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What We’re Reading (Week Ending 11 February 2024)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles for the week ending 11 February 2024:

1. Sal Mercogliano on What’s Happening in the Suez Canal Right Now – Tracy Alloway, Joe Weisenthal, and Sal Mercogliano

Joe: (02:45)

Let’s just start really big picture with how extraordinary and unusual is the scale of this disruption happening right now?

Sal: (02:55)

You’re looking at about 11% of the world’s trade goes through this vital maritime choke point, the Bab-el-Mandeb. This is the Gate of Tears, this is the very southern end of the Red Sea. This is the connection between Europe and Asia, but it’s much more than that. You’re looking at trade that goes not just between those two areas, but actually kind of like a hub and spoke system kind of radiates out around the planet.

And this attack by the Houthis, which started off very small scale, you saw a helicopter assault onto a ship. The Galaxy Leader back on November 19th has now escalated. And what we’ve seen is not just container ships that have started to divert around, but now liquified natural gas carriers, liquified petroleum gas carriers, tankers, and even bulk vessels are now moving around.

And as you mentioned, this adds 3,500 miles. But the biggest thing is it creates massive delays and disruptions. And for the Houthis, which are a small player, you know, one part in a three-way civil war in Yemen, they have created more disruption of global trade than you — you almost have to go back to the world wars to find something similar to this.

Tracy: (04:06)

So Sal, you mentioned that the Houthis have sort of expanded their repertoire of attacks, I suppose to now include LNG and bulk vessels and things like that. What is their strategy here and how has it evolved over time? Because we have seen an escalation since November, but there were sort of isolated attacks happening [even] before then. So what is changing here?

Sal: (04:30)

Yeah, so initially they were focusing on ships connected to Israel. I mean, the root of this issue is the Houthis’ kind of solidarity with the Palestinians and Hamas in the Gaza Strip. And then again, it goes all the way back to the Israel-Hamas issue.

But we’ve seen the Houthis attack ships prior to this. Go back to 2016, 2017, we saw attacks on UAE vessels. We saw an attack on a Saudi frigate. We even saw an attack on a US Navy destroyer. But this effort recently is focusing on Israeli-owned Israeli flagships.

So we saw ships of ZIM and other Israeli companies immediately divert, but then the Houthis expanded. They started targeting vessels, they said [were] connected to Israel, either through their ownership, so for example, Mediterranean Shipping Company, what [is] the largest container liner in the world. They started targeting their ships because the owner’s wife, of Mediterranean Shipping Compan,y has dual citizenship — Switzerland and Israel.

And then we saw attacks that really had no connection at all to Israel, but they would try to make those attacks. And what these attacks are doing aren’t really so much damaging vessels. We’ve seen ships hit and we had a very dramatic one just the other day with a ship called the Marlin Luanda, which caught fire.

But what they’re doing is raising the cost to sail through this area by escalating war risk insurance. And we saw a very similar thing happen in the Red Sea between Russia and Ukraine. But by escalating war risk insurance, the added insurance you need to sail through an area, you make very expensive ships such as container ships, which have a value of between a quarter to a half a billion dollars, cost-prohibitive to sail through. We saw the war risk, for example, jump from 0.02% the value of the ship up to 1%. And when you start doing the math on value of vessels, the very expensive vessels find it more costing economical to sail around Africa.

Joe: (06:27)

Wait, wait. This is interesting. How is war risk insurance assessed? And when you say, like, 1%, is that per trip? How do those… talk to us a little bit more about these deals and the math there.

Sal: (06:44)

Sure. So shipping insurance is done by a group of companies called clubs. And they get together and literally there’s a committee in London that puts together areas of war risk. They identify the areas that there are confrontations and basically whether or not you need this added insurance, kind of like flood insurance for your house. If you don’t have it and your house is damaged by a flood, your normal insurance wouldn’t cover it.

So they identify the area in and around the Red Sea as a potential war risk, initially down to that 0.02%. But as the Houthis attacked and then increased their level attacks, they have ratcheted up that war risk. We’re seeing right now, for example, up in the Black Sea, that war risk is right around 1.25%. That’s come down from about 3%. And so this committee will assess that. And if you want to sail through these regions and they specify latitude and longitude and the distance, you pay it for that one time voyage.

So let’s assume you have a ship of a hundred million dollars, both the value of the ship and the cargo, then you have to pay a million dollars to go through there. And now, you start weighing that against, well, it’s about a half a million to go through the Suez, but it’s going to cost me over a million dollars in extra fuel to go around. What’s the cost-benefit here for doing it?

And what we saw is on the higher end ships, the container ships, the LNG and LPG carriers, then they were weighing as like ‘Okay, it’s much more economical and safer for me to go around Africa than to take this risk.’…

…Tracy: (19:13)

So we have seen [spot] shipping rates go up recently, but my impression is that a lot of the shipping rates are, you know, the shipping rate is sort of pre-agreed, contractually agreed some time ago. And yet we have seen this increase in costs. You described how the wartime insurance rate goes up, it seems [it does so] fairly quickly. You have captains that are presumably wanting additional compensation for taking on this risk. How quickly and how much could shipping rates actually rise from here?

Sal: (19:46)

So, you know what we saw during the height of the supply chain crisis, you see all those charts, that was the spot [rate], right? That’s the rate you pay if you don’t have a long-term commitment in place. Most shipping, most containers, for example, are on long-term charters. And so those, you know, about 70% of the cargo that’s moved is on long-term.

But ironically, the route between Europe and Asia was up for renegotiation as of January 1st. So right when this was taking place, we saw that happen. But even if you have a long-term shipping route agreement, there are charges that can be imposed on top of that surcharges for extra fuel for port stays.

And so a lot of companies that were shipping goods all of a sudden started getting notices like ‘Well, my container’s going to be a thousand dollars more than I thought it was going to be.’ Well, that’s because the company sat there and said ‘Well, I had to stop in South Africa and buy really expensive fuel. Plus we’re not going to the port initially, we were going to drop your container off in, so we’ve got to drop it off in a sub port and it’s got to be moved over there.’

And so we saw the prices begin to escalate because the shipping companies tend to pass that cost on. And what you’re seeing now is even the long-term rates are seeing readjustments because of that. Plus the shipping companies have to readjust their schedules. You know, if you had a container ship that was going through the Suez and stopping in the Med, that’s not happening now. And now you’re seeing ships stop at other terminals dumping their containers and reshuffling them. So the ports at the entrance to the Med, Tangier and Angier and Algeciras, are getting a lot of business because you have to reshuffle containers.

And so now the, the freight rates are changing. If you look at the freight rate charts right now, they kind of peaked and they’ve kind of dipped down and now they’re starting to stabilize at this point. But we’re also seeing impacts in other ways.

So for example, the US freight rates get negotiated by May 1st, but we’re seeing freight rates increase to the United States. Why? Because a couple of factors, if you are shipping containers from Asia to Europe, I mean to Asia, to North America, for example, well you may be shipping it, you know, I don’t want to go to LA and Long Beach anymore because of the issues with LA and Long Beach that happened a couple of years ago. So I’m going to put my containers on these new Neopanamax ships.

They go through the big lane of the Panama Canal that opened in 2016. But, [it’s not] like we don’t have enough choke point issues. Panama Canal’s at low water levels. We’ve seen a two thirds reduction in the number of ships going through there. So now you’ve got this fully loaded Panama, Neopanamax ship, it arrives on the Pacific side of the Panama Canal and they can’t get through because it draws too much water.

Now I’ve got to take 3,000 boxes off rail them across Panama and meet them on the other side. That’s a cost I didn’t plan on. That ship comes to the United States offloads. But instead of going back the way it came, because it doesn’t want to take a passage through the Panama Canal, it’s now going to head back to Asia through the Mediterranean and the Suez Canal. But wait a minute, the Houthis are there. Now I’ve got to head around Africa. And so what you’re seeing is a lot of surcharges and extra charges and most importantly, delays in the movement of goods that were not planned on…

…Tracy: (37:33)

How long until the slowdown, and I guess the additional complexity that you’ve been talking about, how long until that makes its way to US supply chains? Because so far, you know, most people are talking about this as a Europe or Asia specific problem, but as you point out, it just takes some time to reverberate.

Sal: (37:53)

Well, I mean, you’re seeing that right now in Europe. You’ve had a very kind of high visibility [companies], some manufacturers, Tesla and a few others, had to shut down production because they’re waiting to get parts to them. And you’re seeing the impact of that also in the fact that ‘Well, we’ll just throw them on airplanes and send them over.’ Well, 30%-33% of the world’s aviation fuel goes through the Suez Canal and now it’s being diverted. And so now even aviation has issues associated with it.

It tends to be weeks. And we’re going to see it as right after the beginning of February, because what has happened here is a lot of empty containers — which is the most unsexy topic you can talk about is empty containers — empty containers have not been re-positioned back to Asia in time to be reloaded and put on ships to leave Asia before the Chinese New Year, before the second week in February.

Which means that goods that should have been sailing across this week and next week aren’t going to be there. Which means now you’re going to see them about a month later. So we’re going to see some delays. And again, we’re not going to see shortages, we’re not going to have the great toilet paper run that we had during 2020. But what you will see is a little bit of a spike in inflation in terms of transportation costs. A lot of disruptions.

One of the things that we did learn from 2020 and a lot of freight forwarders and smart people who went with companies that do this professionally did, was diversify how their goods come in. So there was a lot of companies who saw what was happening with the Houthis and sat there and said ‘Hang on, let me get my goods on a container ship and I’ll go into LA and Long Beach right now, because even though I hate it, I’ll go in there because I know they’re going to arrive. And I can get them in there and I’ll pay that rail because rail is looking for cargo right now.’

So a lot of people began to make movements, but some didn’t. And the ones who didn’t see this coming ahead of time, they’re the ones who are going to see it. We’re already seeing backlogs of ships, for example, start to pile up off of Savannah and some of the East Coast ports.

2. The risks to global finance from private equity’s insurance binge – The Economist

Adecade or so ago private equity was a niche corner of finance; today it is a vast enterprise in its own right. Having grabbed business and prestige from banks, private-equity firms manage $12trn of assets globally, are worth more than $500bn on America’s stockmarket and have their pick of Wall Street’s top talent…

… Core private-equity activity is now just one part of the industry’s terrain, which includes infrastructure, property and loans made directly to companies, all under the broad label of “private assets”. Here the empire-building continues. Most recently, as we report this week, the industry is swallowing up life insurers.

All of the three kings of private equity—Apollo, Blackstone and kkr—have bought insurers or taken minority stakes in them in exchange for managing their assets. Smaller firms are following suit. The insurers are not portfolio investments, destined to be sold for a profit. Instead they are prized for their vast balance-sheets, which are a new source of funding…

…Firms like Apollo can instead knowledgeably move their portfolios into the higher-yielding private investments in which they specialise…

…Yet the strategy brings risks—and not just to the firms. Pension promises matter to society. Implicitly or explicitly, the taxpayer backstops insurance to some degree, and regulators enforce minimum capital requirements so that insurers can withstand losses. Yet judging the safety-buffers of a firm stuffed with illiquid private assets is hard, because its losses are not apparent from movements in financial markets. And in a crisis insurance policyholders may sometimes flee as they seek to get out some of their money even if that entails a financial penalty. Last year an Italian insurer suffered just such a bank-run-like meltdown…

…As private assets become more important, that must change. Regulators should co-operate internationally to ensure that the safety-buffers are adequate. High standards of transparency and capital need to be enforced by suitably heavyweight bodies. The goal should not be to crush a new business model, but to make it safer.

3. Mark Zuckerberg’s new goal is creating artificial general intelligence – Alex Heath and Mark Zuckerberg

No one working on AI, including Zuckerberg, seems to have a clear definition for AGI or an idea of when it will arrive.

“I don’t have a one-sentence, pithy definition,” he tells me. “You can quibble about if general intelligence is akin to human level intelligence, or is it like human-plus, or is it some far-future super intelligence. But to me, the important part is actually the breadth of it, which is that intelligence has all these different capabilities where you have to be able to reason and have intuition.”

He sees its eventual arrival as being a gradual process, rather than a single moment. “I’m not actually that sure that some specific threshold will feel that profound.”

As Zuckerberg explains it, Meta’s new, broader focus on AGI was influenced by the release of Llama 2, its latest large language model, last year. The company didn’t think that the ability for it to generate code made sense for how people would use a LLM in Meta’s apps. But it’s still an important skill to develop for building smarter AI, so Meta built it anyway.

“One hypothesis was that coding isn’t that important because it’s not like a lot of people are going to ask coding questions in WhatsApp,” he says. “It turns out that coding is actually really important structurally for having the LLMs be able to understand the rigor and hierarchical structure of knowledge, and just generally have more of an intuitive sense of logic.”…

…The question of who gets to eventually control AGI is a hotly debated one, as the near implosion of OpenAI recently showed the world.

Zuckerberg wields total power at Meta thanks to his voting control over the company’s stock. That puts him in a uniquely powerful position that could be dangerously amplified if AGI is ever achieved. His answer is the playbook that Meta has followed so far for Llama, which can — at least for most use cases — be considered open source.

“I tend to think that one of the bigger challenges here will be that if you build something that’s really valuable, then it ends up getting very concentrated,” Zuckerberg says. “Whereas, if you make it more open, then that addresses a large class of issues that might come about from unequal access to opportunity and value. So that’s a big part of the whole open-source vision.”

Without naming names, he contrasts Meta’s approach to that of OpenAI’s, which began with the intention of open sourcing its models but has becoming increasingly less transparent. “There were all these companies that used to be open, used to publish all their work, and used to talk about how they were going to open source all their work. I think you see the dynamic of people just realizing, ‘Hey, this is going to be a really valuable thing, let’s not share it.’”

While Sam Altman and others espouse the safety benefits of a more closed approach to AI development, Zuckerberg sees a shrewd business play. Meanwhile, the models that have been deployed so far have yet to cause catastrophic damage, he argues.

“The biggest companies that started off with the biggest leads are also, in a lot of cases, the ones calling the most for saying you need to put in place all these guardrails on how everyone else builds AI,” he tells me. “I’m sure some of them are legitimately concerned about safety, but it’s a hell of a thing how much it lines up with the strategy.”

Zuckerberg has his own motivations, of course. The end result of his open vision for AI is still a concentration of power, just in a different shape. Meta already has more users than almost any company on Earth and a wildly profitable social media business. AI features can arguably make his platforms even stickier and more useful. And if Meta can effectively standardize the development of AI by releasing its models openly, its influence over the ecosystem will only grow.

There’s another wrinkle: If AGI is ever achieved at Meta, the call to open source it or not is ultimately Zuckerberg’s. He’s not ready to commit either way.

“For as long as it makes sense and is the safe and responsible thing to do, then I think we will generally want to lean towards open source,” he says. “Obviously, you don’t want to be locked into doing something because you said you would.”

4. Famed Short-Seller Jim Chanos says this is the CHEAPEST thing in the Stock Market (transcript here)- Dan Nathan, Guy Adami, and Jim Chanos

Jim Chanos: I think all things being equal, yeah. But I would actually deflect the question and say one of the things that by 1999 could have told you you were getting in the later innings of the tech bubble in the late 90s, was when you began to see a big drop off in the quality of the earnings of the big tech guys like Lucent and Cisco, whatever. And a number of these companies got into the business of not only doing barter transactions, but also having venture arms invest in companies who then bought their products.

Guy Adami: You’re seeing that around the edges now.

Jim Chanos: I was going to say you’re beginning to see people are beginning to report on – which I think is a good thing – the fact that some of these companies now have reasonably large venture operations under the corporate umbrella and are investing in companies that are turning around and buying their products. I would also point out too, a couple of small companies like Microsoft and Google, who are increasingly capital intensive because of their data centers, who are cutting their depreciable lives, which is a one time thing that will help earnings for a while. But the longer this goes, if we start to see more and more big-cap tech companies begin to use more and more fun and games to make their earnings estimates, then the parallel with ‘99, 2000 is going to be hard to miss…

…Guy Adami: If you’re fine, we’ll play another game, as I mentioned earlier. Over the weekend we heard from a couple United States senators, Lindsey Graham, John Cornyn, both said effectively – I’m paraphrasing – “bomb Tehran” or something of that effect. That was out there. I am shocked that the reaction of the market was as muted as it was. So my question is concerning geopolitical risk, which is seemingly as bad as it’s been, I want to say, in the last 30 or so years, yet no impact whatsoever on the broader market.

Jim Chanos: Middle east strife hasn’t made an impact on markets since ‘73, ‘74. So for people that are looking Middle East issues, most investors just go, “it’s a mess, we’re going to be there, kind of, there’s going to be terrorism.” It doesn’t factor in. I do think that something happening in the Pacific, would be a much bigger thing.

Guy Adami: What is that thing that happens in the Pacific? Our relationship with China is probably the worst it’s been in 50 years. You can debate it. I happen to believe that’s the case. Obviously the saber rattling in terms of Taiwan. When President Xi was in San Francisco in the beginning of December, it came out three weeks later that he said – and again I’m paraphrasing – “We will take Taiwan by whatever means necessary.” That came out in the press I think in mid-December. So that’s out there as well. I mean, nobody seems to be focused on it. Maybe again, they think it’s just rhetoric. What are your thoughts on that?

Jim Chanos: I think that the real risk, and we’ve been saying this for a while, is that he gets more aggressive in foreign adventures to distract people from what’s going on domestically in the economy. And the fact of the matter is they cannot get the domestic economy going, because of all the things that we’ve discussed down through the last 15 years and that the model is a bad model and it’s coming to the end of its useful life and they don’t want to address the realities of changing their economic model, which is based on investment in property. And so I don’t know what he does, but boy, the rhetoric is not good and he has made threats. And the curtain dropping there would be something, I think.

Guy Adami: So I brought this up and actually the people agree, disagree. I’m curious about your thoughts. A lot of people think that because of the weakness in China, it makes them less inclined to do something with Taiwan. My pushback would be it makes them more inclined, I think for the reasons you decided, sort of taking your eye off the ball as to what the problems are and then creating sort of a bit of a divergence for lack of a better word.

Jim Chanos: To Xi Jinping, the deal with the citizenry was, “Don’t get involved in politics, the Communist Party knows best, but we will give you prosperity.” In the last five to arguably 10 years, the prosperity engine has slowed down and sputtered, and now it’s becoming, “Support us nationally, in nationalism and patriotism and the greater China.” And that’s a change. That’s a big change. I think that the economy struggling makes the risks worse, not less.

Dan Nathan: Jim, you’ve been making a fairly bearish case about China…

Jim Chanos: Yeah, you might say so.

Dan Nathan: …for a decade. I’m looking at the Shanghai Composite. It’s really trading where it was a decade ago. And then if you think about US companies and all the excitement over this last decade about access to a Chinese consumer that is growing at a scale that we’ve never seen, but then if you look at really how the Chinese consumer has been exposed to risk assets, it’s been in the very thing that you’ve been warning about for a decade, and that is commercial real estate and residential real estate. So they’ve had much more exposure to real estate, both commercial and residential, than they have to the stock market.

Jim Chanos: Much greater.

Dan Nathan: Okay, so when you see a headline like we saw last week, that the Chinese are going to command the SOEs to repatriate maybe $300 billion and put it into the stock market, the stock market rallied, and then it sold back off. Wouldn’t they have much better use of putting that to kind of stem – we saw the China Evergrande story and stuff like that. Is this finally coming undone right now?

Jim Chanos: I don’t know that it’s coming undone. I think you’re just seeing the flaws in the model, which is the Chinese stock market, when we did our bear call on China, the FXI was $41. I think it’s $22, so it’s almost been cut in half since 2009. But if you actually look at the market cap of the Chinese stock market, it’s up now. So what’s the paradox? The paradox is they’re diluting the hell out of you. There’s so much agency risk in China, it’s not funny. And who’s the patsy? Western investors are the patsy. They’ve provided capital over and over again through the VIE structure, which we’ve talked about till we’re blue in the face, which is a complete fraud. And because China sold them on this growth and you want to be part of our growth and whatever, meanwhile, you’ve done nothing but basically provide capital for them to do other things. Having said all that, the problem, the property market dwarfs everything. After US treasuries, it’s the most important asset class in the world, Chinese property. It doesn’t get the attention it should. And that’s where China has its savings. That’s where the Chinese populace is counting on the price of their flat to provide for their retirement and their kids. And if that doesn’t happen and if that doesn’t pan out, then you’re going to have political issues.

5. A beginner’s guide to accounting fraud (and how to get away with it), Part V – Leo Perry

Back in 2017 I ran a job ad that read:

“In 2016 a police investigation of the collapse of a business closed with a public prosecutor recommending more than a dozen individuals be charged with fraud. One of those named as a suspect is the CEO of a UK PLC with a current market capitalisation of several hundred million. A formal indictment could be handed down any day. Name the company.”

The answer was internet of everything stock Telit Communications. In 2015 Avigdor Kelner, founder and former Chairman, had been sentenced to two years in jail for bribing politicians in Israel. He’d previously been arrested in 2007 in relation to alleged insider trading involving several investments made by Polar Investments, including Telit, although no charges were brought.

But that wasn’t the cat I had in mind in the ad, it was then current CEO Oozi Cats. And the 2016 investigation wasn’t his biggest problem. Italian newspaper Il Fatto Quotidiano reported later in 2017 that he was a fugitive from US justice, having done a runner from the country after being indicted for wire fraud in the 1990s!

Oozi and his wife had allegedly been charged for their part in a land flipping scam. Co-conspirators Wayne Weisler and Susan Taylor pled guilty to operating a scheme designed to defraud mortgage companies by inflating the apparent value of a property through a series of related party transactions, and then borrowing against this artificially high value. The scheme used a Massachusetts entity named Dolphinvest. The company’s Articles of Organization show it was incorporated by Weisler, Taylor and one Uzi Katz.

Now I’m guessing Oozi (or is it Uzi again now?) would probably say he was wrongly charged. That may be so. I’m not casting any aspersions here. I don’t know and I don’t care. What matters for us is that this particular story from his past wasn’t easy to find, even though there were details available online. Partly that was because he had changed how he spelt the anglicized version of his name (from Uzi to Oozi, which was obviously odd to an Israeli friend). But mostly because searching for Uzi Katz on Google brought up dozens of websites about people in Boston. There were sites with titles like “Professor of English Literature from Boston – Uzi Katz”, “Uzi Katz, civil engineer from Boston” and just plain “Uzi Katz of Boston”. My own favourite was “Uzi Katz, Boston Dancer”.

The websites seemed like pretty obvious fakes. As in, they did not appear to be about real people. I mean the blogspot for one linked to a Google+ profile with a photo – which Google Images showed was a picture of Ravi Ramamoorthi, Professor of Computer Science at the University of California.

Maybe, just maybe, these websites were designed to create a smokescreen. The fact that the registered contact for one had the email address reputation@seo-properties.com (seo being short for search engine optimisation) didn’t exactly dispel this impression. Or perhaps it was all just a coincidence and there really are a lot Uzis in Boston. Whatever way it happened, the result was the same. Stories about the Uzi Katz in Boston that got charged with wire fraud were buried way down the search rankings, behind all the dancing professors.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have a vested interest in Alphabet (parent of Google), Meta Platforms, and Microsoft. Holdings are subject to change at any time.

What We’re Reading (Week Ending 04 February 2024)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 04 February 2024:

1. China Wants To Ditch The Dollar – Zongyuan Zoe Liu

Ganzhou also hosts the Ganzhou Rare Metal Exchange, where China’s renminbi currency is used to quote prices for spot trading of tungsten, rare earth products and critical minerals like cobalt that are essential to the clean energy transition.

The metal exchange, established in 2019 with the approval of the State Council, now operates as a subsidiary of China Rare Earth Group. It is China’s second mineral exchange, which was established to use the renminbi to price and trade minerals and rare earth products.

The first such exchange, the Baotou Rare Earth Products Exchange, which started operating in 2014, is jointly owned by 14 major Chinese rare earth suppliers and was explicitly set up, at least in part, to increase China’s overall role in pricing rare earth products. To that end, China also launched two renminbi-denominated exchanges — oil futures in 2018 and copper futures in 2020 — on the Shanghai International Energy Exchange.

By establishing commodities exchanges across its industrial cities, China aims to boost the use and power of the renminbi in global commodities pricing to establish an alternative global financial system that is less reliant on the almighty dollar. This effort also involves regional cooperation with China’s neighbors and non-Western multilateral partnerships to develop regional currency arrangements and enhance the use of local currencies in international trade and investment.

In China’s telling, these strategies are less about offense — trying to dethrone the U.S. dollar or replacing it in the global system with the renminbi — and more about defense: strengthening China’s financial security and reducing its geo-economic vulnerabilities within the existing dollar-dominated global economic and financial system. Beijing wants to minimize its exposure to a potential dollar liquidity crunch and ensure its continued access to global capital markets even during times of geopolitical crisis.

No Chinese leaders have publicly expressed an intention to dethrone the dollar despite escalating geopolitical and trade tensions between the U.S. and China beginning in 2018. However, as those tensions persist, Chinese financial regulators and scholars have explicitly expressed concerns about Beijing’s vulnerabilities and urged government officials to step up efforts to protect the financial system…

…Since President Xi Jinping came to power in 2013, he has repeatedly emphasized worst-case scenario thinking to “prevent macro-risks that may delay or interrupt the process of the great rejuvenation of the Chinese nation.”

From Xi’s vantage point, China’s state-owned financial institutions and enterprises must inoculate themselves against potential international sanctions in the event of a military conflict with the West over Taiwan. That concern has only grown more urgent after China witnessed the collective sanctions imposed by the West on Russian entities and individuals to punish President Vladimir Putin for his war against Ukraine.

The West’s decision to freeze Russian foreign exchange reserves has caused particular consternation in Chinese policy circles. Chinese economist Yu Yongding described such a move as “a blatant breach of…trust” and proof of the United States’ “willingness to stop playing by the rules.”…

…At the September 2022 SCO Summit, Xi explicitly proposed expanding the use of local currencies in trade settlement to promote regional integration, strengthening the development of local-currency cross-border payment and settlement systems and promoting the establishment of an SCO development bank to help shepherd such changes. SCO members agreed on a “roadmap” to accomplish these goals.

In a December 2022 address to the China-Gulf Cooperation Council (GCC) Summit, Xi emphasized his hope that China and members of the GCC should increase the use of renminbi for oil and natural gas trading and settlement through the Shanghai Petroleum and Natural Gas Exchange (SHPGX) in the next three to five years.

Since Xi’s speech, Chinese national oil and gas companies have accelerated initiatives to use the renminbi, instead of the U.S. dollar, in their international fossil fuels transactions through SHPGX. In March 2023, an important step towards the de-dollarization of energy trading occurred when China National Offshore Oil Corporation — known as CNOOC, China’s largest offshore oil and gas field operator — used the renminbi to complete the transaction of importing 65,000 metric tons of liquefied natural gas (LNG) from TotalEnergies SE, a French multinational oil and gas company, through SHPGX. The LNG was produced in the United Arab Emirates, a member of the GCC, carried by a Liberian-flagged LNG tanker Mraweh, and finished unloading in May at the CNOOC Guangdong Dapeng LNG receiving station.

This transaction was the world’s first cross-border LNG trade settled using the renminbi. Since then, CNOOC has executed more renminbi-settled transactions using the renminbi through SHPGX. In October, PetroChina, the largest oil and gas producer and distributor in China, settled a purchase of one million barrels of crude oil using the digital renminbi through SHPGX, marking the first cross-border oil transaction using the country’s central bank’s digital currency…

…Among SCO members, China has since signed bilateral currency swap agreements with Uzbekistan, Kazakhstan, Russia, Tajikistan and Pakistan. China also now has swap agreements with SCO observer and dialogue partner countries Mongolia, Turkey and Armenia; last March, Saudi Arabia committed to joining as a dialogue partner and a full member in the near future. While China doesn’t have an agreement with Kyrgyzstan, which is in the SCO, Kyrgyzstan’s national bank signed a letter of intent in September 2015, stating it aims to work with the PBoC toward establishing a bilateral currency swap.

China’s support for the expansion of SCO and BRICS over the last two years to include major commodities-exporting countries like Iran, Saudi Arabia, the United Arab Emirates, among others, suggests it is eyeing new opportunities to accelerate renminbi use in commodities trading.

The expansion has also given SCO and BRICS added significance as political forces in the shaping of commodity markets. SCO members include major hydrocarbon and minerals exporters in Central Asia like Kazakhstan and Uzbekistan, Russia and its newest member as of last year, Iran.

SCO also includes major commodities importers like China and India. In this context, as a non-Western group of countries, SCO potentially represents a potent coalition of exporters and importers of commodities centered around using the renminbi to finance the entire commodities lifecycle from production to trade to consumption…

…Chinese economists have argued that the ultimate goal of renminbi internationalization should be to have central banks and major international financial institutions worldwide willingly hold large amounts of renminbi for international transactions so that China’s currency can become an international reserve currency alongside the U.S. dollar and the euro.

Since then, the Chinese government has put resources into developing a renminbi-based financial infrastructure for cross-border settlement. In 2015, it launched the Cross-Border Interbank Payment System (CIPS) to improve the convenience of using the renminbi in international transactions by providing onshore renminbi clearance and settlement services.

CIPS allows global banks to clear cross-border renminbi transactions onshore instead of through offshore renminbi clearing banks, providing a one-stop alternative to the combination of the SWIFT system — a secure messaging system used by major banks to send financial information to one another — and the New York-based Clearing House Interbank Payments System.

However, CIPS is not a complete departure from SWIFT and still uses SWIFT’s standards to connect with the global system. It has adopted the ISO 20022 international payments messaging standard to be interoperable with other payment systems as well as with correspondent banks around the world.

By adopting existing cross-border messaging standards, China aims to make CIPS a critical piece of the world’s existing financial infrastructure to promote international use of the renminbi. By 2023, CIPS’s annual business transaction volume reached 123 trillion renminbi (roughly $17.3 trillion), according to data on the CIPS website. CIPS now has 139 direct participants and 1,345 indirect participants worldwide, most of which are foreign branches of Chinese banks.

The Chinese government has also used subtle but strategic initiatives to increase the global appeal of its currency and deepen the market depth of renminbi-denominated assets. Despite hesitations around liberalizing China’s capital account to allow capital to move freely in and out of the country, Chinese authorities have worked to broaden international acceptance of renminbi bonds as collateral.

In March 2021, the International Swaps and Derivatives Association (ISDA), a New York-based group composed primarily of the world’s largest banks, together with the China Central Depository and Clearing Corporation, the Beijing-based central depository for all Chinese government bonds, released a whitepaper detailing the usage of Chinese government bonds as an initial margin in derivatives contracts.

This past September, the Hong Kong Exchanges and Clearing (HKEX) and London Stock Exchange started to study the use of Chinese government bonds as eligible collateral for derivatives contracts as a way to reduce Asia’s heavy reliance on cash for margins on derivatives trades. Chinese institutions have also teamed up with leading resource-rich economies to make renminbi-denominated assets more attractive for international investors…

…China’s promotion of an alternative financial system is not about cheering on the demise of the U.S. dollar, but rather about creating an alternative financial system without a dominant currency in which the renminbi is accepted without bias. China has a strong incentive to prevent the dollar’s collapse because it would likely be the largest financial loser should the dollar depreciate. The majority of China’s over $3 trillion in foreign exchange reserves are invested in U.S. bonds and the lion’s share of Chinese sovereign fund portfolios are tied to dollar-based Western markets.

2. TIP602: Same As Ever w/ Morgan Housel – Clay Finck and Morgan Housel

[00:09:27] Clay Finck: He states, risk is what’s left over after you’ve thought of everything. And I just absolutely love this chapter. It’s Everyone wants to know what’s going to happen. What’s the stock market going to do? Interest rates, the Fed. You state the biggest risk and the most important news story of the next 10 years will be something nobody’s talking about today.

[00:09:45] Clay Finck: No matter what year you’re reading this book, that truth will remain.

[00:09:49] Morgan Housel: Yeah one way I think about this is I wrote Psychology of Money, my first book. I wrote most of it in late 2019. So obviously that was weeks or months from COVID completely throwing our life upside down, everybody’s life upside down.

[00:10:02] Morgan Housel: And I and everybody else had no clue about it. We were completely oblivious to what was going on. Staring at us in the face of that at that point, and I think what you can say, what is the biggest news story globally of 2023 of last year? It was, I think most people would say it was Israel Hamas, which is another thing.

[00:10:17] Morgan Housel: If you go to January of 2023, nobody was talking about that. No one was putting that on their radar. Even the day before it happened, virtually no one was talking about it, thinking about it, forecasting it. So it’s always been like that. You can say that for this year. The biggest news story of 2024 is something that you and I are not talking about today that we cannot see coming.

[00:10:35] Morgan Housel: Someone, I just saw this on Twitter just a couple hours ago. I thought it was really good. I’m paraphrasing it, but it was like, if you are making a decision tree or like a list of probabilities and you say, there’s a 20 percent chance of this happening and a 30 percent chance of that happening. If you’re just going through probabilities like that seems like a smart thing to do.

[00:10:51] Morgan Housel: But if all of your probabilities add up to a hundred, then you’re doing it wrong. Because what you are implicitly saying is that every potential possible outcome that there’s going to be. So I think the best you can do in any of these is if your known probabilities and you can think of should add up to 80 or something like that.

[00:11:07] Morgan Housel: Maybe it’s 90. You should always, you always have to leave a percentage chance for something could happen that I cannot even fathom. That I can’t even, no matter how creative I try to get, there can be a risk out there that I cannot even envision. And of course you should do that because that’s how it’s always been.

[00:11:21] Morgan Housel: The biggest news stories of modern times are things like the Great Depression, Pearl Harbor, World War II, 9 11, Lehman Brothers going bankrupt, COVID of course. And the common denominator of all of those is that you could not have seen them coming, at least in their specific nature of how they arrived and what they did, until they happened.

[00:11:37] Morgan Housel: And so it’s always going to be like that. It’s very uncomfortable to come to terms with that, to come to terms with how uncertain and unpredictable the world can be. But I think if you study history, you can’t come to any other conclusion.

[00:11:48] Clay Finck: What I find so fascinating about this is the biggest sort of disasters are those that no one expects, no one forecasted, no one projected.

[00:11:57] Clay Finck: You mentioned in your book that it seems that zero economists predicted the Great Depression. It’s no wonder it was so bad. No one was prepared for it. No one expected it to come. And COVID is very similar. And you’ve lived through the great financial crisis, likely an investor at that time.

[00:12:13] Clay Finck: Did it feel like no one was saw it coming and it was just a total disaster and much worse than anyone could have ever imagined.

[00:12:20] Morgan Housel: See, that’s a little bit different. That’s different than 9 11 because as recently, as re as early as 2003, there were people who are ringing alarm bells about how fragile the economy was and over leverage and whatnot.

[00:12:32] Morgan Housel: So that it’s not, nobody saw it coming. That’s not quite, that’s not quite true, but a lot of the people who quote unquote, saw it coming. When it did happen, it happened for reasons that they could not fathom. So for example, a lot of people, I won’t name names, but as in 2005, 6, 7, they said a giant recession is coming and it’s going to be caused by hyper, it’s going to lead to hyperinflation and interest rates are going to go to double digits.

[00:12:53] Morgan Housel: The exact opposite happened. So what do you do in that situation where they saw trouble coming, but it happened for the exact opposite reason than they saw it coming? That they envisioned. It’s there’s all these weird nuances there where it’s not black and white. There’s also what really sent the financial crisis into hyperdrive was Lehman Brothers going bankrupt.

[00:13:09] Morgan Housel: But there’s all these alternative histories of a lot of people forget that as Lehman Brothers is going down, Barclays was like hours away from buying it. And that deal fell through and Lehman Brothers went bankrupt. But there’s this alternative history of what if Barclays had bought Lehman Brothers and we escaped all of that.

[00:13:23] Morgan Housel: And the economy just zoomed to recovery after that. There’s all these different possibilities. And I think the takeaway from that is you couldn’t have seen it coming. Even if you saw trouble, you saw brewing in the financial crisis. Nobody in their right mind could have known exactly how it was going to play out.

[00:13:35] Morgan Housel: And I think that’s true, even not only during, but after the financial crisis, it was so common if you were an investor in 2009. To say, look, stocks are still overvalued. We’re in the quote unquote, new normal of low growth. That was a phrase that was always thrown around. The CAPE ratio is still just still too high.

[00:13:52] Morgan Housel: Expect lower returns. That was what virtually everybody was saying. I’m not going to say everybody. Of course, there are some people who saw it differently, but that was the very common narrative. And it made sense. If people were saying that you’re like, yeah, that makes a lot of sense. But what happened?

[00:14:04] Morgan Housel: The stock market tripled over the next three years. It was a, ended up being like the best three year period to be an investor in modern times. And so that, that’s a very common story throughout history too, is that the narrative at the moment, that makes sense that the majority of people cling to in hindsight looks ridiculous.

[00:14:19] Morgan Housel: And so we see that a lot across and it’ll be like that going forward whenever the next recession is, of course…

…[00:39:37] Clay Finck: I also wanted to tie in here, the emotional side of investing. The Buffett quote is be greedy when others are fearful and fearful when others are greedy. But you talk about in your book how this is much easier.

[00:39:51] Clay Finck: said than done. And it’s just so hard to put ourselves mentally fast forward in that type of situation when stocks have fallen, it’s the time to buy. And another problem is that when stocks fall, there’s usually a good reason why they’re falling. And I go back to March, 2020, and I had friends calling me at work, telling me how much money they’re making by shorting the market.

[00:40:10] Clay Finck: And yeah, this coronavirus going around and just the emotions just flood in. And it’s just so hard to act rational when those emotions are at play. You write in your book, hard times make people do and think things they’d never imagine when things are calm. And March 2020 was the complete opposite of calm.

[00:40:29] Clay Finck: Talk to us about how our views and goals can quickly change when our environment’s changing.

[00:40:35] Morgan Housel: I think if I today, right now, when the economy and the stock market are pretty strong and prosperous, if I said, Clay, how would you feel if the market fell 30%? Most people would say, I’d view that as an opportunity.

[00:40:45] Morgan Housel: That’d be great. The stocks that I love would be cheaper. I’d be a buying opportunity. That’d be great. Okay. And for some people that really is the case. But then if I said, Hey, Clay, the market falls 30 percent because there’s a pandemic that might kill you and your family and your kids school to shut down and you have to work from home and the government’s a mess, it’s going to run a 6 trillion deficit to try to figure this out.

[00:41:04] Morgan Housel: How do you feel in that situation? You might be like, most people will say, Oh, in that world, or once they experienced that world feels very different. Or if I said, Hey, the market fell 30 percent because there was a terrorist attack on nine 11. And all the experts think that was just scratching the surface of what’s to come.

[00:41:19] Morgan Housel: Do you feel bullish now? A lot of people will say no, they don’t feel. So once you add in the context of why the market fell, most people will realize that it’s much easier to quote Buffett than it is to actually be somebody like Buffett. I experienced this myself. I had some of the smartest people who I knew in March and April of 2020.

[00:41:35] Morgan Housel: Some of the conver I remember two specific conversations. One was somebody who said, Hey, look, there’s about 2 trillion of capital in the entire banking industry. You do not need to be creative to imagine how all of that’s going to be wiped out. The entire capital of the entire banking industry is going to be wiped out.

[00:41:48] Morgan Housel: And I remember thinking that and being like, yeah, no, you don’t. If the entire economy is shut down for three months, all of that capital is gone. The entire banking sector is insolvent. Obviously that did not happen. But when I heard that, I was like, no, that actually makes sense. I don’t know if that’s the base case scenario, but that’s not far fetched.

[00:42:03] Morgan Housel: I also remember during that period of COVID when it was like, no one’s really going to be making their mortgage payments when everyone is on lockdown that people are like, look, the entire non banking lending sector, non bank lending mortgage sector is all going to collapse. And that’s 80 percent of the originations market.

[00:42:17] Morgan Housel: 80 percent of mortgage originations are going to be out of business in two weeks. And I remember piecing that together and be like, that makes sense too. That didn’t happen either. But during this period, Which was in hindsight, and even at the time, you could have seen look, this is the opportunity of a lifetime.

[00:42:30] Morgan Housel: The market fell 50 percent in a short period of time. This is gonna be a great opportunity. When you add in the context, both the health consequences and the potential economic consequences. It’s a much different situation. I would even say to finish this up, this is maybe the most important part about, I think it was in early February, 2020, Warren Buffett went on CNBC and they’re talking about, Hey, there’s all these rumbles about a virus.

[00:42:51] Morgan Housel: Like, where do you get it? Like the market’s starting to fall. What’s going on? And Buffett said, I don’t want to, I’m paraphrasing here. This is not a direct quote, but He said, I don’t know how I’m going to invest in the next month, but I guarantee you, I’m not going to be selling. That’s what he said.

[00:43:03] Morgan Housel: Two weeks later, he dumped every airline stock that he owned. So even in this situation, somebody like Buffett, the originator of the phrase be greedy when others are fearful. When he added in the context of what was happening to the airline industry during the lockdown, he determined, and I think in hindsight, it was probably the right decision to sell those stocks.

[00:43:19] Morgan Housel: And some people have pointed out too that part of the reason that he sold him is that the government could not have bailed out the airlines if he was the largest shareholder, so people asked him to sell those stocks. It is a complicated thing, but once you add in the context of why the market’s falling, most people realize that their risk tolerance is actually much less than they thought.

3. What I Learned When I Stopped Watching the Stock Market – Jason Zweig

I’m back at my regular post at The Wall Street Journal after being away on book leave. That long hiatus disengaged me from the daily hubbub of markets so I could frame investing ideas in a longer historical and broader psychological perspective…

…When my last regular column ran last May 26, the S&P 500 was already up 10.3% in 2023—right in line with the long-term average annual return of U.S. stocks. “Let’s just call it a year right here,” I recall muttering to myself.

That was the last thing I remember. From that day to this week, I tuned out the daily noise of fluctuations in stocks, bonds, commodities and economic indicators…

…It’s a good thing the market gods ignored me, as they always do. Even though I thought a 10.3% return in five months was plenty for an entire year, the S&P 500 finished 2023 up more than 26%, including dividends.

When you don’t watch the market every day, you can finally see with unquestionable clarity that what you would have expected to happen didn’t. The unexpected did.

Had you told me war would break out in the Middle East in October and last for months, I would have been sad but unsurprised. Had you added that crude oil would—after a fleeting surge—finish 2023 at a lower price than the day I left, I would have been amazed…

…You probably can’t disappear for seven months, but you can pretend you did. Hal Hershfield, a psychologist at the University of California, Los Angeles and author of “Your Future Self: How to Make Tomorrow Better Today,” urges investors to “use the tools of mental time travel to escape the tyranny of the present.”

He means that envisioning how you will feel about your actions tomorrow can help prevent you from overreacting today…

…For general templates of such letters, see the “Future Self Tool” at consumerfinance.gov.

Research suggests this technique can help you avoid making decisions you might later regret—and can reduce the anxiety stirred up by negative news.

I’ve long thought financial advisers should encourage this approach to help clients make deliberate and durable decisions. Now I think it’s worth trying on yourself, too.

4. An Interview with Arm CEO Rene Haas – Ben Thompson and Rene Haas

RH: Yeah, two things are key. It’s very, very small, it takes longer to fabricate. So what may have taken you 12 weeks to put a product into production now may take you 26 weeks. That’s a big, big jump in terms of the lead required.

Then you look at these SoCs that are using Arm, back in the day, if we were putting 12 to 16 CPUs into an SoC, that was considered a lot. You now look at some of the recent chips being announced, just look at the Microsoft Cobalt, their recent CPU that they announced using Arm, 128 CPU cores into that SoC. That is a lot of work for someone building an SoC to figure out how those 128 CPUs are going to work together. What’s the cache coherent network look like? What does the interconnect look like? What does the mesh look like?

So what we felt was if we can provide more of that solution, i.e., stitching together all of the system IP, the GPU, the CPU, an NPU, anything around the processor fabric, we could fundamentally allow the customers to get to market much, much faster.

So we started this initiative towards what we call compute subsystems, which was really about developing the overall platform, which not only helps us in terms of getting an SoC to market faster, but it also allows us to work more quickly in terms of the software ecosystem. We can start to think about what gets product in the hands of developers sooner, or what gets the products in the hands of people who are developing the application software, people who are doing the OS work.

So for a myriad of reasons, it just made a ton of sense for us to go up and do that and we’ve started that with our hyperscalers, with our cloud compute, but we see it applicable to almost all the markets, whether it’s a cell phone, whether it is a laptop, whether it is an automotive ADAS [Advanced Driver-Assistance System] system. The same rules of apply, these are complex compute subsystems. The chips take a long time to build. If you can shave off any amount of development time that helps the people get the chips out faster, that’s huge value. What we are seeing is in some cases where it may have taken two years to get a chip to tape out, we’ve cut that in half. One customer came back and said, “Look, you’ve saved us 80 man-years in terms of efforts.” So across the board, we’ve seen pretty strong validation that this is the right thing to do.

Just to get to the nuts and bolts a little bit, you mentioned the savings in terms of design time and things getting smaller and how long it takes to fab a chip. Is this also just a matter of, there’s a lot of reports about interference and stuff like that, particularly when you’re getting even down to 3 nanometers or 2 nanometers in particular. Is that a real driver as well? Would this opportunity be presenting itself absent the real challenges that are coming along in terms of smaller and smaller size chips and the increased design challenges that are coming with that, particularly around interference?

RH: You follow technology for a living, so you know this well. Like everything with these type of things, a number of things need to come together at once. When you have these long cycle times to build the chips, the complexity in closing timing loops, you’re trying to drive the maximum power efficiency, you’re trying to maximize the ultimate work you’re doing with the libraries. Again, with these subsystems, we will not only handle everything in terms of validation and verification, but we’ll do the tuning for the process. So if folks want to make sure they can get that ultimate last mile of performance, that’s just a lot of work that needs to be done that if Arm is doing it with a platform that we control — because it’s our IP, right?

Right.

RH: At the end of the day, it is around the compute subsystem and computer architecture that we’ve delivered, it’s highly beneficial. So again, in the old days you could kind of throw all this stuff over the wall and people could just pull it together and make it work, but the world has changed a lot in terms of just the complexity of these chips, and one thing that’s not relenting is people want to get products out fast. The markets will move really, really quickly and I think actually we’re seeing them moving even faster now. When you look what’s going on with generative AI and everything relative to these multimodal models and large language models, you have so many moving parts relative to what it takes to develop a product. It’s really, really critical to maximize on efficiency of time to market…

… I’m curious because on one respect, a lot of consolidation at one part of the value chain would potentially increase the opportunity for competition in others. You could see how consolidation would play well to say, RISC-V prospects in that regard, open source is as modular and open as you could get. On the other hand, is that sort of drive in a value chain of consolidation at one point, driving modulation the other, is that just overcome by the complexity involved, such that there’s rooms for multiple highly consolidated aspects of this chain? TSMC is pretty centralized as far as things go, and you just feel optimistic that at this point in time, the ecosystem from a software perspective, Arm is x86, 15 years ago on the PC side, and even if you theoretically want to do something different, there’s so much software to build, your lead is just going to be much larger.

RH: I think so, but it’s a very, very good question because it’s a little difficult I think to look backwards to kind of predict the future. One of the things we’re seeing around the future innovation that’s really a gate to innovation is this massive capital investment required, and it’s not just in building a chip, not just in building a fab, it’s not who has enough money to go off and buy new ASML EUV machines.

Let’s take a look, for example, at foundation models and everything going on with generative AI and training. Right now, Nvidia is an amazing position because of just the pure access to GPU technology and how expensive it is now, how scarce it is. That in and of itself, starts to lead to an area of, “Well, you’ve got all kinds of interesting open source models and people in the open source community working with things like Llama. But if people can’t get access to the GPUs and actually training, then who wins?” So, right now you’ve got the Big King.

We saw an excellent example of that in the last few months. He who controls the GPUs controls the world, at least for now.

RH: Correct. So, then when you start to think about — I like to think that Arm is an amazing place because any one of these application areas, we’ve got a huge, huge installed software base and we’ve got a very, very powerful position on power efficiency. So, when I think about where the puck is going relative to an alternative architecture, let’s say, you’ve got to look at either, “Do I have a 10x advantage in performance or a 10x advantage in terms of cost?”. And right now, I think in the areas where Arm is really good at, people would have to look at it really hard and say, “Is it worth the investment to go port everything I’ve got to an alternative architecture? What is the ultimate benefit that I get to the application space?”.

I think what’s really fascinating about everything going on with generative AI right now is I think you’re just seeing huge amount of resources coming into all kinds of development around training and inference, that will drive the growth here, so I think that’s actually where the growth is going to come. I think Arm is in a great place there. Obviously I’m biased but I think when you think about everything that’s going on with generative AI training, all those inference workloads are pretty good for the CPU, and history has sort of shown us that over time, as you add, and we saw this, whether it’s floating point heading into the CPU, or vector extensions, the CPU start to add more and more of the base functionality it allows with some of the workloads and I think you’ll see that in this space…

…Fast forward to where I am now, I don’t spend a lot of time when I talk to people inside of engineering or product groups about, “Hey, who’s catching us from behind?”, I try to think far more about where the world’s going to be in five to ten years. If you think about where the world’s going to be in five to ten years and you focus as much as you can, you’re not going to get it specifically right, obviously, but you want to be directionally investing in that area so when things land in your space, you’re going to be in a good spot.

Take case in point, predicting what the mobile phone is going to look like in 2034, ten years from now, and trying to make sure I do everything defensively to make sure that we’re in a great position is kind of nutty because if you go back to 2008 when the smartphone was invented, folks who were trying to think about protecting what the future phone looked like would have been out of position. Where I really focus on, Ben, is just where are things going and where do we need to invest?

Again, I know this AI drum that gets, people at times try to think, “Oh my God, how many times you got to hear the word ‘AI’?” — obviously, on one level AI is not new, anything that was going on relative to voice recognition or data translation, obviously that was all AI. I think AGI and everything around generative AI that can think and reason, that’s a pretty compelling place, and whether that takes place in five years, ten years, fifteen years, I don’t think anyone can argue that an investment in that space isn’t going to provide huge benefit down the road. I think Arm is a compute platform, I want to be sure that we’ve got everything correct from either an infrastructure standpoint, instructions at architecture standpoint, everything around the subsystem to be able to capture that.

Do you feel pretty confident? I think that you’re trying to sort of tie all of your stuff together to a greater extent, but companies could bring their own neural processor. Google obviously does that at a very sort of small-scale example, scales as far as terms of numbers, not scale in terms of importance of AI obviously, but is this really core to your thesis that as opposed to you needing to bring up a super competitive sort of NPU that, to your point, about the extensions and floating point, which I think is a great analogy, this is all going to be built into the CPU, so regardless, you’re going to need — even if the mobile phone market doesn’t grow just because of the number or it’s limited to this number of humans on earth, that is still going to be a significant opportunity or do you think you have to bring up additional separate IP? Or is this idea of it all being separate meaningless in the long run?

RH: It’s not going to be a one-size-fits-all kind of situation. Today, there’s a lot of investment going on training these very, very large models on highly networked GPUs. Even when you start talking about inference in the cloud, what matters is compute, but less around the interconnect between all of those systems, which is why CPUs over time in the cloud may find themselves to be very, very good solutions without having a GPU necessarily connected to it.You’re going to have a CPU in the cloud no matter what, so at some point it probably makes sense to consolidate.

RH: While Grace Hopper is a fantastic design from Nvidia, there’s a lot of people who I know are asking for, “Just give me Grace and don’t give me the Hopper when I go off and run inference.”…

…But when you see announcements like Microsoft Cobalt — after Graviton was announced, we had a lot of folks saying, “Well, they did it for their own reasons, and there’s not going to be much level of scale.” I would say continue to launch these very, very significant product announcements from company moving to the Arm architecture and I think you’ll see more and more of those over the next 12 to 18 months. And really, those are indicators, whether it’s in the automotive space, in the AI space, look for things, and I can’t tease this out too much, but my example of floating point instructions moving into the CPU, watch for those things on the AI front because that’ll tell you the direction of travel that says, “Yeah, this is moving that way.” I can assure you that we’re not going to stop doing these subsystems, and you’re going to see more and more announcements coming out on those.

5. A beginner’s guide to accounting fraud (and how to get away with it): Part IV – Leo Perry

In September 2011 Quindell (at the time trading as Quindell Portfolio PLC) acquired a business called Quindell Solutions Limited (QSL).

QSL had previously been a subsidiary of Quindell Limited, which in turn reverse merged into Mission Capital in May 2011, to form the then listed business called Quindell. All clear?

In 2009 Quindell sold QSL to its CEO Rob Terry in for a pound. Companies House filings show it had a slightly negative book value at the end of 2009 and again in 2010; sales, costs and cashflow were all nil. So QSL was an empty shell.

In 2011 Quindell re-acquired QSL for two hundred and fifty grand in cash (£251,000 to be precise). At the time it was wholly owned by Quob Park Limited, which was in turn wholly owned by Rob Terry. Quob Park’s previous name was Quindell Portfolio Limited.

If you’re still following, Rob and his wife Louise Terry were both Directors of Quindell (the PLC) and of QLS / Quob Park when the acquisition took place. But it wasn’t disclosed as a related party transaction. I mean this was AIM after all.

So it looks a lot like Quindell made a large undisclosed payment to its CEO, for an empty shell company that it had sold to the same CEO two and a half years earlier – for a pound. Perhaps, surely, there was some great innovation at QSL in the mean time that justified the cost. But there didn’t have to be. And in our case there won’t be…

…I’ve seen a few listed companies stretching the limits of credulity between actual and maintenance capex. But none ever topped a marketing firm I was short about 15 years ago. Beginning in 2005, a little before it listed in London (yes, on AIM) the company went on an investment binge. Capitalised spending rose from only a few percent of sales to over half, and stayed around 20% for the next 5 years.

There are a few ways an investor can get some insight into that number, without even looking to see what it’s spent on. One is to compare it with similar companies. If you looked at the kind of business this management wanted you to believe they were competing with – mobile ad networks like, say, Millennial Media – you were in for a surprise. Millenial spent about 3% of sales on capex.

But you didn’t even need to get that specific. A fifth of sales going into capex is a lot for almost any established business. So another way of making sense of it is to ask what kind of operation needs that level of investment? Before you go and search for the answer, have a guess at what the most capital intensive companies are (I went for transport infrastructure, things like toll roads and airports). If you did screen for companies that had capex over 20% of sales back then you ended up with a pretty short list (leaving out start-ups with little or no revenue, which were mostly biotechs and junior miners). The list was more utilities and telcos than transport as it turned out, but there were a few airports (and some airlines as well). Shockingly no advertising agencies made the cut.

The best clue that the investment was bogus, though, was what the company stated it was spending it on. Software, sure. But not code they developed themselves, this was programming bought off the shelf. When I asked management to break it down the best example they could give was Microsoft licenses!

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have a vested interest in Microsoft. Holdings are subject to change at any time.

What We’re Reading (Week Ending 28 January 2024)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 28 January 2024:

1. Mark Dow – A Behavioural Macro View – Eric Golden and Mark Dow

Eric: [00:08:06] I appreciate you making the arguments here. The notion of the narratives, ones that I want to get into was the Fed. Since 2008, it feels like — the Fed was a topic of discussion. It seems to come and go and be more important to people. And it seems to be one of the central narratives that people go to. I’m curious on your view. You’ve talked in the past about the Fed might not have as much control as people give it credit for, but it sure gets a lot of the headlines as if it does have some complete control over which way the markets go every day.

Mark: [00:08:37] Yes. Well, first thing, it helps with content production. There are a lot of — CNBC and Bloomberg and a lot of people who produce content for a living, they need to say something. So the Fed is kind of the explanation of last resort, sometimes the first resort, but you always can point to something the Fed did and make a plausible argument that that’s what’s driving things. The second is when people are wrong, it’s much easier to say, no, listen, I would have been right in my bearish call, but the Fed cheated. They printed money or they did this.

Even now over the course of this year, as the Fed has shrunk its balance sheet and raised the interest rates by 500 basis points, people are trying to argue., well, this component of the balance sheet is changing, whether it’s the treasury, a general account or the reverse repo facility or whatever it happens to be, they want to say this is liquidity-driven because in a sense that exculpates their fundamental analysis that didn’t play out.

So it creates a lot of emphasis on it. But the big story this year and the one I’ve been talking about in our Behavioral Macro a lot, my subscription Twitter feed, is monetary policy didn’t turn out to be as powerful as everyone thought. And that’s where you made your money.

And there are three main reasons why monetary policy hasn’t been as powerful as people thought. There’s the behavioral reason, the secular reason and the cyclical reason. Just from a cyclical standpoint, we kind of know the story by now. We didn’t a year ago. And I got a lot of pushback on Twitter when I was talking about it.

But now I think everyone has recognized that the initial conditions matter a lot. The quality of the balance sheets in the household sector and the corporate sector and in particular, the financial sector were in much better shape than they were, the GFC, which is kind of the most recent memory people have, right?

So people have kind of been waiting for us to cyclically reproduce that cascading, deleveraging process that we had back then because that’s our PTSD, that’s in our memory. But the initial conditions were a lot better, and therefore, it didn’t happen.

And the recessions tend to happen when it’s about speed, much further level. So if you can deleverage — so basically, recessions happen when people get too far out over their skis taking risk because they got overly optimistic. And then for some reason, people say, oh, wait, I’m really out over my skis now, and things may not be playing out exactly what I thought, and they need to retrench.

So if they’re really out over their skis, they have to cut back on their investments rapidly, they have to fire people rapidly, households have to tighten their budgets, financial entities have to sell assets. All these things happen at once. And when they happen at once, it becomes self-reinforcing.

So if you go from unemployment of three to unemployment of six in two months, it panics people and leads to more layoffs at a faster rate. People go further and they don’t feel like they have the time or the luxury. And the same thing when they’re reducing the average on their balance sheets or households to cut back on their budget, that happens fast.

And then demand has cut back and then more people need to be laid off and it feeds on itself. It’s a self-reinforcing process until it burns out. If you go from 3% unemployment to 6% unemployment over two years, then it’s a more orderly process.

And you don’t get the fire sales and you don’t get the panics. That self-reinforcing feedback loop is a lot weaker, a lot less likely to get into recession. So that’s kind of how I look at this. And since our initial conditions were pretty strong, I didn’t think getting into one of those really aggressive feedback loops was very likely.

The secular reason is the Fed controls a lot less of money supply, if you want to call it that, than it used to. Over the past 30 years, we’ve had global financialization, global financial deepening, however you want to refer to it. And way back in the day, basically, the monetary system was the Fed and banks.

So the banks would issue credit and give you a deposit on the other side. So they would issue the money in the form of deposits into existence. That was the primary form of money creation, not the Fed, but the banks and the Fed supervised this process. They wanted to make sure that the banks were staying within regulatory parameters. They also had other objectives that they needed to fill.

What’s happened over the past 30 years, 40 years is we’ve had an explosion of things like repo and euro dollars. If you want to call them chattel banks or what have you, these guys also create money. When you do a repo, you’re basically liquefying an asset. You’re taking the asset on your books and you’re making it liquid by borrowing against it, and you take that money, and you spend it. That’s money creation.

Euro dollar is the same thing. Fed does not control these processes, not nearly as much as it controlled the system back when it was just kind of the Fed and banks. So a lot more of the system is beyond the reach of the Fed. And if you followed me at all on Twitter, you know that the price incentives using interest rate is a really, really blunt tool, right? It doesn’t always work that well.

And great examples of this are we have the biggest or at least the highest valuations in the stock market in my lifetime, probably ever, in 1999 and 2000 in the dot-com bubble when the Fed funds rate was 5% and 10-year was 7%, and we couldn’t even spell QE.

And we had the nastiest vintages of mortgages extended 2005, 2006, 2007, when the Fed funds rate was also around 5%, and we didn’t have QE. So it’s not as interest rate sensitive as people think. Because if you think you’re going to make 200% in a year or 300% over five years, whatever it happens to be, the difference between borrowing at 3% and 6%, it’s the same number for you. And that’s what happens. And also, when people are very fearful they become price insensitive too.

So just raising the interest rate — unless you go to really, really high levels, obviously, like Paul Volcker did. And within reasonable levels, it just doesn’t turn the dial that much on lending. Lehman had 33 turns of leverage when the Fed funds rate was at 5%. From a secular standpoint, the Fed just doesn’t control the money creation process nearly as much as it used to.

And then behaviorally, we’re all kind of conditioned to think that lower interest rates and higher interest rates have a really big effect. So we were kind of bracing for it. So everyone saw the Fed raised rates aggressively and that led people to say, okay, well, recession is coming for sure.

And we kind of had a precession where everybody saw the rates going up, they expected a recession was going to come in, but it wasn’t coming, but they started a little by little paring back and investing a little bit less, hiring a little bit less. We saw that the back orders for labor declined, all that kind of stuff.

So ultimately, that means people are less out over their skis as the process plays out. So you’re kind of deleveraging in a gradual sense. So we’re kind of braced for it because people will believe deeply that that’s what would happen, and then it didn’t happen.

Eric: [00:15:24] The way you think about the world, it feels clear. I think that for other people, it kind of breaks their brain a little bit that when you say in your example of the monetary policy of unemployment going from 3% to 6%, and the difference is it happens fast or slow.

If you had told people in advance — I think this is always still funding about hard markets are or how humbling they are. The Fed is going to raise rates. This is what’s going to happen. Many people assume this would be disastrous. It would cause a recession. The housing market would break. Like all these bad things would happen and here we are coming into the end of ’23, and I think every asset class is up in the face of that. So that kind of breaks people’s brains. Why do we get that so wrong?

Mark: [00:16:06] Well, I think these are the reasons I was just talking about, people overestimate the power of monetary policy. And they thought the inflation that we had was much more monetary than it wasn’t monetary at all. It was obvious entirely COVID. It was fiscal but people — they have this — we were trained. Milton Friedman said that kind of mindset, people think the high-powered money and the loanable funds model, none of which only worked that way.

Like I said, banks issue money into circulation via deposits. That’s how the bulk of money gets created. In exceptional circumstances, the Fed can expand and contract its balance sheet because there’s a demand for liquidity. So whenever it wants to deleverage, banks need a lot of dollars for settlement. They need to settle with each other.

So the demand goes up a lot like back in the day when we were more agrarian economy and the Fed around harvest time had to produce big boxes of money and send them out to the hinterland so that transactions could get done. The Fed provides the elasticity in the monetary system for rapid expansion and contraction of demand for cash. That’s kind of their role and the banks are supposed to issue the dollars into circulation via credit.

Most people don’t get that. Once you get it, once you understand endogenous credit, then things make a lot more sense to you, but the wrong model has been drilled into people’s heads so thoroughly and it makes a much intuitive sense that people — even though it’s wrong, that it’s hard for people to get past it.

Eric: [00:17:26] So if people are looking at — if they’re looking at the wrong way, when you get something like quantitative easing, quantitative tightening, this idea that the Fed could impact the market and even more powerful, the irony is what you’re saying is so not a consensus, which is why I love it that coming out of 2008, it was the Fed was even more powerful than they’ve ever been before and that they have the implication on the market. So if the QE isn’t really whatever one thinks it is, is that because it’s really just moving money between the banks and the Fed

Mark: [00:17:58] Yes, basically. I mean, the way the mechanics work, you can call it printing money, and I think that leads to a lazy thought process because some people kind of take it literally unless you press them to go, oh, it’s not literally printing money, but really, it’s just an asset swap.

So think about it in the simplest way possible. You have a 60-40 portfolio. Just — to make it simple, your 60% is in an S&P ETF, and your 40% is in T-bills. So you got your risk money, your 60%, and your risk-free money, you’re ballast as it were. So the Fed comes in and they buy all your T-bills, and they give you a deposit at the Fed, which yields roughly the same thing.

Are you going to change your 60-40 allocation because of that? Are you going to go out and buy Tesla stock with that money? Not unless something else changes in your mind and you think you need to take more risk, which is possible, but it’s a totally separate decision.

But that’s what really happens. The Fed liquefies the system and allows for settlements to take place amongst themselves. Now the way QE is supposed to work in theory, and I think a lot of the people who put it in place way back when, if they were to review what happened now, they would say, okay, it didn’t hurt, but it was a lot less powerful than we thought it might be. It’s supposed to work in two ways.

One is what they call the portfolio rebalancing effect. And that is Fed buys bonds, takes them out of circulation. The people who own those bonds, say, I should probably replace that duration in my portfolio, so maybe I’ll buy some government-backed mortgages. So same risk temperature more or less, but it’s a little bit — just a hair out the risk spectrum. And some guys might say, well, yes, I’ll buy some high-grade debt, some high-quality corporate debt, a little bit further out the risk spectrum.

But you also have to keep in mind that most of the people from whom the Fed is buying these bonds, it’s not in their mandate to go out and buy equities, right? They’re buying it from like PIMCO. They’re buying it from fidelity bond funds, and they’re buying it from these guys who have a very clear mandate, and they don’t buy equity.

So that kind of effect is not that strong, first of all. I mean it’s kind of there, but it’s indistinguishable from the natural process of people moving out the risk spectrum with time. And we can talk about that later because it’s a super important point, how risk appetite works over the course of a cycle. This marginal effect is really indistinguishable from this bigger effect, I think, of people over time moving out the risk spectrum during a cycle until we get to that point where we are too far out over their skis, and we have to bring it back.

The second channel is the idea that by taking duration out of the system, it will lower the yields on bonds and that will stimulate lending and things like that. But as I like to say, you can lead a banker to liquidity, but you can’t make it lend. You need the risk appetite for people to lend.

And it’s not even clear how much QE lowered interest rates because we know from a flow standpoint, during QE1, QE2, QE3, every time these things got rolled out and the Fed was buying bonds, the yields were going higher, and they were going higher primarily because of the placebo effect. People believed that the Fed intervening was protecting the downside on the economy.

And therefore, they said, okay, I’m selling bonds and I’m buying equities. That behavioral effect based on perceived change in economic outlook was much more powerful than the mechanistic buying from QE. And this is why I was saying back in September, I said as soon as we get a whiff of slowdown in the economy and inflation cools off, all this talk about supply and fiscal unsustainability is just going to disappear, which is exactly what happened.

So it’s not that these effects don’t matter. It’s — they get swamped by changes in demand triggered by changes in the economic outlook, our perception of growth. So from a flow perspective, it didn’t work. In fact, it worked the other way. Yields tended to go higher when the Fed did QE.

So does it work from a stock perspective? If they buy enough bonds and take them out of circulation, it drives interest rates down? Maybe a little bit. But it’s really hard to say. Look at what’s happened now. We’ve — the Fed balance sheet is down by $1.3 trillion.

So whatever people say about repos or the TGA, the Fed owns $1.3 trillion less of securities, of bonds and mortgages. And we’ve raised rates 500 basis points. And for sure, the 10-year treasury has not gone up 500 basis points. It’s gone up by a lot less than that.

So it’s hard to argue that anything other than economic expectations is the primary driver, yields further out the curve. So it was an experiment worth doing, and a lot of people don’t get this. The first QE was really about the plumbing. They were trying to make sure that the pipes worked, that markets didn’t get gummed up, that things could work smoothly. It wasn’t about, at least the first two-thirds of it, wasn’t about trying to boost economic demand or activity, that came later.

But what QE unambiguously does is in times when there’s a surge in demand for transactional balances like back in the agricultural days when they shipped out those boxes, the Fed provides the elasticity to make sure the payments can flow through the system and the dry cleaner in Cedar Rapids can make payroll. That’s kind of how it’s supposed to work.

But it’s just not very powerful when compared to the changes in economic outlook. This is why supply rarely — and people talk about bitcoin and fixed supply. What matters is demand. Demand is really what swings and supply is rarely the issue. That’s why QE and Q2 are — this is my second time through it.

So I still have the scars from 2008 telling people that QE wasn’t going to cause inflation, and people looked at me like I had 3 eyes, and I remember I was working at hedge fund, we lost a client because of that and a couple of prospects.

I remember one guy telling after having a meeting — I used to get sent to a lot of the meetings because I was good at explaining the economics and a lot of the guys I worked with were flow traders who are maybe not as articulate and kind of had intuition and good risk management, but couldn’t explain things as well to clients.

And I remember explaining the things to a particular client, and afterwards, I heard from the owner of the hedge fund, he came back and he said, “This is what he said, Mark,” he was laughing about it. He said, “Mark is really smart, but he’s just going to get you guys killed with his view on inflation,” and they ended up not investing with us largely for that reason.

But anyway, I’ve been through this a couple of times, and I just retweeted a tweet today that I sent out back in August. You know the depth of the market in August of 2022, saying, if we get to all-time highs anytime within the next 12 months or by the end of 2023, we can eliminate, for sure, the QT effect that so many people fear. And that was kind of peak fear of QT because the market was going down and a lot of people ascribed it to QT. It just doesn’t have that kind of effect.

Eric: [00:24:32] The thing that I remembered was during ’08 when it was going down and being so close to the center of it all, you realized how bad it was. And the reason why — I have two parts here. One is I do remember when QE first happened, it did feel like — and maybe the Fed still has this power that when the system seizes up, it really is the only thing that can reliquefy the system that it has this power to say — if the Fed didn’t step in, in a way, I felt like it would have been significantly worse.

But then after it happened — this is the second part of that question. I remember something like 40 of the greatest investors of all time because I was early in my investing career. I think I’ve been there for about three or four years. All of a sudden, we see the world collapse and then they unleashed this thing, which it felt like it’s saved everything.

It truly felt like it worked, but nobody knew the ramifications. And the smart money — there was this Wall Street Journal article, where 40 of the top hedge funds said, we’re going to go into inflation because of this, because we just unleashed like Pandora’s box. So why are you so confident at that moment.

Mark: [00:25:34] Yes. It was 2010, and I looked at the list, and there are a lot of prominent economists on there and investors and I remember Cliff Asness was on there and Jim Chanos and other names that guys on the Street would recognize. And I was confident because I knew how it worked.

And my time at the IMF, I climbed into so many different central banks and economies, I got to understand the plumbing in a way that most theoretical guys don’t and most Wall Street guys don’t. They kind of gloss over this and they said they had someone summarize Milton Friedman for them, and they think they understand monetary policy. This has been an eye-opening experience for a lot of people.

But if your balance sheet is broken, it doesn’t matter how much liquidity the Fed provides. You’re not going to lend it out, you’re going to fix your balance sheet first. That’s just common sense. And the mechanics don’t work that way anyway. That Fed doesn’t give you money and you lend it out.

Like I was saying earlier, the way it works is the bank makes a loan and then gives you a deposit and their limits are governed by the regulatory framework. They have capital requirements. They have liquidity requirements. They have leverage requirements. They have to stay within those.

But the banks are chartered to issue money, create money through deposits. That’s how it started in 1863 with the National Banking Act. The Fed came in 1913 and started to supervise the process because it became clear that the banks weren’t very good at it either. The banks aren’t going to be taking risk in creating deposits and issuing money if their balance sheets are busted. That for me was just the easiest.

And listen, everybody talks about the power of interest rates, but we had 0 interest rates, and we had ZIRP and QE for four, five years before people started taking any risk at all because you have to fix your balance sheet first. Maybe this is the right moment to talk about it, but risk appetite is driven much less by the price of money than it is by the other factors.

And the two factors can really boil it down to something easy to communicate. The two factors are — I call JPMorgan’s famous quote where he says, “Nothing so undermines a man’s financial judgment as seeing his neighbor get rich.” That means once your situation is okay and you see people around you making money, you say I’m going to make money, too. And then you end up with a stripper in Florida that owns five homes with Megan Mortgages, and the system blows up.

So that’s how it tends to work. We look around — prices go up a little bit and we look around, we see other people making money, then we take a little bit more risk and we see prices go up more. This is why, as I said earlier, nothing brings out the buyers like higher prices. That’s really how Wall Street works. Now from a macro standpoint that matches that is Hyman Minsky’s financial instability hypothesis, and it’s basically stability breeds instability.

So it’s kind of the same thing. Everyone starts making money. The banks look around their [indiscernible] to keep up with Goldman Sachs, and they start underwriting riskier mortgages and everybody starts doing it. It’s not because they think the Fed is going to bail them out or anybody is going to bail them out. No one is going to make a loan apart because I think the Fed is going to come in at $0.40 on the dollar and bail them out. No one wants to take that loss.

What happens is the optimism and the greed blinds people to downside risk. Anybody who’s been in the room, and I have been in these rooms, right, over my career with the risk committees and how people are making these risk decisions, it’s not because they miscalculated the downside, but I think they’re protected somehow since they’re ignoring it. Their greed and their competitive pressure leads them to take too much risk.

I remember Stanley Mack from Morgan Stanley shortly after the Global Financial Crisis was being interviewed on a Bloomberg forum. He told the story of a client of his who’s a good friend and a long-term client, called and asked for a loan and Stanley Mack said, I can’t do that. It’s just not responsible. It’s too much leverage or whatever the reasons were. He said it wasn’t the right thing to do.

And this was the guy whom he had a really good relationship, long term, both personally and professionally. And he said, as soon as I hang up the phone, I knew he was going to Merrill Lynch to get that loan, and he did. So it’s really the competitive pressures and being blinded by greed that leads people to take all the risks, not because they think their downside is protected.

And Hyman Minsky kind of says, all these things end up — when you’re stable, people start taking a little by little more risk, and then you end up — it ends up bringing instability because in a capitalist system, we take things too far. And we should. That’s how we get innovation. We’re supposed to be taking risk, and we’re supposed to be failing.

The Fed’s job is not to stop bubbles and keep us from doing it. The Fed’s job is to make sure that the guardrails of the regulatory system are in place so that collateral damage on to innocent people doesn’t happen.

And this is what they did when you were saying earlier, they stepped in and they flooded the system with a settlement liquidity so that everyone’s transactions could clear and so that you and I didn’t have to go out in our pajamas at three in the morning, waiting in front of an ATM machine in line, hoping that there’d still be money in there when we get up in the front of the line.

2. This Is What’s Driving the Big Surge in US Oil Production – Tracy Alloway, Joe Weisenthal, Stacey Rene, and Javier Blas

Javier (03:15):

We had record levels, and it’s just an incredible number. As Tracy said, if you look just at what we say is ‘crude oil,’ it’s more than 13 million barrels a day. But if you add on top of that number other things that go into the oil, liquids streams or condensates and NGLs (natural gas liquids), a bit of ethanol, etc., etc. — we are well above 20 million barrels a day of oil production that compares to a hundred million worldwide.

So you put everything together, the US is producing one in five barrels of oil consumed. That is just an incredibly high number. And it doesn’t seem to be stopping. Probably it’s going to slow down a bit in 2024, but it’s going to continue to go up.

Tracy (04:04):

Okay, where is all that new oil actually coming from? Because it’s been a while since I’ve brought up the rig count chart. But if you look at the rig count chart, this is such a fun one because you can see the big humps of the early 2010s and then the big slide into 2015, and now it seems kind of flat. So there’s been some increase between 2020 and 2022. The number of new rigs being drilled has gone up, but it’s not like we’re seeing a boom in new gas rigs and new explorations. So where is all this oil coming from?

Javier (04:43):

Well, it’s coming from the very same places that it was coming about 10 years ago, but it’s coming in some way, and for lack of a better word, better. So it’s coming from Texas, it’s coming from New Mexico, and it’s coming a bit from North Dakota, Oklahoma, etc., etc. It’s coming from the shale regions of the United States.

But if we were to say ‘where’ in just one single or two, or in this case, three single words, it’s Texas and New Mexico. That’s where the new oil is coming. And you are right Tracy, the recount is not significantly up. Actually, you look at [it] from a loan perspective, it’s lower than it was during the previous booms of shale.

But it’s just that the oil companies in Texas and New Mexico have [gotten] very good at extracting more oil from those rigs, from those wells that they’re drilling. And they’re also doing much longer wells. If you think about how a shale oil well looks like, it first goes down vertically and then it just turns around 90 degrees and it goes horizontal for a while. At the beginning, those horizontal wells were relatively short. Perhaps a quarter of a mile, half a mile at most. Now they’re going as much as three miles horizontally. They can get a lot more oil than they were able to do a few years back…

…Joe (07:04):

So that really held up well. So what’s changed since 2016 Javier? Tech?

Javier (07:09):

Technologically-wise, we can drill longer, particularly the laterals. We can pump fracking fluids at a higher pressure. And companies are also very good at doing this super quick. Previously our well could have taken 30 days — now it takes 10. Companies and the crews have gotten very good at doing it. And that means that they can do it cheaply. And that’s the funny part of the whole boom of 2023 and 2024, a difference of the previous ones. Companies are making money and investors are making money. So everyone is loving it. This is the first time, and this is what really terrorized OPEC, that shale oil is growing and making money at the same time. And that’s a big problem if you are in Saudi Arabia.

Tracy (07:56):

Definitely want to get to the possible response from OPEC. But just in terms of technology, one of the things, and the reason I brought up that story, was the idea of standardization. So,before you used to have all these bespoke custom fittings for oil rigs or platforms or whatever. But then, I think there was actually an industry-wide effort or attempt to start standardizing some of these things so you didn’t have to order a bespoke component for every single oil project that you were doing. And that seems to have helped make things go faster — to Javier’s point and also brought down costs. Javier, how much of a big deal is that in the industry?

Javier (08:36):

It is a big deal. It has happened everywhere in the oil industry. Let me give you my favorite anecdote of a standardization in the oil industry. So you are working on a North Sea oil platform, this is offshore outside Norway and the United Kingdom. You need to paint a lot of the stuff yellow, kind of yellow [for] danger, very visible etc., etc. Very stormy areas of the wall. The North Sea fog, it’s not the kind of place that you really want to spend an evening in winter there.

So every company has their own shade of yellow. There were 19 different kinds of yellow to paint things in the North Sea. Each company has their own shade with their own specification, and it was just ridiculous. So at one point, a few engineers in the industry got together and said ‘Well, this is a bit ridiculous. I mean, can we not just do a yellow North Sea?’

And so they got together and everyone decided this is the shade of yellow that we’re going to use. And now everyone is painting everything that they need to paint in yellow with the same shade. That at a much bigger scale has happened across the oil industry. Everything has got a standard. And companies within themselves, they like to do everything bespoke. They really, in some way, gold-plated a lot of projects. So each well was a bit different to the other one. Now, companies are designing one single design. And when they have really thought ‘Okay, this is it. This really works very well, now copy and paste for the next 25, 50, 100 wells’ — that has cut costs significantly…

…Joe (10:39):

Yeah. They’re all looking at the different Pantone shades, but got to do so in a legal way. All right, let’s talk about the capital markets aspect because it did seem like, you know, the way people thought about it was that the industry had to face a choice. Would it be pursuing volume or would it be pursuing profitability? And as you’ve just said, there seems to be this very weird situation in which volume is ramping and productivity is sustained. How is that happening and how sustainable is that?

Javier (11:06):

Well, to the question of how long and how sustainable — I’m going to be honest, I don’t know. I thought that production growth would have a slowdown in 2023 and it never happened. It did the opposite, it accelerated. You look [at] every oil executive, if you look at the forecasters of the industry, everyone is saying it’s going to slow down in 2024. But also they said the same for 2023, and they were wrong.

So we’ll see what happens, really. But yes, I mean the industry went into this new era thinking about profitability. So everyone cut CapEx, everyone tried to get more efficient. And everyone thought that production growth was going to slow down because the focus was profitability. The fact that they were able to grow quite strongly came [as] a bit of a surprise to the industry. And then everyone kind of celebrated it.

But here there is a very important question. If OPEC has not cut production to make room for all this new shale oil from the United States, prices will have come down. And then the industry would have faced the same kind of dilemma of the past. You are producing too much, then the prices come down, your profitability comes down, and then you have a problem. So a lot of these that we are putting based on efficiency, it’s true. But if not for OPEC cutting production and keeping prices above $70 a barrel, then shale companies will be in trouble.

Tracy (12:47):

One thing I’m really curious about is who is actually funding production now versus, say, in the early 2010s.

Joe (12:56):

And just to add onto that a little bit, is there any difference between private and publicly-traded domestic US players?

Javier (13:02):

Okay, so let’s in parts. On Tracy’s question, who is funding this? Well back 10 years ago, five years ago, it was Wall Street. It was a mix of equity and credit markets which were funding all of this growth through different instruments. I mean sometimes it was just issuing fresh equity. Sometimes it was bonds, high-yield bonds, reserve lending where a bank is lending to an oil company based on the reserves underground; more or less like a mortgage rather than a house. You mortgage the oil reserves that they’re underground.

And a lot of that is still there, but a lot of the money now needed for the expansion and to finance all this new growth is coming from cash flow generation. It’s the internal cash flow of these companies. They generate enough cash to pay for all the new drilling that they’re doing to pay for all the capital investment that they need to do alongside new pipelines, etc., etc. And to pay the shareholders.

These companies now for the very first time are paying dividends. And that sounds like — well, publicly-listed companies should be paying dividends that’s like normal. Well, that was not the case a few years back. But now they generate enough cash to do all of the above.

And in terms of is there a difference? Yes. Publicly listed companies have been a bit more cautious, they have been trying to. They have the shareholders, they have Wall Street on top of them, and they have to really try to focus as much as possible on paying dividends and buying back shares. Publicly-owned [companies] don’t have that pressure, that super strong pressure. So they have done a bit more growing. And there is a suspicion in the industry that a lot of that growth was to try to maximize the amount of production that you are doing so you can sell yourself to a big player, say ExxonMobil or Chevron. And perhaps that’s not as sustainable as it looks like…

…Joe (21:02):

I think his name — he even wrote a Bloomberg Opinion column on March 20th, 2020 – Ryan Sitton was his name. The railroad commissioner who called on OPEC to coordinate with the US in constraining supply.

I want to pivot for a second and talk about the Red Sea. And we talked about it a couple weeks ago in the context of container freight. What [causes] the rising tensions there? We recently saw the US strike at Houthis assets. What does the rising tension there mean from an oil perspective?

Javier (21:34):

Well, it’s more or less a binary situation. As long as the strait of Hormuz, which is the big outlet from the Persian Gulf for countries like Kuwait or Saudi Arabia into the open markets, as long as that remains open, what’s happening on the Red Sea is of less importance. Yes, it’s going to mean an increase in cost because a lot of the oil tankers and also the LNG carriers, these are liquefied natural gas carriers. They’re going to have to divert, avoid the Red Sea and go around Africa. That adds from the Persian Gulf into Europe probably a good 10 to 15 days extra. So it is not small and it could really increase the cost of shipping, but it’s not the end of the world. And that’s why the oil market is taking it quite relaxed.

I mean, prices have barely increased over the last few days. But then you could think ‘Well, that is basically on a scale of one to 10, probably a two, maybe a three.’ What is the other scenario? Well the other scenario is the open fight with Iran, not with his proxies — the Houthis in Yemen — but actually with Iran and the strait of Hormuz somehow gets in trouble. Shipping is more difficult though it probably is not completely closed, but things get really bad. And that on a scale of one to 10, that’s probably 25. And that’s the problem. That’s what I say, it’s a bit of a binary situation at the moment. So far not so bad…

…Javier (27:19):

I think that you are putting it absolutely right. I mean, the fact that the US is exporting so much oil, and when you count crude and refined products, many weeks, the US on a gross basis is exporting more than 10 million barrels a day. Obviously at the same time, its importing a bit. So on a net basis, about 2 million barrels a day.

But the fact that the US has oil to export on a net basis more than it consumes and it can export is just mind blowing. And particularly, you know, I have been writing about this industry for 25 years. If even 10 years ago you had told me that the US was going to be exporting the amount of crude that it’s doing today, I would have said absolutely not. No way. No way this is happening…

…Javier (30:16):

Well, it’s particularly about how we trade electricity. And you think about a few years back — and by that I mean five, six years ago — a lot of the electricity market in Europe was controlled by the typical names that we all knew. The utilities that have been privatized, but used to be state-owned companies, big names like EDF (Électricité de France), RWE, etc., etc.

And the market was quite sedated. Prices were not really moving much. There was not much volatility. There were very few of the independent traders really making money trading electricity. And a few years back, in the middle of nowhere, Denmark, in a town called Aarhus, it’s a big university town in rural Denmark, a group of companies kind of started to plot how we can make money out of this market.

And they were really driven by two things that were happening in Europe. It was the liberalization of the markets. There was a lot more cross-border electricity trading in Europe. And there was also a lot more volatility in the supply of electricity in Europe because of wind and solar.

You cannot predict how much wind and solar power you’re going to get more than five days, perhaps 10 days [out]. But you know, meteorologists have a limit of how strongly the wind is going to blow or whether it’s going to be cloud covering one area of the continent or not for solar, etc., etc.

So that variability created a lot of price volatility, particularly in the very short [end] of the short-term market. I mean, electricity used to be traded one year in advance, one month in advance. And these companies kind of specialize in trading the next 30 minutes of the electricity market. You know, mid-morning, what is going to be the demand for electricity by lunchtime? That’s what they specialize in.

But, you know, the five or six top of these companies were making perhaps $100 million combined. So not a lot. And they were in the rather of the industry, but not that … In 2022, they made $5 billion. The return on equity in many names of the industry went well above 100%. In some cases, well above 250%. So let me put it this way — the companies that were making a couple of million dollars were making $10, $25, $30 million.

The guys who were making $25, $30 million before were making a couple of hundred million dollars. And the guys who were making a hundred, they just went to a billion. It was just one of the biggest booms in commodity trading profitability I have ever seen. And the piece is about these names, which outside of the industry, basically no one really knows about.

3. Lessons From the Bear Market – Michael Batnick

We did a podcast in December of 2022 at the Nasdaq MarketSite in Times Square with our friends from the On The Tape podcast. At the time, things were…not great. Inflation was skyrocketing and the fed was chasing after it to slow down consumer prices.

The stock market was cratering. And the ones getting hit the hardest are the ones everyone owned. Amazon was 55% off its high. No really, 55%. Meta was worth just one-third of what it was in the previous year. Fear was everywhere.

I asked the audience, how many of you expect a recession in 2023? Every hand in the room went up. Then I asked, how many of you think the stock market bottomed in October? Crickets.

It’s easy to say “Be greedy when others are fearful.” It’s hard to actually do it…

…It’s easy to overestimate your ability to deal with downside risk when stocks are going higher. You only discover who you really are as an investor in bear markets.

Ben and I were getting dozens of emails about triple-leveraged ETFs in 2021: “I know it’s risky but I have a long time horizon.”

I don’t think we saw a single one of those messages hit our inbox (personal emails, personal responses) in 2022…

…I, like many of you, just kept buying over the last two years. It’s not because I’m a genius, and it’s definitely not because I was bullish with every purchase. I bought in my 401(k) every other week and in my brokerage account every month because it happens automatically. Out of sight out of mind.

If I had to physically log on and execute these trades, I’m sure that I wouldn’t be as consistent as I have been. You mustn’t let your emotions determine when you buy. Like Nick first said back in 2017, Just Keep Buying.

4. A beginner’s guide to accounting fraud (and how to get away with it): Part III – Leo Perry

If you’re looking for a role model for how to serially raise capital for a business that really shouldn’t even exist in the first place, you could do a lot worse than Avanti Communications. Avanti was a startup satellite broadband operator that issued half a billion odd of equity, and about as much again in debt, in just five short years. No one seemed to care much that the business case was flawed from the start. That revenue kept falling short and customers got less and less substantial. And, of course, it didn’t matter that the accounts read like a Stephen King novel. Because you can’t get a bigger addressable market than space, can you?

How did I know Avanti was always bound to end up failing its shareholders, even before it took off? The company said so. In black and white. It told me and every other investor that bothered to look at its 2009 annual report. I know corporate filings aren’t exactly gripping but it helps if you read them. Lucky for us, it doesn’t seem like many people do.

When I‘d asked directly, management had flat out refused to disclose what the Mb capacity of its first satellite (called Hylas-1) would be “for commercial competitive reasons”. But they soon went ahead and gave it away in a press release anyway, stating that 320Mb was about 10% of the total. From there it was simple to estimate build cost per Mb, which came in around £35mn. The problem was Eutelsat, which was about to launch its own broadband satellite over Europe too. This bird, KA-SAT, was 15 times as big but only cost about 3 times as much to build. It’s unit cost was more like €4mn per Mb. That was going to be an issue for Avanti.

Don’t take my word for it, take the company’s. In its 2009 annual report Avanti already states that Hylas-1 “will be full with around 200,000 – 300,000 end user customers”, with the higher number only possible if it delivered a lot of them something not much better than a Netscape dial-up service (as in 0.5Mb per second). But even then Eutelsat had a 3.6Mb per second product in the market, for €17 a month wholesale. And had said publicly it would be keeping that price point once KA-SAT was up, but for a 10Mb per second service. Hylas-1 was going to be competing with that, but at those speeds it would be able to serve a lot less customers. It’s not quite a straight line calculation because of contention – basically congestion from other users – but it wasn’t good news for Avanti. Commercial wholesale revenue for Hylas-1 would end up end peaking at around €15mn while sell side consensus was still “modelling” four times that.

5. Data Update 3 for 2024: A Rule-breaking Year for Interest Rates – Aswath Damodaran

As you can see, while treasury rates, across maturities, jumped dramatically in 2022, their behavior diverged in 2023. At the short end of the spectrum, the three-month treasury bill rate rose from 4.42% to 5.40% during the year, but the 2-year rate decreased slightly from 4.41% to 4.23%, the ten-year rate stayed unchanged at 3.88% and the thirty-year rate barely budged, going from 3.76% to 4.03%. The fact that the treasury bond rate was 3.88% at both the start and the end of the year effectively also meant that the return on a ten-year treasury bond during 2023 was just the coupon rate of 3.88% (and no price change).

I noted at the start of this post that the stock answer than most analysts and investors, when asked why treasury rates rose or fell during much of the last decade has been “The Fed did it”. Not only is that lazy rationalization, but it is just not true, and for many reasons. First, the only rate that the Fed actually controls is the Fed funds rate, and it is true that the Fed has been actively raising that rate in the last two years, as you can see in the graph below:

In 2022, the Fed raised the Fed funds rate seven times, with the rate rising from close to zero (lower limit of zero and an upper limit of 0.25%) to 4.25-4.50%, by the end of the year. During 2023, the Fed continued to raise rates, albeit at a slower rate, with four 0.25% raises.

Second, the argument that the Fed’s Fed Funds rate actions have triggered increases in interest rates in the last two years becomes shaky, when you take a closer look at the data. In the table below, I look at all of the Fed Fund hikes in the last two years, looking at the changes in 3-month, 2-year and 10-year rates leading into the Fed actions. Thus, the Fed raised the Fed Funds rate on June 16, 2022 by 0.75%, to 1.75%, but the 3-month treasury bill rate had already risen by 0.74% in the weeks prior to the Fed hike, to 1.59%.

In fact, treasury bill rates consistently rise ahead of the Fed’s actions over the two years. This may be my biases talking, but to me, it looks like it is the market that is leading the Fed, rather than the other way around.

Third, even if you are a believer that the Fed has a strong influence on rates, that effect is strongest on the shortest term rates and decays as you get to longer maturities. In 2023, for instance, for all of the stories about FOMC meeting snd the Fed raising rates, the two-year treasury declined and the ten-year did not budge. To understand what causes long term interest rates to move, I went back to my interest rate basics, and in particular, the Fisher equation breakdown of a nominal interest rate (like the US ten-year treasury rate) into expected inflation and an expected real interest rate:

Nominal Interest Rate = Expected Inflation + Expected real interest rate

If you are willing to assume that the expected real interest rate should converge on the growth rate in the real economy in the long term, you can estimate what I call an intrinsic riskfree rate:

Intrinsic Riskfree Rate = Expected Inflation + Expected real growth rate in economy…

…That said, it is remarkable how well the equation does at explaining the movements in the ten-year US treasury bond rate over time. The rise treasury bond rates in the 1970s can be clearly traced to higher inflation, and the low treasury bond rates of the last decade had far more to do with low inflation and growth, than with the Fed. In 2023, the story of the year was that inflation tapered off during the course of the year, setting to rest fears that it would stay at the elevated levels of 2022. That explains why US treasury rates stayed unchanged, even when the Fed raised the Fed Funds rate, though the 3-month rate remains a testimonial to the Fed’s power to affect short term rates.

It is undeniable that the slope of the yield curve, in the US, has been correlated with economic growth, with more upward sloping yield curves presaging higher real growth, for much of the last century. In an extension of this empirical reality, an inversion of the yield curve, with short term rates exceed long term rates, has become a sign of an impending recession. In a post a few years ago, I argued that if the slope of the yield curve is a signal, it is one with a great deal of noise (error in prediction). If you are a skeptic about the inverted yield curves as a recession-predictor, that skepticism was strengthened in 2022 and 2023:

As you can see, the yield curve has been inverted for all of 2023, in all of its variations (the difference between the ten-year and two-year rates, the difference between the two-year rate and the 3-month rate and the difference between the ten-year rate and the 3-month T.Bill rate). At the same time, not only has a recession not made its presence felt, but the economy showed signs of strengthening towards the end of the year. It is entirely possible that there will be a recession in 2024 or even in 2025, but what good is a signal that is two or three years ahead of what it is signaling?…

…If there are lessons that can be learned from interest rate movements in 2022 and 2023, it is that notwithstanding all of the happy talk of the Fed cutting rates in the year to come, it is inflation that will again determine what will happen to interest rates, especially at the longer maturities, in 2024. If inflation continues its downward path, it is likely that we will see longer-term rates drift downwards, though it would have to be accompanied by significant weakening in the economy for rates to approach levels that we became used to, during the last decade. If inflation persists or rises, interest rates will rise, no matter what the Fed does.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have a vested interest in Amazon and Meta Platforms. Holdings are subject to change at any time.

What We’re Reading (Week Ending 21 January 2024)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 21 January 2024:

1. Learning from significant investment statistics of the past – Chin Hui Leong

Outfoxed by rising interest rates

Interest rates are another favourite among forecasters. In 2022, the US Federal Reserve raised interest rates from zero to between 4.25 and 4.5 per cent.

As you know, the stock market suffered one of its worst performances during this period.

When two trends coincide with one another, it is tempting to put two and two together and conclude: Interest rates rose, and therefore, that is why the stock market fell. But we cannot say the same about 2023. Last year, rates were hiked again by another percentage point to between 5.25 and 5.5 per cent. This time, the stock market staged a rally.

The contrast between 2022 and 2023 is a timely reminder that correlation is not causation. Given yourself time to learn the right lessons – preferably over multiple years, rather than the past 12 months. If you learn the wrong lessons from past events, then you will be doomed to repeat them in the future.

Outfoxed by GDP growth

Speaking of trends, China’s gross domestic product grew from around US$493 billion in 1992 to an astonishing US$18 trillion in 2022, said the World Bank. The annualised GDP growth rate for this period is almost 12 per cent.

But the same cannot be said about China’s stock market returns. The MSCI China index has recorded negative gains from its inception at end-1993 until end-2023. In other words, the rapid GDP increase did not translate into positive stock market returns even after more than 30 years.

What is the reason for this disconnect?

The underlying earnings per share for the Chinese businesses within the index barely grew for much of this period. Over the long term, stock market returns depend on business growth. Without it, you end up with flat to negative returns, as you see today…

…Invest for the long term

When you hold stocks for the long term, you will occasionally record negative returns. It is the price you pay for a positive outcome. And yet, staying invested for the long haul gives you the best chance of success.

Since 1928, there has never been a 20-year period where the S&P 500 produced negative returns, noted Carlson. What is more, if you missed the five best days (read: positive returns) in 2023, the index’s gain would almost halve from over 24 per cent to 12.6 per cent. Miss the best 15 days, and the returns would be negative.

To put these figures into context, let us assume there are 252 trading days every year. Miss five of the best days or 2 per cent of trading days and your returns could be vastly lower. Miss 15 days, or less than 6 per cent, and you could be sitting on losses.

The good news is: You do not have to do anything to stay invested for the long term. Surround yourself with like-minded friends. As the saying goes: If you want to travel fast, go alone. If you want to travel far, go together.

2. Gucci is cheap and eggs are pricey in Russia’s surreal economy – Kate de Pury

As Russia enters 2024, and the campaign for President Vladimir Putin’s inevitable re-election heats up, the regime is keen to tell a good story about the country’s ability to withstand the war. It can muster a surprising amount of evidence to support this case.

The Russian economy has not collapsed under the unprecedented sanctions of 2022, as some predicted. Oil and gas sales to the West plummeted, but higher energy prices eased the pain and the government found new buyers in Asia. The rouble depreciated sharply in 2023, but has stabilised since. Vast public spending on the war has meanwhile created jobs. Inflation remains stubborn, and a slowdown is expected in 2024 as the central bank keeps interest rates high to fight it, but Putin was able to boast last year, not implausibly, that the economy had grown by more than 3%.

Russia still has to import many products, which a weakened rouble makes more expensive. But those who aren’t poor seem able to absorb the price increases, at least for now. There were initial supply hiccups when Russian banks were first cut off from international transfer systems. But middle-class Muscovites found workarounds, and can now buy Western brands over the internet with little difficulty. usmall, an online marketplace, lists iPhones and Ralph Lauren children’s clothes priced in roubles, which can be bought from third-party suppliers with Russian bank cards.

Moscow shops are well stocked with designer goods. Most Western luxury brands stopped shipping to Russian stores in 2022, but when I visited tsum, the Russian equivalent of Harrods, just before Christmas, a sales assistant was proudly showing customers the newest handbags from Gucci, Chanel and Louis Vuitton. Bought in Europe and carried back to Russia in the luggage of a “personal shopper”, there weren’t many of these new-season items on the shelves, but just enough to justify the sign “2023-24 Collection”.

Some of the items on display were second-hand. The sales assistant showed off an app the store has developed to make it easy for Russian clients to re-sell unwanted luxury goods. Even a used Gucci bag isn’t exactly cheap, but because it’s priced in roubles, fluctuations in exchange rates can make it become, by the tortuous logic Muscovites follow, a bargain in euro terms. “A good deal for the Russian shopper,” the assistant said snippily…

…Elsewhere there are signs that the invasion of Ukraine may have disrupted the Russian economy more severely than the frothy party scene suggests. The Olivier salad, a mayonnaise-drenched confection of root vegetables, sausage and boiled eggs, is a staple at every table during the holidays. This winter the price of eggs suddenly rocketed (no one is quite sure why, but it may have been because farms were short of labour since so many workers have been conscripted or left the country). In some regions people cannot afford a box of six eggs and have to buy them individually. One pensioner even raised this with Putin during the president’s annual end-of-year call-in with the public. Putin promised to look into it.

3. Claudia Sahm: it’s clear now who was right – Robert Armstrong, Ethan Wu, Claudia Sahm

Unhedged: It’s true, unemployment’s great. The most relevant signals of inflation are within spitting distance of 2 per cent. But no matter how you cut it, wage growth is around 4 per cent. Is that a potential problem?

Sahm: I have not, and do not now, subscribe to the view that the inflation we have been living through since 2021 is primarily demand-driven, like Larry Summers and my friend Jason Furman did. Those folks thought we put too much money into people’s pockets and there was too much pent-up demand. If you were in that camp, you thought we needed to jack up rates and see wage growth come down.

Wages are rising at a pace that’s better than before the pandemic, which was a very good time for the economy, but we’ve moved out of the very acute labour shortages. And obviously, we want to get workers off the sidelines. To do that, you’re going to have to pay them more!

I look at inflation and say that’s because of disruptions from Covid and the war in Ukraine. And because those will eventually work out in some way, inflation will come down. That leads to very different policy prescriptions to fight inflation. And it leads to very different views on the things like whether the $1.9tn American Rescue Plan was a good idea; or whether waiting to raise rates was a good idea. If it’s all demand, then you’ve got to destroy demand. But I don’t think it’s all demand.

On wages, too, we have seen some good productivity numbers. If you’re more productive, you get paid more. And that’s coming after the crap productivity growth we had after the Great Recession. If we’re getting better productivity growth, we should not be using pre-pandemic wage growth as the baseline…

…Unhedged: You’ve called for banning the Phillips curve, the economic model positing a trade-off between inflation and unemployment. Now that we have a bit more hindsight, what’s your retrospective on the Phillips curve in this cycle? And if we ban the Phillips curve, what replaces it?

Sahm: This fundamentally goes back to a view about how much of inflation is demand versus supply. If you think it’s demand-driven inflation, you can fight that with the Fed’s tools. But how do you know how much monetary tightening to do, how much unemployment you need to get inflation down? So then you march off to the Phillips curve. There are more sophisticated versions of the Phillips curve that incorporate supply shocks. No one brought those out. The versions of the Phillips curve that were brought out in policymaking circles went back to the 1950s or 1960s — essentially just inflation versus unemployment.

The Phillips curve was used by the same people denouncing the American Rescue Plan to make statements like, “We need five years of 6 per cent unemployment.” But it goes back to why did inflation spike, demand or supply? It’s clear now who was right: it was largely supply. It was completely valid to argue in 2021 that when inflation took off, it was demand. The American Rescue Plan was big, it came after two very big fiscal relief packages and the Fed had been adamant about not raising rates. But the fact this year that inflation has notably come down and unemployment has stayed low only happens if it was mostly supply-driven.

In terms of what other model to use, backing off from the Phillips curve would have been a good idea. And then the thing that economists need to think harder about is how we think about supply shocks. Most of the effort in macroeconomic research goes into thinking about demand disruptions. The [industry gold standard] New Keynesian dynamic stochastic general equilibrium model has wedged into it a Phillips curve that can do supply shocks. But we don’t really know how to calibrate [these sorts of models].

A lot of this is art, not science. The academic stuff looks like science, but what actually is useful in the real world is much more judgment-based. But you ought to have tools that at least don’t do damage. The Phillips curve has done damage.

Unhedged: There’s a lot of worry now about excessive debt and deficits. Olivier Blanchard is saying we need to get r minus g, the real interest rate paid on debt minus the growth rate, on a sustainable trajectory. What’s your perspective on debt sustainability?

Sahm: First off, Olivier is adorable, what a great way to frame it. My view is that it’s completely misguided to have a discussion about the size of the federal debt. The entire conversation about r minus g, while maybe useful for macroeconomists to think about, ignores that it matters what we spend on. If we are on a path for higher productivity growth after the pandemic, the American Rescue Plan, the infrastructure act, the Chips act, the Inflation Reduction Act — they all get a piece of that pie.

4. A beginner’s guide to getting away with accounting fraud, part two – Leo Perry

Now normally the way it works when you sell something is you then get paid. You get cash in return. That’s what money is after all, credit to buy more stuff in return for what you sold (which, most often, is yourself). You might not get paid right away. You might allow a few weeks for your customer to cough up (which is giving actual credit). But in the end you get your money. Otherwise you’re not really selling, you’re a charity (or a slave).

But of course we’re never going to collect on the lemons we invoiced for. And that’s going to start to show on our balance sheet, thanks to the beautifully simple logic of double entry bookkeeping. This says that for every action there has to be an equal and opposite reaction (OK that’s Newton’s Third Law but it’s close enough). Booking a profit increases the value due to owners of the business. And that’s a liability because these shareholders will want to get paid one day (good luck with that). So there must be an asset to match.

In our case that asset is definitely not going to be cash. What we get instead is more and more payments receivable from our customers.

Unattainable cash proved the undoing of Bio-On. In 2019 it was one of Italy’s only tech unicorns. This was back when being a unicorn was a good thing, because there weren’t any adults in the room…

…One thing Bio-On was great at was announcing licensing deals. Collecting on them, not so much, which is why we can learn from it.

By way of example, in July 2015 it put out a press release on a deal with French sugar co-operative Cristal Union (in fact the tie-up was with a joint venture between the two companies, B-Plastic). Bio-On’s 2015 accounts show it booked €3.25mn of license revenue from this JV — and collected none of it in cash. By the end of 2017, €2.75mn was still due from B-Plastic but the accounts for the JV show no liability, or cash to pay it with.

Oddly, Bio-On accounted for its stake in the JV with a €1mn book value at the end of 2015. But it then removed the item the following year, writing off the investment but not restating its 2015 accounts. So Bio-On appeared to have invested €1mn in the JV then written that off — while collecting license fees worth, at most, only half the money it put in.

Not collecting on sales made Bio-On a pretty obvious target for investigation. In the three years to the end of 2018 it reported €65mn revenue. Receivables were €60mn.

A few months after my visit to Bologna, the activist short seller Quintessential Capital published a report that highlighted a few issues at the company. In October 2019, Bio-On’s founding CEO and chair Marco Astorri was arrested on suspicion of accounting fraud and market manipulation, shortly before the company was declared insolvent…

…I first spoke to Quintessential’s principal Gabriel Grego back in 2015, after he published a report on another business I was short, Globo. This was a UK company but it was all Greek to me. Management claimed it had a hugely successful bring-your-own-device app, GO!Enterprise, which allowed you to use your own mobile securely at work.

And apparently this had hundreds of thousands of paying users. I was a bit sceptical because its Google appstore listing showed fewer than 5000 installs. The fact that the corporate website touted Lehman Brothers as a customer in 2013 was also a bit of a red flag

On the face of it, though, Globo was having no trouble collecting on these sales. The results for the first half of 2013 reported trade receivables up by only 4 per cent, despite strong revenue growth. But then, this wasn’t exactly an apples-to-apples comparison.

You see on December 3, 2012, Globo sold control of its Greek operations to local management for €11.2mn and with it went €40mn-odd of receivables. Of course, no one was really going to pay much money for nothing much. But the consideration was deferred, so everyone was happy (for now).

5. Harley Bassman on What Investors Are Getting Wrong About the Fed – Tracy Alloway, Joe Weisenthal, and Harley Bassman

Tracy (03:58):

So I have a question to begin with and this is completely out of self-interest as a journalist who’s had to write about convexity at many times during their career and has always struggled to define it in a way that satisfies my editors who want to encapsulate a financial relationship in as few words as possible, how would you describe it?

Harley (04:20):

Convexity is an X word, so everyone gets a little rattled about that, but it’s actually rather simple. It’s just unbalanced leverage, which was also a hard concept. Let’s simplify it a little bit.

If you have a bet, you’re making a wager where you make a dollar or lose a dollar for equal up and down equal opposite payoffs, that’s zero convexity. If you make $2 and lose one, that’s positive convexity. If you could lose $3 and make $2 — negative convexity.

The reason why we hired all these PhD quants in the nineties was to basically figure out what that’s worth. Clearly, you’d rather own something that makes $2 and loses $1 than is one-to-one. And if it’s lose $3, make $2, you better get paid for that. And so all the mumbo jumbo we go do around pricing out these various paths and payoffs is just to make it a fair bet when you have these different payoff profiles. And that’s it. Convexity just means that the payoff is not linear. It’s not one-to-one…

…Let’s just go one step back. When you’re in the bond market — not equities — the bond market, you have three buttons you could push. That’s it. Duration, credit, convexity. Those are your three risks.

You start with cash, overnight cash, and anything you do past there is taking one of those three. Duration is when you get your money back. Credit is if you get it back, convexity is how you get it back. And what a bond manager is trying to do is move around those three buttons to find the best risk-return, the best value.

Presently, selling convexity in the bond market is the best thing to do out there right now.

What’s duration? It is when you get your money back. So a two-year security will move 1.8 points for a one point move. So if rates go from four to five, a two-year bond will move by 1.8 points. A 10-year by about eight points. A 30-year by maybe 17 points, you’re usually paid more to take longer maturity risk because there’s more uncertainty.

An inverted curve is kind of upside-down land because you’re getting paid less to take more risk. We could talk why that is in a little bit, but right now, duration is a very weird place to take risk right now because you’re paid less to go out the curve and by a 10-year versus a two-year versus overnight cash.

Credit right now, investment grade credit is trading about 57 basis points. So a little over half point over the yield curve. And you get that from looking at these interest rate derivatives on your Bloomberg, it’s going to be CDX five-year. That’s actually tighter, [a] smaller number than its historic average of about 65, 66. You’re paid 57 now. Junk bonds, you’re paid about 360, 350, 370, which is also much tighter than usual 440, 450, 460.

So going into credit now, that’s not a great bet. I mean, I wouldn’t say it’s a disaster, but I mean, considering we’re concerned about the possibility of over tightening, a possibility of recession which an inverted curve kind of signals. I don’t really want to go and take credit risk. Convexity, right now, the MOVE Index, which is a measure of the price of convexity the same way it’s –

Tracy (08:22):

Which you invented, right?

Harley (08:23):

I did. It’s the VIX of bonds, plain and simple. The VIX of bonds, its average is maybe 90 or 100. It’s trading 120 now, which averages out to about maybe seven, eight basis points a day of market movement. That’s higher, much higher than its historical average. That’s the kind of trade you want to go and do…

…Joe (11:35):

When you say, okay, short convexity, what is the type of instrument that allows any trader or investor to express that idea?

Harley (11:43):

Well, the most simple strategy would be for an investor who owns a stock portfolio to go and sell covered calls. I mean, you’re selling options. You’re selling convexity when you go and you sell covered calls, what are you really doing? You’re kind of converting potential capital gains to current income. You’re limiting your upside. Your downside, of course is still large because the stock can go down a lot.

But you’re basically kind of doing a conversion there of taking risk off the table for current income. And there’s a price where you want to go and do that. And there’s prices where you don’t. When the VIX is at 40 or 50, I mean, you probably want to sell covered calls, of course you won’t do it because you’ll be in a panic. But that’s kind of the idea. And theoretically portfolio managers are supposed to have no blood in their veins, and they can go and do these various trades when the time is right…

… Harley (25:09):

If you go look at, you know, various derivatives, it indicates right now the Fed’s going to cut rates, you know, four, five, six times. So call it 120 basis points of cutting in the next year, which seems kind of crazy unless we crash market, we have a market crash.

I think what’s happening is this, I don’t think it’s the market’s predicting that rates are going to come down by a hundred and a quarter basis points. I don’t think that’s it. I think what’s happening here, it’s like an 85% chance that rates don’t move, and a 15% chance that rates go to 1%, that we have some kind of disaster. It’s a bimodal. And if you add those two things together, that’s how you get the down 125. No one’s saying 125, I think it’s zero and 400 and people are using the two-year rate or the five-year rate as an insurance policy against a bad thing happening. If you think of it in those terms, it kind of makes sense because, we only quote one number, but how do we get that number?

Joe (26:05):

Right. So the idea is if you’re long risk assets, which most people are most of the time, one way to hedge that would be to sort of make big bets on rates coming down sharply. It doesn’t mean that that’s your main view. It just means that if your bullish view is going to go wrong, a way to hedge that is to place big bets on rates.

Harley (26:26):

Yeah, well, that’s why the curve’s inverted. But I mean, I think buying 10-year rates is kind of silly right now. I mean, if you’re going to go and buy this theoretical insurance policy of the Fed doing a massive cut because of a hard landing, you want to buy the two-year rate and that’s why we created another product that’s basically a 5x levered two-year…

…Harley (28:17):

Circling back to the duration, credit, convexity idea. Duration is ‘I buy it here, it ends up there.’ Credit, ‘I buy it here. It ends up there.’ It doesn’t matter how it gets to the final destination. Convexity is path dependent. It matters how you get there.

And so what we’re arguing about now is not where we’re going to be, but how we get there. And I’m saying that we’re going to get there much slower than the market thinks, and I want to go and invest accordingly. And if I do that, this is where mortgage bonds come in.

I’ll say, if you want the big prediction, here it is. The Fed wants a 2% inflation rate. They’ll get it eventually, I presume. They’re going to put the funds rate at two and a half, 50 over for a 50 basis point real return. Historically, if you’re a, bond geezer like I am, funds rate to two-years, 50 basis points. So now we’re at three, 2s-10s, a hundred basis points. So now we’re at four.

So we’re kind of looking at, the 10-year right now is what? 380, 390, 404? Whatever it is. I mean, it’s done. You stick a fork in it, man, the 10s aren’t moving. And I think with the 30-year rate, it probably goes up from here as the curve resteepens again, all the action’s the front end, that’s where all the action is going to be when it happens.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have no vested interest in any companies mentioned. Holdings are subject to change at any time.

What We’re Reading (Week Ending 14 January 2024)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 14 January 2024:

1. The Impact of Shipping Disruptions in the Red Sea – Tracy Alloway, Joe Weisenthal, Mohsis Andam, and Craig Fuller

Joe (04:00):

There really is a lot to talk about, but why don’t we start off with the disruptions in the Red Sea. Why don’t you characterize, as you see it, the situation right now?

Craig (04:10):

So, I think there’s the short term anxiety that exists in terms of the safety of the crews, the dependability of the global supply chain. A lot of short-term concern, but I think the bigger story [that] is going to play out over the next couple of years is we’re now reaching a point in history where global trade and global shipping is no longer as dependable or as predictable as it has been really since the post Cold War period. Civilian ships are being fired upon. And this is an unusual development that we haven’t seen for really many decades…

…Tracy (04:46):

So walk us through the importance of the Red Sea route. What kind of ships are actually going up and down?…

…Craig (04:59):

There’s a lot of oil and gas, obviously being in the Middle East, it has a lot of exposure to oil and gas and the derivative products that come out of that portion of the world. But it’s also one of the major trade lanes for container flows. And so, think of what moves in container. It’s largely manufactured and consumer goods that are largely dependent upon containers. A lot of these products are coming from Asia, and particularly China into Europe, some products going to the United States East Coast. But the predominance of the products that move through the Suez in the container freight is largely related to products out of Asia, going to Europe for European consumption.

Tracy (05:36):

What other routes are available for that kind of trade?

Craig (05:40):

Well, you have to go around South Africa, and so you’re really adding thousands of miles of additional distance when you aren’t able to cut through the shortcut that is the Suez. I mean, [the] Suez Canal has cut out an enormous amount of distance that geographically the ships have historically had to go around with the Suez. It was able to sort of expedite trade flow from Asia, in particularly to Europe. We do benefit from it in North America, but a much smaller percent of the freight that we depend on in the United States is dependent upon the Suez.

Joe (06:16):

What is the historical role of the US Navy in securing or protecting some of these routes, and what are we seeing from US defense officials now at this acute moment?

Craig (06:29):

There’s a lot of conversation in geopolitical circles about whether the Navy’s role has changed or shifted or is no longer effective in the role that it was believed to be played for the last, really since World War II. So if you think about it, the United States has the largest navy in the world. It’s also a one of the only Blue Water navies that can go anywhere to defend any place on the planet. And that’s really the call to fame.

Joe (06:57):

Sorry, what does it mean “Blue Water?”

Craig (06:58):

It means that they can go into deep oceans…

…They can be anywhere. Basically, there’s no place on the planet that the Navy and the Marines can’t actually reach. And so, the whole purpose of that is to protect trade lanes. That is one of the primary calls of the US Navy is its role is to protect commerce and ensure global trade and really the world. And China has mostly benefited from that, [the] US Navy’s role of protecting sea from things like pirates and state sponsors that want to attack global trade.

And the question now is in a post-, we’re now in this sort of new generation of trade, what does it mean? There’s a lot more protectionism that happens with US policy. And really to be able to defend the role of the US Navy being able to protect all aspects of it with geopolitical tensions in East Asia means that we may not have the resources to actually protect all aspects of trade the way that we did at one point in time.

Joe (08:02):

Just real quickly, pirates and pirate attacks, and you mentioned them, they’re somewhat common. They’re in the news, but what’s different about this is that it’s missiles being fired. They’re not trying to steal the cargo. These are military attacks on private corporation.

Craig (08:23):

These are military techniques…

…Craig (08:26):

We’ve seen helicopters actually land on tops of ships and actually take cruise hostage by way of helicopter. It looks like a SWAT. You probably have seen the video floating around where it looks like a SWAT video. Where they’re flying in and they’re basically taking over a ship through use of a helicopter. We’re seeing situations where, as you mentioned, they’re using missile technology, military grade technologies, which is an unusual development. And then with the proliferation of drones, you now have a low cost way to actually avoid some of the defenses that are set up to protect these ships that they’re able to reach them without, without obstruction.

And I think that has changed the game. And look, we can argue whether these are truly state sponsored or not, but at the end of the day they have access to military grade technology and they are using this to attack civilian vessels. And their goal is to disrupt global trade.

Tracy (09:23):

This was going to be my next question, which is, even if the Navy said, yes, absolutely, we’re going to go in, we’re going to protect all the ships. How much can they actually do in the face of that kind of threat, which has new technology that they’re clearly using, but is also very, very flexible in terms of what it can do?

Craig (09:45):

I think the question is at what cost? Because, I think the US has the capabilities to largely defend every ship or the ships that we have decided to defend. But at what cost? I mean, you’re looking at a missile, anti-missile technologies, a million dollars. We’re firing these defense missiles off at a million dollars apiece, and you’re fighting a drone that cost a couple thousand dollars. I mean, at some point there is a massive tax on US consumers and the US economy for us to do this. And the question is what is our appetite to continue to fund this type of defense technology when the United States is not the primary beneficiary of that type of trade.

Tracy (10:25):

And on a similar note, I’m always curious about the decision-making process to not go through a certain route. So, Maersk said it wasn’t going to go through the Red Sea anymore after the missile was fired. What are the factors that go into making that type of decision? And then if the Navy were to say tomorrow that “We’re going to escort all of these ships”, would that completely address their concerns? Would they [say], “Okay, yes, we’re going to resume this route”?

Craig (10:52):

It’s a great question because, I don’t know that the US with all of our other geopolitical commitments, particularly around China and what’s happening around Taiwan. I mean, the Chinese want our Navies in the Middle East. That’s where they want them because [that] enables them to have an enormous amount of power over East Asia. They want us moving our assets and being distracted in the Middle East. So they actually win geopolitically in terms of their power over their region by moving, forcing us to be distracted in the Middle East. But I don’t know that we have all the resources to defend every single ship from these attacks. And ultimately, what the container lines have to really think about is what’s the cost of a ship? You’re talking hundreds of millions of dollars. What’s the cost of a cargo, again, measured in probably billions of dollars when we a look at a 20,000 TEU (Twenty-foot equivalent unit) ship. And then you have the insurance companies which are saying, “Hey, we’re not going to insure these ships that go through these channels.” And that means that ultimately Maersk and others have to look at alternative routes. They will obviously protect their crews. The crews do understand that, the nature of their jobs is on occasion they put themselves in harm’s way. And we’ve seen that with the movie with Tom Hanks plays as the Captain…

…Joe (28:26):

Well, I’m glad you mentioned the freight tech companies because that’s where I was going to go next. So we already said, we already know it was bad for a lot of companies in 2023. But, going back to 2021, 2022, we got interested in freight, obviously on the Odd Lots podcast, that was also a big year for tech and tech investing.

A lot of VCs suddenly probably woke up to this idea, this world we’re like ‘Oh, the freight industry looks like a mess. I’m sure if we just apply our software magic, we can solve all of these problems.’ We saw some really huge fundraising, but then also in 2023, we saw the reversal of it. So we saw the freight brokerage, Convoy, just basically completely go out of business. I think we saw a pretty big downturn at Flexport. We’ve had their CEO Ryan Peterson on the show a couple of times.

What happened with freight tech? What were the theses maybe of the investors who were going in, they’re [thinking] ‘Oh we can solve this.’ And what reality did they run into that maybe it’s a bit harder to solve some of these problems then they may have assumed?

Craig (29:31):

You know, they were playing the Uber, Lyft, even Airbnb playbooks, which is, ‘Hey, I have this capacity and I can go out and create a digital app. If I could disrupt the taxi industry the way Uber did. Then I could also disrupt the trucking industry.”…

…Craig (29:47):

Here’s the problem, is that the investors that really drove the high valuations didn’t understand freight. They didn’t understand the boom and bust cycle. Convoy arguably had the best roster. Like, it had a dream team of investors. I mean, you had Bill Gates, Jeff Bezos, you had Reid Hoffman, you had the who’s who of sort of Silicon Valley and legacy tech that were investors. I mean, it was the best lineup of investors of probably any company in supply chain you could possibly have. And yet that did not help them survive.

And the reason is that really the investors and the management team, when it first raised money and got into this business, did not understand how cyclical this industry is and how fungible the capacity is. So if I want to disrupt the taxi industry, the reason that that works is I have all of these consumers sitting at home with their cars that are idle 90% of the time. That can create incremental capacity in and out of a market. So as the market surges, you can have, and Uber has piloted this with their search pricing, they will send out messages to their drivers and say, ‘Hey, there’ a football game in town, or there’s a big event in town, please come out and get three to four or five X your normal rate.’ And they’ve created this sort of surge flexible capacity model that works really well in a business like Uber and personal transportation.

The problem in trucking is there is none of that excess capacity sitting against the fence that can flex in and out of a market. And so what ultimately happened is that they were able to apply some digitization to the dispatch process and to the driver management process. But that was incremental. And one would argue, and Brad Jacobs has argued that the incumbents were doing the same thing, is that effectively all of these companies were spending billions of dollars to build technology that everyone else was also building. And not just existing companies like XPO and CH Robinson, but you also had all these tech vendors, companies that provide software that were also building technology that they could sell to hundreds of companies.

All this was happening at the same time. And effectively what Convoy did not understand early on, which I think they certainly understood at the late part of the cycle, a late part of their business is that freight is commodity, it’s highly fungible. The capacity is highly fungible. And no matter how much money I spend acquiring the capacity, there is nothing to keep that capacity from going to the next highest bidder. And because of that, all of the money that they wasted in acquisition costs to acquire capacity was effectively meaningless at the end of the day because that capacity could be found elsewhere….

…Craig (37:35):

So it’s interesting because Brad talked about the fact that when he got in this industry 10 years ago it was largely humans and then over time it had digitized. And I think the statement was he had 97% of its freight was electronic. That very well may be the case for his business. Think of XPO’s role in the business. It’s a big really predominantly, in its focus on LTL, which means it has very large enterprise shippers, big commitments. It’s able to digitize a lot of the transactions. And most of the bigger trucking companies are digital. Like if you go look at Knight-Swift’s operation, okay, look at Schneider’s operation, go look at Old Dominion.

Joe (38:13):

And so that is like placing an order on a thing and it automatically…

Craig (38:15):

That’s right. Okay. And that’s what the big companies want to do. Okay. Is they actually want to eliminate human contact as much as possible. Yeah. Because that’s how they’re able to optimize the, the model. They use technology to do electronic transactions and that is, that probably represents 20% of the business. It’s the cream of the crop business. It’s the business that every company wants because it’s the high volume shippers, dependable volume and…

Joe (38:41):

Standardized lanes, standardized shippers, standardized carriers. Over and over.

Craig (38:45):

Exactly. Highly predictable. Yeah. Highly consistent business. And if you’re building a network, then that’s what you want. Because I can depend on it day in, day out. That’s what the larger companies focus on. I see. And if, if you ask the CEO of Knight-Swift, you would probably get a similar answer about how much of its freight is electronically tendered. CH Robinson the largest freight broker in the country publishes that 78% of its freight doesn’t have a human touch. But the reality is, Joe, is that the hundreds of thousands of freight broker people that are out there making up, at least, the numbers are as high as registered freight brokers in the 60 to 80,000 numbers. We track and think there’s about 5,000 high scale freight brokers that do more than about $10 million in revenue a year. They’re still predominantly human-based and what they’re dealing with are the exceptions…

…Craig (39:39):

So what happens is, a large volume shipper takes 95% of its freight and sends it over to the XPOs and the CH Robinsons and the Knight-Swifts. And so they get all of the electronic stuff dispatched. What’s left over is the really hard to manage. It’s either a lane that nobody wants, it’s somebody who literally chop shops price on every single load. It’s a commodity that nobody wants. And you’ll see in the meme, if you go on Twitter or on X, you see all the memes and freight making fun of the kinds of freight that nobody wants. This is the type of freight that’s left over.

Joe (40:13):

What’s an example of a type of freight that no one wants to deal with?

Craig (40:16):

Grocery. Driver unload…

…Craig (40:21):

Well, it’s typically going to a grocery store. It takes a long time to unload it. They’re miserable because they’re in a cold trailer, in a refrigerated trailer, they have to use something called a Lumper. A Lumper is, I pay somebody at the dock to unload me, or the driver has to unload themselves. They can take eight to 10 hours to load at a farm. They go into a farm facility or distribution center because they’re all hand loaded. Think of like a crate of tomatoes or oranges or something. A lot of it’s loaded not on pallets, but actually sort of flow loaded. So this is undesirable freight for a lot of these guys. It has really tight transit times. So that’s a type of undesirable freight.

Flatbed, which is hauled to project sites. You’re not going to a warehouse, but you’re going to a construction site that has to be manually unloaded. It can take sometimes hours or longer where the truck’s got to sit. And so there’s a lot of freight that’s just undesired. And that’s where a lot of the freight brokers, the humans still take and manage a lot of these sort of long tail transactions. That isn’t the world that an XPO plays in. That is the world that the predominance of your freight brokerage…

…Joe (48:18):

One last quick question. I’m going to pivot. Founder and CEO of FreightWaves. We always talk to you about freight. You also have this whole other business and aviation media and other aviation assets. I want to do like an hour with you at some point. Talk about that. But just real quickly, is it really true that there’s more airports than McDonald’s in United States?

Craig (48:36):

This is an insane stat that no one, I think everyone finds it hard to believe. So if you take the total amount of private, this includes private airports and public airports. So most people think of airports, I’m thinking of like JFK and LaGuardia and Newark. The predominance, the vast majority of airports in the United States are actually privately owned airports or community owned airports. Places that have very small runways of a thousand to 2000, 3000 feet can’t accommodate even a jet. They’re accommodating small aircraft. Yeah. There’s 19,000 of those. And I think the number on McDonald’s is like 16,000…

…Craig (49:26):

People think that private airports is all about jets. And they always think it’s like really rich people. But the predominance of the folks that use these small airports are farmers and their agriculture. And our entire [agriculture] ecosystem is dependent upon airplanes and bees, but airplanes to do things. And so a lot of the airports are used in places out in the heartland for farming. They’re also used for things like mining extraction and stuff. And so the vast majority of those airports are very small airports that most people will never see, will never notice unless they get in a small airplane.

2. My Parents’ Dementia Felt Like the End of Joy. Then Came the Robots – Kat McGowan

WHEN MY MOM was finally, officially diagnosed with dementia in 2020, her geriatric psychiatrist told me that there was no effective treatment. The best thing to do was to keep her physically, intellectually, and socially engaged every day for the rest of her life. Oh, OK. No biggie. The doc was telling me that medicine was done with us. My mother’s fate was now in our hands…

…Beyond physical comfort, my goal as their caregiver was to help them to feel like themselves, even as that self evolved. I vowed to help them live their remaining years with joy and meaning. That’s not so much a matter of medicine as it is a concern of the heart and spirit. I couldn’t figure this part out on my own, and everyone I talked to thought it was a weird thing to worry about.

Until I found the robot-makers.

I’m not talking about the people building machines to help someone put on their pants. Or electronic Karens that monitor an old person’s behavior then “correct” for mistakes, like a bossy Alexa: “Good afternoon! You haven’t taken your medicine yet.” Or gadgets with touchscreens that can be hard for old people to use…

… Instead, the roboticists I learned about are trained in anthropology, psychology, design, and other human-centric fields. They partner with people with dementia, who do not want robots to solve the alleged problem of being old. They want technology for joy and for flourishing, even as they near the end of life. Among the people I met were Indiana University Bloomington roboticist Selma Šabanović, who is developing a robot to bring more meaning into life, while in the Netherlands, Eindhoven University of Technology’s Rens Brankaert is creating warm technology to enhance human connection. These technologists in turn introduced me to grassroots dementia activists who are shaking off the doom loops of despair…

…The robot-makers are a shaft of light at the bottom of the well. The gizmos they’re working on may be far in the future, but these scientists and engineers are already inventing something more important: a new attitude about dementia. They look head-on at this human experience and see creative opportunities, new ways to connect, new ways to have fun. And, of course, they have cool robots. Lots and lots of robots. With those machines, they’re trying to answer the question I’m obsessed with: What could a good life with dementia look like?

THE ROBOT’S TORSO and limbs are chubby and white. It seems to be naked except for blue briefs below its pot belly, although it does not have nipples. It is only 2 feet tall. Its face, a rectangular screen, blinks on. Two black ovals and a manga smile appear.

“Hello! I am QT, your robot friend,” it says. It says this to everyone, because that’s its job. QT raises both arms in a touchdown gesture. The motors whir. They sound expensive.

It might look and sound sort of familiar if you know anything about humanoid social robots—contraptions built to respond to us in ways we recognize. You may also remember their long history of market failures. RIP Kuri, Cozmo, Asimo, Jibo, Pepper, and the rest of their expensive, overpromising metal kin. QT is not like them. It is not a consumer product; it’s a research device equipped with microphones, a 3D camera, face recognition, and data recording capabilities, built by a Luxembourgian company for scientists like Šabanović to deploy in studies. She’s using QT to explore ikigai, a Japanese word that roughly translates to a reason for living or sense of meaning in life, but also includes a feeling of social purpose and everyday joy. Doing a favor for a neighbor can create ikigai, as can a hard week’s work. Even reflecting on life achievements can bring it on. Her team, funded by Toyota Research Institute, is tinkering with QT to see what kind of robot socializing—reminiscing, maybe, or planning activities, or perhaps just a certain line of conversation—might give someone a burst of that good feeling…

…One challenge is that dementia is never the same for any two people. There are different varieties, such as Alzheimer’s, frontotemporal dementia, and Lewy body disease, and they are dynamic, changing with time. Some people have no problem with memory but struggle with words; others make strange decisions. Many say their perception of time changes, or their senses become more acute. Some people are angrier, some calmer, and others lose all filters and say whatever they think…

… Today, Hsu will demo a storytelling game between person and machine. Eventually QT will retain enough information to make the game personalized for each participant. For now, the point is to test QT’s evolving conversational skills to see what behaviors and responses people will accept from a robot and which come across as confusing or rude. I’m excited to see how this plays out. I’m expecting spicy reactions. People with dementia can be a tough audience, with little tolerance for encounters that are annoying or hard to understand…

…Soon, Maryellen, an energetic woman in a red IU ball cap, walks in and takes a seat across from the robot. Maryellen has enjoyed talking to QT in the past, but she’s having an off day. She’s nervous. “I’m in early Alzheimer’s, so sometimes I get things wrong,” she apologizes.

The robot asks her to select an image from a tablet and make up a story. Maryellen gamely plays along, spinning a tale: A woman, maybe a student, walks alone in the autumn woods.

“Interesting,” says QT. “Have you experienced something like this before?”

“I have,” Maryellen says. “We have beautiful trees around Bloomington.” The robot stays silent, a smile plastered across its screen. QT has terrible timing, pausing too long when it should speak, interrupting when it should listen. We all share an apologetic laugh over the machine’s bad manners. Maryellen is patient, speaking to QT as if it were a dim-witted child. She understands that the robot is not trying to be a jerk.

Today’s robot-human chat is objectively dull, but it also feels like a breath of fresh air. Everyone in this room takes Maryellen seriously. Instead of dismissing her pauses and uncertainty as symptoms, the scientists pay careful attention to what she says and does.

Next enters Phil, a man with a tidy brush mustache, neatly dressed in chinos and a short-sleeve button-down printed with vintage cars. After taking a seat across from the robot, he chimes in with QT to sing “Take Me Out to the Ball Game.” He faces the machine, but he’s playing to us, mugging and rolling his eyes. Song over, he first teases Hsu, then another resident, then pretty much every woman in the room. In other circumstances he’d be patronized or “diverted”—someone would attempt to distract him. Instead, we join him in being silly, joking about the situation and the robot.

QT pipes up with another round of awkward conversation (“I love the song. Do you?”), and Phil replies with a combination of graciousness and sass (“You sing very well. Did you have that recorded, maaaybe?”). Hsu asks Phil how he felt talking to the machine. “Like I’m a fool talking to nothing,” he says sharply. “I know it’s not a real person.” Theatrically, he turns to the robot. “You’re not real … are you?” He winks, and laughs uproariously.

He likes the robot? He doesn’t? It’ll be the team’s job to figure out these enigmatic yet relatable reactions. The three of us plus robot pack up and head back to Šabanović’s R-House Lab at the university. In the big conference room there, her team will converge, students of informatics, data science, computer vision, and psychology. They’ll pick apart Maryellen’s kindness and hesitation and Phil’s glee and annoyance, looking for their next task, the next skill QT needs to learn…

…In 2005 she spent time with the pioneering roboticist Takanori Shibata at Japan’s National Institute of Advanced Industrial Science and Technology and his robot seal pup Paro. Handcrafted, the little critter responded to speech and touch by bleating—it was programmed with actual seal pup cries—closing its eyes, and flipping its tail and flippers. It was one of very few robots at the time that could be used outside the lab without expert assistance.

Even at this early stage, elderly people were the target audience. The researchers took the machine to care homes, and Šabanović was startled to see the effect. “People would suddenly light up, start talking to it, tell you stories about their life,” she says. Shibata’s studies, then and later, showed that the cuddly seal improved quality of life; it got people to interact more, reduced stress, and eased depression.

So Šabanović joined the emerging field of human-robot interaction. Her experiments since have explored how we project our “techno-scientific imaginaries”—our cultural baggage, fears, and fantasies—onto these hunks of metal and plastic. Sort of like if Isaac Asimov became an experimental psychologist.

In one early study, she brought Paro into a nursing home to study how the device turned wallflowers into butterflies. Most residents would ignore the seal pup until other people showed up—then it would become an icebreaker or a social lure. They’d gather to touch it. They’d comment on its sounds and movements, laughing. The robot, she saw, seemed to open a door to other people…

…A PAIR OF round, white blobs sit side by side, each the size and shape of a pumpkin. Every 10 minutes or so, the orbs croak like frogs, or chirp like crickets, and sparkle with light. They want your attention. Pick one up, and depending on whether you stroke it, tap it, or shake it, it will respond with noise and light. If the orbs are set to “spring” mode, and you stroke one, it will sing like a bird and blush from white to pink. If you ignore the second blob, it will act jealous, flushing red. If your friend then picks up orb number two, they will mimic each other’s light and sound, encouraging you to play together.

The blobs are called Sam, and together they form a social robot boiled down to its essence: an invitation to connect. Sam is one of the otherworldly creations emerging from the Dementia and Technology Expertise Centre at the Eindhoven University of Technology in the Netherlands. Rens Brankaert and his colleagues don’t call this—or the other things they make—a robot. They call it warm technology. “We want to contribute to the warmth between people,” he says. And to create gadgets that a wider range of people would enjoy using…

…One of the warmest technologies from the Eindhoven group and their collaborators is Vita, a patchwork pillow with vinyl panels. Pass your hand over a patch and a sensor detects your presence, playing a personalized, familiar soundscape: a stroll down a cobblestoned street in the rain, maybe, or the clatter of coffee cups and servers and spoons at a café. Family members and caregivers select the sounds they think will resonate with the user. Over years of testing, the pillow has been fine-tuned, and Brankaert is currently talking to a partner to produce it and bring it to market.

In one demonstration, a white-haired woman sits quietly, looking dreamy, or very possibly sleepy. “Good morning,” says her daughter, but the woman does not respond. The daughter places the pillow on her mother’s lap and guides her mother’s hand over a large yellow patch. The chorus of the World War II chestnut “We’ll Meet Again” emerges. The older woman’s eyes brighten, and a smile of recognition creeps over her face. She begins to sing.

What is this pillow gadget for? It doesn’t restore her speech or fix her memory or replace anything she no longer can do. It helps the two of them find each other again across the dim and confusing terrain of dementia…

…You learn a lot about people by hanging out with robots. QT made it plain to me how much human interaction depends on tiny movements and subtle changes in timing. Even when armed with the latest artificial intelligence language models, QT can’t play the social game. Its face expresses emotion, it understands words and spits out sentences, and it “volleys,” following up your answer with another question. Still, I give it a D+…

…It’s four days before Christmas, and QT is visiting Jill’s House again, decked out in a Santa hat and a forest-green pinny for this visit. With the help of ChatGPT, QT is now more fun to talk to. A few dozen residents, family members, and staff are here, plus much of Šabanović’s team. Šabanović’s 3-year-old daughter, Nora, is nestled on her lap, carrying on the family legacy. She stares shyly at the robot.

This is a holiday party rather than a formal experiment. The session soon devolves into friendly chaos, everyone talking over one another and laughing. We all chime in to sing “Here Comes Santa Claus,” the robot flapping its arms. Phil plays peek-aboo with Nora. It really does feel like a glimpse of the future—the people with dementia as just regular people, and the machine among the humans as just another guest.

3. A Framework For Spotting Value Traps – Dan Shuart

As for value traps, I like to think of them as somewhat of the anti-compounders. They display the opposite of the characteristics described above. Specifically, they demonstrate some combination of;

A need to retain a significant amount of the profits they generate just to maintain existing levels of profitability. In other words, they tread water or slowly drown.
They have very poor incremental, or even negative, returns on incremental invested capital. This results in the business retaining profits and standing still or shrinking.
They return too much capital to shareholders and do not reinvest in the business to an adequate degree or take on excessive leverage to fund unsustainable capital return programs…

…Here is how we look for value traps and a few real world stock examples.

Cash-in, Cash-out Framework

An initial test/filter Matt and I use to spot a potential value trap, or identify a potentially good business, is what we call the cash-in, cash-out framework. It’s simple yet very powerful.

We are trying to answer a simple two-part question: how much cash does the business reinvest and what are the returns on the reinvested cash? We prefer to work from cash flow statements, as normally cash doesn’t lie and it is much more difficult to manipulate than GAAP earnings or balance sheet figures. Just don’t forget to consider stock compensation, which is a very real expense.

I like to look at ten year increments and add up how much cash came into a business from all sources – operating cash flow, debt issuance, and share issuance – versus how much cash left the business via debt repayments, share repurchases, and dividends. Add the two together and you get the dollar amount of cash retained (from all sources) over that time period.

Next, we look at the cumulative profits over the same time period to get an idea what the reinvestment rate is as a percentage of total operating profits. Finally, by looking at the change in operating profits (often this requires some normalization) over the time period and dividing by total retained profits we can assess incremental returns on retained capital (incremental ROIC or I-ROIC). If profits grew by $1B and it took $5B of retained capital to generate that extra $1B, I-ROIC is 20% ($1B/$5B). Reinvestment rate and I-ROIC, in conjunction with shareholder yield, tell me roughly how the business has compounded in value on a per share basis…

…Verizon is puzzling to me as I would expect it to be a better business given it operates in a lightly regulated oligopoly with hard to replicate assets. Alas. The company soaked up 90% of earnings over the last ten years and barely grew for a measly 1% compounding rate. A generous debt-fueled dividend payout took business returns to an underwhelming 6%. While the yield seems attractive, a high dividend payout cannot go on forever if it’s driven by increasing levels of debt.

Macy’s has been a disaster. Left behind by better positioned specialty retailers and ecommerce businesses, Macy’s reinvested a third of profits at highly negative rates and has become far less valuable over the past decade, as you can see…

…To be clear, these stocks are cherry picked and meant to illustrate a point. I’m sure you can find a plethora of stocks that had cheap starting valuations, poor returns on capital, and still re-rated to a higher stock price for some reason over a ten year period. While those stocks undoubtedly exist, and probably in great quantity, I seriously doubt most people’s ability to reliably predict those situations for any extended period of time. I certainly couldn’t do it, it would be akin to throwing darts.

The point I’m making is, by assessing the economic fundamentals of a business whose stock may look cheap, you can implement guard rails as to whether or not you may be looking at a value trap. I’m skeptical of any stock that looks cheap but has flunked the cash-in, cash-out test over a many-year period. This filter at least gives us some hope of not fooling ourselves when we are enamored only by a cheap purchase price. Cheap businesses can be fine investments, but cheap and good businesses can be spectacular, and more importantly, limit your downside. To us, it’s also a far more replicable process, and a lot easier to stick with over the long run.

There are a few more critical other points to this discussion, as what I’ve described above is the easy part of the analysis (anyone can plug numbers into a spreadsheet).

The historical numbers are the result of what happened over the past ten years, and what matters is what happens over the next ten years.
Understanding what happened is easy, understanding why it happened and, more importantly, if it will continue to happen is where superior qualitative judgement and experience are required…

…Finally, using this I-ROIC framework will cause you to miss opportunities when businesses are at key inflection points and the future looks dramatically rosier than the past. That’s fine with us, because I think it causes us to “miss” more losers by keeping us out of trouble. It also means we will almost surely not find the next Amazon, but that’s not the game we are trying, or equipped, to play.

4. A beginner’s guide to accounting fraud (and how to get away with it) – Leo Perry

But now that I’ve worked out how to read accounts, and find it quite easy to spot signs of fraud, I also have some ideas for how we could run a good one of our own. And I’m not so sure there won’t be a lot more money in that line of business, if you can call it that.

The mechanics of making up sales are pretty simple. If we’re running a business and want to boost our top line, all we have to do is phone a friend. A good friend to be sure, who doesn’t ask questions. It’ll only take them a few hours to do the paperwork for setting up a shell company and then we have our customer, one we can invoice whatever we want. We have our fake sales (and I’m pretty sure our mate has done nothing wrong, in the eyes of the law).

You might think that sounds too easy, that someone would spot the problem and the con would quickly fall apart.

Well back in 2014 I explained what I thought looked like the most obvious fraud to an FT journalist. One of the things that caught my eye about Wirecard was the accounts of a company it bought in Singapore. Tucked away in the notes were references to specific customers — like Ashazi Services. [1] This was a Bahrain entity with no apparent operating business. A dormant shell that had never filed financials. Even the product Wirecard said it was licensing to it, the Elastic Platform, seemed to be a fiction (at least I never found any other mention of it by the company):…

…Dan McCrum, the FT journalist I met with, went to visit what there was of Ashazi as a part of a long-running series of Alphaville posts on Wirecard. And the whole scam did come crashing down . . . a mere six years later…

…Even if some over-eager analyst does turn up at our sham customer, we can always move the goalposts. A few years ago I asked a Chinese-speaking colleague to visit some companies on the mainland. These were businesses that were reported to have signed purchase agreements with a western mining startup, which I was short. This startup had announced a deal to sell product a few years earlier. Then the contract was suddenly cancelled and simultaneously replaced with a similar agreement, but with a different Chinese entity — which we’ll call Tulip Industries. The deal equated to an outlay of approximately $150mn a year by the customer.

What we found at Tulip Industries was little more than a startup itself, with only a few field trials in progress. Even its most ambitious presentation forecasts involved a fraction of the product it had apparently agreed to buy. And its CEO was very clear that the deal wasn’t a firm commitment, only a loose framework. In fact he said he’d never spoken to the company that I was short, the deal was agreed through a friend in Hong Kong whose nephew worked for the miner. (He was much more committed to explaining to my colleague why China needed to invade Japan.)…

…If we don’t want to rely on a third party there’s also the DIY approach, using an entity that we control. A related party.

One of the first sets of financial statements I really struggled to reconcile with the story company management was telling was for Cupid, a UK-listed operator of dating apps and websites. I don’t know how many of its shareholders bothered to try out the sites it ran, even briefly, but I would guess not many. For anyone who did it seemed like they were too good to be true. Wherever you signed in from in the world, dozens of very keen and very attractive women would quickly get in touch. And they all happened to live nearby.

The Kyiv Post looked into how the company might be managing this back in 2013. Australian short seller John Hempton at Bronte Capital even took the trouble to log in from the most remote island in the UK (not in person, he used a virtual private network) and still found no shortage of admirers in the local area — even though the population there was small enough to all know each other. The fact that his profile stated he had syphilis apparently wasn’t a problem either.

Cupid commissioned KPMG to investigate; its report found there was “no evidence of a company-organised practice” of staff using fake profiles to encourage subscriptions.

Cupid’s accounts were not as straightforward as its business model, and shareholders seemed to have even less time for them than they did for its services.

The annual report for 2011 had a chunky £2mn receivable from a company called Amorix, which was controlled by Cupid’s founders. Cupid said Amorix owed it this money because it had been collecting customer subscriptions on its behalf. But Amorix’s own accounts showed it only had about £80,000 in the bank, and no other assets to speak of. There was no trace of the money Cupid said was being collected for it…

…The magic thing about fake sales is they are 100 per cent margin. All profit. You don’t need to go to the trouble of actually producing whatever it is you are pretending to sell, do you? So £100 in sales is £100 of profit. Hold that thought for a minute.

Now let’s think about what kind of business we want to start with to run our little fraud out of. Not a profitable one obviously. That would cost us good money to get control of in the first place, and we want nothing to lose. What we need is a business that has a lot of turnover but makes no money, but isn’t burning cash either. Something like a very low margin distribution business…

…So let’s say we go into the fruit wholesale business. We buy boxes of bananas and sell them on at cost. Why? Well, while we’re only washing our face, if we turn over £100mn in bananas who’s going to notice when we add £1mn that’s lemons? That’s still less than 1 per cent of our sales after all. But if the £1mn is fake then it’s all profit. And as we make no money shipping bananas, the fake lemons are all of our profit.

The reported value in our business now all comes from made up sales to a fictitious customer; a customer set up by a mate that no one outside our office is ever going to know about. No one can pay them a visit if they don’t know its name. And they won’t, because at that size we wouldn’t even have to mention it exists. From the outside there’s just no way to spot anything wrong in our revenue numbers.

5. Why Wasn’t there a Recession? – Michael Batnick

So, how did everyone get 2023 so wrong? Michael Cembalest hit on this in his 2024 outlook.

Monetary policy is tighter but below the level of real rates that led to prior recessions; corporate cash flow is still in good shape, unlike the cash flow deficits which preceded prior recessions; and the corporate sector termed out debt maturities before the rise in rates, partially immunizing itself from the interest spike that preceded prior recessions. Private sector credit creation was similar to prior cycles, but debt servicing risks are lower for companies and households that termed out maturities.

Even though the Fed aggressively raised rates, monetary policy wasn’t as restrictive as it was in the lead-up to prior recessions (not including 2020). That’s not to minimize their efforts of cooling inflation, only putting in perspective that historically, they just weren’t that tight.

And even if they raised rates to 6% or higher, it’s hard to say for sure that we would have had a recession. Almost 90% of S&P 500 debt is long-term fixed, which is why net interest costs didn’t go up with interest rates. Paradoxically, thanks to all the cash on the balance sheets actually earning something, net interest costs went down!

What We’re Reading (Week Ending 07 January 2024)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 07 January 2024:

1. What the Solow Model can teach us about China – Noah Smith

The question of why economies grow, and why they stop growing, is perhaps the most important in all of economics. It’s also an incredibly difficult question, both because growth is such a complicated thing, and because it’s very hard to compare different countries’ experiences. The Solow model is an incredibly simple thing — so simple that a bright junior high school student can learn it. It has only a few variables and a few parameters. There’s no possible way that such a simple model can tell us most of what we need to know about how and why economies grow.

And yet the amazing thing about the Solow model is that it does tell us a few incredibly important things about growth…

…The Solow model assumes that economic output — also called “production” or “GDP” — comes from three things:

Labor (human work effort)
Physical capital (machines, buildings, vehicles, etc.)
A mysterious quantity called “total factor productivity” (TFP), usually abbreviated as “A”, which some people associate with technology

The Solow model deals mostly with the question of how physical capital affects growth. Physical capital is everything you can build that helps you build other stuff or create economic value. It includes machine tools, factories, office buildings, delivery vans, highways, port infrastructure, trains, and so on. In my mind, the easiest type of physical capital to imagine is a machine tool — a sewing machine, or a drill press, or a lathe, or a nanolithography machine. So I’ll usually use machine tools as my examples of physical capital…

…Solow’s model makes three very reasonable assumptions about how physical capital works. It assumes:

You can build more physical capital by saving and investing.
Physical capital depreciates over time (at a constant rate).
On its own, physical capital has diminishing returns.

The first of these assumptions is actually the most subtle. The basic intuition is that you can set aside a certain amount of your GDP every year to build physical capital — like a farmer choosing to reserve a certain percentage of the annual corn harvest as seed corn for planting next year’s crop. But most real types of physical capital don’t work like seed corn — a sewing machine can’t be used to create new sewing machines, etc. So what Solow is actually assuming is that we set aside a certain percent of our financial income and use it to pay people to build more capital. It basically assumes a market where sewing machines, and any kind of capital, can be constructed for a price.

The second and third assumptions are pretty straightforward. If you’ve ever owned a car or a house, you know that it needs regular maintenance, upkeep, and renovation over time. If you have an economy with a lot of capital, some portion of it wears out every year and has to be replaced. (In the Solow model, the portion that wears out every year is just some constant percentage — 5% or 7% or whatever.) Replacing or maintaining your old worn-out capital costs money.

Finally, on its own, capital has diminishing returns. That means if you hold the number of people constant, eventually building more machines and buildings and such won’t help you produce more. To see why, just imagine one person trying to operate 100 sewing machines at once. They definitely wouldn’t produce 100 times as much as one person operating one sewing machine!…

…So what does this tell us about how economies grow? It tells us one incredibly important thing. It tells us that because of depreciation and diminishing returns, a country simply can’t build its way to infinitely high standards of living. If you just keep trying to build more and more, at some point depreciation overwhelms you. and you just can’t build any more!

Let’s think about that in the context of China. Over the last four decades, China has built an absolutely incredible amount of physical capital — in absolute terms, the most any country has ever built in history. Think about the vast, sprawling factories filled with robots and machines, the forests of skyscrapers and apartment buildings, the rivers of highways and high speed rail, the fleets of cars and trucks and buses and ships and planes.

The Solow model gives a simple explanation for how China was able to build this much, this fast: It had a very high rate of savings and investment, far higher even than other Asian countries.

China dedicated everything it had to building massive amounts of physical capital, leaving relatively little of its economic output left over for its people’s consumption. As a result, it grew very very quickly.

But the Solow model says that this type of growth has a limit. Just as the model would predict, China started hitting diminishing returns. We started seeing “ghost cities” and massive overcapacity in all sorts of industrial sectors. China’s incremental capital-output ratio — the dollars of capital needed in order to generate an additional dollar of GDP — rose relentlessly from around 2007…

…And just as the Solow model foretold, China’s growth is slowing:

Slowing growth from physical capital accumulation is the Solow model’s first big insight. The second is that it’s actually possible for a country to save and invest so much of its income, and build so much physical capital, that it actually makes its citizens poorer.

The reason is, again, depreciation. If you save and invest a huge fraction of your income — as China has done — you will build an enormous amount of physical capital. But the more you build, the more you have to pay to upkeep in the future. There’s a point called the “golden rule”, above which saving and investing more of your national income just forces your citizens to forego more and more consumption in order to stave off capital depreciation.

Does China save and invest more than Solow’s “golden rule” would suggest? It’s hard to tell. But if any country is above the healthy limit, it’s China. Note that in the Solow model, the optimal savings rate is lower if population growth is lower; China’s population is now shrinking, and its working-age population is falling rapidly. So the Solow model serves as a warning to China’s leaders that they should consider encouraging their people to consume more…

..Of course, there is a vast amount that the Solow model can’t tell us about economic growth. Most of those unanswered questions are contained in that innocuous little letter “A”; as one of Solow’s contemporaries put it, total factor productivity is a measure of our ignorance. One factor exacerbating China’s growth slowdown is that TFP growth has slowed relentlessly over the last three decades:

2. China’s Japanification – Robin Wigglesworth

The biggest question in global macroeconomics at the moment is whether China is on the cusp of a “balance sheet recession”. This sexy bit of economic jargon was first coined by Nomura’s Richard Koo to describe Japan’s lost decade(s), but is most commonly known as “Japanification”.

It can be described simply as a protracted period of deflation, economic sluggishness, property market declines and financial stress as households/companies/governments unsuccessfully try to deleverage after a debt binge…

…JPMorgan doesn’t explore cinematic history in its report but notes that there are a few eerie other similarities between China’s current predicament and Japan’s in the early 90s.

First is similarity in housing market development. As we have argued, China’s housing market correction since 2021 is not only cyclical (or policy-induced), it is also structural reflecting major changes in demand vs. supply in the housing market. This is similar to Japan’s housing market correction in the 1990s.

Second is similarity in financial imbalance, i.e. the pace of increase and level of debt problem. According to the BIS, China’s total non-financial credit/GDP ratio approached 297% of GDP by end-2022, similar to Japan in the 1990s. Also similarly, debt is mainly domestic and domestic saving rate is high in both countries.

The problem of population aging is also similar. The share of aged population (65 and above) was 12.7% in 1991 in Japan, similar to China in 2019 (12.6%).

On the external front, Japan’s large trade surplus vs. the US led to trade conflict, as exemplified in the Plaza Accord in 1985 (5-6 years before the start of Japan’s lost decade) and US-China tariff war that started in 2018. From a broader perspective, the rise of Japan (30 years ago) and China (right now) to challenge the status of the US as the largest economy in the world is quite similar, leading to the fight-back from the US that initially focuses on reducing the bilateral trade imbalance…

…Let’s look at what JPMorgan thinks are the “good” differences, before turning to the ugly. First of them (and JPMorgan reckons perhaps the most important difference) is a much lower urbanisation ratio in China.

China’s urbanization ratio was 65% in 2022, and if excluding migrant workers who live in urban areas but do not have the same privileges as urban citizens, the hukou ratio was only 47%. In Japan, urbanization ratio exceeded 77% in 1988. Lower urbanization ratio points at larger potential for productivity increase associated with labor migration from agricultural to non-agricultural sectors…

…Second, China has a much larger domestic market, a larger pool of STEM graduates and comprehensive manufacturing sectors. While China may be facing a more challenging external environment than Japan in the 1990s, there is also hope that China can achieve technology upgrade and commercialization in some areas…

…Third, perhaps somewhat debatably, we think China’s housing price overvaluation is less severe than Japan in the 1990s. This is in part due to prolonged administrative control on new home prices and in part due to solid income growth. Our estimates show that housing affordability has continued to be a big problem in tier-1 cities: it took 21.1 years of household income to buy a 90-sqm apartment in 2010, and 16.6 years of household income in 2022. By contrast, housing affordability is much better in tier-2 and tier-3 cities that account for the majority of China’s housing market. Using the same house price/income measure, the ratio fell from 13.4 in 2010 to 8.3 in 2022 in tier-2 cities, and from 10.2 in 2010 to 6.1 in 2022 in tier-3 cities.

Fourth, China’s capital account is not fully liberalized. This will reduce the risk of fire sale of domestic assets (mainly housing) to invest overseas…

…Lastly, the Chinese government has stronger control of both asset and liability sides of the debt problem. This could be a double-edge sword: it implies that the probability of a sudden-stop debt crisis is smaller in China, but the zombie parts of the economy will continue to stay and likely further expand, intensifying the moral hazard problem and weakening incentives for structural reforms. This may crowd out more productive activities in the economy and lead to faster-than-expected slowdown in economic growth…

…JPMorgan’s main concern is that China is actually ageing more rapidly than Japan was, which has led to predictions that it will ‘grow old before it grows rich(opens a new window)’ — a kind of demographics-caused middle-income trap.

In Japan’s case, the share of population aged 65 and above exceeded 10% in 1983, and exceeded 14% in 1994. The birth rate fell from 12.7 (per 1000 people) to 10.0 during that period. In China’s case, it took only 7 years (from 2014 to 2021) for the 65 plus population to increase from 10% to 14% of total population, and the birth rate has fallen faster from 13.8 (per 1000 people) to 7.5 during that period (and further down to 6.77 in 2022, similar to Japan in 2020 at 6.80). In addition, China’s total population started to decline in 2022, while Japan’s total population started to decline in 2008, nearly two decades after the start of the lost decade.

Second, China’s GDP per capita was around US$12,800 in 2022, much lower than Japan in 1991 at US$29,470. While lower GDP per capita may imply higher growth potential, it suggests that China is becoming old and high-indebted before it becomes rich…

…JPMorgan’s economists also point out that the global economic backdrop is worse for China than it was for Japan in the 1990s, and thinks the Chinese government has less scope for stimulative fiscal measures than is commonly assumed:…

…In recent years, technology decoupling from the US has replaced the tariff war to become the major challenge for China. Beyond the bilateral relationship with the US, the globalization process has slowed down notably after 2008 (when the share of global trade as % of global GDP peaked), in sharp contrast to the golden days of globalization in the 1990s. The Russia-Ukraine war in 2022 further accelerated global supply chain relocation, which weighs on China’s potential growth.

Moreover, the room of macro policy stimulus is more limited in China nowadays than Japan in early 1990s. On the fiscal side, government debt was 61.9% of GDP in Japan in 1991, the start of the housing bust. Government debt rose to 131% of GDP by 2000 in Japan. In China’s case, although central government debt was only 20% of GDP, if adding local government debt and LGFV debt, total public debt reached 95% of GDP by end-2022…

…JPMorgan warns that “the room for fiscal stimulus for China in the next 10 years is much smaller than Japan in the 1990s”. Nor do its economists think that China has any more scope to combat the economic miasma with monetary policy.

Similarly, on the monetary policy front, the BOJ’s policy rate was 8.1% in January 1991. The BOJ moved quickly after the housing bubble burst: by end-1993, the policy rate was cut to 2.4%; and in 1999, the BOJ became the first central bank to adopt zero interest rate policy. By comparison, China’s policy rate (7-day reverse repo rate) is already as low as 1.9%. The room for policy rate cuts for the PBOC, if deemed necessary, is much smaller than the BOJ in early 1990s…

…So why then does JPMorgan think that China isn’t about to suffer a Japan-style long-term balance sheet recession? It boils to the differences between “ordinary” economic downturns and Koo’s diagnosis of Japan’s pretty unique travails.

When asset prices fall, firms face binding borrowing constraints with balance sheet deteriorating, forced asset sales can further push asset prices lower and form a self-reinforcing downward spiral between asset prices and economic activities. In other words, asset price decline is critical in understanding the phenomenon of balance sheet recession.

Following this argument, balance sheet recession is not a reality yet in China. The Chinese government has adopted the strategy of protecting house prices but letting volumes correct dramatically. This is in sharp contrast to the Japan’s episode, when prices and volume fell simultaneously. As a consequence, the macro cost (sharp decline in volume activity and slower real estate investment) is larger in China, but the benefit is that financial risk associated with asset price decline has stayed under control.

Also Japan’s balance sheet recession manifested itself in a huge deleveraging by households and companies, but a massive increase in the government’s debt burden.

Corporate debt fell from the peak of 144.9 per cent of Japan’s GDP in 1993 to 99.4 per cent in 2004, and household fell from 71 per cent in 1999 to 60 per cent in 2007, even as government debt ballooned, pushing the overall burden for the economy as a whole higher.

In contrast, China’s debts have been building up across the board with hardly any interruptions since 2008, and this is likely to continue, according to JPMorgan…

…But the fact that Chinese debts have continued to rise and are likely to do so for the next few years — and that the property market hasn’t imploded yet — is not really an argument against China’s Japanification. Indeed, it might only indicate that a full-scale version just hasn’t started yet…

…But there are enough broad similarities to think that the overall disease — a protracted period of declining demographics, economic sluggishness, deleveraging and deflationary pressures that defies fitful government efforts to dispel the miasma — might end up being pretty similar.

3. 36 quick thoughts to end 2023 – Thomas Chua

#3 There’s zero benefit in dwelling on how luck shapes a person’s success. Instead, focus on controllable factors that can increase the probability of your success.

#4 As we progress in life, how we perceive wealth changes based on who we compare ourselves to. Define your ‘enough’ to avoid living your life solely pursuing wealth.

#5 If you don’t eat food that nourishes your body, sooner or later you’ll have to eat your medicine as food.

#6 Fast growth and quick wins are sexy in business and investing. Sustainable growth and compounding, however, are key to long-term outperformance…

#7 Just as food affects your body, the information you consume shapes your thoughts…

…#19 If you pursue any endeavors with half heartedness, your mind will become like a magnet for fear and doubts. When you encounter difficulties, you’ll come up with various reasons to tell yourself why you shouldn’t do it.

#20 The fastest way to end your life is to retire and do nothing.

#21 The biggest wall separating high achievers from the rest is excuses.

#22 Knowledge isn’t power. It’s a potential power. Only when knowledge is applied, it becomes power…

…#24 For a list of book recommendations, check out the bibliography section of books written by your favorite authors.

#25 You seldom regret what you did. You often regret what you didn’t do.

#26 More is not always better when setting goals. Reduce, reduce, reduce.

#27 Advice from people who are older aren’t laws. They’re like clothes. If it doesn’t fit you, try others.

#28 It’s inevitable to avoid pain in life. But suffering is optional…

…#32 Ordinary returns over a long time period will give you an extraordinary result…

…#34 No book can substitute the experience of navigating a stock market downturn. The best way to learn is to start.

#35 It’s not enough that you believe in investing for the long term. This idea must also be embraced by your spouse, family, and friends.

#36 Complexity gives you a false blanket of accuracy and control. It is usually the person who is able to explain things simply who knows what they are talking about.

4. The Nine Breakthroughs of the Year – Derek Thompson

1. CRISPR’s Triumph: A Possible Cure for Sickle-Cell Disease

In December, the FDA approved the world’s first medicine based on CRISPR technology. Developed by Vertex Pharmaceuticals, in Boston, and CRISPR Therapeutics, based in Switzerland, Casgevy is a new treatment for sickle-cell disease, a chronic blood disorder that affects about 100,000 people in the U.S., most of whom are Black.

Sickle-cell disease is caused by a genetic mutation that affects the production of hemoglobin, a protein that carries oxygen in red blood cells. Abnormal hemoglobin makes blood cells hard and shaped like a sickle. When these misshapen cells get clogged together, they block blood flow throughout the body, causing intense pain and, in some cases, deadly anemia.

The Casgevy treatment involves a complex, multipart procedure. Stem cells are collected from a patient’s bone marrow and sent to a lab. Scientists use CRISPR to knock out a gene that represses the production of “fetal hemoglobin,” which most people stop making after birth. (In 1948, scientists discovered that fetal hemoglobin doesn’t “sickle.”) The edited cells are returned to the body via infusion. After weeks or months, the body starts producing fetal hemoglobin, which reduces cell clumping and improves oxygen supply to tissues and organs.

Ideally, CRISPR will offer a one-and-done treatment. In one trial, 28 of 29 patients, who were followed for at least 18 months, were free of severe pain for at least a year. But we don’t have decades’ worth of data yet.

Casgevy is a triumph for CRISPR. But a miracle drug that’s too expensive for its intended population—or too complex to be administered where it is most needed—performs few miracles. More than 70 percent of the world’s sickle-cell patients live in sub-Saharan Africa. The sticker price for Casgevy is about $2 million, which is roughly 2,000 times larger than the GDP per capita of, say, Burkina Faso. The medical infrastructure necessary to go through with the full treatment doesn’t exist in most places. Casgevy is a wondrous invention, but as always, progress is implementation.

2. GLP-1s: A Diabetes and Weight-Loss Revolution

In the 1990s, a small team of scientists got to know the Gila monster, a thick lizard that can survive on less than one meal a month. When they studied its saliva, they found that it contained a hormone that, in experiments, lowered blood sugar and regulated appetite. A decade later, a synthetic version of this weird lizard spit became the first medicine of its kind approved to treat type 2 diabetes. The medicine was called a “glucagon-like peptide-1 receptor agonist.” Because that’s a mouthful, scientists mostly call these drugs “GLP-1s.”…

…3. GPT and Protein Transformers: What Can’t Large Language Models Do?…

…This spring, a team of researchers announced in Science that they had found a way to use transformer technology to predict protein sequences at the level of individual atoms. This accomplishment builds on AlphaFold, an AI system developed within Alphabet. As several scientists explained to me, the latest breakthrough suggests that we can use language models to quickly spin up the shapes of millions of proteins faster than ever. I’m most impressed by the larger promise: If transformer technology can map both languages and protein structures, it seems like an extraordinary tool for advancing knowledge.

4. Fusion: The Dream Gets a Little Closer

Inside the sun, atoms crash and merge in a process that produces heat and light, making life on this planet possible. Scientists have tried to harness this magic, known as fusion, to produce our own infinite, renewable, and clean energy. The problem: For the longest time, nobody could make it work.

The past 13 months, however, have seen not one but two historic fusion achievements. Last December, 192 lasers at the Lawrence Livermore National Laboratory, in California, blasted a diamond encasing a small amount of frozen hydrogen and created—for less than 100 trillionths of a second—a reaction that produced about three megajoules of energy, or 1.5 times the energy from the lasers. In that moment, scientists said, they achieved the first lab-made fusion reaction to ever create more energy than it took to produce it. Seven months later, they did it again. In July, researchers at the same ignition facility nearly doubled the net amount of energy ever generated by a fusion reaction. Start-ups are racing to keep up with the science labs. The new fusion companies Commonwealth Fusion Systems and Helion are trying to scale this technology…

...5. Malaria and RSV Vaccines: Great News for Kids

Malaria, one of the world’s leading causes of childhood mortality, killed more than 600,000 people in 2022. But with each passing year, we seem to be edging closer to ridding the world of this terrible disease.

Fifteen months ago, the first malaria vaccine, developed by University of Oxford scientists, was found to have up to 80 percent efficacy at preventing infection. It has already been administered to millions of children. But demand still outstrips supply. That’s why it’s so important that in 2023, a second malaria vaccine called R21 was recommended by the World Health Organization, and it appears to be cheaper and easier to manufacture than the first one, and just as effective. The WHO says it expects the addition of R21 to result in sufficient vaccine supply for “all children living in areas where malaria is a public health risk.”…

…6. Killer AI: Artificial Intelligence at War…

…In the world’s most high-profile conflict, Israel has reportedly accelerated its bombing campaign against Gaza with the use of an AI target-creation platform called Habsora, or “the Gospel.” According to reporting in The Guardian and +972, an Israeli magazine, the Israel Defense Forces use Habsora to produce dozens of targeting recommendations every day based on amassed intelligence that can identify the private homes of individuals suspected of working with Hamas or Islamic Jihad. (The IDF has also independently acknowledged its use of AI to generate bombing targets.)…

…Meanwhile, the war in Ukraine is perhaps the first major conflict in world history to become a war of drone engineering. (One could also make the case that this designation should go to Azerbaijan’s drone-heavy military campaign in the Armenian territory of Nagorno-Karabakh.) Initially, Ukraine depended on a drone called the Bayraktar TB2, made in Turkey, to attack Russian tanks and trucks. Aerial footage of the drone attacks produced viral video-game-like images of exploded convoys…

…But Russia has responded by using jamming technology that is taking out 10,000 drones a month. Ukraine is now struggling to manufacture and buy enough drones to make up the difference, while Russia is using kamikaze drones to destroy Ukrainian infrastructure.

7. Fervo and Hydrogen: Making Use of a Hot Planet…

…Eleven years ago, engineers in Mali happened upon a deposit of hydrogen gas. When it was hooked up to a generator, it produced electricity for the local town and only water as exhaust. In 2023, enough governments and start-ups accelerated their search for natural hydrogen-gas deposits that Science magazine named hydrogen-gas exploration one of its breakthroughs of the year. (This is different from the “natural gas” you’ve already heard of, which is a fossil fuel.) One U.S.-government study estimated that the Earth could hold 1 trillion tons of hydrogen, enough to provide thousands of years of fuel and fertilizer.

8. Engineered Skin Bacteria: What If Face Paint Cured Cancer?…

…Some common skin bacteria can trigger our immune system to produce T cells, which seek and destroy diseases in the body. This spring, scientists announced that they had engineered an ordinary skin bacterium to carry bits of tumor material. When they rubbed this concoction on the head of mice in a lab, the animals produced T cells inside the body that sought out distant tumor cells and attacked them. So yeah, basically, face paint that fights cancer…

…The ability to deliver cancer therapies (or even vaccines) through the skin represents an amazing possibility, especially in a world where people are afraid of needles. It’s thrilling to think that the future of medicine, whether vaccines or cancer treatments, could be as low-fuss as a set of skin creams.

5. TIP595: Stock Market History & The AI Bubble w/ Jamie Catherwood – Clay Finck and Jamie Catherwood

[00:34:02] Clay Finck: And then this also brought to mind another solution that could be brought about and that’s to restructure the debt. Are there examples in history that you’ve looked at where debt restructurings have occurred?

[00:34:15] Jamie Catherwood: Yeah. So in the U.S, it’s not something that tends to get acknowledged but in the first few years of our nation, we restructured our debt.

[00:34:26] Jamie Catherwood: I mean, that’s what Hamilton was tasked with doing when he. Assumed office as the first secretary of the treasury. When he came into his role in 89, 1789, there was a dire financial state. At that point, I’ll take you back to US history class from high school but before we had the constitution, we had the Articles of Confederation, which were designed to severely curtail the central government authority because obviously Americans were very fearful after having fought a war with a British monarch that any type of new government in the U.S. would fall kind of victim to a similar. And so the articles of confederation essentially gave Congress no power.

[00:35:16] Jamie Catherwood: And so, for example, they did not have the authority to collect taxes, which is insane. And so that means that during those years, there was not a lot of revenue coming in. And so even after the constitution was passed and the government we have today was put into place, there was a real problem because there were.

[00:35:34] Jamie Catherwood: It was not a lot of revenue coming in, but there had been massive accumulation of debt incurred during the revolutionary war to fight the British. And I mean, we owed, I think, like 80 million, a lot of it to foreign governments and when Hamilton took office, he had to write to the French government asking.

[00:35:54] Jamie Catherwood: For a delay in payments because the U.S. was basically struggling to get on its feet. In fact, in the 1st year of his time in office, he had to write to Washington President Washington saying that, if we don’t get the exact amount, but a certain amount of money into the treasury’s coffers in the next month, then we’re not going to be able to pay congressmen their salaries. And there are going to be a lot of other departments and cabinet positions that won’t be able to receive their funds because. we’re just so on the whole and so what Hamilton’s novel kind of idea was, and it was politically very challenging and a difficult thread to needle was he had to essentially convince American debt holders to exchange their existing higher paying debt and U.S. bonds that they owned for a public loan. Package of new debt securities that he would issue, which would have a lower interest rate, but his premise to these investors was the only alternative for continuing to pay out these higher interest rates would be to introduce new taxes or, raise higher taxes, both of which we know would lead to probably armed rebellion, as you can see, in the case of the whiskey rebellion, when there’s a whiskey tax introduced.

[00:37:10] Jamie Catherwood: And so if you want to really avoid that, then the only way we can do so is if you accept the fact that instead of being paid 6% interest on these bonds, we’re going to give you 4% interest going forward. And that was obviously a tough sell, especially when the nation was very divided and people were still very wary of strong central government implementing new taxes or having too much control and, changing their commitments to pay out what they had promised originally at 6%. And so that was very difficult, but in a matter of, I think, 2 years or so, he had successfully converted something like 98 % of the outstanding debt into this package of new securities that were lower paying, lower interest bearing securities and it saved. Tens of millions for the government and so that was restructuring literally at the founding of our nation. That was very successful. And one of the ways that he also was able to retire a lot of the debt, just kind of as an interesting side note, is by allowing investors to purchase shares of the Bank of the United States, which was kind of like an early central bank esque institution in the U.S. And the bank IPO ed on July 4th, 1791, I believe very patriotic IPO date and he allowed investors that held U.S. government bonds to pay for shares of the Bank of the United States with these bonds. So it was kind of a win for the government because, it injected capital into this new bank, but also it reduced the amount of debt outstanding that they would have to pay interest on by allowing someone to use like three government bonds to purchase one share of the Bank of the United States stock and so interesting and often under referenced example of a restructuring in U.S. history, because when there’s talk of debt restructurings or defaults, et cetera, people tend to pull out the line that U.S. has never defaulted on its debt or something like that.

[00:39:14] Jamie Catherwood: The reality is that there have been these moments in U.S. history where we were in pretty dire times and some novel solutions were needed…

…[00:40:37] Clay Finck: But then another major factor I sort of think about in terms of market efficiency is the massive impact of passive flows on index funds. And you did a write up that referenced the telegraph looking all the way back and investors first getting access to this quick information. So talk to us about the efficiency of markets and how that’s changed over time.

[00:40:58] Jamie Catherwood: Yeah. So what prompted kind of my recent interest in this again was a quote from Cliff Asness in a recent financial times article, but he said something along the lines of people that think technology. It’s going to make asset pricing markets more efficient are the same ones who 20 years ago said that social media would make us all like each other more, which I think is just a fantastic way to put it because definitely social media does not make us like each other more and has increased the divisiveness in society.

[00:41:31] Jamie Catherwood: But also, I mean, it makes sense on its face throughout history that when you suddenly get these innovations and kind of communication and data. That markets have become more efficient because people have more information. And while that’s certainly true to a certain extent, there is. It’s definitely nowhere near kind of an elimination of mispricing and, inefficient markets, because I remember when the telegraph cable first took over the world and people could get information in India to London, for example, on something like 8 hours where it used to take much longer.

[00:42:07] Jamie Catherwood: Someone said that there would be no need for crises moving forward because now all the information would simply be known. And I just loved the kind of matter of factness with, I can’t remember his name is Arthur something, but he was a person of high authority and he just. I just put it so bluntly as if why would we have panics and crashes moving forward?

[00:42:28] Jamie Catherwood: Because now everybody will have access to information at the tips of their fingers, at least in their day, that was considered tips of their fingers. And so how could there be more panics and crashes? And obviously, if anything, the 19th century had more panics and crashes than any century and so there is this.

[00:42:46] Jamie Catherwood: Just the belief that technology will always make markets extremely efficient but throughout history, you see the introduction of these technologies and the opposite occurs where, ironically, you know, when the telegraph and the ticker were introduced there was a study done that showed how the states that as their ticker subscriptions increased.

[00:43:09] Jamie Catherwood: Within each state, people started gravitating towards companies listed in their state and so basically a home country bias but at the state level, if you can imagine it, and people started just hurting into the same kind of like top 10 stocks within their state and instead of. The ticker and telegraph broadening the speculation across a broader set of stocks, people just continue to concentrate into the same names.

[00:43:39] Jamie Catherwood: And you see this throughout history in the 1600s, when markets in London during the 1690s were kind of going through their first bubble is this IPO bubble and kind of the first technology mania you saw a list of securities in one of the kind of market write ups market commentaries that was published every two weeks by this guy, John Houghton, he had a list of 20 securities that he monitored the prices of and even though.

[00:44:08] Jamie Catherwood: There were a couple of hundred securities trading on the London exchange, the vast majority of all trading volume on the exchange was concentrated into the same list of securities that he provided prices for in his market commentary every two weeks, and so while that’s not necessarily technology by modern standards, it’s still just shows that even when investors are presented with A lot of different stocks to invest in, they tend to concentrate into the same ones that everybody else does.

[00:44:35] Jamie Catherwood: And so it’s just this interesting phenomenon throughout history that technology does not necessarily change our approach to investing and, cause us to expand our universe of stocks to select from. And I think during COVID, we saw that same phenomenon with the Robinhood tracker. I don’t know if you remember that, but it showed just the level of trading on Robinhood that was concentrated in the top 10 most popular stocks.

[00:45:01] Jamie Catherwood: And it was just crazy to see even in this modern age, when literally you have unparalleled access to information at the tips of your fingers. That’s still, we kind of just heard into these same names as everyone else, even though you could be looking at a really exciting micro-cap stock or something

[00:45:18] Jamie Catherwood: And I could be looking at mid-smith cap stock doing something exciting, the energy sector or something like that but instead people tend to just kind of hurt into the same us large cap stocks.

What We’re Reading (Week Ending 31 December 2023)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 31 December 2023:

1. How Not to Be Stupid About AI, With Yann LeCun – Steven Levy and Yann LeCun

Steven Levy: In a recent talk, you said, “Machine learning sucks.” Why would an AI pioneer like you say that?

Yann LeCun: Machine learning is great. But the idea that somehow we’re going to just scale up the techniques that we have and get to human-level AI? No. We’re missing something big to get machines to learn efficiently, like humans and animals do. We don’t know what it is yet.

I don’t want to bash those systems or say they’re useless—I spent my career working on them. But we have to dampen the excitement some people have that we’re just going to scale this up and pretty soon we’re gonna get human intelligence. Absolutely not…

…Why are so many prominent people in tech sounding the alarm on AI?

Some people are seeking attention, other people are naive about what’s really going on today. They don’t realize that AI actually mitigates dangers like hate speech, misinformation, propagandist attempts to corrupt the electoral system. At Meta we’ve had enormous progress using AI for things like that. Five years ago, of all the hate speech that Facebook removed from the platform, about 20 to 25 percent was taken down preemptively by AI systems before anybody saw it. Last year, it was 95 percent…

…The company you work for seems pretty hell bent on developing them and putting them into products.

There’s a long-term future in which absolutely all of our interactions with the digital world—and, to some extent, with each other—will be mediated by AI systems. We have to experiment with things that are not powerful enough to do this right now, but are on the way to that. Like chatbots that you can talk to on WhatsApp. Or that help you in your daily life and help you create stuff, whether it’s text or translation in real time, things like that. Or in the metaverse possibly…

…One company that disagrees with that is OpenAI, which you don’t seem to be a fan of.

When they started, they imagined creating a nonprofit to do AI research as a counterweight to bad guys like Google and Meta who were dominating the industry research. I said that’s just wrong. And in fact, I was proved correct. OpenAI is no longer open. Meta has always been open and still is. The second thing I said is that you’ll have a hard time developing substantial AI research unless you have a way to fund it. Eventually, they had to create a for-profit arm and get investment from Microsoft. So now they are basically your contract research house for Microsoft, though they have some independence. And then there was a third thing, which was their belief that AGI [artificial general intelligence] is just around the corner, and they were going to be the one developing it before anyone. They just won’t.

How do you view the drama at OpenAI, when Sam Altman was booted as CEO and then returned to report to a different board? Do you think it had an impact on the research community or the industry?

I think the research world doesn’t care too much about OpenAI anymore, because they’re not publishing and they’re not revealing what they’re doing. Some former colleagues and students of mine work at OpenAI; we felt bad for them because of the instabilities that took place there. Research really thrives on stability, and when you have dramatic events like this, it makes people hesitate. Also, the other aspect important for people in research is openness, and OpenAI really isn’t open anymore. So OpenAI has changed in the sense that they are not seen much as a contributor to the research community. That is in the hands of open platforms…

…But isn’t an open source AI really difficult to control—and to regulate?

No. For products where safety is really important, regulations already exist. Like if you’re going to use AI to design your new drug, there’s already regulation to make sure that this product is safe. I think that makes sense. The question that people are debating is whether it makes sense to regulate research and development of AI. And I don’t think it does.

Couldn’t someone take a sophisticated open source system that a big company releases, and use it to take over the world? With access to source codes and weights, terrorists or scammers can give AI systems destructive drives.

They would need access to 2,000 GPUs somewhere that nobody can detect, enough money to fund it, and enough talent to actually do the job.

Some countries have a lot of access to those kinds of resources.

Actually, not even China does, because there’s an embargo.

I think they could eventually figure out how to make their own AI chips.

That’s true. But it’d be some years behind the state of the art. It’s the history of the world: Whenever technology progresses, you can’t stop the bad guys from having access to it. Then it’s my good AI against your bad AI. The way to stay ahead is to progress faster. The way to progress faster is to open the research, so the larger community contributes to it.

How do you define AGI?

I don’t like the term AGI because there is no such thing as general intelligence. Intelligence is not a linear thing that you can measure. Different types of intelligent entities have different sets of skills.

Once we get computers to match human-level intelligence, they won’t stop there. With deep knowledge, machine-level mathematical abilities, and better algorithms, they’ll create superintelligence, right?

Yeah, there’s no question that machines will eventually be smarter than humans. We don’t know how long it’s going to take—it could be years, it could be centuries.

At that point, do we have to batten down the hatches?

No, no. We’ll all have AI assistants, and it will be like working with a staff of super smart people. They just won’t be people. Humans feel threatened by this, but I think we should feel excited. The thing that excites me the most is working with people who are smarter than me, because it amplifies your own abilities.

But if computers get superintelligent, why would they need us?

There is no reason to believe that just because AI systems are intelligent they will want to dominate us. People are mistaken when they imagine that AI systems will have the same motivations as humans. They just won’t. We’ll design them not to.

What if humans don’t build in those drives, and superintelligence systems wind up hurting humans by single-mindedly pursuing a goal? Like philosopher Nick Bostrom’s example of a system designed to make paper clips no matter what, and it takes over the world to make more of them.

You would be extremely stupid to build a system and not build any guardrails. That would be like building a car with a 1,000-horsepower engine and no brakes. Putting drives into AI systems is the only way to make them controllable and safe. I call this objective-driven AI. This is sort of a new architecture, and we don’t have any demonstration of it at the moment.

2. China’s debt isn’t the problem – Michael Pettis

IMF in its latest Global Debt Monitor highlighted how China’s overall debt-to-GDP ratio has increased fourfold since the 1980s. It has been particularly rapid over the past decade. Over half of the increase in the entire global economy’s debt-to-GDP ratio since 2008 is solely due to an “unparalleled” rise in China, according to the IMF.

That $47.5tn total debt pile has grown further in 2023, which might mean that China has now finally overtaken the US in debt-to-GDP terms…

…However, the surge in Chinese debt is not itself the problem but rather a symptom of the problem. The real problem is the cumulative but unrecognised losses associated with the misallocation of investment over the past decade into excess property, infrastructure and, increasingly, manufacturing.

This distinction is necessary because much of the discussion on resolving the debt has so far focused on preventing or minimising disruptions in the banking system and on the liability side of balance sheets.

These matter — the way in which liabilities are resolved will drive the distribution of losses to various sectors of the economy — but it’s important to understand that the problems don’t emerge from the liability side of China’s balance sheets. They emerge from the asset side…

…In proper accounting, investment losses are treated as expenses, which result in a reduction of earnings and net capital. If, however, the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cost, it has incorrectly capitalised the losses, ie converted what should have been an expense into a fictitious asset.

The result is that the entity will report higher earnings than it should, along with a higher total value of assets. But this fictitious asset by definition is unable to generate returns, and so it cannot be used to service the debt that funded it. In an economy in which most activity occurs under hard-budget constraints, this is a self-correcting problem. Entities that systematically misallocate investment are forced into bankruptcy, during which the value of assets is written down and the losses recognised and assigned.

But, as the Hungarian economist János Kornai explained many years ago, this process can go on for a very long time if it occurs in sectors of the economy that operate under soft-budget constraints, for example state-owned enterprises, local governments, and highly subsidised manufacturers.

In these cases, state-sponsored access to credit allows non-productive investment to be sustained. And as economic activity shifts to these sectors, the result can be many years of unrecognised investment losses during which both earnings and the recorded value of assets substantially exceed their real values. Because the debt that funds this fictitious investment cannot be serviced by the investment, the longer it goes on, the more debt there is.

But once these soft-budget entities are no longer able — or willing — to roll over and expand the debt, they will then be forced to recognise that the asset side of the balance sheet simply doesn’t generate enough value to service the liability side. Put another way, they will be forced to recognise that the real value of the assets on their balance sheets are less than their recorded value.

That is the real, huge and intractable problem China faces…

…The third and most important impact is what finance specialists call “financial distress” costs. In order to protect themselves from being forced directly or indirectly to absorb part of the losses, a wide range of economic actors — workers, middle-class savers, the wealthy, businesses, exporters, banks, and even local governments — will change their behaviour in ways that undermine growth.

Financial distress costs rise with the uncertainty associated with the allocation of losses, and what makes them so severe is that they are often self-reinforcing. As we’ve seen with the correction in China’s property sector, financial distress costs are almost always much higher than anyone expected.

The point is that resolving China’s debt problem is not just about resolving the liability side of the balance sheet. What matters more to the overall economy is that asset-side losses are distributed quickly and in ways that minimise financial distress costs. That is why restructuring liabilities must be about more than protecting the financial system. It must be designed to minimise additional losses.

3. The pharma industry from Paul Janssen to today: why drugs got harder to develop and what we can do about it – Alex Telford

The biopharmaceutical industry expends huge sums shepherding drug candidates through the development gauntlet and satisfying regulatory requirements. In 2022, the industry spent around $200 billion on R&D, more than four times the US National Institute of Health’s (NIH) budget of $48 billion. Pharmaceuticals is the third most R&D intensive sector in the OECD countries.

The bulk of that spending goes towards clinical trials and associated manufacturing costs; roughly 50% of total large pharma R&D spend is apportioned to phase I, II, and III trials compared to 15% for preclinical work. While early phases may cull more candidate compounds in aggregate, the cost of failure is highest during clinical development: a late-stage flop in a phase III trial hurts far more than an unsuccessful preclinical mouse study. By the time a drug gets into phase III, the work required to bring it to that point may have consumed half a decade, or longer, and tens if not hundreds of millions of dollars.

Clinical trials are expensive because they are complex, bureaucratic, and reliant on highly skilled labour. Trials now cost as much as $100,000 per patient to run, and sometimes up to $300,000 or even $500,000 per patient for resource-intensive designs, trials using expensive standard of care medicines as controls or as part of a combination, or in conditions with hard-to-find patients (e.g., rare diseases). When these costs are added on top of other research and development expenditures, like manufacturing, a typical phase I program with 20-80 trial participants can be expected to burn around $30m. Phase III programs, involving hundreds of patients, often require outlays of hundreds of millions of dollars. Clinical trials in conditions where large trials with tens of thousands of patients are standard, such as cardiovascular disease or diabetes, can cost as much as $1 billion.

Because executing late stage clinical trials and manufacturing enough of the drug to cover them is so expensive, companies prefer to manage risk by conducting studies sequentially, even though many steps could in principle be done in parallel.

A major reason that COVID-19 vaccine development was so fast was not because shortcuts were taken, but that the funding from operation warp speed and advance purchase agreements allowed companies to parallelize much of the process, scale up manufacturing early, and jump quickly into phase IIIs because they were insulated from the financial risk of failure. Early trial phases were combined in multiphase designs, Pfizer commandeered existing manufacturing infrastructure and repurposed it for COVID-19 vaccine production, and employees and regulators worked around the clock. The FDA and other regulators took reviewers off of non-COVID-19 drugs and redeployed them to review the COVID-19 vaccines; there were essentially no delays in safety reviews that you would otherwise see in other clinical trials. The little delays that crop up in development were powered through with extra manpower and resources: at one point during Operation Warp Speed the military recovered a vital piece of equipment needed to manufacture Moderna’s vaccine from a stalled train, and put it on an aeroplane so it could arrive in time. While the vaccines were approved under expedited emergency use regulatory pathways, they were nevertheless rigorously tested. Allocating such extensive resources for every new drug, as was done during the pandemic, is unsustainable and comes with substantial opportunity cost.

In business-as-usual times, the industry’s expenditure on drug R&D nets us about 40 new US FDA drug approvals a year — and a similar number (though not always exactly the same drugs) approved by the equivalent agencies in other regions, as well as some new indications for existing drugs.

All that money spent by the industry on R&D appeared to go a lot further in the past10. Despite continued growth in biopharmaceutical R&D expenditure, we have not seen a proportionate growth in output. Industry R&D efficiency — crudely measured as the number of FDA approved drugs per billion dollars of real R&D spend — has (until recently) been on a long-term declining trajectory11. This trend has been sardonically named “Eroom’s law” – an inversion of Moore’s law. Accounting for the cost of failures and inflation, the industry now spends about $2.5 billion per approved drug, compared to $40 million (in today’s dollars) when Janssen was starting out in 1953…

…Even though we’re spending more money than ever before, historical statistics on drug candidate failure rates suggest that we haven’t really gotten much better at developing drugs that succeed where it counts — in clinical trials. The real bottleneck is not finding drug candidates that bind and modulate targets of interest, it’s finding ones that actually benefit patients. Almost paradoxically, despite huge improvements in the technologies of drug discovery, the rate of new drug launches has hardly shifted in 50 years. High-throughput screening, new model systems, machine learning, and other fancy modern techniques have done little to change the statistic that 9 in 10 drug candidates that start clinical trials will fail to secure approval.

What’s behind this ‘Red Queen’ effect, where we seem to be expending more and more resources to keep running at roughly the same speed?

For one, as we’ve seen across scientific fields, new ideas are getting harder to find. There are more academic researchers than ever — 80,000 in the 1930’s vs. 1.5 million today in the USA — yet we have not seen a proportionate growth in the rate of meaningful discoveries. This may be because ideas are getting inherently more difficult to find, or it may be that the institutions and processes of science have become less effective: bogged down in bureaucracy, sclerotic, chasing the wrong metrics, and thereby limiting the impact of individual researchers.

The biopharmaceutical business is built on top of basic discoveries, and so it is not immune from this general trend afflicting all of science. Without the discovery of methods to stabilise coronavirus spike proteins and enhance immunogenicity prior to the pandemic, it’s unlikely that we would have had effective vaccines for COVID-19 as fast as we did. Imatinib, a breakthrough targeted therapy for a rare blood cancer, was predicated on the discovery of the mutant protein produced by the “Philadelphia chromosome” rearrangement. In support of the ‘low hanging fruit’ argument is data showing changes in the landscape of drug targets over time: compared to past decades, drugs in development are now much more frequently going after targets that would have historically been viewed as intractable. Modern protein targets are more likely to be disordered, with shallow or non-existing pockets for small molecules to bind, or otherwise difficult to interact with.

The more important reason for the decline in R&D efficiency, however, is that it is not enough for drugs to simply be novel and safe, they must also improve meaningfully over the available standard of care, which may include a large armamentarium of effective and cheap older drugs.

This is the so-called ‘better than Beatles’ problem. Imagine if in order to release new music it needed to be adjudicated as better than ‘Hey Jude’, or ‘Here comes the sun’ in a controlled experiment. New experimental music might have a hard time getting past the panel, and wouldn’t have the chance to refine its sound in future iterations. The situation for new drugs is somewhat analogous…

…Yet, even though there are major forces pushing against drug developers, there is a sense that the industry is still underperforming, and that it could do more. One reason for optimism can be seen in the recent flattening of the slope of Eroom’s law following decades of declining productivity. It remains to be seen whether the recent uptick is a sustained turnaround or not. The pessimistic view is that it is illusory, a result of how drugmakers have side-stepped fundamental productivity issues by focusing on developing drugs for niche subpopulations with few or no options where regulators are willing to accept less evidence, it’s easier to improve on the standard of care, and payers have less power to push back on higher prices: rare disease and oncology in particular. It’s no coincidence that investment has flowed into areas where regulatory restrictions have been relaxed and accelerated approvals are commonplace: 27% of FDA drug approvals in 2022 were for oncology, the largest therapeutic area category, and 57% were for rare/orphan diseases.

There is however, a more charitable and optimistic take for the flattening and possible reversal of Eroom’s law. The first possibility is that advances in basic science are finally being widely adopted in the drug development process and bearing fruit. Historically, it takes upwards of 20 years for new drug targets to lead to new medicines. Consider that the sequencing of the human genome was completed in 2003; genomics research has by now improved our understanding of many relatively simple monogenic genetic disease, and has identified new targets for more common conditions through genome-wide association studies (GWAS) that look for associations between gene variants and disease phenotypes in large populations. The PCSK9 inhibitors alirocumab and evolucumab, as an archetypal example, were developed after screening for genetic mutations in families with elevated cholesterol levels identified the PCSK9 gene as a key driver of cholesterol regulation. Drug programs with genetic support are more likely to succeed, and we may have only recently truly started to benefit from our improved understanding of human genetics.

4. Peter Lynch 1994 National Press Club Lecture (transcript here)- Monroe Carmen and Peter Lynch

Peter Lynch: And if you can’t explain – I’m serious – you can’t explain to a 10 year old in two minutes or less why you own a stock, you shouldn’t own it. And that’s true, I think, about 80% of people that own stocks.

And this is the kind of stock people like to own. This is the kind of company people adore owning. This is a relatively simple company. They make a very narrow, easy to understand product. They make a 1 MB SRAM CMOS bipolar risk floating point data, I/O array processor with an optimising compiler, a 16-dual port memory, a double diffused metal oxide semiconductor monolithic logic chip with a plasma matrix vacuum fluorescent display. It has a 16 bit dual memory. It has a Unix operating system, four whetstone megaflop polysilicone emitter, a high bandwidth – that’s very important – six gigahertz metalization communication protocol, an asynchronous backward compatibility, peripheral bus architecture, four wave interweave memory, a token ring and change backplane. And it does in 15 nanoseconds of capability. Now, if you own a piece of crap like that, you will never make money. Never. Somebody will come along with more wetstones or less wetstones or a big omega flop or a small omega flop. You won’t have the foggiest idea what’s happened. And people buy this junk all the time.

I made money in Dunkin Donuts. I can understand it. When there was recessions, I didn’t have to worry about what was happening. I could go there and people were still there. I didn’t have to worry about low price Korean imports. I can understand it. And you laugh. I made 10 or 15 times my money in Dunkin’Donuts. Those are the kind of stocks I can understand. If you don’t understand, it doesn’t work…

…Peter Lynch: I’m trying to convince people there is a method. There are reasons for stocks that go up. Coca Cola, this is very magic. It’s a very magic number. Easy to remember. Coca Cola is earning 30 times per share what they did 32 years ago. The stock has gone up 30 fold. Bethlehem Steel is earning less than they did 30 years ago. The stock is half its price of 30 years ago. Stocks are not lottery tickets. There’s a company behind every stock. The company does well. The stock does well. It’s not that complicated…

…Peter Lynch: Considering there’s not that many billionaires on the planet, I had logic – so I had syllogism and studied these when I was at Boston College – there can’t be that many people who can predict interest rates because there’d be lots of billionaires and no one can predict the economy.

A lot of people in this room were around in 1981 and 82 when we had a 20% prime rate with double digit inflation, double digit digit unemployment. I don’t remember anybody telling me in 1981 about it. I didn’t read – I study all this stuff. I don’t remember anybody telling we’re going to have the worst recession since the Depression. So what I’m trying to tell you, it’d be very useful to know what the stock market is going to do. It’d be terrific to know that the Dow Jones average year from now would be X, that we’re going to have a full scale recession or interest rate is going to be 12%. That’s useful stuff. You never know it though. You just don’t get to learn it. So I’ve always said if you spend 14 minutes a year in economics, you’ve wasted 12 minutes. And I really believe that.

Now, I have to be fair. I’m talking about economics in the broad scale, predicting the downturn for next year or the upturn, or M1 and M2, 3B, and all these all these M’s. I’m talking about economics, to me, is you talk about scrap prices. When I own auto stocks, I want to know what’s happening to used car prices. When used car prices are going up, it’s a very good indicator. When I own hotel stocks, I want to know hotel occupancies. When I own chemical stocks, I want to know what’s happening to price of ethylene. These are facts. If aluminium inventories go down five straight months, that’s relevant. I can deal with that. Home affordability, I want to know about, when I own Fannie Mae or I own a housing stock, these are facts. There are economic facts and there’s economic predictions. And economic predictions are a total waste.

And interest rates. Alan Greenspan is a very honest guy. He would tell you that he can’t predict interest rates. He could tell you what short rates are going to do in the next six months. Try and stick him on what the long term rate will be three years from now. He’ll say, “I don’t have any idea.” So how are you, the investor, supposed to predict interest rates if the Head of the Federal Reserve can’t do it? So I think that’s – But you should study history, and history is the important thing you learn from.

What you learn from history is the market goes down. It goes down a lot. The math is simple. There’s been 93 years, a century. This is easy to do. The market’s had 50 declines of 10% or more. So 50 declines in 93 years, about once every two years the market falls 10%. We call that a correction. That means – that’s a euphemism for losing a lot of money rapidly, but we call it a correction. So 50 declines in 93 years, about once every two years the market falls 10%. Of those 50 declines, 15 have been 25% or more. That’s known as a bear market. We’ve had 15 declines in 93 years. So every six years the market’s going to have a 25% decline. That’s all you need to know…

…Peter Lynch: So you only need a few stocks in your lifetime. They’re in your industry. I think of people – if you’d worked in the auto industry, let’s say you’re an auto dealer the last 10 years. You would have seen Chrysler come up with the minivan. If you’re a Buick dealer, a Toyota dealer, Honda dealer, you would have seen the Chrysler dealership packed with people. You could have made 10 times your money on Chrysler. A year after the minivan came out, Ford introduces the Taurus Sable, the most successful line of cars in the last 20 years. Ford went up sevenfold on the Taurus Sable. So if you’re a car dealer, you only need to buy a few stocks every decade…

…Peter Lynch: And then I want to conclude with, there’s always something to worry about. If you own stocks, there’s always something to worry about. You can’t get away from it. What happens in the 50s, people were worried about the only reason we got out of the depression was World War II. We got another recession in the early 50s. We said, “We’re going to go right back into a depression.” People worried about a Depression in the 50s and were worried about nuclear war. Back then, the little warheads they had then, they couldn’t blow up McLean, West Virginia, or McLean, Virginia, or Charlestown. Now, all these countries that end in ‘stan – there’s nine of these ‘stan countries that have come out of Russia. They all have enough warheads to blow the world up, and no one worries about.

When I was a kid, people were building fallout shelters and we used to have this civil defense drill. Remember this one in high school? You get under your desk. I never thought even then that was a particularly good thing to do. They’d blow us and some people put a hat would, all get under our desk. But in the ‘50s, people wouldn’t buy stocks. Except for the ‘80s, the ‘50s was the best decade in the century of the stock market, and people wouldn’t buy stocks in the ‘50s because they’re worried about nuclear war and they’re worried about depression. Remember when oil went from $4 to $40 and it was going to go to $100 and we’re going to have a depression. Remember that one? Well, about three years later, the same experts, now higher paid, oil is now at $10. They said it was going to go to $4 and we’re going to have a depression…

…Monroe Carmen: Are you concerned about the volatility in the financial markets today? Do you think something needs to be done to reduce it?

Peter Lynch: I love volatility. I remember when in 1972, the market went down dramatically and Taco Bell went from $14 to $1. They had no debt, they never had a restaurant close. And I started buying at $7, but I kept onto it and it went to $1. And it was the largest position in Magellan in 1978 when it was bought out for $42 by PepsiCola. And I think it would have gone to $400 if they didn’t buy it out. I think volatility is terrific.

I think these collars are very important. I don’t think the market going up 80 points one day and down 80 the next is a good thing for the public. I think that’s not a very good thing, but I think all these collars and all these other things to keep the volatility down each day is important. But the market’s going to go up and down. Human nature hasn’t changed a lot in 25,000 years and some event will come out of left field and the market will go down. Or the market will go up. So volatility will occur. Markets will continue to have these ups and downs. I think that’s a great opportunity if people can understand what they own. If they don’t understand what they own, they can own mutual funds. Try and figure out mutual funds they own and keep adding to it.

Basically, corporate profits have grown about 8% a year historically. So corporate profits double about every nine years. The stock market ought to double about every nine years. So I think the next market is about 3,800 today, 3,700. I’m pretty convinced the next 3,800 points will be up, it won’t be down. The next 500 points, the next 600 points, I don’t know which way they’re going. So the market ought to double in the next eight or nine years, it ought to double again in the eight or nine years after that because profits will go up 8% a year and stocks will follow. That’s all there is to it…

…Peter Lynch: October has always been a special month. I remember in 1987 I was very convinced that the market was not in trouble and I didn’t worry about things. And Carol and I had planned this great golf vacation to Ireland. And we’re going to visit one course and stay in a little house and visit another. Go all along the west coast of Ireland and play golf. And we left on a Thursday night and the market went down 55 points that day, which was not too good. And the next day we got to Ireland. Because of the time difference, we’d completed our day and I got back to hotel and I called and the market had gone down 112 on Friday. I said to Carolyn, “I think if the market goes down on Monday, we’re going to have to go back.” We stayed there for the weekend and on Monday the market went down 508 points and my fund went from, I think, $12 billion to $8 billion and that gets your attention. In two working days. I said, by the end of this week, I’d have no funds.

Now, there wasn’t a lot I could do. I mean, here I was on Monday, because the market didn’t open by 12:00 – it was in Ireland, it was still 07:00 in New York. So we did spend that day and we played around golf in the morning. Then we went somewhere and sort of watched the market deteriorate. And I did come back. There wasn’t nothing I could do. I mean, just nothing I could do about it. But I think my shareholders, they called up and they said, “What’s Lynch doing?” They said, “Well, he’s on the 6th hole and he’s even par up to now, but he’s in a trap. This could be a triple bogey here. This could be a big inning.” And I don’t think that’s exactly what they want to hear. So I could do something about this damn thing. So I came back home and suffered with everybody else…

…Peter Lynch: I had this biggest position in my fund one time was Hanes, which owned Leggs and was a huge stock. And it was bought eventually by Consolidated Foods and it was the best division of Consolidated Foods. But it’s my biggest position. Made a monopoly on this Leggs. And Leggs is a really big hit. And I knew somebody would come along with a new product, and it was – Kaiser Roth introduced No Nonsense. I was worried that this thing was better and I couldn’t quite figure out what was going on. So I went to the supermarket and I bought 62 pairs of No Nonsense. Different colors, different shapes, different – they must have wondered what kind of house I had when I was going back. But I brought it in. I brought to the office and I passed that to anybody, male or female, anybody who wanted these things, just take them home and tell me how it is. And they came back in about three weeks and they said, it’s not as good. And that’s what research is. That’s all it was. And I held onto Hanes and the stock was a huge stock. So that’s what it’s about.

5. From Penny-Farthings to Pounds: The Great British Bicycle Bubble of 1896 – Nicholas Vardy

The bicycle’s humble beginnings can be traced back to the “dandy horse” – a pedal-less bike patented in Germany in 1818. Over the next half-century, inventors tweaked the design. In the 1860s, a French enthusiast added pedals and a rotary crank to the dandy horse, creating a rudimentary version of the modern bicycle.

However, the later penny-farthing design, with its oversized front wheel, proved hazardous and cumbersome. It wasn’t until the 1890s that the innovations of chain-driven transmission captured the British public’s imagination. It was also when John Boyd Dunlop invented the pneumatic tire in 1887, making it easy to ride bicycles on hard roads.

Overnight, the bicycle became a technological marvel and a revolutionary new mode of transportation.

What accounted for the bicycle’s remarkable early success?

First, the bicycle liberated the British public from the constraints of railway schedules. The bicycle became synonymous with the freedom to travel when you want, where you want.

Second, the bicycle was cheaper to buy and maintain than horses. It also provided a much-needed solution to the horse manure-laden streets of London.

Third, even women could ride bicycles. That alone doubled the size of its potential market. By 1895, the bicycle came to represent feminine independence.

The bicycle had a large effect on Britain’s infrastructure.

Much like their counterparts did for railroads 60 years before, cycling organizations began to lobby for a network of good roads to connect cities and rural communities. The first roads were built for commuters and travelers on cycles, not in cars.

With every successful new road, the pool of consumers and their need for a bicycle grew. Predictions of hypergrowth abounded. Companies were keen to meet the seemingly endless demand…

…The venture capitalists of their day in the United States and Britain quickly pounced. They bought up Bicycle companies. They bolstered balance sheets with vast amounts of intangible goodwill and patents. This financial sleight of hand allowed them to leverage companies up to invest in increased production.

As a result, the 1890s saw a tremendous boom in bicycle shares in the Birmingham stock exchange, not dissimilar to today’s EV boom.

In 1896, there were roughly 20 British bicycle companies. But demand was quickly outpacing supply. Enter Ernest Terah Hooley, a property dealer from Birmingham, who saw an opportunity. He bought a company called Pneumatic Tyre for a staggering 3 million pounds, a hefty premium given its modest profits.

Thanks to Hooley’s sales prowess, shares in the newly renamed Dunlop Pneumatic Tyre Company skyrocketed by 1,138% in the spring of 1896. Other British bicycle companies followed suit, with their share prices tripling. Speculators made fortunes overnight, and more and more people flocked to get in on future growth.

In 1896 alone, 363 cycle, tube, or tire firms were listed on the London Stock Exchange, with another 238 added in the first half of 1897. The British press hailed the bicycle as a revolutionary technology. The Financial Times even dedicated a daily page to the share prices of bicycle companies…

…Then, the narrative began gradually to shift.

Cycles were made not just in Birmingham but also in the United States.

Suddenly, advances in manufacturing meant new bicycles flooded the market.

Investors learned that expansion in the market did not necessarily translate into the same profit growth.

Competition soon drove prices down. Profit margins fell…

…The bicycle companies had become overleveraged. Vast orders anticipated that failed to come through. You only need to buy a new bicycle every five or ten years. The market became saturated. Sales growth entered a slow-motion collapse. Intense competition led to oversupply and plummeting prices.

Meanwhile, technology had advanced. Other competitors emerged. The automobile was even more of a game-changer than the bicycle. The fortunes associated with the bicycles’ promise of hypergrowth dissipated rapidly.

Only with the benefit of hindsight did it become clear that bicycles were a bubble…

…By December 1897, an index of bicycle-related stocks had plummeted by 40%. In 1898, bicycle stocks traded at an average of 71% below their peaks. More than 80% of the companies participating in the 1890s British bicycle boom went bust.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have a vested interest in Meta Platforms. Holdings are subject to change at any time.

What We’re Reading (Week Ending 24 December 2023)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 24 December 2023:

1. Google DeepMind used a large language model to solve an unsolved math problem – Will Douglas Heaven

Google DeepMind has used a large language model to crack a famous unsolved problem in pure mathematics. In a paper published in Nature today, the researchers say it is the first time a large language model has been used to discover a solution to a long-standing scientific puzzle—producing verifiable and valuable new information that did not previously exist. “It’s not in the training data—it wasn’t even known,” says coauthor Pushmeet Kohli, vice president of research at Google DeepMind…

…Google DeepMind’s new tool, called FunSearch, could change that. It shows that they can indeed make discoveries—if they are coaxed just so, and if you throw out the majority of what they come up with.

FunSearch (so called because it searches for mathematical functions, not because it’s fun) continues a streak of discoveries in fundamental math and computer science that DeepMind has made using AI. First AlphaTensor found a way to speed up a calculation at the heart of many different kinds of code, beating a 50-year record. Then AlphaDev found ways to make key algorithms used trillions of times a day run faster.

Yet those tools did not use large language models. Built on top of DeepMind’s game-playing AI AlphaZero, both solved math problems by treating them as if they were puzzles in Go or chess. The trouble is that they are stuck in their lanes, says Bernardino Romera-Paredes, a researcher at the company who worked on both AlphaTensor and FunSearch: “AlphaTensor is great at matrix multiplication, but basically nothing else.”

FunSearch takes a different tack. It combines a large language model called Codey, a version of Google’s PaLM 2 that is fine-tuned on computer code, with other systems that reject incorrect or nonsensical answers and plug good ones back in.

“To be very honest with you, we have hypotheses, but we don’t know exactly why this works,” says Alhussein Fawzi, a research scientist at Google DeepMind. “In the beginning of the project, we didn’t know whether this would work at all.”

The researchers started by sketching out the problem they wanted to solve in Python, a popular programming language. But they left out the lines in the program that would specify how to solve it. That is where FunSearch comes in. It gets Codey to fill in the blanks—in effect, to suggest code that will solve the problem.

A second algorithm then checks and scores what Codey comes up with. The best suggestions—even if not yet correct—are saved and given back to Codey, which tries to complete the program again. “Many will be nonsensical, some will be sensible, and a few will be truly inspired,” says Kohli. “You take those truly inspired ones and you say, ‘Okay, take these ones and repeat.’”

2. How Energy Traders Left A Country In The Cold – Stephen Stapczynski and Faseeh Mangi

Within a few weeks, Alleyne’s colleagues identified a candidate: Gunvor’s deal with Pakistan, which depends heavily on LNG but is a far smaller customer than major importers such as China and Japan. After some internal debate, the traders ran the idea of scrapping it past the firm’s legal team and decided to proceed. When the Russian army invaded Ukraine on Feb. 24, 2022, gas prices soared more than 150% in 11 days. Around the same time, according to people familiar with the events, Gunvor stopped responding to communications from the Pakistani government. Then it terminated Pakistan’s deal, saying the country had underpaid for one of its LNG shipments. (Pakistan disputes this.)

Under the terms of the contract, Gunvor was supposed to supply Pakistan with five tankers’ worth of LNG over the next several months. Instead, ship-tracking data show, Gunvor sent the cargoes to countries including the UK and Italy, where buyers paid the “spot,” or market, price. If the gas had been delivered to Pakistan as originally planned, the value of the sales would have been about $200 million, according to calculations by Businessweek. By the same arithmetic, Gunvor’s traders unloaded it for more than $600 million. Some would receive seven-figure bonuses for the year, the highest of their careers.

Gunvor’s decision to redirect its supplies—and other canceled gas deliveries by Eni SpA, a state-controlled Italian energy group—helped prompt an energy crisis in Pakistan that continues today. The nation of 240 million people, which has a per capita gross domestic product of just over $1,500, uses natural gas to heat homes, power industry and even run cars and buses. When it ran short, factories were forced to shut or dramatically cut their output, throwing workers into poverty; so were fertilizer plants, threatening food production. As it scrambled to procure replacement LNG, Pakistan paid record spot-market prices, draining its modest foreign currency reserves and pushing it to the brink of default. Now its government is trying to implement economic reforms after receiving a bailout from the International Monetary Fund before elections scheduled in early 2024…

…There’s no suggestion that Gunvor or Eni acted illegally. Both appear to have operated within the bounds of their contracts—albeit in a way that’s all but unique in an industry where suppliers have traditionally done whatever they can to meet customers’ need for gas. Moreover, Pakistan’s woes are the result of much more than a fuel shortage. Successive governments—some installed through military coups—have mismanaged its economy for decades. Notably, politicians have long subsidized power and gas rates, providing little incentive for energy efficiency and forcing the government to pick up the difference between the true cost and what consumers pay.

The situation nonetheless provides a stark example of how traders in the cutthroat world of commodities can profit at the expense of some of the world’s least developed nations. When they agreed to long-term gas deals, Pakistani officials thought they were protecting their economy and citizens from the vagaries of commodity markets. Instead they learned just how quickly, and brutally, those markets could turn against them…

…For countries that can’t meet their energy needs domestically, LNG provides major benefits. Until it was commercialized in the 1960s, the most common way to ship large quantities of gas was through pipelines, which have obvious disadvantages for places that are isolated, far from reserves or both. By contrast, a tanker full of LNG can be sent to any port with a so-called regasification terminal, where the fuel is heated up into usable form. To ensure reliable supplies, governments and utilities try to make long-term LNG deals to guarantee deliveries at a relatively stable price, rather than take their chances on the spot market. Even a single shipment that arrives late—or, worse, not at all—can have a significant impact on local energy supply.

Pakistan’s entry into the LNG market was engineered by former Minister of Petroleum and Natural Resources Shahid Khaqan Abbasi, who’d worked in the Saudi energy industry before shifting to politics. (He later served as prime minister.) In 2016, Abbasi made a $15 billion, government-to-government deal for LNG imports from Qatar. The shipments made up for dwindling production from domestic gas fields and eased conditions for Pakistani companies almost overnight. GDP grew more than 5% in 2016, the biggest rise in more than a decade, in part because of stronger output from large manufacturers.

Abbasi wanted to do more, and he opened two additional requests for LNG contracts: one for a five-year supply deal, the other for as long as 15 years. Roughly two dozen companies expressed interest, including Gunvor and Eni. Some had concerns about dealing with such a poor country. According to a person who participated in the tenders, gas traders applied an unusually high degree of scrutiny to the proposed contracts, seeking terms that ensured Pakistan would pay in full and on time. Pakistani officials, who were focused on securing the best possible price, didn’t insist on strict penalties for failing to deliver gas; at the time, cancellations were rare. (The Gunvor spokesperson says the company was “required to sign up to terms stipulated” by Pakistan, without amendment. The Eni spokesperson says that the relevant agreements “were not the results of a bilateral negotiation,” and that Pakistan set out their contents.)…

…In December 2020, Pakistani officials received a curious email from Eni. The Italian company said it would deliver only part of its LNG shipment for the following month, explaining that an unnamed supplier had failed to make its own delivery. Eni’s head of LNG portfolio, Ilaria Azzimonti, apologized and said her team would try to send replacement gas later…

…Under the terms of Eni’s contract, it didn’t have to provide details about the supplier default. But even after telling Pakistan it lacked sufficient gas to meet its commitments, according to a person with direct knowledge of the transaction, Eni sold an LNG shipment elsewhere at the spot price of roughly $100 million.

Although it was just part of the expected cargo, representing less than 10% of the country’s monthly supply from long-term contracts, losing the Eni gas put Pakistan in a difficult position. Cold weather was coming, increasing the need for fuel, and domestic production had declined significantly, the result of years of underinvestment. The government tried to find a spot-market shipment to make up the shortfall, but it deemed all the options too expensive. It had no choice but to temporarily curtail supplies to some households and factories.

There are occasional cancellations in the LNG business, often when problems at an export terminal affect supplies, and at first the undersize Eni delivery looked like a one-off. Regular shipments resumed in February 2021, coinciding with a collapse in spot prices. But later that year, with the recovery from the Covid‑19 pandemic driving energy demand, more of the gas expected by Pakistan failed to arrive. In August, Eni blamed reduced output at an Egyptian LNG plant for a missed shipment…

…Then, in November 2021, both companies canceled their deliveries, documents reviewed by Businessweek show. Gunvor cited a “force majeure,” a legal term for an unavoidable event that makes it impossible to fulfill a contract. Specifically it blamed an outage at a plant in Equatorial Guinea, a tiny, hydrocarbon-rich Central African dictatorship. (Although Gunvor didn’t offer details, there had been technical problems at a facility at the country’s Alba gas field that September.)

That justification from Gunvor, as well as the earlier statement by Eni about production in Egypt, took advantage of another part of Pakistan’s contracts. Unlike other LNG deals, which stipulate where a supplier will obtain the gas it’s selling, the Pakistani agreements said shipments could come from anywhere within Gunvor’s and Eni’s global portfolios. Pakistani officials have said they believed this would insulate them from disruptions, by allowing the companies to provide any gas they could source.

In their communications with Pakistan, people with knowledge of the discussions say, Gunvor and Eni turned that logic on its head, arguing that because no source was specified, a disruption anywhere gave them the right to cancel delivery. Problems in Equatorial Guinea therefore qualified as a force majeure, even though Gunvor rarely shipped gas from the plant to Pakistan. Over the next several months, Gunvor declared force majeure on two additional shipments and only partially delivered one more. At the same time, it was continuing to sell large quantities of gas to wealthier countries at spot prices, according to traders who participated in the deals…

…The events of early 2022 provided Alleyne and her team with an opportunity for a once-in-a-lifetime payday. At the average price of LNG from 2010 through 2020, a single tanker cargo could be sold on the spot market for about $30 million. Suddenly the potential number was north of $150 million. Alleyne and her colleagues, people with knowledge of the matter say, were under significant pressure from Gunvor’s billionaire chief executive officer and controlling shareholder, Torbjörn Törnqvist, to find ways to capitalize. (Gunvor denies this.)

Poor and politically isolated, Pakistan was an easy target. Gunvor traders were also conscious of an incident that had occurred in 2020, when the pandemic caused gas prices to crash globally. At the time, Pakistan had threatened to pull out of its LNG contract, since it was cheaper to pay the cancellation penalty and source gas on the spot market. Now it was the traders who had the advantage…

…Decision-makers in Pakistan’s energy industry say they’ve learned a painful lesson about international commodity markets. “As a supplier, if you have the option to sell it to Germany over Pakistan, 99 times out of a hundred you sell it to Germany,” Maniar, the Sui Southern Gas executive, says in an interview at the company’s offices in Karachi. To conserve electricity, the hallways of the building are dark. “You cannot stop people from making money.”

3. Xi Jinping repeats imperial China’s mistakes – The Economist

The rigours of imperial China’s civil-service examination system—the keju, used to select scholar-officials for over 1,300 years—are described in a new book by Yasheng Huang called “The Rise and Fall of the east: How Exams, Autocracy, Stability, and Technology Brought China Success, and Why They Might Lead to Its Decline”. Arguing that the exams stifled innovation in ancient times, Professor Huang sees lessons for Xi Jinping’s China.

The keju became more doctrinaire over time. First instituted in 587, the exams progressively shed such subjects as mathematics and astronomy. Soon, they only tested candidates’ mastery of dense Confucian texts filled with injunctions to revere fathers, officials and monarchs. The curriculum narrowed again in the 14th century, requiring candidates to memorise ultra-conservative commentaries on Confucian classics. The commentaries advocated unquestioning obedience towards rulers. A final refinement was added during the Ming dynasty: answers had to follow a rigidly scripted format, the “eight-legged essay”, described as “the greatest destroyer of human talent” by Ch’ien Mu, a historian…

…But a dataset of 11,706 Ming-era keju candidates shows that exam-takers who reached the third and final stage of the keju got there in middle age, on average. Millions sat the exams and never passed. This focus on bureaucratic glory crowded out other paths to social mobility. It was handy for autocrats, as test preparation left scholars “no time for rebellious ideas or deeds”, the book argues. The keju’s Confucian values promoted conformity of thought and disdain for commerce. Over time, the exams smothered the scientific curiosity that saw ancient China develop many technologies before the West, including the compass, gunpowder, movable-type printing and paper, known in China as the country’s “four great inventions”.

The keju was scrapped in 1905, but its legacy lives on today, in civil-service tests and in the fearsome gaokao, the college-entrance examination which rewards relentless toil. In the book’s telling, the curse of the keju spirit was broken once in China’s history, when Communist Party leaders embraced market-based reforms after the disasters of Maoism and central planning (and revived the gaokao, abandoned during the Cultural Revolution). During that reform era, lasting for 40 years after 1978, the book credits the party with successfully balancing stability, economic growth and technological progress. As in imperial times, a strong state overshadowed a weak society. But the reform-era party also praised private entrepreneurs and allowed policy experiments by regional governments. To harness the world’s dynamism, officials sought out foreign capital and international academic exchanges.

Then, in 2018, Mr Xi abolished the only term limits that constrained him as leader. His China is increasingly autocratic, statist and inward-looking. Private businesses endure more meddling by party cadres, and youth unemployment is high. In a flight to safety, almost 2.6m people applied to sit civil-service exams this year, chasing 37,100 posts. Too often, in public institutions that once boasted of being meritocratic, “merit” means fealty to one man. Officials and university students must devote ever more hours to studying Xi Jinping Thought and other dogma.

4. The Revenge Of The Ottoman Empire – Louis-Vincent Gave

In recent years, we have seen:

1. The Western world attempt to trigger a collapse in the Russian economy by blocking access to the US dollar, euro, British pound and Swiss franc. Unsurprisingly, Russia immediately shifted to selling its commodities for renminbi, Indian rupees, Brazilian real or Thai baht, and trade between Russia and the world’s major emerging markets went parabolic…

…2.The United States encourage domestic producers to repatriate production from China which is a non-democratic Communist country. Or, alternatively, to move production to countries that happen to not be non-democratic and nominally communist—for example, Vietnam.

The end result? China’s trade surplus has essentially tripled over the past few years…

…China’s trade surplus did not triple due to North American or European consumers deciding to buy three times as many plastic toys for their kids. Necessity is the mother of invention, as the saying goes, and the surge in China’s surplus is linked to it opening up new markets for its products. Back in 2017, the value of Chinese exports to Asean economies amounted to 60% of China’s exports to the US. Today, China’s exports to Southeast Asia stand at roughly 120% of China’s exports to the US.

China did this by moving up the value chain and exporting decent quality, aggressively-priced capital goods and other higher value-added products. The most visible example of this is how China came from nowhere five years ago to become the world’s largest car exporter. These cars are typically not sold in the US or Europe, but have been snapped up by drivers in Southeast Asia, the Middle East and Latin America. Just as importantly, while the cars have captured the general public’s imagination (hard not to notice Chinese cars when every shopping mall, or airport, one enters in an emerging economy now has very attractive Chinese cars on display), one can draw parallel stories for power plants, earth-moving equipment, tractors, telecom switches, turbines, and machine tools—basically, all the capital goods that are heavily in demand across India, Indonesia, Brazil and Saudi Arabia…

…How could China withstand both a frontal attack from the US (a country that controls the pipes of global financial flows to an even greater degree than the Ottoman Empire controlled the Eastern Mediterranean), and a real estate slowdown? The answer, as with Columbus and Vasco da Gama, is that necessity is the mother of all discoveries and inventions. Trade will tend to flow, either where it is the most profitable; or alternatively, if walls and barriers are put up, then trade will flow around these walls and find new destinations.

All of which brings us back to the Gavekal foundational concepts of Ricardian growth and Schumpeterian growth.

From its infancy as a firm, Gavekal has identified economic development as deriving from one of two sources:

Ricardian growth that stems from falling trade barriers, new roads, and improvements to modes of transport and communication. Such developments pave the way for a more efficient use of existing resources, whether land, labor or capital.
Schumpeterian growth, when new inventions trigger sharp productivity improvements…

…In fact, in recent years, global trade has continued to grind higher, thanks mostly to a sudden acceleration of trade within emerging economies…

…hardly a month goes by without the announcement of some new road, railway, canal or free trade deal linking the economies of the Istanbul-to-Jakarta axis described in the above reports (draw a line from Istanbul to Jakarta and one finds a population of roughly 3.5bn people—excluding China—that is growing by 1% a year, and with some of the highest income growth in the world).

Construction of new roads, railways and canals are appearing all across emerging economies because countries across the “Global South” can now:

Purchase commodities in their local currencies, from Russia.
Purchase capital goods from China, either in their local currency (if they have good relations with China), or, alternatively, in renminbi.

The combination of these two factors is a game changer for emerging economies like Indonesia, India and Brazil, which can now break free from the tyranny of the US dollar funding constraint. This explains why, for the first time in living memory, we have just seen a significant Federal Reserve monetary tightening cycle without a single emerging market going bust. On the contrary, in recent years the US dollar returns offered by most emerging market bonds have trounced those of US treasuries, along with German bunds or Japanese government bonds.

Indeed, for the first time ever, the yield on investment-grade sovereign emerging market debt is now lower in aggregate than that on US treasuries…

…If an economy contains two cities, it requires one link (say a railway line) to connect them. If an economy contains three cities, it needs three links to connect each city with the other two. If an economy contains four cities, the number of required connections rises to six.

For any number of cities, N, the number of links needed to connect each city to the others, is stated by the formula N*(N-1)/2. As more cities/countries join the system, the number of links therefore rises at an accelerating rate. For example, from the early 2000s, global economic activity was massively boosted, not just by connecting China to the rest of the world, but also by connecting Chinese cities to each other, with all the associated construction of rail, air, road, telecommunications and power links this involved.

And what occurred in China is now occurring across the broader Eurasian continent. Obviously not at the same pace (no country will ever be able to match China in mobilizing land, labor capital and natural resources towards the delivery of infrastructure) but it is happening nonetheless. Take India as an example. Over the past few years, India has opened 70 new airports and currently has plans to start the construction of another 70. And as more cities start talking directly with each other, this should mean more growth, more productivity and lower prices. Such dynamics bring me back to another staple of Gavekal analytics, namely, the acceleration phenomenon.

The concept of “acceleration” was developed by Albert Aftalion, a French economist active in the inter-war years. It is most useful in abrupt adjustments but is not easily explained mathematically, which may explain why it has not secured the following it deserves. Here goes the CliffsNotes version:

Most socioeconomic variables are distributed according to the “normal” law, the famous Gaussian bell-shaped curve.
This is especially true of incomes: in a “normal” country, where a large share of people have an income close to the average, a few people have very low incomes and few very high incomes. At both ends of the curve (the tails), one finds a very small population in percentage terms.
As incomes grow over a period of a few years, the right side of the tail will grow much faster (the acceleration phenomenon) than the growth of income. This is where it gets complicated since our minds are accustomed to thinking in linear patterns, yet the number of people earning a certain amount actually grows exponentially.

This matters because when it comes to the purchase of certain goods and services, history points to the existence of key income “thresholds’’. For example, if the average income in a country is below US$1,000, nobody owns a television; when incomes move above US$1,000, almost everybody buys one. For smartphones, the level seems to be around US$2,500. For the automobile industry, the critical level seems to be US$10,000 a year. For university education, the level is US$15,000 and above. For financial products like life insurance, brokerage accounts and mutual funds, the level seems to be US$30,000…

…Now let us further imagine a few things, namely that:

Just as incomes grow, the prices of goods delivered to consumers—whether cars, or smartphones, or personal computers—actually go down
As incomes grow, interest rates charged to consumers actually go down (“on ne prête qu’aux riches” and all that)

Then all of a sudden, one could face a double-, or triple-charged acceleration phenomenon.

Unsurprisingly, as cars replaced bicycles on the streets of Beijing, Shanghai and Chengdu, China’s energy demand also accelerated, as shown in the chart below. Could similar events now unfold across Southeast Asia, India and the broader Middle East? Given the growth in incomes, the fact that China is now offering high-quality sub-US$10,000 cars, and the funding for such purchases, is this not the path of least resistance?

The fall of Constantinople did not trigger “the end of globalization”. Instead, it unleashed a sharp move higher in global trade. Could the same thing happen as a result of the sanctions against Russia and the US’s attempts to take China out of global supply chains? Actually, this is precisely what seems to be unfolding. Both of these events mean that the likes of Indonesia, Brazil, Saudi Arabia and India can now use their own currencies to pay for the commodities they need to power their growth and the machine tools they need to industrialize. At the very least, they no longer need US dollars. Last year, for the first time, China made more loans to EM economies in renminbi than in US dollars.

And this is before the recent announcement of Saudi Arabia signing a RMB50bn swap line equivalent with the People’s Bank of China and the possible sale by China of nuclear power plants to the kingdom.

Today, the notion that the world is deglobalizing would seem laughable to anyone living in Dubai, Singapore, São Paulo or Mumbai. Rather, the world is going through a new wave of globalization, which is different from its predecessors.

5. Car wars – Noah Smith

Over the past two years, China has gone from an also-ran in the auto industry to the world’s biggest car exporter. EVs are a huge chunk of those exports, and most of China’s EV sales go to Europe.

Some forecasts say that by 2025, about 15% of EVs bought in Europe will be made in China — some by Western automakers like Tesla and Volkswagen, some by Chinese companies like BYD.

It’s very easy to understand why this is happening. China massively subsidizes the production of electric vehicles, and Europe massively subsidizes the consumption of electric vehicles. When that happens, any Econ 101 model can easily predict the outcome — China will produce a lot of EVs that are sold in Europe…

…But China’s EV export surge is more recent, so let’s go over some of the reasons it’s happening.

First, here’s a good Bloomberg article about the EV subsidy regime in China. China pays manufacturers a subsidy worth more than $1400 per EV they produce, provides EV companies with cheap land and financing, and heavily subsidizes R&D in the sector. Both China and Europe pay people to buy EVs, and their governments buy EVs directly. But China subsidizes local production a lot more than Europe.

That’s one reason for China’s export dominance, but not the only one. Another is that China controls nearly the entire supply chain for EV batteries, except for the initial mining.

An electric vehicle is a much simpler machine than an internal combustion car — it’s basically just a battery with wheels. The battery in an EV represents about 40% of the car’s purchase price. Making EVs in large numbers is a lot easier when the supplier is right nextdoor; batteries are 33% more expensive in Europe than in China.

Batteries are also about a quarter of an EV’s weight. The fact that they’re all made in China cuts down on the amount of shipping cost you can save by locating car factories close to consumers.

Yet another reason is macroeconomic. As everyone knows, China is in the middle of a big economic slowdown, which has cut local demand for new EVs despite all the consumption subsidies. Europe’s economy is in the dumps as well, but China basically planned to produce enough EVs for a much faster-growing Chinese economy than the one they ended up with. So Chinese EV producers are stuck with massive inventory that they can’t sell domestically. So they’re slashing prices and dumping the inventory on Europe.

And finally, let’s not discount the ingenuity and innovation of Chinese auto and battery engineers and entrepreneurs. The industry shift toward EVs gave upstart carmakers a once-in-a-century opportunity to do an end run around the entrenched dominance of the old-line companies that knew internal combustion engineering backwards and forwards. European startups could have challenged Volkswagen and Renault and Mercedes-Benz. They did not. Instead it was Chinese companies like BYD and SAIC, along with one American company, Tesla, who seized the day…

…Losing the car industry could thus push Europe further along the path to deindustrialization. Cheap Chinese EVs are a boon to European consumers, and they help speed the green transition and reduce carbon emissions. But the competition also threatens to put a bunch of European workers out of a job — 7% of the region’s workforce work in the automotive sector. Traditionally, Europe has been much more concerned than the U.S. about protecting its industries from foreign competition; the EV spat with China will be a test of whether this is still the case, or whether Europe has embraced more of a “neoliberal” approach to trade.

But there could also be a national security angle here too…

…A domestic auto industry gives Europe much more ability to repurpose production lines and ramp up defense production when needed. If the auto industry flees to China, Europe will be that much more vulnerable to Russia. In fact, this is one reason the auto industry is so globally distributed today; during and after World War 2, lots of countries decided they needed car industries in order to maintain strong militaries.

So if Europe does decide to protect its car industry, what might it do?…

…tariffs don’t do much to help European carmakers become more competitive in the export markets they used to dominate. The fact is that Chinese-made EVs are mostly just better than European-made ones right now, and tariffs aren’t going to change that.

In order to address these issues, Europe would need more than tariffs. It would need an equivalent of the U.S.’ Inflation Reduction Act — a major program of production subsidies, not just for EVs themselves but for the batteries and the mineral processing facilities necessary to make them. Europe would also need to simplify and slash some of the overgrowth of regulation that it has piled up around the auto industry over the last few years. And it would need to subsidize R&D in the EV sector more heavily.

And another important step would be something Europe has shied away from doing in recent times: encouraging startups. It’s no coincidence that Tesla, a startup automaker, was able to run rings around the stodgy old giants of GM and Ford, with their deep reliance on legacy markets and legacy technology. Europe has no Tesla; if it really wants to compete with China, it needs at least one.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have a vested interest in Alphabet (parent of Google) and Tesla. Holdings are subject to change at any time.

What We’re Reading (Week Ending 10 December 2023)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 10 December 2023:

1. Charlie Munger – A Conversation with Charlie Munger & John Collison – Charlie Munger & John Collison

John: [00:15:25] So my question is, how do you think about the quality of the business when overarching tech changes are really going to shake it up?

Charlie: [00:15:32] You’ve got to recognize the tech changes do cause some new businesses to flourish and other businesses that looked impregnable to fail. And that’s one of the realities you have to understand.

John: [00:15:44] So you secretly are a tech investor because your reasoning about the effects of tech on Costco or on…

Charlie: [00:15:51] Yes, it’s just that — take, for instance, pharmaceuticals. The American pharmaceutical industry is better than any other pharmaceutical industry in the whole world. And number two is not remotely even close. So we have one of the great achievements in the whole history of the world in science and technology and so forth. At the same time, there’s a fair amount of sleaze in the way pharmaceuticals are distributed. Everybody rooks the government…

John: [00:16:16] The PBMs, yes.

Charlie: [00:16:17] Yes. And that’s just the system. By and large, we haven’t invested in pharmaceuticals because we’ve got no edge. I don’t know enough about biology and medicine and chemistry to have any edge in guessing which new pharmaceutical attempt is likely to succeed and other people who know those things, not that they have perfect knowledge, but it’s way better than mine. Why in the hell would I play against other people in a game where they’re much better at it than I am when I’m playing for something desperately important to me like a way of feeding my family. So of course, we didn’t go near it.

I would argue that they’re — in practical life, you want to succeed, you got to do two things. You got to have a certain amount of confidence. And you have to know what you know and what you don’t know. You have to know the edge of your competency. And if you know the edge of your competency, you’re a much safer thinker and a much safer investor than you are if you don’t know it. And I constantly meet people, better to have an IQ of 160 and think it’s 150 than an IQ of 160 and think it’s 200. That guy is going to kill you because he doesn’t know the edge of his own competence and he thinks he knows everything.

Partly, Warren and I, we pretty much know what we know and what we don’t know, what we’re good at, what we’re not good at. And one of the things we’re not good at is guessing which new pharmaceuticals. So we don’t even look at it. After all, it’s a big universe out there and if we have to leave a certain kind of investment behind because we lack the capacity to deal with it as well as some other people. That’s all right. We don’t need an infinite number of opportunities…

…John: [00:21:36] So what examples do you prefer of businesses driving capital efficiency without squeezing small suppliers?

Charlie: [00:21:43] Well, Costco is one.

John: [00:21:44] By turning the inventory quickly?

Charlie: [00:21:46] Yes and doing that because they have fewer stocking units and they’re way more efficient.

John: [00:21:51] You’re on the board, right?

Charlie: [00:21:53] Yes. I am somewhat the older member. But Costco, it’s an amazing culture. The whole damn culture of the place is so subtle and it just marches from triumph to triumph. It was smart to have a small number of stocking units flowing through with enormous speed. It was right to have a membership system.

There are three things that Costco didn’t want. Didn’t want people who stole merchandise. They didn’t want the people who used bad checks, and it didn’t want people cluttering up his goddamn parking lot without spending a hell of a lot of money in stores. So a membership system, where they accept only a certain kind of a member, all of a sudden now they’ve got nothing but people who buy a lot per trip.

Costco has always had the lowest shrink rate in the world. Tricks the inside too. So the net theft rate at Costco was always below 2/10 of 1%. That’s unheard of.

John: [00:22:46] I hadn’t thought of the parking lot efficiency with the membership system.

Charlie: [00:22:49] You can’t go to Costco just to buy bottle of iodine, just drop in. You got to be a member and then you got to pay enough, so to an ordinary person, they’re not going to pay an extra $100 to buy a bottle of iodine or something. We keep the peach pickers, the little buyers out.

Sol Price used to say “A business should be careful in the business it deliberately does without”. Of course, that’s straight out of a Munger book. You figure out what you want to avoid. And they want to avoid theft losses, embezzlements, bad checks and cluttering up the parking lot without buying much. And their system caused all those effects at once.

John: [00:23:27] It’s like your first speech in the book, start with the business you don’t want, work backwards.

Charlie: [00:23:30] I know, but it’s so simple.

John: [00:23:32] Any others? Of businesses driving capital efficiency without squeezing suppliers.

Charlie: [00:23:35] There are lots of others. Practically all of the aerospace businesses have learned to make very high returns on capital.

John: [00:23:42] How do they do it?

Charlie: [00:23:43] They specialize in being good at something and handling the government well as a paying customer.

John: [00:23:49] Did you ever look at TransDigm?

Charlie: [00:23:51] Sure. I don’t like that way of making money.

John: [00:23:54] Because the price increases.

Charlie: [00:23:56] It’s too brutal. They figure out something that has a little monopoly due to the defense department regulations, and they raise the price 10 times. And they’re famous for it. I regard that as immoral…

…John: [00:24:25] One of the things you raised in the book is this question of when you have a small number of players in the industry, say, two or three players in the industry, it is not always easy to predict who will earn good profits and who will not. And so the airlines lost money since the Wright brothers versus the cereal manufacturers, very durably profitable. If you’re looking at the business today and you know that the industry will consist of two or three players, how can you predict will those players make money?

Charlie: [00:24:50] I don’t think it’s possible to be 100% accurate in making these predictions. But certainly, we’re looking backward, the people who had branded profits like coffee and oatmeal and so forth, made very high profits and airlines basically made no profits at all for their shareholders.

John: [00:25:09] But the airlines were branded goods.

Charlie: [00:25:11] But everybody had big capital equipment if they didn’t use it, they obviously were losing a lot of money. So that everybody was almost forced into a very destructive competition by the logic of the individual situations. There are a lot of businesses that are very hard to make money in permanently.

If you want to go into the business like restaurants, most people fail, small percentage of restaurants even last long enough to make a living to the people who own them. Too competitive. That’s why they fail. Just like there are too many deer on an island and no predators, pretty soon there are too many deer. So all the deer suffer because there are too many of them.

John: [00:25:49] But again, to go back to this question, if I want to understand, will the business be like an airline or like a cereal company. Is this then the ongoing capital expenditure that’s required where airlines fundamentally, they have lots of CapEx on an ongoing basis, it’s like the original Berkshire textile mills?

Charlie: [00:26:02] The airlines are like a guy who builds a big hotel and it’s just sitting there and he makes some incremental profit from filling it. And if it’s got up and staff, that’s better than just letting it sit there vacant. It almost forces irrational intense competition. The same thing does not happen within cereals.

John: [00:26:19] BNSF was one of the biggest acquisitions you guys did. And my sense from the outside is that it’s maybe even been more successful than you would have expected. Is that accurate? Or did you expect it to be this successful?

Charlie: [00:26:31] The railroads were a lousy investment. There were a few people when they were first created that basically stole all the money by milking the government, bribing legislators and doing all kinds of terrible stuff. But by and large, most railroads are lousy investors, like the airlines for a long time. And finally, it got down after years of fighting unions and consolidations, so you get down to a few big systems.

Now there are just two big transcontinental systems, and we’ve got one of them. Of course, that’s a less competitive market than it was — than it existed earlier when there were 100 different railroads. But early railroads when they were terribly competitive, they were terrible places to invest money.

John: [00:27:12] But again, airlines, bad business, not a good investment.

Charlie: [00:27:16] Early railroads, bad business.

John: [00:27:19] Early railroads, yes. Railroads today still require a lot of ongoing CapEx.

Charlie: [00:27:23] Yes, but they’re so dominant. Once you have a railroad that can put shipping containers on that stack too high on tracks. It’s one of the most efficient ways of transferring assets all over the country. It’s way more efficient than trucking. So that they have a system that just accidentally happened. Nobody anticipated you’d be able to double the capacity of the railroad just by shoving containers one on top of the other. So they got very efficient finally. And now they’re so efficient. They’re more efficient than anything else. And of course, they do well…

…John: [00:32:38] You have been famous for criticizing gold earlier on and now cryptocurrency.

Charlie: [00:32:46] I like to gold a lot better than I like cryptocurrency.

John: [00:32:49] You’ve criticized both.

Charlie: [00:32:51] Before there was cryptocurrency, I never bought gold. So I didn’t like gold. But I don’t hate gold as an investment as much as I hate cryptocurrency. I think cryptocurrency ought to have been driven out as illegal.

John: [00:33:03] At the risk of maybe getting ejected from the premises, if I can try to defend cryptocurrency, isn’t the perspective you have where — I think you would say, invest in a productive business. Isn’t that a reasonably U.S.-centric perspective, where absolutely, we have a great currency here. We have a great respect for property rights here. If you’re in Turkey and their property rights aren’t as strong, the currency is inflating 80% a year as it has this year, then the ability to move your wealth…

Charlie: [00:33:34] Well, if I lived in Turkey, I might do something odd. Buy my gold if I were in Turkey, but I would never buy cryptocurrency.

John: [00:33:39] Even in Turkey?

Charlie: [00:33:40] No. I don’t think that buying a percentage of nothing is a good investment, even though it’s hard to create more nothing.

John: [00:33:47] But isn’t gold functionally an investment in the percentage of nothing?

Charlie: [00:33:50] It is similar, except it’s been established so long as a…

John: [00:33:57] An agreed upon store of wealth…

Charlie: [00:33:58] With the history we have and with the need for a currency and a currency that is backed by something and gold is hard enough to mine and so forth. Gold is a perfectly reasonable thing to use as a currency. And the evolution of use of gold as a currency was a very good thing for civilization. I don’t have the feeling that gold is evil. Gold helps civilization develop. But I think cryptocurrency is scumball activity. And I think by and large, the people who promoted it are scumballs or delusionary. And I don’t know which is worse, being a scumball or a delusionary. But I think they’re both pretty bad.

John: [00:34:31] Some people can manage to be both. There’s plenty of scams in crypto. That’s absolutely not up for debate. But are we talking about questions of degree here between gold and cryptocurrency, where they are societally agreed upon stores of value, which trade above…

Charlie: [00:34:46] Let’s put it this way. If we didn’t have gold, we might have invented something like cryptocurrency as a substitute. But once we have gold and fiat currencies that are now long established, we don’t need to add in cryptocurrency.

John: [00:34:59] But isn’t cryptocurrency handier? If you can work with it in just software, you don’t need to actually go get some physical gold, trade it, melt it down. It’s much harder to seize cryptocurrency than it is to seize gold in an autocratic regime.

Charlie: [00:35:10] You don’t have to bother with any physical inventories or anything has any intrinsic value. You can create system very efficiently dealing in it. I don’t want to officially deal in nothing and craziness. I want to make it illegal. All nations have had anti-counterfeiting laws. And I think the anti-counterfeiting laws ought to have been used to totally bar cryptocurrency.

John: [00:35:33] But nothing’s being counterfeit here.

Charlie: [00:35:34] Well, if I am a nation and I have a currency, I don’t want a new currency established.

John: [00:35:38] But it’s not really a new currency. It’s a new store of wealth.

Charlie: [00:35:42] You can call it a store of wealth, I call it a store of delusion. I don’t think it’s good to participate in delusion even when it gets quite common. A second medium of exchange widely used. It’s ideal for drug dealers, dope dealers, scam artists of various kinds. Every kind of criminal you can imagine. Very good in extortion, kidnapping.

Why would we want a wonderful crime facilitating new medium of exchange? Why wouldn’t we just say this is like counterfeiting? You’re coming into the government’s business and you’re trying to create a fiat currency and you can’t do that. It’s a feel they don’t…

John: [00:36:18] All right. Well, I will agree to disagree on crypto. But…

Charlie: [00:36:20] You don’t have to agree. I can handle it if you like crypto. I don’t like it, but I can handle it.

John: [00:36:25] We’re staring into a recession, potential stagflation. What advice do you have for people thinking about how to work their way through the…

Charlie: [00:36:35] I have one standard set of advice for all difficulties, suck it in and cope. That’s all any human being can do, suck it in and cope. Partly, you have to be shrewd. That’s one way of coping is to be as shrewd as you can possibly be. But that’s my recipe. And I must say it’s worked pretty well for me. It will work very well for any other person who uses my methods…

…John: [00:37:59] How do you feel about American society over the coming decades?

Charlie: [00:38:03] Old men have always tended to think that new generation is going to hell. The old Romans, o tempora, o mores. That goes back to the earliest civilizations we had. The old guys were saying when I get out of the world, it’s going to hell. And it really wasn’t going to hell net by and large. But I do not like the way politics has morphed in my lifetime in the United States. I don’t like democracy. The way it actually morphed into existence with these primaries and the dominance of two parties where only the most extreme members of each party have a lot of pulling power and therefore, they control the nominees and so forth.

I think our way of getting nominees is deeply flawed now. It may have worked pretty well up until now. It worked better when we had those old, crooked bosses in the cities then it’s working now with the primaries. I wish those old, crooked bosses would come back and replace the present primaries. Wanted to control the patronage so they actually nominated some pretty good people like Teddy Roosevelt. And these modern primary systems, the worst people often win…

…John: [00:39:10] How do you feel about declining birth rates?

Charlie: [00:39:11] It creates a different kind of a world. Well, I don’t see that mankind would be at all smarter if everybody had six children. I think that just jams up population way too much starting with 7 billion for the whole world. So I think it’s good that the population is growing more slowly. But do I think it is good for people to be quite self-centered below 35 and then get married compared to marrying at 21 or 22 and having a lot of children?

No, I think the people who married at 21 or 22 and grew up fast because they had to because they have those young children. In a sense, I think they were a luckier generation than the people who came along with all these different options and who delay marriage into late age and have one or two children, I’m not at all sure it’s good for the people who are having these new options, but it is good for the population…

…John: [00:43:15] Where do you think the world is getting worse?

Charlie: [00:43:17] I think we have a political game problem that’s probably as bad as we’ve ever had. We have some crazy dictators on the verge of creating a nuclear war. We’ve got lots to worry about. The world has never been a perfectly safe place and it isn’t now.

John: [00:43:32] Kind of a societal version of your avoiding mistakes framework from Poor Charlie’s Almanack, where societies need to avoid the major mistakes just like individuals do, avoiding nuclear war.

Charlie: [00:43:42] We’re lucky to have done it so far. But if enough crazy people have enough hydrogen bombs, there will eventually be enough hatred, we’ll have an atomic war of some kind someday. You can almost count on it. So you can say that our generation, it was quite unlikely, but I think it’s getting more likely and not less…

…John: [00:46:15] And what’s an example of where you are more multidisciplinary than the architects in some of the buildings you’ve designed?

Charlie: [00:46:19] If you take the building, the graduate residence at the University of Michigan. They had a magnificent site with a parking lot. They had no other site. They’d used up all the land in the dormitory. They have a second campus, but on their main campus, they’d used up all the sites. And there is one little parking lot left. And I realized that if they used their power of eminent domain and doubled the size of that parking lot, they’d get it with a big square building on the site tha would hold a lot of graduate students.

But there was no way to do that without creating a window shortage in some of the bedrooms. And I also knew that it didn’t matter that there was a window shortage in the bedrooms because I went around Ann Arbour and saw the private builders in Anna Arbour now have already created apartment rooms with no windows and relying on artificial light. And I walked side-by-side exactly identical bedroom, one with a real window and one with just a blank wall. And the one with just a bank wall renting for 10% less.

So it wasn’t much of a problem. I looked for the evidence and then once I realized that, I could do all kinds of wonderful things in that building once I got over this prejudice that it was absolutely required under any and all circumstances that every bedroom have a window. So it’s just an example of just the most elementary common sense. I looked at the evidence at Ann Arbor. I understood geometry well enough to know. And then too, I was well aware that every ship has exactly the same problem. Every ship has a window shortage automatically. Every cruise ship. Yeah, and they pay $20,000 a week to be on the ship and so forth.

And if they don’t want a little light, they walk out of the ship and go into one of the common rooms. And of course, that’s what I arranged they do in the dorm. So I was following correct precedents from marine architecture. But show me an architect that’s learned anything from marine architect. I think you could go into any school of architect in the country and you won’t find anybody studying marine architecture. They think it has nothing to do with it. It has a lot to do with what they’re doing. If you don’t look, you won’t find.

John: [00:48:27] I feel like another example of understanding the customer is giving the students in the dorms single rooms where most people design…

Charlie: [00:48:32] Oh, well, that — talking about insanity. Now, I have sent a lot of children through a lot of graduate education. And I’ve never had a child that liked being in a room with one or two other unrelated people sleeping in the same room…

…John: [00:49:19] Why did this shared delusion persist for so long?

Charlie: [00:49:22] What happened was that the fire codes, they worry that the fireman would need a ladder to go and look through the window and crawl in through the window and haul somebody who had passed out from smoke. So they required that every sleeping space have a window. So the fireman could crawl up on a ladder. There were two things wrong with that.

One, it never happened. Nobody could find a case were a fireman — they would crawl up by ladder and look through and they had found somebody lying in bed passed out of smoke. And two, of course, a modern building with automatic sprinklers, that’s why there was going to be zero.

And that’s why the fire codes changed. And when the fire codes changed because — but the people are used to doing it in a certain way. Of course, they keep doing it the same way they’ve always done. Isn’t it the Mayo Clinic is one of the best places on earth in terms of an admirable culture. They kept doing hip replacements by a procedure that the doctors knew how to do because the new one that was better for the patient was very hard for the doctor to learn. And so they just kept doing it the old way. Architects are no different. They do what they’re used to.

John: [00:50:32] Again, for say, someone who’s 25 or 30, is the lesson that there are a lot of $20 bills lying on the sidewalks? There’s a lot of inefficiency in the world to be rectified that people should not assume the world works efficiently?

Charlie: [00:50:45] Well, of course, there’s always a lot of things that can be improved, always a lot of people who are getting ahead by doing something new. And that’s one of the pleasures of modern civilization. And imagine a postal clerk in the United States can go to Hawaii on a 2-week vacation on a superjet and have a nice time. A postal worker could do that in the world that you’re up in.

You can learn a whole new profession just punching buttons on the Internet and so forth, so the possibilities of self-education is fairly enormous. So all kinds of things have been greatly improved. Of course, that causes new opportunities for some people, and it causes absolute economic destruction from certain people who get obsoleted.

Imagine the Kodak company, which hired all the PhD chemists, totally dominated the chemistry of film and so forth and had the most reliable trademarks in the whole world. Go through Africa when I was young, there are 2 things you always saw: a Coca-Cola and Kodak. That was the brands all over Africa, the poorest villages. And of course, Kodak went totally broke because somebody invented a new way of taking photographs and developing photographs. And it just obsoleted their whole damn business, and Kodak wiped out its common shareholders. That happens all the time, that kind of thing. And you can’t blame the management for it and say, “Well, didn’t Kodak invent its own destruction?” That’s hard to do.

I mean for human nature, you’ve got a business as big as Kodak, everybody’s lived over for years. They’re like the surgeons who didn’t want to learn a new trick that was lot harder to learn when they were old. People don’t welcome having to learn something new. It’s really hard to learn. Everybody would rather get ahead using what he already knows…

…John: [00:53:18] You spend a lot of time in the book talking about businesses that are win-win for both sides and the importance of this for their long term.

Charlie: [00:53:24] How can anything be more important? It isn’t just that it works better in terms of creating plenty for all. It’s better morality. Of course, both sides want both sides to win, that’s more moral than trying to take advantage of other people when it’s so obviously the right way to live and it’s the right way to do business…

…John: [00:55:56] So you wouldn’t invest in drugs, tobacco or the Grateful Dead?

Charlie: [00:55:59] No, that’s correct. I would not. When I sell you a tennis racket for $100, one side gets the tennis racket they’d rather have than a hundred dollars they’re partying. The other guy, he likes what he’s getting, too. It’s win-win.

That’s the beauty of capitalism. It makes win-win transactions very easy and almost automatic. That’s such a hugely important idea. And people like Bernie Sanders and Elizabeth Warren, both of whom I regard as quite talented in some ways, but they just don’t get it.

John: [00:56:27] But I think you mean that as a backhanded compliment.

Charlie: [00:56:29] It’s both a compliment and a criticism.

John: [00:56:32] Is the fundamental thing they don’t grasp that a lot of the win-win businesses are net positive and win-win for both sides and they…

Charlie: [00:56:40] It’s automatic in a capitalist transaction, unless one side is making a big mistake. And most people are pretty good at not making mistakes over and over again with their own money.

John: [00:56:49] It’s not fully automatic, right? We can…

Charlie: [00:56:51] No, it’s not. But a lot of good happens automatically.

John: [00:56:54] Do you worry about the rise of this faction of the political spectrum who don’t really believe in capitalism?

Charlie: [00:57:00] Of course, look at the misery that’s happened to the Russian people. They didn’t like their old system with a bunch of serfs serving a bunch of landlords and so forth, corruption and so forth, so they went to something worse.

They were rebelling against something that was awful, so they substituted something that turned out to be actually worse. It’s hard to create a new form of government worse than Russian serfdom, but Russia has managed to do it. And not only that. They’re proud of having done it. You should never be proud of your defects.

John: [00:57:30] What are Berkshire’s defects?

Charlie: [00:57:31] We haven’t eliminated all mistakes of judgment or even all mistakes of morality. So nobody gets anywhere near perfect ever in human affairs. It’s not exactly a defect. A lot of what worked for us in the early days, we can’t do anymore because the world is more competitive.

The low-hanging fruit has all been picked, and we can’t get fruit out of barren branches where the fruit has gone away. And so we have to go to something else. And of course, that’s harder. A lot of people have that problem, and they go to the new systems in new ways.

John: [00:58:01] I’ve always liked the quote capitalism is how we take care of people we don’t know.

Charlie: [00:58:05] It’s certainly remarkable how it works. I like a social safety net, but I’m different from other people. If I were running the government, the modern civilization, I would be quite liberal at rewarding everything that can’t be faked, like being blind or not blind or something. I’d just give a very blind person a lifetime pension, which goes up with inflation.

If life is tough enough for you, we can afford to do it, and you and your handlers can figure out how you use the money. So I would be very liberal. I would give anybody any education right through college, courtesy of the government, but it would be meritocratic. You have to be able to do the work or you don’t qualify for the benefit.

So I wouldn’t let people pretend to be learning things in some half-assed institution and send the bills to the government. But places like Caltech or MIT, anybody could get in and do the work, if I was the government I’d pay for it all the way through college and graduate school, which they do in places like New Zealand and Australia and so on.

Again, everything in medicine, that is almost automatic, I would pay for that, too. But would I pay for Freudian analysis? No. Stuff that can be gamed and it was crazy, I would not pay for. And I wouldn’t allow the people to get rewards for low back pain, even though they have real low back pain. And it’s easily faked. I wouldn’t pay. It just causes too much cheating and the cheating gets to the eventual and so forth.

I would just say we can’t do that. It’s not that we don’t sympathize with your low back pain and your poor life adjustment? But we can’t give lifetime pay just because you say, “My lower back hurts.” or, “my life adjustment is imperfect.” That’s the way I would organize the government. Nobody thinks the way I do. I feel lonely. I would be quite generous, but I will be quite tough on people with low back pain or psychological problems…

…John: [01:12:23] If Patrick and I came and put you on Stripe, what would you want to understand about the business? What would your concerns be?

Charlie: [01:12:30] That’s an interesting question, considering how much Berkshire Hathaway has made out of other payment systems, including American Express. We recognize the power of having a dominant position in payments in a way that’s very efficient. And of course, anything in modern payments that enables all this Internet stuff is very useful. So you’ve come into a field and made a contribution and made yourself very useful.

I’m for all these payment systems that get better and better. So I think you’ve made your money honorably and you’ve made a lot of it, and good for you. I admire what you people have done. Why wouldn’t I? I regard everything that you’re doing as a little bit threatening to American Express, but American Express actually has a position where it’s like Hermes or something, and so it won’t necessarily be ruined by Stripe.

John: [01:13:22] In evaluating a business like Stripe, what questions would you want to answer for yourself?

Charlie: [01:13:26] Is it likely to remain forever as a money generator? And that’s a more complicated subject. It’s hard to know how the world is going to evolve. If Kodak could suddenly be obsoleted away, maybe it’s not utterly unthinkable if Stripe could.

The company that dominates software for architects, terribly prosperous company, but some other companies come up in that field a lot and it no longer dominates as much as it did. So not everything in software always wins. So I do not have the feeling — the venture capitals tend to think everything in software is always going to win. I don’t believe that for a minute…

…John: [01:14:48] Why has NetJets done so well?

Charlie: [01:14:50] It’s better in its niche than anybody else. In NetJets, the whole culture, safety is first, customer service is second. And after that, we’ll start worrying about the capitalists who own NetJets. And of course, there’s enough fanaticism of that kind of a culture. We create a hell of a product for the person who can afford anything. And ours is better than anybody else in the country, and it’s now big. It’s a big business. And we have yet to kill our first passenger. All these many years, we’ve never killed a passenger…

…John: [01:15:33] I can feature the magazine ads. NetJets- “No one has died yet”.

You’re very bullish on China. Why?

Charlie: [01:15:41] Well, first reason is that their economy was growing faster than ours. That isn’t necessarily true as we consider this exact minute, but for a long time, that economy grew a lot faster than ours. Number two, we could get way better and stronger companies at a much lower price in China than we could get in the United States. Now on the other side, we had to take the political risk of buying into a peculiar system of government that’s not different from ours.

As long as we were getting enough bargains, I was willing to run the — as with part of our assets is we would never invest all of our money in China, for Gods’ sake. But we were certainly willing to invest part of it. That’s perfectly logical. And of course, we were investing through Li Lu, he was a very exceptional money manager. And we put all those 4 things together, the ones, of course, that made sense…

…John: [01:17:19] How does the current geopolitical hawkishness change your view on investing in China, if at all?

Charlie: [01:17:24] Obviously, I’m more uncomfortable now than I was. The guy who changed the whole system and said, “I don’t care if the cat is black or white as long as it catches mice.”, he wanted the goddamn economy of China to work like Singapore’s. Of course we love that guy. And the new guy isn’t quite as much like that guy as we would consider ideal. We think the political risk in China should be run, and I think we should go out of our way to have a lot of friendly relations with big atomic powers.

Both China and the United States ought to get along with one another as a matter of wholly duty because they’re 2 big atomic powers. And the way you get along best is we should carefully work out a bunch of win-win transactions between us and China and actually work to make them work even better. That is the right policy in the United States.

We should not be trying to discipline China by telling them like a nattering nanny how China ought to behave and say, “We know better. We’re a democracy and you’re not.” We have a lot to be ashamed of in our own form of government. We shouldn’t be going around lecturing everybody else. And we should organize win-win transactions with China. Anything else is madness.

And for a long time, we had that. You can argue that China came to modernity primarily in win-win transactions with the United States because we’re so open to their imports. That’s what enabled them to get ahead so fast. And I’m proud of that, and I’m glad we helped them. And I want to do more of it. I don’t want this hostility on both sides.

John: [01:18:53] Tom Wolfe wrote a short story about Bob Noyce. I’m a huge Tom Wolfe fan of his books, but he has a great short story about Bob Noyce. And you can read the short story as it’s really about Grinnell, Iowa and the effect of Midwestern culture in Silicon Valley.

Charlie: [01:19:11] It’s a huge success, of course. And the success is interesting, but I would argue that the failure of Intel was just as interesting a story. Intel was on the ground floor of modern chip making. Absolutely ground zero. They were at the absolute best place. And they just grew and grew and so forth. And they eventually lost all their leadership completely, and they’re just a little pissant company compared to the big guys now.

John: [01:19:40] Why did that happen?

Charlie: [01:19:41] Firstly, some of that’s inevitable. In competitions, somebody are going to lose. It’s — partly it demonstrates the inevitable even if you’re successful, so a little guy that really scrambles, be sure that there’s some accidents, but partly, they were so interested in always reporting more earnings. They didn’t go to the leap enough, just stay on top.

If you’re serving along the edge of a new development like that, you have to just absolutely be going flat out all the time, and you have to be leading all the time. Berkshire, we don’t have to invent new things, particularly, compared to most places. They’re in the business of inventing new things, and you have to be totally fanatic.

And the truth of the matter is that the people in China were way more fanatic than Intel. In China, you had one old guy that controlled the place and he was a fanatic, and Intel had an army of bureaucrats, and they were interested in their executive rewards and the way the price earnings ratios and the approval of Wall Street. A whole lot of other things. And they were powerful. Now they look good for a while just by using their power to make the earnings go up.

But they should have been using their power to make sure their goddamn chips stayed way ahead of everybody else. And they had to be a totally reliable supplier, which they weren’t. They disappointed a lot of customers, and you can’t disappoint customers if you wanted to have a Mayo system of trust. That’s the interesting part of that, not the Noyce story. The story of the failure of Intel was the great story there…

…John: [01:31:17] Is the secret of Berkshire’s culture just the anti-bureaucracy bend? Could you sum it up…

Charlie: [01:31:22] Berkshire is pretty extreme in culture. We are deeply aware of how bureaucracies tend to create their own internal dynamics so that everybody protects everybody else and nobody changes anything, ruffles any feathers. And the net result is that a lot of bureaucracies make some very stupid decisions and we try and avoid that.

But the way we’ve done it, mostly, is by not having anybody around. They can’t be bureaucratic if they’re not there. There is nobody in the head office. So we avoided the bureaucracy. We just don’t want other people to do it. Nobody else is as extreme as we are in that. It’s a huge advantage to us.

And another thing is, we like very trustworthy people. I’d rather have a brief telephone with somebody I trust than I would a 40-page contract prepared by the finest law firm in the world with somebody I don’t trust. And so we like to deal with trustworthy people and to be able to count on their oral promises.

If you look to go into a Mayo operating room is what I call a seamless web of deserved trust. The surgeons trusting the anesthesiologist, the anesthesiologists trusting the surgeon, the nurses are trusting — everybody trusts everybody else. There’s no bureaucracy at all. They don’t have time for bureaucracy.

It’s in patients’ interest to get it over as soon as possible. And so that seamless web of deserved trust can do these very complicated procedures. We like a business system that operates as much as possible like a Mayo operating room, and that requires having very good people who are experienced enough with one another to trust one another.

John: [01:32:55] And that trust is internally between the Berkshire folks or between the Berkshire folks and the managers?

Charlie: [01:33:00] Both. We want the internal and all the Berkshire people to trust one another internally, and we also want the customers to trust us. We’re all for trust. Trust is one of the greatest economic forces on earth.

2. Charlie Munger’s Life Was About Way More Than Money – Jason Zweig

It’s 1931, and a boy and girl, both about seven years old, are playing on a swing set on N. 41st St. in Omaha. A stray dog appears and, without warning, charges. The children try to fight the dog off. Somehow, the boy is unscathed, but the dog bites the girl.

She contracts rabies and, not long after, dies. The boy lives.

His name? Charles Thomas Munger.

Charlie Munger, the brilliant investing billionaire who died on Tuesday in a California hospital 34 days before his 100th birthday, told me that story when I interviewed him last month. I’d asked the vice chairman of Warren Buffett’s Berkshire Hathaway BRK.B -0.75%decrease; red down pointing triangle: What do you think of people who attribute their success solely to their own brilliance and hard work?

“I think that’s nonsense,” Munger snapped, then told his story, which I can’t recall him ever publicly recounting. “That damn dog wasn’t 3 inches from me,” he said. “All my life I’ve wondered: Why did it bite her instead of me? It was sheer luck that I lived and she died.”

He added: “The records of people and companies that are outliers are always a mix of a reasonable amount of intelligence, hard work and a lot of luck.”

I had the extraordinary good luck to get to know Charlie Munger in the past two decades. If you think his life was only about piling up money, think again. Few people have ever been wealthier, in all the senses of the word, than Munger was.

Those who know only a little about him think Munger was a paragon of how to pick stocks—which he was. But those who knew him well consider him a moral exemplar—someone who showed how to think clearly, deal fairly and live fully. He took nothing for granted.

More than almost anyone I’ve ever known, Munger also possessed what philosophers call epistemic humility: a profound sense of how little anyone can know and how important it is to open and change your mind…

…“Part of the reason I’ve been a little more successful than most people is I’m good at destroying my own best-loved ideas,” Munger told the Journal in 2019. “I knew early in life that that would be a useful knack and I’ve honed it all these years, so I’m pleased when I can destroy an idea that I’ve worked very hard on over a long period of time. And most people aren’t.”…

…Munger deliberately kept himself surrounded by people he liked. “Many of the richest people have holes inside of them that they’re always trying to fill,” Munger’s friend Peter Kaufman said last month. “But Charlie knows you can’t fill those holes with money. That’s why he spends so much time with friends and family.”…

…One lesson: the importance of what Munger called “a seamless web of deserved trust” in which a company deals fairly with employees, customers, competitors and other constituencies.

“If you’re structurally adversarial to those adjacent to you in the ecosystem, maybe you prosper for five years,” said Collison, “but not for 75 years!”…

…“You know how a lot of old people say, ‘At my age I don’t even buy green bananas’?” regular guest John Hawkins, co-founder of private-equity firm Generation Partners, said recently. “Well, Charlie is buying green bananas by the truckload. He’s making investments for the next 10, 20, 30 years. He has his foot on the gas and is not taking it off.”…

…He mocked the marketing of short-term investment performance by telling a story about a man who walks into a fishing-tackle store and sees a bunch of gaudy, iridescent lures. “My God, they’re purple and green!” he says to the owner. “Do fish really take these lures?” The store owner answers, “Mister, I don’t sell to fish.”…

…Then I asked what he might want for an epitaph of no more than 10 words.

His reply was immediate and full of epistemic humility: “I tried to be useful.”

Not “I was useful.” That would be for other people to judge. But “I tried.” That much he knew.

3. What Will It Take for China’s GDP to Grow at 4–5 Percent Over the Next Decade? – Michael Pettis

There are two different groups of economists in China that believe that with the right—albeit very different—set of economic policies, China’s economy will be able to grow sustainably by 4–5 percent for many more years. One group argues that China must maintain the investment-driven and manufacturing-intensive strategy it has followed during the past three to four decades. The other group argues instead that China can maintain high growth rates only if it sharply reduces the investment share of GDP and replaces it with a greater reliance on consumption, something which Beijing has been trying to do for over a decade…

…Can China maintain high GDP growth rates driven by high investment? Some simple arithmetic is useful here. Globally, according to the World Bank, investment represents on average 25 percent of each country’s GDP and has remained within a tight range of between 23 percent and 27 percent during this century…

…China, however, is a huge outlier. It currently invests 42–44 percent of its GDP. What’s more… for the past two decades China’s investment share of GDP has never been below 40 percent; it reached as high as 47 percent in 2010 and 2011. In the previous two decades, the investment share of GDP was lower, but it still exceeded 35 percent on average, leaving China during the past four decades with the highest investment share of GDP, and the fastest growth rate in investment, in history.

The obvious implication is that while China accounts for a disproportionately small share of global consumption, it accounts for a disproportionately large share of global investment… According to the World Bank, China’s $18 trillion economy accounts for just under 18 percent of global GDP, making it the world’s second-largest economy after the United States, which accounts for about 25 percent. But China comprises only 13 percent of global consumption and an astonishing 32 percent of global investment…

…if China maintained its high investment share of GDP—in other words, if investment continued to grow as fast as GDP—and GDP grew at rates of 4–5 percent for the next decade, China’s share of global GDP would rise by less than 3 percentage points, to 21 percent, while its share of global investment would rise by more than 5 percentage points, to 38 percent. Its share of global consumption, however, would rise by well under 2 percentage points, to less than 15 percent.

Can China really account for 38 percent of global investment while its economy comprises just 21 percent of global GDP and 15 percent of global consumption? Every $1 of investment has required approximately $3 of consumption globally to sustain it during this century. In China, however, $1 of investment is balanced by only $1.30 of consumption. If the global relationship between consumption and investment held over the next decade, an increase in the Chinese share of global investment from 32 percent today to 38 percent in a decade would require that the rest of the world disinvest to accommodate China’s domestic imbalances.

To give a sense of just how extreme this requirement is, it would mean that to prevent a global overproduction crisis (which would hit China especially hard), the rest of the world would have to agree to reduce the investment share of its GDP by roughly 1 full percentage point, to 19 percent of GDP, well under half of the Chinese level. Needless to say, this is very unlikely, especially with the United States, the EU, and India putting into place policies aimed at boosting domestic investment.

What’s more, to the extent that the surge in China’s debt burden is driven by its extraordinarily high investment share of GDP, it would require China’s debt-to-GDP ratio to rise from just under 300 percent today to at least 450–500 percent in a decade. Given the huge difficulties the Chinese economy is already facing at current debt levels, and the difficulties Beijing has had in its attempts to reduce the debt burden, it is hard to imagine that the economy could tolerate such a substantial increase in debt…

…Globally, according to World Bank data, manufacturing represents 16 percent of GDP and has ranged from 13 percent to 17 percent during this century.

China, once again, is an extreme outlier, with manufacturing representing 28 percent of the country’s GDP. This share had declined from 32 percent in the decade before 2020, but it has risen in the past two years. This recent increase is not surprising. As a consequence of the contraction since 2021 in China’s long-lasting property bubble, there has been a major, policy-driven shift in investment from the property sector to the manufacturing sector, even though the evidence suggests that investment in Chinese manufacturing has been constrained by weak demand—not by scarce capital—so that even more investment in the manufacturing sector implies a further growth in excess capacity (that is, growth in domestic capacity that exceeds growth in domestic demand)…

…While China accounts for 18 percent of global GDP and only 13 percent of global consumption, it currently accounts for an extraordinary 31 percent of global manufacturing. If China maintained annual GDP growth rates of 4–5 percent while also maintaining the role of manufacturing in its economy, its share of global GDP would rise by less than 3 percentage points in a decade, to 21 percent, even as its share of global manufacturing would rise by more than 5 percentage points, to 36 percent…

…To accommodate this and prevent a global overproduction crisis, the rest of the world would have to allow its manufacturing share of GDP to drop between 0.5 and 1.0 percentage points. It would also have to allow a surge in China’s trade surplus—currently equal to nearly 1 percent of the GDP of the rest of the world—as a 5–8-percentage-point increase in China’s share of global manufacturing would be backed by a 2-percentage-point increase in China’s share of global consumption.

Again, this is very unlikely, especially with the United States, the EU, and India enacting policies aimed at protecting and boosting domestic manufacturing. In fact, given China’s determination to increase its reliance on manufacturing to drive growth, I expect global trade relationships to deteriorate sharply in the next few years as the world’s major economies battle over their respective manufacturing sectors…

…The net result would be persistent downward pressure on global demand as major economies competed by subsidizing production at the expense of consumption. This would only worsen global trade relationships because, in the end, only economies that were willing to protect their manufacturing sectors, or maximize the subsidies they delivered to domestic manufacturers, would be able to prevent their manufacturing sectors from contracting as a share of total GDP…

…If they set off a global trade conflict involving the United States, the EU, India, and Japan, the results would be especially painful for countries such as China that rely on large trade surpluses to balance weak domestic demand with an overreliance on manufacturing to drive growth.

That’s because without sustained trade surpluses, there are only two ways a country can balance excess supply with weak domestic demand. One way involves a painful and potentially disruptive collapse in production, as occurred most famously in the United States in the early 1930s, when it had to try to resolve its huge trade surplus in a contracting world economy exacerbated by beggar-thy-neighbor trade and currency policies. The other way is to boost domestic demand as quickly as possible…

…To put it another way, if China wanted to maintain GDP growth rates of 4–5 percent, Beijing would have to engineer policies that caused consumption to grow by at least 6–7 percent a year, with investment growing at roughly 1 percent annually.[3] Any lower consumption growth rate would mean that China could not rebalance its economy in a decade and still maintain current GDP growth rates.

If China pulled this off, at the end of the ten-year period its GDP would comprise 21 percent of global GDP (up from 18 percent in 2022). Its economy would be far more balanced, with investment comprising 29 percent of global investment (down from 31 percent in 2022) and consumption comprising 18 percent of global consumption (up from 13 percent in 2022). In that case, as its share of global GDP would rise by nearly 3 percentage points, its share of global investment would decline by 2 percentage points and its share of global consumption would rise by 5 percentage points.

With consumption growing at roughly 4 percent a year before the pandemic (and much less since), is 6–7 percent growth in consumption possible? No country in history at this stage of the development model has been able to prevent consumption from dropping, let alone cause it to surge, but that doesn’t mean it’s impossible.

But it won’t be easy. With investment growth slowing, which means fewer jobs building bridges, train stations, and apartment complexes, the only way to accelerate consumption growth sustainably is to get household income growth to accelerate through transfers—either directly (such as through wages and other income) or indirectly (such as through a stronger social safety net).

The problem with transfers is that they must be paid for, and there are only three sectors that, in theory, can meaningfully pay for them. One sector that can pay is the rich, who consume a much lower share of their income than ordinary households…

…A second sector that can be forced to pay is the business sector. For example, businesses can pay for these transfers in the form of rising wages, higher taxes, a strengthening currency, or higher borrowing costs (if these are matched by higher deposit rates for household savers). The problem is that with China’s manufacturing competitiveness based primarily on the very low share of income Chinese workers retain relative to their productivity, this would seriously undermine Chinese manufacturing.

The only other sector that can pay is government. There are in fact two levels of government in China: Beijing and local governments. Given the structure of payments and social transfers in China, along with Beijing’s explicit refusal to absorb the various debt and adjustment costs, it is very unlikely that Beijing will be willing to take on the full costs of transfers, which would require mainly central government borrowing.

That leaves local governments as the sector most likely to absorb the costs. By my calculations, if Beijing forced local governments to transfer roughly 1.5 percent of GDP every year to households, it would be possible to drive the growth in both household income and household consumption to around 7 percent annually. This is not as hard as it might at first seem. In spite of terrible cash flow pressures in recent years, local governments may own assets worth as much as 20–30 percent of China’s GDP.

But transferring such a large share of local governments’ assets won’t be easy. Such substantial transfers would be politically contentious and require a transformation of a wide range of elite business, financial, and political institutions at the local and regional level…

…The arithmetic, however, is quite straightforward: unless the rest of the world is willing to reverse its strategic economic priorities to accommodate Chinese growth ambitions, global constraints imply that China cannot continue growing its share of global GDP without sharply reducing the growth rate of investment and manufacturing.

4. The CRISPR Era Is Here – Sarah Zhang

Four years ago, she joined a groundbreaking clinical trial that would change her life. She became the first sickle-cell patient to be treated with the gene-editing technology CRISPR—and one of the first humans to be treated with CRISPR, period. CRISPR at that point had been hugely hyped, but had largely been used only to tinker with cells in a lab. When Gray got her experimental infusion, scientists did not know whether it would cure her disease or go terribly awry inside her. The therapy worked—better than anyone dared to hope. With her gene-edited cells, Gray now lives virtually symptom-free. Twenty-nine of 30 eligible patients in the trial went from multiple pain crises every year to zero in 12 months following treatment.

The results are so astounding that this therapy, from Vertex Pharmaceuticals and CRISPR Therapeutics, became the first CRISPR medicine ever approved, with U.K. regulators giving the green light earlier this month; the FDA appears prepared to follow suit in the next two weeks. No one yet knows the long-term effects of the therapy, but today Gray is healthy enough to work full-time and take care of her four children…

…The approval is a landmark for CRISPR gene editing, which was just an idea in an academic paper a little more than a decade ago—albeit one already expected to cure incurable diseases and change the world. But how, specifically? Not long after publishing her seminal research, Jennifer Doudna, who won the Nobel Prize in Chemistry with Emmanuelle Charpentier for their pioneering CRISPR work, met with a doctor on a trip to Boston. CRISPR could cure sickle-cell disease, he told her. On his computer, he scrolled through DNA sequences of cells from a sickle-cell patient that his lab had already edited with CRISPR. “That, for me, personally, was one of those watershed moments,” Doudna told me. “Okay, this is going to happen.” And now, it has happened. Gray and patients like her are living proof of gene-editing power. Sickle-cell disease is the first disease—and unlikely the last—to be transformed by CRISPR.

All of sickle-cell disease’s debilitating and ultimately deadly effects originate from a single genetic typo. A small misspelling in Gray’s DNA—an A that erroneously became a T—caused the oxygen-binding hemoglobin protein in her blood to clump together. This in turn made her red blood cells rigid, sticky, and characteristically sickle shaped, prone to obstructing blood vessels. Where oxygen cannot reach, tissue begins to die…

…The basic technology is a pair of genetic scissors that makes fairly precise cuts to DNA. CRISPR is not currently capable of fixing the A-to-T typo responsible for sickle cell, but it can be programmed to disable the switch suppressing fetal hemoglobin, turning it back on. Snip snip snip in billions of blood cells, and the result is blood that behaves like typical blood.

Sickle cell was a “very obvious” target for CRISPR from the start, says Haydar Frangoul, a hematologist at the Sarah Cannon Research Institute in Nashville, who treated Gray in the trial. Scientists already knew the genetic edits necessary to reverse the disease. Sickle cell also has the advantage of affecting blood cells, which can be selectively removed from the body and gene-edited in the controlled environment of a lab. Patients, meanwhile, receive chemotherapy to kill the blood-producing cells in their bone marrow before the CRISPR-edited ones are infused back into their body, where they slowly take root and replicate over many months.

It is a long, grueling process, akin to a bone-marrow transplant with one’s own edited cells. A bone-marrow transplant from a donor is the one way doctors can currently cure sickle-cell disease, but it comes with the challenge of finding a matched donor and the risks of an immune complication called graft-versus-host disease. Using CRISPR to edit a patient’s own cells eliminates both obstacles. (A second gene-based therapy, using a more traditional engineered-virus technique to insert a modified adult hemoglobin gene into DNA semi-randomly, is also expected to receive FDA approval for sickle-cell disease soon. It seems to be equally effective at preventing pain crises so far, but development of the CRISPR therapy took much less time.)

In another way, though, sickle-cell disease is an unexpected front-runner in the race to commercialize CRISPR. Despite being one of the most common genetic diseases in the world, it has long been overlooked because of whom it affects: Globally, the overwhelming majority of sickle-cell patients live in sub-Saharan Africa. In the U.S., about 90 percent are of African descent, a group that faces discrimination in health care. When Gray, who is Black, needed powerful painkillers, she would be dismissed as an addict seeking drugs rather than a patient in crisis—a common story among sickle-cell patients…

…Doctors aren’t willing to call it an outright “cure” yet. The long-term durability and safety of gene editing are still unknown, and although the therapy virtually eliminated pain crises, Hsu says that organ damage can accumulate even without acute pain. Does gene editing prevent all that organ damage too? Vertex, the company that makes the therapy, plans to monitor patients for 15 years.

Still, the short-term impact on patients’ lives is profound. “We wouldn’t have dreamed about this even five, 10 years ago,” says Martin Steinberg, a hematologist at Boston University who also sits on the steering committee for Vertex. He thought it might ameliorate the pain crises, but to eliminate them almost entirely? It looks pretty damn close to a cure…

…The field is already looking at techniques that can edit cells right inside the body, a milestone recently achieved in the liver during a CRISPR trial to lower cholesterol. Scientists are also developing versions of CRISPR that are more sophisticated than a pair of genetic scissors—for example, ones that can paste sequences of DNA or edit a single letter at a time. Doctors could one day correct the underlying mutation that causes sickle-cell disease directly…

…We have opened the book on CRISPR gene editing, Frangoul told me, but this is not the final chapter. We may still be writing the very first.

5. Introducing Gemini: our largest and most capable AI model – Sundar Pichai and Demis Hassabis

I believe the transition we are seeing right now with AI will be the most profound in our lifetimes, far bigger than the shift to mobile or to the web before it. AI has the potential to create opportunities — from the everyday to the extraordinary — for people everywhere. It will bring new waves of innovation and economic progress and drive knowledge, learning, creativity and productivity on a scale we haven’t seen before…

…Millions of people are now using generative AI across our products to do things they couldn’t even a year ago, from finding answers to more complex questions to using new tools to collaborate and create. At the same time, developers are using our models and infrastructure to build new generative AI applications, and startups and enterprises around the world are growing with our AI tools…

…We’re approaching this work boldly and responsibly. That means being ambitious in our research and pursuing the capabilities that will bring enormous benefits to people and society, while building in safeguards and working collaboratively with governments and experts to address risks as AI becomes more capable…

…Now, we’re taking the next step on our journey with Gemini, our most capable and general model yet, with state-of-the-art performance across many leading benchmarks. Our first version, Gemini 1.0, is optimized for different sizes: Ultra, Pro and Nano. These are the first models of the Gemini era and the first realization of the vision we had when we formed Google DeepMind earlier this year…

…We’ve been rigorously testing our Gemini models and evaluating their performance on a wide variety of tasks. From natural image, audio and video understanding to mathematical reasoning, Gemini Ultra’s performance exceeds current state-of-the-art results on 30 of the 32 widely-used academic benchmarks used in large language model (LLM) research and development.

With a score of 90.0%, Gemini Ultra is the first model to outperform human experts on MMLU (massive multitask language understanding), which uses a combination of 57 subjects such as math, physics, history, law, medicine and ethics for testing both world knowledge and problem-solving abilities.

Our new benchmark approach to MMLU enables Gemini to use its reasoning capabilities to think more carefully before answering difficult questions, leading to significant improvements over just using its first impression.

Gemini Ultra also achieves a state-of-the-art score of 59.4% on the new MMMU benchmark, which consists of multimodal tasks spanning different domains requiring deliberate reasoning…

…Until now, the standard approach to creating multimodal models involved training separate components for different modalities and then stitching them together to roughly mimic some of this functionality. These models can sometimes be good at performing certain tasks, like describing images, but struggle with more conceptual and complex reasoning…

…Gemini 1.0 was trained to recognize and understand text, images, audio and more at the same time, so it better understands nuanced information and can answer questions relating to complicated topics. This makes it especially good at explaining reasoning in complex subjects like math and physics.

We designed Gemini to be natively multimodal, pre-trained from the start on different modalities. Then we fine-tuned it with additional multimodal data to further refine its effectiveness. This helps Gemini seamlessly understand and reason about all kinds of inputs from the ground up, far better than existing multimodal models — and its capabilities are state of the art in nearly every domain…

…Gemini Ultra excels in several coding benchmarks, including HumanEval, an important industry-standard for evaluating performance on coding tasks, and Natural2Code, our internal held-out dataset, which uses author-generated sources instead of web-based information.

Gemini can also be used as the engine for more advanced coding systems…

…Using a specialized version of Gemini, we created a more advanced code generation system, AlphaCode 2, which excels at solving competitive programming problems that go beyond coding to involve complex math and theoretical computer science.

When evaluated on the same platform as the original AlphaCode, AlphaCode 2 shows massive improvements, solving nearly twice as many problems, and we estimate that it performs better than 85% of competition participants — up from nearly 50% for AlphaCode. When programmers collaborate with AlphaCode 2 by defining certain properties for the code samples to follow, it performs even better…

…We trained Gemini 1.0 at scale on our AI-optimized infrastructure using Google’s in-house designed Tensor Processing Units (TPUs) v4 and v5e. And we designed it to be our most reliable and scalable model to train, and our most efficient to serve.

On TPUs, Gemini runs significantly faster than earlier, smaller and less-capable models. These custom-designed AI accelerators have been at the heart of Google’s AI-powered products that serve billions of users like Search, YouTube, Gmail, Google Maps, Google Play and Android. They’ve also enabled companies around the world to train large-scale AI models cost-efficiently.

Today, we’re announcing the most powerful, efficient and scalable TPU system to date, Cloud TPU v5p, designed for training cutting-edge AI models. This next generation TPU will accelerate Gemini’s development and help developers and enterprise customers train large-scale generative AI models faster, allowing new products and capabilities to reach customers sooner…

…Gemini has the most comprehensive safety evaluations of any Google AI model to date, including for bias and toxicity. We’ve conducted novel research into potential risk areas like cyber-offense, persuasion and autonomy, and have applied Google Research’s best-in-class adversarial testing techniques to help identify critical safety issues in advance of Gemini’s deployment.

To identify blindspots in our internal evaluation approach, we’re working with a diverse group of external experts and partners to stress-test our models across a range of issues.

To diagnose content safety issues during Gemini’s training phases and ensure its output follows our policies, we’re using benchmarks such as Real Toxicity Prompts, a set of 100,000 prompts with varying degrees of toxicity pulled from the web, developed by experts at the Allen Institute for AI. Further details on this work are coming soon.

To limit harm, we built dedicated safety classifiers to identify, label and sort out content involving violence or negative stereotypes, for example. Combined with robust filters, this layered approach is designed to make Gemini safer and more inclusive for everyone. Additionally, we’re continuing to address known challenges for models such as factuality, grounding, attribution and corroboration…

…Starting today, Bard will use a fine-tuned version of Gemini Pro for more advanced reasoning, planning, understanding and more. This is the biggest upgrade to Bard since it launched. It will be available in English in more than 170 countries and territories, and we plan to expand to different modalities and support new languages and locations in the near future.

We’re also bringing Gemini to Pixel. Pixel 8 Pro is the first smartphone engineered to run Gemini Nano, which is powering new features like Summarize in the Recorder app and rolling out in Smart Reply in Gboard, starting with WhatsApp — with more messaging apps coming next year.

In the coming months, Gemini will be available in more of our products and services like Search, Ads, Chrome and Duet AI.

We’re already starting to experiment with Gemini in Search, where it’s making our Search Generative Experience (SGE) faster for users, with a 40% reduction in latency in English in the U.S., alongside improvements in quality.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have a vested interest in Alphabet (the company behind Gemini) and Costco. Holdings are subject to change at any time.

What We’re Reading (Week Ending 03 December 2023)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 03 December 2023:

1. Charlie Munger, Warren Buffett’s Partner and ‘Abominable No-Man,’ Dies at 99 – Jason Zweig and Justin Baer

No equal business partner has ever played second fiddle better than Charlie Munger.

Warren Buffett’s closest friend and consigliere for six decades, the billionaire vice chairman of Berkshire Hathaway died Tuesday at age 99 in a California hospital. A news release from Berkshire confirmed his death.

In public, especially in front of the tens of thousands of attendees at Berkshire’s annual meetings, Munger deferred to Buffett, letting the company’s chairman hog the microphone and the limelight. Munger routinely cracked up the crowd by croaking, “I have nothing to add.”

In private, Buffett, who is 93, often deferred to Munger. In 1971, Munger talked him into buying See’s Candy Shops for a price equivalent to three times the chocolate stores’ net worth—a “fancy price,” Buffett later recalled, far higher than he was accustomed to paying for businesses.

See’s would go on to generate some $2 billion in cumulative earnings for Berkshire over the coming decades…

…Buffett nicknamed Munger the “abominable no-man” for his ferocity in rejecting potential investments, including some that Buffett might otherwise have made. But Munger, who was fascinated by engineering and technology, also pushed the tech-phobic Buffett into big bets on BYD, a Chinese battery and electric vehicle maker, and Iscar, an Israeli machine-tool manufacturer.

Munger was a brilliant investor in his own right. He began managing investment partnerships in 1962. From then through 1969, the S&P 500 gained an average of 5.6% annually. Buffett’s partnerships returned an average of 24.3% annually. Munger’s did even better, averaging annualized gains of 24.4%.

In 1975, shortly before he joined Berkshire as vice chairman, Munger shut down his partnerships. Over their 14-year history, his portfolios gained an average of 19.8% annually; the S&P 500 grew at only a 5.2% rate…

…“I have been shaped tremendously by Charlie,” Buffett said in 1988. “Boy, if I had listened only to Ben [Graham], would I ever be a lot poorer.”

In 2015, Buffett wrote that Munger taught him: “Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.”

Berkshire “has been built to Charlie’s blueprint,” Buffett added…

…Munger also confronted tragedy: In 1955, his son Teddy died of leukemia at age 9. Munger later recalled pacing the streets of Pasadena in tears at “losing a child inch by inch.” More than six decades later he would still choke up at the memory of his son’s suffering.

In 1978, a surgeon bungled a cataract surgery, leaving Munger blind in one eye, which later had to be surgically removed. The investor refused to blame the doctor, noting that complications occurred in 5% of such procedures. For him, as always, it was about the numbers.

Munger taught himself Braille, then realized he could still see well enough to read. He ended up driving his own car, often to the consternation of friends and family, until his early 90s…

…At Berkshire’s annual meeting in 2000, a shareholder asked how the speculation in Internet stocks would affect the economy. Buffett answered with nearly 550 words. Munger growled, “if you mix raisins with turds, they’re still turds.”

When a shareholder asked at the 2004 meeting how Berkshire sets pay for executives, Buffett spoke for more than five minutes. Munger drawled, “Well, I would rather throw a viper down my shirtfront than hire a compensation consultant.”…

…Munger never stopped preaching old-fashioned virtues. Two of his favorite words were assiduity and equanimity.

He liked the first, he said in a speech in 2007, because “it means sit down on your ass until you do it.” He often said that the key to investing success was doing nothing for years, even decades, waiting to buy with “aggression” when bargains finally materialized.

He liked the second because it reflected his philosophy of investing and of life. Every investor, Munger said frequently, should be able to react with equanimity to a 50% loss in the stock market every few decades.

Munger retained his sense of humor into his 90s, even though he was nearly blind, could barely walk, and his beloved wife, Nancy, had died years earlier. Around 2016, an acquaintance asked which person, in a long life, he felt most grateful to.

“My second wife’s first husband,” Munger said instantly. “I had the ungrudging love of this magnificent woman for 60 years simply by being a somewhat less awful husband than he was.”

2. How Geopolitical Risks Are Impacting Iranian Stocks – Tracy Alloway, Joe Weisenthal, Aashna Shah, and Maciej Wojtal

Maciej (04:03):

But what’s interesting and why we are doing this is that you mentioned that you were surprised how big Iran’s economy is and I would say that no, it’s actually very small compared to how big it could get because Iran, you know, it’s around 90 million people, the largest combined oil and gas reserves in the world, and a properly developed and diversified economy. Well, thanks to decades of sanctions, they didn’t have a choice. They had to develop all different parts of the economy.

And all this— in terms of GDP — is around, depending how you calculate it, but it’s around $200 billion. Now when you look at Turkey, which is a similar size country in terms of population and geographical size, but no natural resources, Turkey is around $800-$900 billion. If you look at Saudi Arabia, which has no other sectors except for oil and some petrochemicals, the GDP over there is around $1 trillion. So in some super optimistic, very positive scenario, if everything went well for Iran, Iran could become basically the combination of the two, which is anywhere between $1.8 to $2 trillion dollars.

So the upside for the economy is eight times from where it is right now. So this is the potential, this is the optionality that is in the market. On top of that, once the country starts to open up, obviously there is a long list of things that would have to come in place, then we expect to see a lot of capital flowing into the market and right now it’s only domestic capital and us, which means that because there is not enough capital the local assets are valued at very low levels.

So what we are seeing in the market is that we are buying stocks at four to five times forward net earnings and those earnings are growing, they are paying dividends. The average or the median dividend yield for the top 100 companies is probably close to 15%. So strong double digit dividend yields valuations at such levels that they cannot really fall further as long as those earnings are growing.

So investment risks are pretty small, pretty limited. You have different sorts of risks. You have geopolitics, exactly as you mentioned. I mean those equities basically are priced for war and obviously there is a reason, there might be a reason for that. It’s because it’s the Middle East and it’s amazing how the narrative, you know, the region reminded everyone that the situation and the perception of the region can make a u-turn overnight. Because a month ago, it was not only what you mentioned in the introduction that there was some sort of arrangement between Iran and the US which led to the prisoner exchange, which was very important because historically prisoner exchange was usually the first step to something bigger. Then on top of that, Iran is selling a lot of oil so obviously sanctions are probably not enforced very strictly and so on.

But the bigger story a month ago was in the whole Middle East where Iran basically signed what you can call a peace treaty with Saudi Arabia after many years of not having diplomatic relations. Then what followed were discussions and restoration of diplomatic ties with Iran and Egypt, Bahrain, all Saudi allies and so on…

…Maciej (12:22):

So on the seventh of October, I believe that it was the case for the whole region that the local currencies sold off and local stock markets went down. What happened was that initially everything went down. For the first three weeks, the local equity index measured in dollar terms was going down with the lowest point around 10% in terms of the correction.

Since then it started bouncing back. In local currency terms, the equity index is actually at the level from the seventh of October so it made up for all the losses. The currency is still down. So for a foreign investor who is measuring the P&L in dollar terms, you are still roughly 3% down. So it’s actually not that bad given the circumstances, given the risk for local markets and especially Iran which is involved in everything that is going on.

The worst case scenario is that potentially there is a military conflict war, and I don’t know, Iranian refineries or petrochemical plants are military targets and so on. And people were quite scared. We could see this. Some of the sectors went down in the meantime by about 20%, bounced back since then, but mainly that was happening due to very low liquidity.

So what was the biggest impact? Actually, we could see was on liquidity. Normal liquidity is around $150 million per day, and it went to as low as $30- 40 million. So what was going down the most was actually the most illiquid stocks or illiquid industries. So when I look at sectors that really were hit the most, it’s textile producers, confectionaries, so things that are not related to war or geopolitics at all, but they are basically illiquid.

And, oh. One thing important to remember, so the stock market is driven by retail investors. 90% of daily trading is done by retail. So, it’s very emotional, it’s very short term momentum, I would say. So they are selling or buying depending on the, you know, recent price action. So they were driving the share price direction basically…

…Maciej (15:36):

Yes, and the thing that is most volatile in Iran is the currency. So the stock market is much less volatile in the local currency than when measured in dollar terms. The local stock market is actually well hedged against currency depreciations because the majority of the biggest companies are actually exporters so they benefit from currency depreciation, but share prices react with a lag…

…Maciej (19:47):

There are two interesting facts about the performance of the market. So first of all, when I looked at the last 15 years and big geopolitical events for example, like previous conflicts with Hamas in Gaza, or there was a situation between Iran and the US where people were saying that this was close to a military conflict when Iranian general Soleimani was killed and then Iran retaliated by firing some missiles at an American base in Iraq. When I looked at the performance of the market, it never went down more than 10% in dollar terms, actually.

So what happened right now, I think the bottom was around almost 11% was pretty much in line with those historical geopolitical events that also presented a big risk for the local market. But another way of looking at the Iranian market is the historical performance. And this is very interesting because if you look at the performance of the benchmark equity index, it’s called TedPix Index, total return.

For the last 15 years, so since the inception in 2018, the annualized return in dollars is around 11%, which I think is quite amazing because it’s pretty much the same as for S&P 500, maybe 12% for S&P 500, so it’s in the same ballpark and the environment was completely different. I mean, couldn’t be more different because over the last 15 years in the US you had a technology revolution, those mega caps appearing on the market, interest rates initially going to zero, top of the cycle valuations and in Iran, you had two episodes of currency depreciation of more than 75%. You had some crazy presidents and you had US sanctions, UN sanctions and still, at the end of the day, when you compare performance over the last 15 years, it’s pretty much the same, obviously with much bigger volatility because in Iran, the volatility was probably around 40% or something.

But that shows you that when you’re buying assets at very, very low valuations, and I’m say talking about this four times net earnings, let’s say, and the economy and those companies are actually naturally hedged against the currency volatility or big depreciation, then even in those countries where things are going really bad you can still make money. But what is more important is that if in bad times you are still averaging 11% per year, just think what you can make, what you can expect, when things finally go the right way for Iran and the country opens up and so on? That’s the potential that we are obviously hoping for…

…Maciej (30:25):

There are several asset classes in Iran for retail investors. So real estate is the big one, the biggest one, but it’s a high ticket item so not everyone can trade in and out of apartments. It’s a well understood asset class as everywhere. That’s why it’s a bit less interesting for us. So if Iranians have any spare cash, they will buy real estate. From what I heard, 30% of apartments in Tehran are actually empty because they are basically used as a store of value just to park somewhere, assets, savings and they’re not even rented out, they’re just empty.

And also just bear in mind that in Tehran in the best places, the best neighborhoods of Tehran prices are quite expensive. So in the north of Tehran, if you want to buy an apartment, you have to pay around $10,000 per square meter. So a 100 square meter apartment, I don’t know three bedrooms will cost you a million dollars or something, in Iran, which is a poor country. So this is real estate. Real estate is the number one asset class.

Then a very important asset class are used cars. So people trade used cars because they are, again, a hedge against inflation against the currency depreciation, because car manufacturers will always adjust prices based on inflation. Some of the components have to be imported, which is not easy. They produce more than one million cars, or actually closer probably to 1.5 million cars per year, but this is not enough. So the demand is much higher.

So they’re trading used cars and there are platforms that help you trade used cars. It’s a proper asset class, and yes, every Iranian is actually a currency trader, because the currency has been so volatile historically. It’s very important that you know what’s happening to the dollar or the local currency against the dollar. So everyone is tracking the exchange rate and it’s not easy to buy and sell dollars. There are quotas for individual Iranians due to capital controls. So that’s why, instead of buying dollars or to get a bigger position, they go to those proxy asset classes, like used cars or real estate. Also interest rates so you can buy/sell Treasury bills, Treasury bills up to two years maturity. They pay around 25% yield to maturity, maybe a bit more right now so interest rates are high.

When you look at Iran, there is not enough capital there. There’s basically not enough money, credit doesn’t exist. I mean, you cannot get a mortgage at 25%, right? I mean, you cannot finance anything at 25%. And because of very volatile macro people also tend to postpone investment decisions, whether these are individuals or more importantly companies, right?

Everyone is looking like six months ahead, maybe 12 months ahead, right? And they are managing a crisis, because there is always some sort of a crisis, right? So when you think about it, for example, I don’t know, every company is running big inventories just in case, just so that they have enough material to manufacture their products. So they’re not optimized, organized in this very efficient, lean way. They are organized just to survive, basically, war conflict, currency depreciation, sanctions, trade disruptions, whatever…

…Maciej (35:41):

So when sanctions were reintroduced in 2018, they haven’t hurt manufacturing, they haven’t hurt exports, companies that much, to be honest. I mean, because people find a way. I mean, companies that export in the region, they’re not really affected by sanctions, big exporters that used to send products to Japan and so on, yes, they were affected, but they found other routes and manufacturers.

Sanctions caused one thing. I mean, sanctions caused currency volatility so the big depreciations of Rial and manufacturers who have costs in Rial, but they either sell in hard currency or at prices linked to some regional benchmarks that are in hard currency, their margins actually expanded.

Look, it’s an interesting thing that the highest earnings growth that we’ve seen over the last couple of years was one year after the 2018 sanctions. This is crazy because this is not intended, I would assume. And, who got hurt by sanctions? Well, households, because they are price takers. So when the inflation shut off because of the currency depreciation, their spending power went down massively, right? And they were able to survive and it was actually quite interesting that they were holding up quite well. And this is because of those savings, right?

Because of the savings that Iranian households had. I’m not sure what’s the situation right now, because they’ve been, I think, on a net basis, those savings have been decreasing over the last couple of years because they had just had to spend them. But yes, that’s what helped them survive the inflation basically.

3. Frugal vs. Independent – Morgan Housel

Frugal, by my definition, means depriving yourself of something you want and could afford.

Not wanting something to begin with because you get your pleasure and identity from sources that can’t be purchased is something entirely different. The best word for it is probably independent…

…The world tells you – even by a mere whisper – that everyone should want the same things: A big house, a nice car, advanced degrees, credentials, social clubs, etc.

I like most of those things. But you have to realize how much of their appeal is an attraction to status, which can be completely different from happiness.

There’s a recent example of someone understanding the difference in real time that I think is more fascinating than Holt or Read’s story.

Chuck Feeney, who founded Duty Free stores, died last month.

The well-known part of Feeney’s story is that he gave away 99.99% of his $8 billion fortune years ago, before he died. He and his wife kept $2 million, lived in a small apartment, flew coach, and gave the rest to charity.

The less well-known part of Feeney’s story is that he once gave the High Life an honest try. The Washington Post wrote of his life in 1980s, when he was newly rich:

He had luxury apartments in New York, London and Paris and posh getaways in Aspen and the French Riviera. He hobnobbed with the other mega-rich on yachts and private jets. If he wanted it, he could afford it.

He quickly realized it wasn’t for him. Society told him he should want those things. But it wasn’t what actually made him happy.

Giving money away was.

“I’m happy when what I’m doing is helping people and unhappy when what I’m doing isn’t helping people,” Feeney said…

…He didn’t follow a typical path of what other people told him to like or how to live.

He found what made him happy.

He may have looked frugal, but he was actually the freest, most independent person you’ll ever hear of.

4. Value Investing with Legends: Nicolai Tangen – Decision-Making and Intuition in Investing (transcript here) – Michael Mauboussin, Tano Santos, and Nicolai Tangen

Mauboussin: What motivated you to do that? And a slightly odd question. Do you see parallels between the investing and the art worlds at all?

Tangen: So I had been very well paid at Egerton and so could afford to take a break. I wanted to do something which was very different. And so I studied German Expressionist Woodcuts, pretty black and white. And it’s wonderful to study with people who think differently and who really want to dig down. And of course, you get your attention span back up from like 2 seconds to 2 hours when you have to write a dissertation and so on. So that was good.

Are there any similarities between art and investing? Well, I don’t think so. Some people claim there is. It’s not for me. I love art because it’s very different from what I do on a daily basis. But perhaps it’s good for creativity. It’s certainly good for the soul. It’s fun, it’s beautiful, interesting.

Santos: You know, when I was telling that we had this point of connection, it’s because I came very close to studying art history when I was a young man. I became completely obsessed with our history. And I spent every summer during my teenage years travelling around France and Italy, trying to absorb as much as I could, you know. And at some point I learned that I also like teaching, so that’s when I decided to go in a different direction. But you’re absolutely right, it’s something that sustains you throughout life.

Tangen: A big difference is you study art, it’s something dead, it’s on the wall. Finance, it’s alive, it’s incredible. I just think finance is just an amazing thing to study because it’s everything that you eat, wear, drive, consume, all these kind of things. It’s about the people, it’s about the psychology, it’s about corporate culture, it’s about – in the market, greed and fear, it’s related to macro. Security, wars, geopolitics and it changes all the time. All the time. And if you’re good at it, you make money. And so it is just the most interesting thing you can ever spend your time doing…

…Tangen: Now, we started off as a mid cap firm and then gradually went a bit larger cap because we thought we could add value also there. Also gradually we gravitated towards the higher quality spectrum of stocks and now that’s all I care about. It’s the high quality end. It’s companies which can grow earnings, high return on capital and solid moats. A lot of these things we look for. The rest of it is basically a waste of time. The fewer decisions you can make, the better they become. So if you can just sit there and compound, I just think it’s such a wonderful idea. Is it easy? No, it’s super tough. It’s super tough.

And why is that? Well, I kind of think, you come home from work, your husband or wife asks you, “What have you been doing today?” “Well, I’ve done nothing.” Next day, Tuesday, “What have you been doing today?” Nothing. Wednesday, nothing. Thursday nothing, Friday nothing. You just feel like a failure. So therefore you feel you have to trade a bit, but it’s mostly not very profitable…

…Mauboussin: Do you guys know this book came out this year called How Big Things Get Done? Do you know this, Nicolai? Bent Flyvbjerg and Dan Gardner?

Tangen: Yeah, I read it. It’s very good.

Mauboussin: But I think Chapter One is called Think Slow, Act Fast. And I really like that because the “think slow” part is, a lot of it is contemplation and from time to time you do have to act quickly. But for the most part it’s just sitting around and thinking and trying to line things up. You mentioned that finance is wondrous. I clearly agree with that. But I do want to come back to one of the educational items on your CV and that’s a Master’s in social psychology from the London School of Economics. And I believe you’ve suggested that social psychology is something that everyone should study. I think we spend a little bit of time on it in our finance curriculum, but probably not as much as we should. So tell us a little bit about your takeaways from studying behavior and how that applies to markets, both in good times and in challenging times.

Tangen: I think everybody should study it. And I saw that increasingly everything I read was within the social psychology area and I did it actually part time when I still ran AKO. I did my dissertation on looking at gut feel versus analysis and I interviewed the 15, who I thought were the best performing fund managers in Europe, and analyzed how were they actually going about making decisions. And it’s quite interesting because psychologists don’t typically have access to these well paid hedge fund managers and so on. So it was kind of gold dust kind of sample that I had there.

And what you see is that people, if you call it gut feel, nobody believes in it. If you call it pattern recognition, everybody believes in it, even though it’s the same thing. You don’t believe in anybody else’s gut feel, only your own. And you can mainly use it if you are quite senior in the firm, because you can’t come and say, listen, hey, I’m 22 years old, I really believe I have a gut feel that this and that. Now you’re 55, you’re the boss, everybody listens to you and you have more data points and more experience. So your gut feel is basically better or pattern recognition. That’s interesting. Then you use it when you have very little time, when things are urgent, and you use it when the problems are really complex and difficult to analyze.

My impression was that the best ones go from one to the other, so it depends on the situation. But that was really interesting…

…Tangen: I also spent time on people’s risk appetite. Now it’s very, very important when you run an asset management company, is to understand people’s risk appetite. Risk appetite is linked to different things, such as gender. So women take less risk than men. And you only look at the drowning statistics from Norway. Nine out of 10 people who drown are men, so they take more risks. You see it in traffic accidents and so on. Has to do with age, has to do with geographies, introvert, extrovert. So introverts take less risk. And you need to know that, because if an introvert woman aged 50 comes to you and want to take risk, that means something different from an extrovert guy, 22, from America. You need to dial it up and down. The noise level is really, really important.

The last thing I spent time on in social psychology was just to how to unbias your decisions. Extremely important that you’re able to question your own decision making and change your mind when the facts change. So really interesting, everybody, you just have to study it. It’s just the best thing to study.

Mauboussin: So, Nicolai, on that last one, are there a couple guides you would give to folks to debias as they go through their process, or there are tools that you would pull out?

Tangen: Well, the biggest bias people have is the fact that you don’t think you’re biased. Adam Grant’s book, Think Again, the whole mindset there of confident humility, that’s where you need to be as an investor. You need to be confident and you need to be really stubborn, because where you make money is, of course, where you do the opposite of everybody else. But when things change, you just need to change your mind. So that combination of being stubborn and agile is rare. But those are the guys who make the most money. I mean, look at Stan Druckenmiller, who is very confident about his decisions, but then, bang, something changes and he changes tact…

…Tangen: I sail. And at that stage, I sailed quite a bit of competition and I sailed with some spectacularly good sailors, some Olympic people. And I asked, why are you so good? And the whole debrief process was key. So two things which were key to their success. It was the bounce back ability – so how you get back on your horse after a loss, which you also, of course, need in investing. But then the debrief process was really important. And so we started to work with sports psychologists in terms how to improve these kind of things.

And one of the important thing when you look at high achievers in sport is that they focus in on the process rather than the results. And if your process is right, the results will come. And of course, in investing, this is more important than anywhere else, because in investing in the short term, there is just no correlation between process and outcome, whilst in the long term, that’s what it’s all about. And so you need to judge your process. And we kind of split the investment process into different categories and then we graded each analyst on each part of that process with regular intervals. And that’s a really good thing to do because if you go through a period of underperformance, as long as you see that your process is improving, you shouldn’t be too depressed about it…

…Tangen: I probably spend more time now on corporate culture than I did in the past. It’s so unbelievably important. And you have two companies which from the outside look exactly the same, right? They pretty much have the same product and so on. And then one of them is doing extremely well, and the other one is just not doing well. Gee, look at the banking. Look at the banking sector. On my podcast, I interviewed James Gorman, 14-year CEO of Morgan Stanley, and how Morgan Stanley has really done well compared to other banks. So it’s just intriguing how important corporate culture is. And that is also something that CEOs are very keen to talk about but the analysts generally are not so keen because the result of corporate culture work you see only in the long term, and most of the analysts are very short term.

And another interesting thing is that when you are young, you’re 25 years old, you are so in a hurry, despite having the whole life ahead of you. Now, when you are like 57, like me, and about to die, you suddenly get this long term time horizon. It makes no sense. But I think that’s just interesting. And I just met this 85 year old Spanish guy the other day and he was just planting some pistachio trees and he couldn’t wait. I can’t remember how long time it took for them to bear fruit, but it was certainly – I mean, he would probably not be alive then. He was really excited about it. I thought that was so cool…

…Tangen: Norway found oil in 69, on the very last attempt, on the very last well, they were drilling. If they hadn’t found oil on that last one, they would have just packed up the toys and gone home. So pretty amazing. Now, this was told to the Norwegian people on the day before Christmas Eve, 69, and wow, what a Christmas gift.

But the thing was that was it really? Because in a lot of other countries it had been a curse and it had led to corruption and crowding out effects and so on. And then some very clever politicians decided, you know what, let’s put the money into a fund. So they did, 27 years ago, started with a deposit of 2 billion Norwegian kroner, and that has now grown to more than 15,000 billion. So it’s been just an unbelievable success…

…Tangen: Now we are also generally pretty vocal on ESG because we think it’s very very important. We do think the link between climate and finance is strong and getting stronger. Climate is driving food inflation through bad harvests and food price increases. It’s also not driving it through productivity. So that link is strong and established…

…Mauboussin: So, Nicolai, when you end up hanging up your cleats, finally, how will you define success for the fund? I’m sure returns are obviously very important, but what other factors you think will be important to judge your success, as CEO of Norges?

Tangen: We have a clear goal in our strategy document. We want to be the best large investment fund in the world. How do you define that? Well, one thing is performance, but it has to do with process, reputation, risks. And also, I would judge it, just how happy are people working there? Are they using their full potential? Are they thriving? Do they have a good life? Very, very important. And are they having fun? Fun – completely underestimated. People who get fun, they’re more creative. It’s a great leveller. It’s kind of, in a way, the goal of everything we do. You want to have fun and you want to be fulfilled…

…Tangen: I do think a lot about productivity and the lack of productivity growth. And in particular, I’m thinking about Europe versus the US. Because in the US, there is more innovation, there is more speed, and Europe is pretty slow.

And what is it with Europe? Why don’t we have great technology companies? Why is growth pretty pedestrian? And it’s just a combination of so many things. It’s a mindset thing. In Europe, we think 2% growth is fine. Well, perhaps it should be five, perhaps it should be 10. We have very few kind of hairy goals. And you read the Elon Musk book and you understand what a hairy goal is. The speed, the speed by which you move. It just struck me here. I’m in New York now, and just the speed by which they pack a sandwich, right? It’s just like five times quicker than they do it in Europe. The depth of capital market, the lack of depth in the corporate bond market, you’ve got more risky capital here, or risk-seeking capital, you’ve got more venture capital. You can fail. And now in Europe, it’s not good to fail. Much bigger public sector, which probably slows down the thing. I really think union is a great thing, but it does something with structure of businesses. So you have a whole range of things which make Europe slower than America, then that worries me. But I’m doing more work here. This is my next thinking project. Really interesting.

5. Parallel Bets, Microsoft, and AI Strategies – Matthew Ball

Parallel bets strategies are best suited to (1) cash-rich companies . . . that are (2) pursuing “must-win” categories” . . . in which (3) their assets and strategies are a good fit . . . but (4) may not be configured correctly . . . and (5) there is a high rate of change . . . and (6) many uncertainties . . . and (7) many players . . . with (8) progress often occurring out of sight. Deployed correctly, a company can cover all of the bases while also neutralizing the existential threat of a new competitor. Parallel bets are therefore likely the right strategy generally for “Big Tech” and during this phase of AI, during which there are many unresolved and interconnected hypotheses.

Will closed or open models be more capable? If closed models are technically superior, will open models nevertheless be considered “superior” on a cost-adjusted basis? What is the trade-off between the quality of a generative AI response and its cost? How does this vary by vertical?
How many of the potential uses of generative AI will result in new companies/applications, rather than new or improved functionality in the products of existing market leaders? Put another way, is the technology or distribution more important? Is there a hybrid model in which users access existing applications, such as PhotoShop or Microsoft Office, but while logging into a third-party AI service, such as OpenAI?
Which AI products or integrations will warrant additional revenue from the user, rather than just be baked into the core product as a new table-stakes feature?
To what extent are the answers to these questions path-dependent, that is, subject to specific decisions by specific companies and the quality of their specific products—as was the case with Meta open-sourcing its Llama 2 LLM). And how, again, do the answers differ by vertical

Eventually, though, it will be necessary for parallel bets to be winnowed; all strategy is eventually about execution. Note how quickly Microsoft focused its OS strategy on Windows after the success of Windows 3.0 in 1990 (the company was later accused of following an “Embrace, Extend, Extinguish” model where one-time partners would be crushed once emerging markets stabilized). The questions here, of course, are “When,” “How Much,” and “How do you know?”

Microsoft never halted its investments in applications and productivity tools, nor Internet services, and is better off as a result. Sometimes parallel bets lead to growth in new adjacent markets, rather than displace a current one (to that end, Microsoft’s more direct OS-bets were eventually paired). It’s possible that Amazon’s Alexa device footprint will still yet enable the company to regain market leadership. Indeed, OpenAI’s CEO, Sam Altman has confirmed reports that it is considering its own foray into consumer hardware (led, according to rumours, by Apple’s long-time design chief, Jony Ive).

And sitting alongside all of the above considerations is the biggest question: how might the focus on current AI architectures and opportunities distract from the development of artificial general intelligence? John Carmack, who is considered the “father of 3D graphics” due his pioneering work at Id Software, which he co-founded in 1991, and joined Oculus VR as its first CTO in 2013, founded his own AI start-up in 2022, Keen Technologies, which is exclusively focused on developing artificial general intelligence. According to Carmack, the number of [contemporary] “billion-dollar off-ramps” for AI technologies has become a de facto obstacle to achieving true AGI. “There are extremely powerful things possible now in the narrow machine-learning stuff,” Carmack told Dallas Innovates in his first major interview after founding Keen, “[but] it’s not clear those are the necessary steps to get all the way to artificial general intelligence.”

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have a vested interest in Microsoft. Holdings are subject to change at any time.