting on commodities, Mr. Buffett is essentially taking an “oligarch-proof” stance. Powerful groups may rise to greater power around the world, fighting for control of raw materials and driving up their prices further. As long as there is growth somewhere in emerging markets, on some basis, Mr. Buffett will do fine.

If everyone is cheating, is it wrong? Clearly the politicians in Washington and the banksters in New York are setting poor examples for the rest of us. Between not paying their taxes, orchestrating secret bailouts at the expense of the taxpayer, and awarding themselves enormous bonuses in the midst of a terrible recession, it is understandable that an outside observer would conclude that there are no laws governing these folks. The question is how does this affect the actions of others? According to one of my favorite behavioralists, it might make us all a little more prone to gaming the system any way we can:

Trickle down really does work. Consider these inspired words, from an online reader of USA Today, reacting last week to news that Americans were lying, cheating and law-breaking to get their hands on an $8,000 tax credit for first-time homebuyers:

“The system is scamming you, so why not scam back a little,” wrote the reader, using the name “None in 08.” “You’ve seen what crooks in Washington and on Wall Street can get away with.” So “it’s time to get yours.”

There is also the simple matter of bad examples: The more people observe bad guys getting away with it, the more they cheat, says Dan Ariely, author of “Predictably Irrational: The Hidden Forces That Shape Our Decisions.”

Ariely worries about what he calls “the Madoff effect,” a swine-flu-grade virus that causes people who witness corruption to conclude that cheating has become acceptable, and to wind up cheating, too. When Mom and Dad are putting their tots’ names on the income-tax forms to scam $8,000, Ariely says, “we’re seeing the aftershock of all this dishonesty on Wall Street.”

Fixing the problem is unlikely in an era when the saving of one guy’s bonus is of such crucial importance that it motivates a few-hundred-million-dollar corporate transaction. Averting future financial crises requires entirely new banks in which compensation runs in the hundreds of thousands, not millions, of dollars a year, says Ariely.

Fantastic. Another way in which Wall Street proves its overall worth to society. Not only do banksters set bad examples for our impressionable children, but their firms also apparently (see above) may not even contribute to growth. So why do we need such a large financial industry? Oh yes, to further increase the gap between the rich and the lowly middle class and poor. I am with Bernie Sanders: break ‘em up!

(Map of Zimbabwe courtesy of