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Omaha: the 50th Anniversary Jamboree

Omaha: the 50th Anniversary Jamboree

A continuación puedes leer el relato en primera persona que el analista de Exane BNP, Santiago López Díaz, ha hecho de su asistencia a la Convención anual de Berkshire Hathaway en Omaha. Reproducimos su opinión personal en ingles sobre el evento. Francamente interesante sus reflexiones personales que muestra su opinión particular  que no tiene por qué coincidir con la de BNP.

Recordemos que Santiago es uno de los mejores analistas europeos del sector bancario. La recensión de su amplia nota sobre la conferencia es responsabilidad exclusiva nuestra. Esperamos haber trasladado lo mejor de sus reflexiones.

This note is a personal reflection of Exane’s Spanish banks analyst’s trip to Berkshire Hathaway’s 50th Anniversary event. It is not intended as a piece of relative recommendation investment advice and should not be read as such. Enjoy, and bear that in mind

Omaha, here we come again

Last weekend we travelled halfway round the world, together with 40,000 other Buffett and Munger fans, to attend Berkshire’s 50th Anniversary Jamboree. Berkshire’s Woodstock for Capitalists is unique and so different that we believe is well worth the effort. Learning from The Sage and Charlie is an opportunity we always cherish.

Why bother going there?

Value investing is the cornerstone of our research approach. It is impossible to summarise the value investment philosophy in just a few lines but we continue with our tiny contribution to the investment world, adapting our thinking process to what we believe to be a very rational system. We have learnt to pay extra attention to: a) second-level thinking, b) conventional wisdom (which is frequently wrong), c) tail risk events (which are always underestimated), d) the power of incentives and e) the unintended consequences of seemingly harmless actions.

How do we apply that to our stocks?

This time around we focus on general issues which will help our clients understand our approach to research: the difference between a medium of exchange and a store of value, the definition of inflation, the misguided focus on consumption, the bond bubble, how interaction with complex systems generates unintended consequences that are impossible to predict, how incentives drive behaviour and our (very different) approach to valuation – price defines risk.

We maintain our Underperform ratings on all the Spanish banking stocks we cover

Protection of capital is our main concern. Unfortunately, and even as we acknowledge that there have been improvements in Spain, we do not believe prices are compelling enough for the stocks we cover to offer a decent long-term risk/reward with a reasonable margin of safety. The negative yield environment points to huge hidden risks (which may or may not materialise).

Omaha, the 50th Anniversary Jamboree

Last weekend we travelled halfway round the world, together with 40,000 other Buffett and Munger “fanfreaks”, to attend Berkshire’s 50th Anniversary Jamboree in Omaha, Nebraska. Berkshire’s Woodstock for Capitalists is a truly unique event and the 50th anniversary is something we didn’t want to miss.

When the two eventually leave the stage (Warren is 84 years old and Charlie 91) their annual meetings will be greatly missed. We know we are attending a show, but this is one put up by people we consider to be living legends of the investment community. Berkshire’s Annual Shareholder’s Meeting is unique and so different from anything else we have seen that we believe it is well worth the 18-hour journey to get there.

We verified some years ago that Omaha exists. We had our doubts about some of these square states located in the Midwest but we were wrong. This time around we can confirm that Iowa exists too. Demand for accommodation in Omaha was so strong that we had to leave Nebraska to secure a room (paying 3x the normal rate...capitalism at its best). At least our hotel had beautiful views of the Correctional Center.

We followed Charlie’s recommendation for luxury travel from the airport to the city and took an air-conditioned bus. The overcrowding led us to see capitalism at work. The queue for taxis was more than three hours long; Über provided transportation in less than five minutes. As Warren said “no business thrives for long ignoring the client”. In Spain (and many other European countries), the service is banned...

Our 18-hour trip from Madrid seemed like a walk in the park compared with what some Australians and Chinese had to do to get there (the Asian crowd was quite substantial and at least half a dozen people from Shanghai asked questions during the Q&A).

Two years ago we had to adapt to below-zero (Celsius) temperatures and to the snow in Omaha in May (a very rare event which has happened only two other times in the past century: 1907 and 1967). Following the contrarian approach we should have deducted that things could only improve (weather and market wise). The Ibex has, in fact, increased from 7,800 points to 11,470 (+46%) since that day. This time around the sun was shining and the temperatures unusually mild, so maybe it was time to be more cautious in case things unexpectedly turned for the worse. Two minutes (literally) after we entered the Century Link auditorium, the monsoon hit Omaha and a massive downpour drenched everybody outside, highlighting how fast (and unexpectedly) events can change.

Everything was worth it when we reached our ringside seats and the event kicked off with a movie (directed by none other than John Landis) of The Fight between Floyd “Money” Mayweather and Warren “The Berkshire Bomber” Buffett. We didn’t even need to go to Las Vegas; Buffett brought Las Vegas to us! We realized though that The Berkshire Bomber stood no fighting chance against Mayweather when he used See’s Candies chocolates as a mouthpiece.

We think that Charlie was the smarter of the two; instead of fighting Mayweather (not likely to be a pleasant experience in our view) he dated Nicolette Sheridan, who made the rest of the Desperate Housewives girls jealous.

Most of our readers know significantly more about value investing than we do. Dozens of books have already been written about the subject by people far more intelligent than us, starting with Security Analysis by Benjamin Graham and Benjamin Dodd in 1934. This seminal work was followed by The Intelligent Investor in 1949, also by Ben Graham, and later on by the many memos and shareholders letters published over the past decades by the likes of Howard Marks, Warren Buffett, Jeremy Grantham and Seth Klarman, among many other remarkable investors.

The principles of value investing are well known and there are several ways to implement a successful value strategy. Back in 1984 Warren Buffett gave his famous speech on “The Superinvestors of Graham-and-Doodswille” at the Columbia University School of Business in honour of the 50th anniversary of the publication of Security Analysis. Buffett spoke of how a number of investors pursuing different investment tactics but following the same mental thought process expounded by Graham and Dodd achieved returns that were significantly above market performance (over a long period of time).

But just because this approach is simple and well known does not mean it is widely adopted. And when it is indeed implemented, not all practitioners will obtain decent investment results, no matter how disciplined or how many times they have read The Intelligent Investor. The technique of a jump shot is simple but not everybody can be Lebron James. Only a talented few can achieve sterling results.

Why did we bother to go all the way there? It is very difficult to explain to anyone who does not already subscribe to the philosophy of value investing why we would use a three-day weekend to go to the middle of nowhere to listen to two elderly guys speak for six hours (even though some shopping can be done on the side: 50th Anniversary Special Edition Charlie and Warren rubber ducks were in high demand – see the picture at the end of this note). In fact, this analyst told his wife he was going to attend a stag party in Ibiza with his friends (this was easier to explain than the reality).

On top of that we are not investors but brokers – not exactly a breed particularly appreciated by value investors. And this is not to mention that not many people (because of their investment mandate) can afford to look five years into the future.

There are, however, several reasons we undertook the trip:

– The first one is that we believe that the best way to serve our clients is if we are well informed and educated

Value investing (which is a very broad concept) has been the cornerstone of our research approach for many years now. Our 81⁄2-year long (and counting) Underperform rating on all the domestic Spanish banks that we cover (including at a different institution) is a clear indication of how we think. We do not care too much about the next quarter, even though many of our clients do. And we are aware that patience and Underperform ratings are not all that helpful in generating commissions, gaining the appreciation of our sales team.

Reputation comes first to us. In Congressional hearings on Salomon in 1991, Warren Buffett (chairman of the company at the time) said he told Salomon employees: “lose money for the firm and I will be understanding, lose a shred of reputation for the firm and I will be ruthless”.

– We believe the best way to serve our clients is to think like company owners, which is exactly what they are. That does not mean we are not going to make mistakes, but it does suggest we are unlikely, for example, to suggest raising capital in order to pay a dividend. Contrary to accepted wisdom, more often than not, management does not own the company (although in some cases they behave as if that was the case).

– Our thinking process also fits an absolute return strategy with a focus on having a margin of safety. Having protection against a permanent loss of the capital invested is the cornerstone of our approach. When people care more about missing opportunities than about protecting capital, bad things happen.

Note that Exane’s, and hence our, recommendations are based on sector relative performance with one year target prices and investment horizons.

– We pay a great deal of attention to tail risks and the possibility of oblivion. You do not want to be the Russian roulette player who happens to be successful 95% of the time. Like Howard Mark says, “it is more important to ensure survival under negative outcomes than it is to maximise returns under positive ones”. Warren and Charlie taught us a long time ago that an investor needs to do very few things right as long as he or she avoids big mistakes. Munger, in fact, has always emphasized learning from mistakes (preferably other people’s) rather than successes. This philosophy is exemplified by his stated desire: “all I want to know is where I’m going to die so I will never be there”.

– When we are asked “how is this stock going to perform versus the index over the next two months (make that over the next two weeks)?”, our answer is usually “we have no idea” (followed by “if we knew we would be sailing in Mallorca). Not only do we not have any idea, we do not even pretend to have one. In our humble opinion anybody that claims otherwise is either a fool or a charlatan (or, most likely, both). John Kenneth Galbraith clearly explained our thinking process: “there are those who don’t know and those who don’t know they don’t know”. We mainly take a look at the issues which might affect companies 3-5 years down the road.

It is going to be a small contribution to the investment world but we want to apply the company-owner-absolute-return-careful-about-risks approach to our analysis. We have in fact been doing that for years, with a special focus on Value Investing, behavioural economics and the Austrian approach. In banking analysis, given the super-leveraged and duration mismatch nature of the business, you need to pay extra care to tail risk because if you get it wrong, you may get smashed to smithereens.

To be honest we have not been particularly successful in attracting more people to value investing. Reports with titles such as “The Socratic Dialogue” (February 2015) and “Memento Mori” (February 2014) do not help. To attract a wider audience we think we will need to title the next one something like “Fifty Shades in the Austrian School” or “The Value Game...of Thrones”.

– If we were to summarise the main issues we have learnt to pay extra attention to (although there are many more) we would highlight: a) second-level thinking, b) conventional wisdom (which is frequently wrong), and c) tail risk (unexpected events are always underestimated). There are, however, two concepts that we think deserve our outmost attention in explaining the world we live in: 1) the power of incentives, and 2) the unintended consequences of seemingly harmless actions.

– Last, but not least, the opportunity to watch Warren play a newspaper tossing contest with Bill Gates is something we would not want to miss. That alone was worth the trip.

We are also reconsidering our diet and our thinking towards certain businesses after the trip. Sugar and caffeine can influence decision making and sharpen reasoning; in that sense, we feared Warren and Charlie might not have been as sharp as before, given that we only counted two Cokes for Charlie during the meeting (compared with four a couple of years ago) and Warren was drinking what looked suspiciously like beer from where we sat (he later clarified it was pineapple juice).

Fortunately a full box of peanut brittle and another one of chocolates were gone by the time the meeting was over. Their fondness for the snack could be explained by the fact that they bought the peanut brittle business from Walter White and Jesse Pinkman (Breaking Bad) two years ago...at least that is what the corporate movie showed.

Excessive glucose levels in the form of refined sugar can be detrimental to your brain and your body in general. An injection of sugar into the bloodstream stimulates the same pleasure centres of the brain that respond to heroin and cocaine. All tasty foods do this to some extent – that is why they are tasty. (In 1700 the average Englishman consumed four pounds of sugar a year; today the average American consumes 77 pounds of added sugar annually, or more than 22 teaspoons a day.)

Warren and Charlie are living proof that sugar promotes longevity. Warren (jokingly) claimed that approx. 25% of his calorie intake over the past thirty years came from Coca-Cola. Basically he is not only the largest shareholder of the company but is 25% Coca-Cola himself! With both geniuses being at such an advanced age, it is difficult to argue that their diet is bad for health (plus they probably would not have been as happy if they had followed a diet based on just broccoli).

And business wise? Lots of room to grow. Cost of a can of soda? USD0.75. Cost of a bottle of water? USD1.75

Not only can Berkshire’s businesses grow, the company has found a way to achieve complete vertical and horizontal integration across business lines. Berkshire already markets planes (Netjets), trains (BNSF) and cars but the company has apparently decided to add stagecoaches (four horses were pulling a Wells Fargo stagecoach to the convention centre entrance) and steers (two gigantic Texas longhorns, ridden by two executives) to their transportation division. We do not know if this will prove to be a popular transportation option among the general public but, now that the bullfighting season is at its peak in Madrid, we would have loved to bring Norman and Jake (the two longhorns) back to Spain with us, though admittedly with each weighing a tonne, it would have been kind of difficult to fit them into the overhead lockers.

Two years ago the company invited a professional short seller to pitch tough questions to management. Not an easy task to do in front of a 40,000-strong fan base with a fervent admiration for the two guys on stage (especially if we consider that over the years, the pair have turned many in the audience into millionaires – and some even into billionaires). We were not lucky in this regard – no short seller surfaced. Charlie looks like a nice chap but we guess that trying to challenge him intellectually is not a proposition many people look forward to. Not to mention that Berkshire shares are up 85% since that day two years ago...perhaps short sellers are not in great supply).

Note from the analyst: We do not plan to comment on what Mr. Buffett and Mr. Munger said during the AGM. Most of the questions were Berkshire-related and we do not want to extrapolate to other markets or try to interpret the pair’s response to questions that were not Berkshire-specific (like the ones about Quantitative Easing, negative interest rates, market valuation or the euro, among others).

Mr. Buffett and Mr. Munger’s opinions about many issues might be different from the ones we have and we do not want to work their message into our conclusions. In fact, our views might be completely different from theirs.

There was ample media coverage and you are surely likely to find a complete transcript somewhere. Plenty of information about the event is already available through the internet. For the live version you will have to travel to Omaha, something we strongly recommend (and the only way to watch the corporate video).

This analyst and his family own a very, very, very tiny amount of Berkshire Hathaway stock directly and a larger amount (that is still very, very, very small by Berkshire shareholder standards...what we would describe as a tenth decimal rounding error in the shareholder’s list) through an investment vehicle.

We are admittedly biased. You do not frequently travel around the world to listen to people you dislike. The same can be said about the 40,000 people present, who attribute almost messianic qualities to the Sage and Charlie. The standing ovation the two old men received when they took to the stage was truly impressive (we are not sure that even the Rolling Stones get such a rousing welcome). In our opinion, they deserve every applause.

However, we think that (without getting into specifics) we can try to use their mental approach and try to apply it to our everyday business and to the issues which concern us the most.

It is amazing, coming from a country like Spain where, in our opinion, corporate wisdom and wit are rarely shared with others, that people of the calibre we met use part of their valuable time (a significant amount of it in some cases) to teach others what they know and what they have learnt in a long life of successful investing.

We couldn’t possibly be more thankful to them both personally and professionally.

There is no need to fully explain our investment thesis about Spain or the Spanish banks. We have done that extensively in the past and we will continue to do so in the future. We have been preaching about the value approach, behavioural economics and the Austrian school for years.

There are some issues, however, that we believe are worth highlighting within the context of our long-term view so you can better understand our thinking process and where we stand. We are not talking about “momentum” (something we know nothing about) or next week’s “catalyst” (something we know even less about) but about issues we think could have material long-term consequences for the stocks we cover. This is not about the exposure to real-estate developers, the evolution of margins or the most pressing issues but about thinking out of the box.

As you will have ascertained form the preliminaries to this note it is not intended to provide EPS estimates for the next quarter or to discuss management guidance.

The commonly accepted (incorrect) wisdom

We started as bottom-up stock pickers many years ago. In the distant past it was relatively easy to pick Spanish banking stocks which were going to skyrocket, fuelled by a massive credit expansion. Easy money led to mass manias such that in 2005- 2006 the important thing was not to select the good stocks (bottom-up style) but to understand the mortgage market, which would soon unleash a tsunami that risked destroying the financial system.

We learnt the hard way that banking stocks move in sync when major events erupt. The Great Bubble demonstrated that credit standards were equally bad across the board with no differences between institutions. Things changed in 2007-2008 and the focus moved to the macro environment. We also learnt the hard way that individual banking stocks do not perform well when the country is facing serious risks, no matter what the operational performance of the different institutions might be (we also saw that when Argentina defaulted in 2002).

Now the focus has changed again and the point is not, in our opinion, whether the cost income or the margins are going to improve but what will happen to money and interest rates and the effects on the bond market. This is the third time in a short span of time in which we have had to adapt our thought process to completely different issues.

The focus changed again when Draghi arrived (2011). From that day onwards you better have a pretty clear view about the bond market (bonds are after all one of the main products on the banks’ balance sheets). Financially speaking we are not in 2015 AD but in 4 AD (After Draghi). We wonder how long this era will last. People can make a lot of money (for a long time) dancing to the siren song of easy money but we would advocate Odysseus’ approach and try to resist temptation.

Charlie and Warren do not make macro forecasts and they have never made an investment based on the macro outlook.

“We produce thirty year projections of social security deficits and oil prices without realising that we cannot even predict these for next summer. Our cumulative prediction errors for political and economic events are so monstrous that every time I look at the empirical record I have to pinch myself to verify that I’m not dreaming. What is surprising is not the magnitude of our forecast errors but our absence of awareness of it...Our inability to predict in environments subjected to the Black Swan, coupled with a general lack of the awareness of this state of affairs, means that certain professionals, while believing they are experts, are in fact not. Based on their empirical track record, they do not know more about their subject matter than the general population, but they are much better at narrating it”, Nassim Taleb, The Black Swan

Not being able to forecast does not mean that we do not try to understand how banking works and how certain issues might affect the industry going forward. In the current market environment we think it is critical to understand how the product banks sell (money) works and how the price of that product (interest rates) might develop.

Money is a medium of exchange and a store of value?

The traditional definition of money assumes money is a medium of exchange and a store of value. The reality (and as you can see in the graph below) is that in a fiat currency fractional reserve banking system, money is no store of value at all. That has been the reality since civilisation. Although the Romans dominated the world for more than 1,000 years you are probably not going to be able to buy anything today using the sestertius. Money is simply the commonly accepted medium of exchange of the day (and, specifically, the item used to settle tax liabilities).

The basic unit for the monetary system is the post-1971 fiat dollar. 1971 was, incidentally, the year this analyst was born. It is interesting to see how the “store of value” instrument has lost 97% of its value since. After the Spanish Civil world (1939) the typical food in this analyst’s home region (pulpo a feira) cost 1 peseta (less than 1 euro cent). Today, the same good costs the equivalent of 1,331 of the old pesetas (EUR8), implying a 99.93% loss in purchasing power (the loss is even higher if we consider that rations are now smaller than in the past).

This is not a unique event we have seen only in a poor, hyperinflation-ridden, small rural area of Northwest Spain. Since the Fed was created in 1914 the purchasing power of the US dollar has decreased by more than 95%.

Many people clearly confuse money with wealth (because during limited periods of time the two terms are temporarily synonymous).

Evolution of the fiat currency in pruchasing power terms

All production must be funded by real resources and money is merely a medium of exchange and a tool of economic calculation. Printing more of it (euphemistically called QE) cannot magically increase the economy’s capacity; it can only misallocate limited resources into bubble activities (the concept of malinvestment).

If money printing and currency debasement were the solution to all economic ailments, Zimbabwe (or Argentina or Venezuela) would be economic miracles. Maybe central banks have perfected the alchemy of wealth creation through money printing and they have (after millennia of searching) finally found the philosopher’s stone – but we seriously doubt it.

In fact the current bout of currency debasement has many precedents in financial history (none of which ended particularly well).

The Romans, for example, were well known for issuing different coins made from different base metals (of a lower and lower quality) in order to reduce the underlying value of the coins used to pay for state expenses (sounds familiar?). In the year 301 Diocletian issued the Edict of Maximum Prices, which although nominally successful briefly after it was imposed (there was a death penalty for speculators, which we guess helped in promoting adherence) eventually generated significant inflation caused by price tampering and currency debasement. Merchants stopped producing (prices were too low because the currency was depreciating) and trade and commerce were heavily disrupted.

More recently, in one of the most famous bubbles of all time, John Law (a famous gambler and an advocate of paper currency versus gold or silver) was hired by the Duke of Orleans in 1716 to resolve the gigantic debt problem that plagued the French Kingdom. La Banque Generale soon began operations and bank notes were issued as a claim on a specific amount of silver. But, as always, the amount of silver tied to the claim was gradually but steadily diluted. The amount of currency in circulation increased from 40m livres to 1bn livres in just one year (25x expansion). The massive expansion of the bank favoured the creation of bubbles, including that of the Mississippi Company (also controlled by Law). Monetary expansion and the increase in the Mississippi Company’s share price created, for a while, what appeared to be an era of endless prosperity.

But the wealth creation was just an illusion built on monetary expansion; the whole house of cards came crashing down in 1720 once confidence was lost in the notes issued by La Banque Royale (holdings of gold and silver by individual citizens were declared illegal, which exacerbated the lack of confidence in fiat paper). Wealth inequality widened (and heavy indebtedness continued to affect the government in the following decades), making everyday life more difficult. Everything ended in an interesting way in 1789.

Inflation is an increase in prices?

Money is created by central banks (expanding their balance sheets through the purchase of debt securities) and, in a fiat currency fractional reserve banking system, through credit expansion. Inflation is incorrectly defined as an increase in CPI. This is clearly an incorrect way to look at inflation. To begin with, CPI is a very narrow measure focusing on consumer goods and completely ignores other types of assets.

More importantly, some people confuse inflation (which is related to an increase in the money in circulation) with price increases (CPI or otherwise). Like Jim Grant says: “nothing is as unstable as a stabilised price level...inflation is not too many dollars chasing too few goods. Pure and simple inflation is just too many dollars. What the redundant dollars chase is unpredictable”. Inflation and the rate of increase in consumer prices are not synonymous.

CPI is an incorrect way to look at inflation but because consumer prices remain depressed (as a consequence of, among other things, deleverage) central banks are doing everything in their power to meet their stated mandate of a stable 2% increase in prices (which, by the way, is a completely arbitrary rate; why not 5% or -6%?). It is interesting to see that the ECB defines a stable price level as a rate of inflation of close to 2%. “Stable price level” is one way of defining it; it is likely more palatable than describing a stable price level as “a 50% loss in savers’ purchasing power every 35 years”. It is bizarre to define price stability as an exponential function quadrupling every 70 years.

It reminds us of a scene in the TV sitcom the Big Bang Theory. Howard (an MIT engineer) complains that Sheldon (a theoretical physicist who looks down on engineers) never tells him how good he is at his job, to which Sheldon replies: “You’re obviously good at what you do. I understand the confusion. I have never said that you are not good at what you do. It’s just what you do is not worth doing”. Central banks are good at printing money. It is a debate however, whether this is a task that should be undertaken in the first place.

Price deflation, in a highly leveraged fractionally reserved fiat system, implies a distribution of wealth from debtors to creditors (and because governments are big debtors, they do not tend to cheer at the prospect of deflation).

However, according to a Federal Reserve Bank of Minneapolis study (dated January 2004) that looked at data from 17 countries and covering a time period of more than 100 years, “Our main finding is that the only episode in which we find evidence of a link between deflation and depression is the Great Depression (1929—34). We find virtually no evidence of such a link in any other period. Nearly 90% of the episodes with deflation did not have depression”. In fact prices declined steadily in the US during most of the XIX century (as a consequence of better productivity) and it did not prevent wealth creation.

Conventional wisdom, however, continues to beat the “defeat deflation” battle drum, mainly because, as we previously mentioned, governments are huge debtors. The BIS, however, published in its March 2015 Quarterly report a very interesting analysis titled “The cost of deflations: a historical perspective”. In it the BIS states that concerns about deflation – falling prices of goods and services – are rooted in the view that it is very costly. But the BIS studied 38 economies over 140 years and concluded that the evidence suggests a very weak link between deflation and growth and a much stronger link between growth and asset price deflations (specially property price deflations).

Goods and services price deflation and per capita real GDP growth

According to the BIS the evidence raises questions about the prevailing view that goods and services price deflations, even if persistent, are always pernicious. The analysis suggests that it is misleading to draw inferences about the costs of deflation from the Great Depression, as if it was an atypical period (the episode was an outlier). More generally, when calibrating a policy response to deflation, it is critical to understand the driving factors (more specifically booms and busts in asset prices) and, as always, the effectiveness of the tools at the authorities' disposal.

But everything is about the consumer and cheap credit, right?

Well, no. Framing is everything and we still shiver every time we hear that the solution to a credit crisis is more credit. It would be different if the approach was framed differently. The approach would probably be less well received if it is described as “we need families and companies to get themselves deeper into debt”.

Furthermore, everybody seems to have forgotten the debt part of the equation. Spain’s GDP increased during 2014 by approx. EUR10bn and if the economy expands by 2-3% in 2015, we could be talking about an additional EUR20bn-EUR30bn. Unfortunately, the total outstanding debt of the Spanish government climbed approx. EUR620bn in the 2007-2014 period. This does not seem like an impressive return on investment. Obviously the debt incurred to achieve the marginal growth is always conveniently forgotten by politicians because it is a claim on future taxes, which will always be the problem of the next administration and the next generation.

Given a sufficient amount of funds (provided by someone else, of course) we would be able to organise a pretty lavish party. It is like the old joke about the Texan oil mogul who is asked about whether he is worried about having lost EUR3bn in his last three drilling projects. “I would have been more worried if the money had been mine” was his answer.

Standard economic policies are also based on the commonly accepted truism that the economy is highly dependent on the consumer. In fact the strength of consumer spending (or lack of) is commonly cited as an important indicator of economic health; hence, any economic policy has to be directed to support consumer spending.

Unfortunately, and as we previously mentioned, all consumption must be funded by previous production. The GDP calculation overstates the weighting of consumption because the greater share of economic activity related to the production of intermediate goods is partly ignored in the calculations. As such, savings and investments are deemed to be less important than consumption, which is absurd because investment has to precede consumption (see The Paradox of Savings by Friedrich A. Hayek, from Prices and Production and Other Works, Ludwig von Mises Institute, for additional details).

Why are all the above-mentioned factors important? It is not only, as we previously said in this report, the fact that the issues affect the product banks sell (money) and the price at which the product is sold to the market (interest rates; more about that in the following section), but the very definition of investing is also affected.

Warren and Charlie define investing as laying out cash today in order to get more cash in the future. They specifically mention that the return investors might expect to receive is a function of the price paid, how much cash investors will get back and when investors will receive that cash back.

Investing is basically transferring purchasing power to a third party in order to (hopefully) enjoy higher purchasing power (receiving more money might not fit the definition) at a later date.

The conclusion in our view is that although we have no clue whatsoever about what the future holds, we can be sure that the tail risks have significantly increased (not decreased). This does not mean we should start ignoring banking investments but instead that we need to exercise extra care to assess a proper margin of safety in order to obtain reasonable long-term returns in purchasing power terms.

In The Economic Consequences of Peace (published in 1919, almost 100 years ago) Keynes said that: “Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens...The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose” (Hitler, in fact, tried to destabilise the British economy with Operation Bernhard, a secret plot to flood the economy with counterfeit pound notes).

The Bond Bubble and the cost of equity

Mr. Draghi recently stated that he sees no evidence of a bubble forming in the bond market. We are no bond market experts but we respectfully disagree with Mr. Draghi. With 30%-40% of all European government bonds (give or take) trading with a negative yield and some states financing themselves up to 7-10 years with negative rates (even Spain and Portugal, as well as some corporates like Nestle are issuing debt at negative yields), we know three things: a) we do not understand what is going on, b) we do not understand the long-term unintended consequences of the current policies (but none we can think of look pretty) and c) we clearly do not understand what Mr. Draghi would consider to be evidence of a bubble (although we would love to know).

It is very important to keep in mind that “absence of evidence” is not the same as “evidence of absence”. The confusion between the two statements is indeed what Nassim Taleb calls the mother of all mistakes. The movie The Sixth Sense had a famous quote: “I see dead people”. We might be mistaken, but “we see bubbles. Big ones” (and, unlike the kid in the movie, we are probably not the only ones to see them).

I’m really flabbergasted. How many in this room would have predicted negative interest rates in Europe? Raise your hands. [No hands go up]. That’s exactly the way I feel. How can I be an expert in something I never even thought about that seems so unlikely. It’s new territory... I think something so strange and so important is likely to have consequences. I think it’s highly likely that the people who confidently think they know the consequences – none of whom predicted this – now they know what’s going to happen next? Again, the witch doctors. You ask me what’s going to happen? Hell, I don’t know what’s going to happen. I regard it all as very weird. If interest rates go to zero and all the governments in the world print money like crazy and prices go down – of course I’m confused. Anybody who is intelligent who is not confused doesn’t understand the situation very well. If you find it puzzling, your brain is working correctly.”, Charlie Munger

A race to the bottom

Financial repression is keeping interest rates at artificially low levels for a prolonged period of time, hamstringing the creative destruction process and allowing some companies (and governments) to remain artificially alive. The ever-growing debt burden seems to be irrelevant because debt can be issued at close to zero rates and debt costs appear low and manageable, allowing politicians to (temporarily) carry on without having to make painful adjustments (which would no doubt lead to many of them losing their jobs).

A zero interest rate policy distorts markets in many ways: a) coupled with money printing and unlimited liquidity, it leads to asset price inflation (but not CPI inflation); b) it promotes moral hazard and the notion of risk is cast aside, leading to reckless behaviour among market participants; c) the creative destruction process is hamstrung; d) it creates an incentive to tax savers (through inflation) to make debt sustainable; e) wealth is redistributed (Cantillon effect), favouring not traditional risk-takers but well connected parties (like too-big-to-fail banks).

Interest rates serve as a signal of the size of the available pool of savings. The manipulation of interest rates (to create an illusion of stability) as well as the creation of money out of thin air leads to malinvestments (the traditional concept from the Austrian school) due to the wrong signals about the amount of available savings. If rates are not where they are, the accumulated pile of debt will cease to be sustainable. Like Jim Grant says, it is as if the invisible hand of the markets has been replaced by the very visible hand of central bankers

As a result of current policies, savers are denied a positive return on their investments because of the incorrect assumption that consumer spending (and not investment) drives the economy.

Time preferences cannot be negative. Economically speaking, interest rates cannot be negative (consumption today will always be preferable to lower consumption in the future). When central banks force interest rates to artificially low levels, market and price distortions are likely to occur due to the shifting of time preferences. Interest rates are indeed negative (just check your Bloomberg screen) due to a number of factors: a) investors buying debt with the aim of selling it to the ECB at a profit, b) companies buying debt for regulatory reasons (like insurance companies) and c) companies buying debt for liquidity reasons (banks).

Banks are seizing the opportunity. Their business model has been subsidised by central banks so they can bail out governments and recapitalise themselves in the process, with a booming stock market as a side effect. This virtuous cycle works as long as interest rates remain at zero and the sustainability of the government debt is not questioned.

Where are the profits coming from?

According to our estimates, at the end of December 2014 the amount of sovereign paper on the banks’ books was equivalent to 2.2x the tangible equity of the listed institutions we cover, leaving the companies quite vulnerable to a sovereign shock.

One might argue that the ECB has been de facto subsidising banking results through indirect QE and implicitly funding local deficits and governments (through the bank holdings of securities), raising questions about: a) the medium term sustainability of the banks’ business models (securities-related income and trading gains represent 25% of the banks’ revenues and 247% of PBT); b) the multiple any value investor should pay for such a business practice (you don’t need a bank to do that); and c) the cost of capital any investor should apply to a sector making a third of its revenues through the trading and arbitrage of BBB-rated fixed-income securities.

And the cost of capital discussion

Low yields are a reflection of the fact that investors can’t find alternative investments and have plenty of liquidity available. In this “Alice in Wonderland” world, anything yielding more than zero seems to be a good investment. Fair enough. But in theory low yields should also go hand in hand with a reduction in associated risks. We do not think that Spanish debt (a major component of the Spanish banks’ balance sheets) carries the lowest risk in history considering that the total stock of debt is at an all-time high and that the sustainability of that debt depends on interest rates staying low forever.

The first chapter of “Banking Analysis for Dummies”, namely “How to Boost valuations”, correctly points to “lower the cost of capital” as a standard operating procedure. With interest rates at zero (or below) that mantra is truer than ever. It just seems reasonable to lower the cost of capital alongside the yield of government bonds.

Unfortunately, when the aberrational becomes the new normal we need to think out of the box. The only fundamental justification for government bonds yielding in negative territory would be outright deflation but that is a scenario which seems incompatible with the sustainability of the debt and with the survival of the euro. The current interest rate environment calls not for a positive “g” but for a negative one...a very negative one. Contrary to common perception (and accepted wisdom) the risk of the investment, in our opinion, goes up, not down.

As we have mentioned in previous reports, we also apply a very high cost of capital to bond trading activities and a very low P/E to their related earnings.

“...what is new today is the overlay of officially sponsored bull markets on governmentally suppressed interest rates. To muscle up stock prices (and bond and real estate prices) central banks have been pushing down the cost of capital. It is a species of price control....Just because the public servants do their well-intended work under the banner of the law does not make the results any less subversive....many take risks that will be revealed as such only after the speculative tide has turned”, Jim Grant.

We don’t know exactly where we stand but the situation is similar to Wile E. Coyote already past the cliff edge waiting for gravity to work its magic.

Unintended consequences and the power of incentives

Unintended Consequences

We have mentioned several times in the past that government intervention through financial repression or otherwise tends to have very negative consequences. The problem is that we don’t tend to focus on the alternative options and the long-term collateral consequences.

Frederic Bastiat introduced the Broken Window Parable back in 1850 to explain how opportunity costs as well as the law of unintended consequences affecting economic activity in ways we can’t see. Henry Hazlitt clearly explained 70 years ago that in studying the effects of any economic proposal we must examine: a) not merely the immediate results but also the long-term impact; b) not merely the primary consequences but also the secondary consequences; and c) not merely the impact on any special group but the impact on everyone.

In that sense, everybody assumes that zero interest rates are manna from heaven for investors and the economy, but in our opinion, that is incorrect. A recent report published by Swiss Re entitled “Financial Repression: The Unintended Consequences” highlights that if government bonds had been trading close to their “fair values” it would have meant USD20bn-USD40bn of additional income for insurance companies.

More importantly (and this is one of the most interesting pieces of research we have recently seen) the report estimates that American households have foregone USD470bn in interest rate income, net of lower debt costs, since the global financial crisis due to the Fed’s low interest rate policies. The stock market has appreciated by USD9tr during the same period of time which, at least in theory, should offset the foregone interest income.

But that is not how the real world functions. To begin with only the very wealthy are significantly leveraged to the stock market (hence the policies exacerbate inequality). Savers perceive interest income as more recurrent than volatile stock market gains so it is reasonable to assume that a bigger proportion of that foregone income would have been spent (among other things because it would have been more evenly spread than stock market gains).

To add insult to injury, low rates force soon-to-be retirees to save even more in order to have a larger pot from which to extract income from when retirement comes (obviously spending less in the process of doing so). As a consequence Swiss Re concludes that “there is no evidence of equity-related gains having translated into additional consumption and thus no real economic growth”

Swiss Re obviously has vested interests in conveying such a message, but independently of whether it is right or not and independently of whether its economic calculations are correct it is important to keep in mind that conventional wisdom can be frequently wrong and that unintended consequences are not as obvious as they seem.

Back in 1973 the US Endangered Species Act imposed heavy land use restrictions on property where endangered species inhabited. The Act incentivised land owners to avoid these restrictions by killing the endangered species found on their property, masking the appearance of their inhabitancy. This practice was then referred as The Three S “shoot, shovel and shut up” (similar to the Spanish Summer Battle cry, which is also referred to as The Three S; “Sun, Sand and Sangría”). The unintended consequences were not precisely what the designers of the Act predicted.

Tampering with complex systems (and the economy and human behaviour are complex systems) can lead to unexpected consequences. In certain areas, flood control efforts, such as levee and dam construction, have led to more severe floods by preventing the natural dissipation of excess water in flood plains also increasing the flood-related damage costs as plains were more densely populated in the (incorrect) belief that they were safe.

The point is that there is no such thing as “side effects” related to certain actions. There are just “effects”. Whether we can anticipate these effects is another issue. The “side effect” concept is just an excuse to justify certain behaviours which do not work as planned because of the narrow mental approach or too short a time horizon. Indeed, people focus on the primary effect and try to get credit for it but label whatever causes harm or undermines the original policy as a “side effect”.

The Power of Incentives

The most important issue (and the one to which we dedicate more time) to understand not only the long term performance of the stocks we cover, but also the world in general, is the power of incentives. Incentives drive behaviour. The incentive structure is what matters in order to understand what is going to happen in the future. Specifically, what we need to avoid is to be involved in a perverse incentive structure.

Perverse incentives cause people to behave increasingly foolishly. Incentives are all too powerful a control over human behaviour. We learned a long time ago to stay away from companies with the wrong incentive structure (there are many companies in which management and owner’s interests are not aligned).

We have offered several examples in the past about how incentives drive behaviour like the British tax on windows which led people to wall them up (coining the term “Daylight Robbery”) or the bounty offered by the British government for every dead cobra in Delhi which, obviously, lead to the proliferation of cobra farms. When the reward was scrapped the owners of the worthless cobra farms set them free, increasing the overall population and making the original problem worse.

There are many more examples. Day care providers in several day centres in Israel were upset that parents came late to pick up their children so they implemented a small fee for parents arriving late in order to reduce the delays. Contrary to what they expected, the late pick-up rate rose considerably. The parents felt less guilty because they were paying for the delay and because the fee was small (which allowed them free time in exchange for a token payment). When the fee was removed the late pick-up rate remained high as the social stigma of being late wore off.

Incentives do not have to be only monetary. When Swiss authorities tried to increase the voting rate in elections through the possibility of voting by mail the voting rate dropped, especially in smaller communities. Many voters were going to the poll just to avoid the social stigma (in what is a very polite country) of not doing it. They wanted their neighbours to see that they were fulfilling their civil duty (something even more important in smaller places where everybody knows each other). When the possibility of mail voting was introduced, some people simply stopped pretending because nobody knew whether they were voting or not.

Economics and Human Behaviour. The Yerkes-Dodson Law

Gary Becker was awarded the Nobel Prize in Economics in 1992 for extending the domain of microeconomic analysis to a wide range of human behaviour and interaction. The award, according to former Secretary of the Treasury and current Harvard University President Lawrence Summers, was “the most overdue prize they’ve ever given”. Becker’s contribution (among others) was to broaden the scope of economics into areas previously ignored with a focus on human behaviour and rationality.

The title of his 1992 Nobel lecture was “The Economic Way of Looking at Behaviour” and in the speech he described how he had used economics to explore areas of decision-making. He established, among many other things, the Rotten Kid Theorem stating that if a household head is sufficiently rich and benevolent towards others household members, then it is in the self-interest of other household members to take those actions that maximise the total income of the group.

Dan Ariely, professor of psychology and behavioural economics at Duke University, and his team took the Yerkes-Dodson Law (related to an experiment performed with rats more than 100 years ago) and applied it to people and financial incentives. Subjects were asked to perform certain tasks and received a monetary reward. The money increased cognitive performance to a point and then became a drag. Money is both a motivator and a stressor.

He tried pitching this idea to Wall Street but the answer was that Wall Street people thrived under stress (although they were not interested on testing that in Ariely’s lab). They turned instead to another high-stress, high-reward environment, the NBA, showing that the accuracy of “clutch” players did not improve under stress. They just took more shots.

Ariely’s research shows that because of people’s strong propensity for loss avoidance (people fear losing money more than they gain pleasure from gaining it) clawing back bonuses could dramatically increase the stress of financial incentives.

All the abovementioned factors are of paramount relevance when assessing the business environment and the potential long-term performance of the companies we cover. We have extensively written in the past about what we believe to be a lack of alignment of interests between the management of the companies we cover and the owners (our clients) of the companies we cover.

We want to highlight one very important point once again. We are not against big paycheques. On the contrary, we favour big paycheques. Some of the investors we admire the most are in fact billionaires. We guess no Berkshire Hathaway shareholder is unhappy about the fact that Warren Buffett has become one of the richest men in the world. We guess nobody can argue that Warren has achieved his wealth at the expense of his shareholders when his annual salary was just USD100,000 last time we checked. The key issue is that managers and shareholder’s interests should be absolutely aligned.

There are two of Berkshire’s Owner-Related Principles we frequently repeat which should be, in our opinion, framed at the door of every company (including ours).

“In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking...Charlie and I cannot promise you results. But we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner. We have no interest in large salaries or options or other means of gaining an “edge” over you. We want to make money only when our partners do and in exactly the same proportion...” (Owner-Related Business Principle #2)

“A managerial “wish list” will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own...The size of our paycheques or our offices will never be related to the size of Berkshire’s balance sheet” (Owner-Related Business Principle #8)

These two principles are particularly important because the incentive structure (compensation) drives corporate behaviour and strategy and corporate strategy drives shareholder’s returns. If managers are remunerated based on size of the company the incentives to pursue acquisitions at any cost are clear. The impacts of those acquisitions on the owners’ returns come only as a secondary consideration. If the managers were compensated based on per-share tangible equity growth (penalising extra units of capital employed) behaviour would be different.

Long term performance

Over the past 15 years SAB, for example (note that we are using SAB and SAN as examples for no particular reason – we could have included similar tables for other Spanish banks we cover) has acquired close to 15 players of different size in a series of transactions over the past years. All the deals have been flawlessly executed from the technological and operational point of view, highlighting SAB’s positive integration track record.

SAB’s asset base has increased by a factor of 9x (778%) over a 15-year period, which, in our opinion, is a reasonably long period of time to get a good idea of the value creation for shareholders. Operating profit has increased by a factor of 8x (677%) and profits have almost doubled over the 2000-2014 period.

Unfortunately, during the same period of time EPS has declined by 65%, the cash DPS has declined by 70% and the share price has declined by 30%. We know that the future is what counts not the past. Like Warren says “If merely looking at past financial data would tell you what the future holds, The Forbes 400 would consist of librarians”. We also acknowledge that 2014 might be an unusually low year. However, if we take 2017 as the end point, we still get a significantly negative performance from the operating profit per share, EPS and cash DPS point of view.

We think the data points to an incentive structure favouring growth over total shareholder’s returns. SAN has acquired significantly more than 15 businesses during the same period of time (we have lost count). Some of them have really transformed the company into the powerhouse of today (which we sincerely believe is one of the best retail operations in Europe).

Since the dawn of the 21st century SAN’s asset base has multiplied by a factor of 4x and operating profit has multiplied by a factor of 5x. Operating profit on a per share basis has only increased by 50% in spite of the significant increase in size, and profits (also on a per share basis) remain 11% below those reported 15 years ago. The share price has declined by 39% over a 15-year period (not restated for the bonus element of rights issues). When we consider our 2017 expectations (to avoid using 2014 as the end point, which might be a relatively low profitability year) we still see DPS 26% below that reported in 2000 and only 1% profit CAGR over a 17-year period. This is not, in our opinion, what should have been expected from a company that has expanded in fast growing markets.

15 years is a long period of time and encompasses a full economic cycle. The company has suffered some bad years in Spain recently but has enjoyed some excellent years too (2000-2007). The environment in some of the countries in which the company operates (like Brazil) has been excellent for many years too.

We don’t have enough information to calculate how the incentives of management have evolved since 2000 (not enough details) but in previous reports, for which we have information to calculate the incentive scheme (see “Road Trip to Omaha”, dated May 9th 2013) we have shown that management’s incentives do not seem to be aligned with the shareholders’ best interests.

We need to clarify three points before we continue.

The first is that we obviously pay a great deal of attention to Spanish banks, but they are not unique in the banking world or even in the general corporate world. If we had performed a similar analysis on many other companies through Europe (not only banks) we would have probably obtained similar results in a wide range of economic sectors.

The second is that top talent needs to be compensated for the risks and rewards of their role. We like capitalism and as the saying goes “if you pay peanuts you get monkeys”. More importantly, a big paycheque and a declining share price might not be an irrational situation. Individual performance needs to be based on what the person can influence. Maybe if a certain person hadn’t been in charge, losses would have been higher and he needs to be remunerated because of the avoidance of a higher loss (something that is not easily quantified)

For example, BBVA’s CEO retired this week with a EUR26m pension (we are using the example of BBVA because two years ago we used SAN’s CEO, also retiring at the time, as an example). Since he took over at the end of 2009 BBVA’s EPS has declined by 60% and BBVA’s share price has declined by 22%. May be the reduction in profits and the share price would have been higher under different management. In any case, if we were able to ask one question (and one question only) to the new CEO the question would be: “what is your incentive structure?”

The third point is that although the future is what matters, we pay a great deal of attention to track records. We analyse them with a surgical approach, CSI-style. Cicero is famous for saying that the man who doesn’t know what happened before he was born goes through life like a child.

We have repeatedly stated that the long-term performance of the companies we cover (and many others, this is not specific to Spanish banks) is mainly related not to operational excellence but to capital allocation. Many companies are great at managing their businesses but only a limited number of people excel at capital allocation (although those who don’t are not normally aware of their lack of skills).

Charlie and Warren are the true Masters of the Universe in terms of capital allocation (not Sherman McCoy in The Bonfire of Vanities). That is why they require their managers to manage their businesses and send the money to Omaha so they take care of the capital allocation. That is why they can manage a 350,000 employee business (and one of the largest companies in the world) with a 23 people headquarter. They might surely know a thing or two about incentives considering that over a 50 year period no sitting CEO of the company (normally very wealthy people who could chose to play golf or go fishing instead of working) has ever left Berkshire to start a competing business.

We acknowledge, however, that it is absolutely unfair to compare anybody to Warren and Charlie, who will probably go down in history as the greatest investors and managers of all time. Seth Klarman (another record breaking example), for example, has managed to increase Baupost’s assets under management from USD27m to USD29bn over a 32 year period (after returning capital twice). USD24bn relates to net investment gains (reinvestment and compounding of profits) not new money. If we were to use that performance as the yardstick for excellence everybody will look bad.

It is quite rare that management redeploys capital from declining operations (or closes underperforming businesses) into other completely unrelated activities. Such a movement would imply the recognition of mistakes and, probably, cause influential people within the companies to be embarrassed. Warren tends to be particularly candid about his mistakes. Over the past 7 years no Spanish bank has issued an explicit profit warning in spite of the biggest collapse in corporate profitability in living memory. They have had (give or take) 200 opportunities to do it. How many times have we heard that a certain acquisition has been a mistake? Very rarely.

It is also very difficult for management to avoid historical biases considering the vested interests (not to mention the myriad of corporate advisors who only get paid if there is some action and who are eager to provide the next “synergy-generative-strategic-deal”) and their long-time association with a certain business. Warren expressed it quite brilliantly in his 2014 letter to shareholders: “If horses had controlled investment decisions, there would have been no auto industry”.

How to solve this conundrum? We have proposed several options in the past although our hopes that any of them are ever implemented are very small. Four easy steps could help:

– It would be a good (even obvious) idea that decision makers (Board Members too) had a significant part of their net worth invested in the company. Note that we are not proposing that a significant part of their salary is related to the company but that a significant part of their net worth is invested in the company. The investment needs to be acquired in the market at market prices and not obtained as part of the compensation scheme. That would definitively help the alignment of interests. If you ever wonder why so few planes crash, just consider that such an event might inconvenience the pilots.

– Each time a deal is proposed, the bank should hire another investment bank whose fee is dependent on the deal not going through. There are already plenty of advisors whose fee depends on the deal being completed, whatever the price (in fact, the higher the price, the higher the fee), with limited concern for the long-term well-being of the companies’ owners. We volunteer for the job. It is inconceivable that we would actually be hired for such a task, but if we were, we would never appeal to reason. That never works. Charlie already taught us a long time ago to always follow Benjamin Franklin’s advice; “If you would persuade, appeal to self-interest not to reason”.

– Each time a deal is proposed, projections to justify it mushroom no matter how unrealistic the projections prove to be (see some examples in the next section and keep in mind that we have only focused on the quantitative projections. The qualitative comments deserve another section not included in this note). Fees paid to advisors should be contingent on the targets proposed in the pitch being achieved. This would be similar to the long-term performance salaries with clawback clauses currently put in place for individual employees. The proposed synergies failed to appear? Sorry, no fee. The expected growth has not materialised? Sorry again. That once-in-a-lime-strategic- opportunity turns out to be a lemon? Bad luck.

– A post-mortem analysis of past acquisitions three years after the deal should be conducted using exactly the same presentations used when the deal was proposed. If you are able to find them. Such presentations tend to disappear as fast as a secret message in Mission Impossible.

But not even Daniel Kahneman (a Nobel Prize Winner and one of the brightest minds of our time) can do something like that. In our recent The Socratic Dialogue report (dated February 17th 2015) we mentioned his experience of the issue, which we think is something worth repeating again: “I’m very impressed, actually, by the combination of curiosity and resistance that I encounter. The thing that astonishes me when I talk to business people in the context of decision analysis is that you have an organization that’s making lots of decisions and they’re not keeping track. They’re not trying to learn from their own mistakes; they’re not investing the smallest amount in trying to actually figure out what they’ve done wrong. And that’s not an accident: They don’t want to know.

So there is a lot of curiosity, and I get invited to give lots of talks. But the idea that you might want to appoint somebody to keep statistics on the decisions that you made and a few years later evaluate the biases, the errors, the forecasts that were wrong, the factors that were misjudged, in order to make the process more rational — they won’t want to do it.

Even Benjamin Graham threw the towel. In the first edition of The Intelligent Investor he dedicated 34 pages to “The Investor as a Business Owner” while in the 1973 revised edition he only dedicates 8 pages to dividends. After decades of preaching in the desert he had already given up on investors taking any interest in monitoring the behaviour of corporate managers.

Our investing framework

Scepticism and pessimism aren’t synonymous. Scepticism calls for pessimism when optimism is excessive” - Howard Marks

All my life I’ve gone through life anticipating trouble....it didn’t make me unhappy to anticipate trouble all the time and be ready to perform adequately if trouble came. It didn’t hurt me at all. In fact it helped me” - Charlie Munger

Taking a value approach with a 3-5 year investment horizon, would lead us to be contrarian a lot of the time (which we assure you is not a pleasant experience). Our analysis calls for events that might take years to materialise and as Howard Marks says; “being right too early is often indistinguishable from being wrong”. We are fully aware that the markets can stay irrational for a long time. Our approach doesn’t get us many invitations to cocktail parties or many pats on the back (even if we are proven right).

In many cases there is an asymmetric approach to analysis with a significant bias towards Buy ratings. Everybody is happy with a Buy rating; companies, clients and, mainly, brokers, which see commissions flowing (after all not all clients can short stocks but all of them can buy). A Sell rating is quite different but “avoid risk” is our battle cry.

There is a clear optimistic bias in human nature. As Nassim Taleb mentions in The Black Swan: “inadequate appreciation of the uncertainty of the environment inevitably leads economic agents to take risks they should avoid. However, optimism is highly valued; people and companies reward the providers of misleading information more than they reward truth tellers. An unbiased appreciation of uncertainty is a cornerstone of rationality – but it isn’t what organizations want

Being contrarian doesn’t mean anything. In fact there is a fine line between being contrarian and just stubborn. The important thing is to be contrarian and right. This is an asymmetric game. Rising prices benefit many people and it becomes an irritation to hear about market irrationalities that refuse go away. Anybody trying to take away the punchbowl is quickly dismissed as a kill-joy, antipatriotic or as a perennial pessimist. People clearly confuse pessimism with scepticism.

In the current world of financial repression and central bank planning, our job becomes extremely difficult. In year 4 AD (after Draghi) the main game in town is forecasting what Mr Draghi and Mrs Yellen might do, which is definitely out of our circle of competence. Central banks are expected to come to the rescue no matter what. Expectations seem to be perfectly rational because that is exactly what they have been doing so far and nothing reinforces self-confidence more than quick, easy and large gains.

Markets assume that valuations will reach new highs every day fuelled by never ending money provided by central banks which can run the printing presses at full steam with no consequences. The faith in this new paradigm (which we consider to be flawed) is similar to the faith we saw in the never ending profit growth related to technological stocks and house prices (among others). This utopic environment, in our opinion, contains the seeds of the next bust. We just don’t know when these seeds will germinate.

We might be proven wrong for a long period of time. When situations become irrational (just check the negative yield environment) and you think the graphs need to stop rising...they actually accelerate their rate of growth. And when the pain becomes unbearable...the graph’s rate of growth becomes parabolic. And if you think that once graphs reach a 90 degree slope they can’t accelerate more think again. They can rocket to the stratosphere. At some point in time, however, they usually enter into a reverse loop (roller coaster style) and end up well below where they started.

If we are going to be wrong (possible and even likely) our rationale should be based on our best thinking process, not based on playing a bubble we don’t believe in. We wonder how long this era will last. People can make a lot of money (for a long time) dancing to the easy money siren song, but we follow Odysseus approach and try to resist the temptation. We don't have a mast to tie ourselves to...but we have started by throwing the Bloomberg machine out of the window so we don't have to look at it every day. We don't want to be lured to a shipwreck

Markets are driven by human nature, and by greed and fear, with the same mistakes repeated over and over and over. Charlie Munger mentioned that if people were more rational they wouldn’t be so rich. Jim Grant defines the situation perfectly when saying that in engineering and science knowledge is cumulative (building new knowledge on old) while in financial markets knowledge is circular (repeating the same mistake over and over again). Benjamin Graham specifically warned us that only one in every 100 investors survived the 1929 crash if they were not negative in 1925.

Price defines risk. That is a statement everyone in the financial industry should have tattooed on their arms. Protection of capital is our main concern when analysing stocks and recommending companies to buy. Unfortunately, and acknowledging that several things have improved in Spain, we do not believe price is compelling enough among the stocks we cover to offer a decent long-term risk return equation with a reasonable margin of safety.

The negative yield environment points in our opinion, to huge hidden risks (which might or might not materialise). Draghi might (and probably will) pull another rabbit out of the hat but we find ourselves in unchartered territory, which could lead to all type of unintended consequences (good or bad). What was supposed to be an exceptional (previously unthinkable) economic policy has now become the standard approach. Analysing Spanish banks (or any other investment), ignoring those events in order to obtain a short term profit might be tantamount to picking up pennies in front of a steamroller. Like Voltaire said: “Those who can make you believe absurdities can make you commit atrocities”

Risk is counterintuitive. Uncertainty reaches its peak at the point of maximum confidence.

In terms of valuations we want to consider: the Total US Market Value as a percentage of GDP, a measure which to Warren Buffett is probably the best single metric of where valuations stand at any given moment (although he uses GNP), and Robert Schiller’s S&P Cyclically Adjusted Price Earnings Ratio. We think it is impossible to get a sense of where we stand in terms of Spanish banks’ valuations without taking a look at the broader picture.

(*) the second measure Warren likes to use is corporate profits to GDP which normally stand at around 4%-6% (versus 8%-10% now). We are sure he uses many more metrics and there is no single magic number capable of accurately describing how cheap or expensive the market is. It is also important to keep in mind that companies (and profits) have a very different value if rates are low than if rates are high.

We are no experts on the US markets and we do not pass any judgement on whether they will go even further higher from current levels. There is an ongoing debate about it. Different investors (people we have a significant respect for) have different views about whether the market is cheap or expensive. We are aware of the limitations of both measures and about the bull and bear case arguments and, more importantly, we are aware that financial repression and money printing have completely changed the way market participants value stocks

Not that we are experts but...

According to Mr. Shiller’s data, the S&P’s CAPE stands at 27.2x, a level only seen twice in the past 143 years: back in 1929 (a very famous year) and in 2000 (another famous year). Interest rates are now, contrary to previous occasions, at almost zero (maybe the ratio will go to 50.0x and there is a lot of upside from here; as we said, we are no experts). Similarly, according to the Federal Reserve the total market cap to GDP stands at 127%. “Only” 65 years of data are provided but we sense an interesting pattern developing here.

As we previously mentioned, there are several different opinions about the issue, but one of the most interesting pieces we have read was published by John Hussman quite recently (“Two Point Three Sigmas Above the Norm”, May 4th 2015). Mr. Hussman quotes Benjamin Graham to explain the current market conditions: “Observation over many years has taught us that the chief losses to investors come from the purchase of low quality securities at the time of good business conditions. The purchasers view good current earnings as equivalent to earnings power and assume that prosperity is equivalent to safety

Mr. Hussman analysis concludes that, in his opinion, based on the most reliable valuation measures stock markets are already 2.3 sigmas above reliable historical norms. The note is worth a read. Not because we agree with it or not (we don’t have an educated opinion) but because of the thinking process. Jeremy Grantham (GMO) another investor we greatly respect (and who we frequently quote) has a different view and considers the Shiller P/E is just 1.5 standard deviations above the historical average (not to mention that comparisons versus historical averages could be misleading).

Understanding where we stand is of paramount importance to get a sense where we are going. In the 2014 Letter to Shareholders Buffett explains that, going forward (The Next 50 Years at Berkshire) the chance of permanent capital loss for patient Berkshire shareholders is as low as can be found among single-company investments but he cautions that if an investors’ entry point is too high (at a price, say, approaching double book value) it may well be many years before the investor can realize a profit.

There have been three times since 1965 when Berkshire stock has fallen 50% from its highs. The Sage continues with the caveat emptor: “someday, something close to that kind of drop will happen again and no one knows when. Berkshire will almost certainly be a satisfactory holding for investors. But it could well be a disastrous choice for speculators employing leverage” (note of the analyst: Berkshire shares are not trading close to double book value right now. We do not pass any opinion about whether the shares are cheap or expensive or about whether the company is a good or a bad investment).

We make two observations. The first is that price, as we previously mentioned, defines risk. Even the most laudable company can be a horrible investment if purchased at the wrong price. The second is that we are not used to any company CEO urging investors not to buy shares in his company if the valuation reaches a certain level.

But here is the issue. In Wall Street, nearly everyone wants to talk up their stories, praise their company and declare how much more the company is worth (no matter how egregious valuations might be). Warren and Charlie, on the contrary (and assuming that their holding period is forever), always argue that if they were “talking their book” they would probably downplay as much as possible any story they like...so they were able to buy it on the cheap or buy back the shares. No wonder 98% of the shareholders voted against a dividend payment and invited management to reinvest all the earnings.

Regarding Spanish banks we are wary of forecasts and business plans (although forecasts could be right).

In fact business plans might prove to be counterproductive (Berkshire strategy is, precisely, that they don’t have a strategy) because they force institutions to meet market expectations even if that is not possible.

Hostorical corporate events

Charlie (jokingly) mentioned that the key to a successful marriage is not to look for somebody with great character or outstanding qualities but with low expectations...so one is not disappointed. Maybe a successful analyst or investors should use the same approach and keep expectations low.

Charlie’s trademark comment: “I have nothing else to add” is quite appropriate to finish.

We managed to get a picture of Warren and Charlie wearing tuxedos



Analyst Certification

Santiago López Díaz, (authors of or contributors to the report) hereby certify that all of the views expressed in this report accurately reflect my personal view(s) about the company or companies and securities discussed in this report. No part of my compensation was, is, or will be, directly, or indirectly, related to the specific recommendations or views expressed in this research report.

Non-US Research Analyst Disclosure

The research analysts named below were involved in preparing this research report. Research analysts at Exane Ltd and Exane SA are not associated persons of Exane Inc. and thus are not registered or qualified in the U.S. as research analysts with the Financial Industry Regulatory Authority (FINRA) or the New York Stock Exchange (NYSE). These non-U.S. analysts are not subject to the NASD Rule 2711 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

Santiago López Díaz Exane SA

Exane SA is regulated by the Autorité des Marchés Financiers (AMF) in France, Exane Ltd is authorised and regulated by the Financial Conduct Authority (FCA) in the United Kingdom, and Exane Inc. is regulated by FINRA and the U.S. Securities and Exchange Commission in the United States.

Research Analyst Compensation

The research analyst(s) responsible for the preparation of this report receive(s) compensation based upon various factors including overall firm revenues, which may

Disclosure of the report to the company/ies

Companies NONE


For an explanation of definitions used in Exane research reports, please see the glossary at https://www.exane.com/jsp/action/commun/JSPacLexique.jsp

Commitment to transparency on potential conflicts of interest: BNP Paribas

While BNP Paribas (“BNPP”) holds a material ownership interest in the various Exane entities, Exane and BNPP have entered into an agreement to maintain the independence of Exane's research reports from BNPP. These research reports are published under the brand name “Exane BNP Paribas”. Nevertheless, for the sake of transparency, we separately identify potential conflicts of interest with BNPP regarding the company/(ies) covered by this research document.

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  1. Top 25
    11/05/15 13:48

    Me lo guardo en favoritos, sólo por su extensión y un par de comentarios leídos al vuelo sé que merecerá la pena leerlo con calma.

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