Low interest rates are cancerous.
Low rates have created huge structural imbalances.
Economics without accounting is voodoo – Life in a frog pond – Low rates and disappearing equity – The cancer in the system – Chemo can hurt the host also – Further danger in the system – What to look for in valuable businesses.
Economics without accounting is voodoo.
It would be obvious to a pink plastic lawn pelican that modern Keynesian macroeconomics is a corpse awaiting burial. They’re continual changing equations to get desired results is bad enough, but the absurd measure of GDP is clownish.
How can you say the economy is increasing when the government at no level can finance itself? How? By claiming money expansion is growth.
But what stunned me was discovering that economics does not require a working knowledge of accounting.
Why accounting matters.
In business (Or any endeavor) what you know is not as important as how you’ve learned it.
It’s not enough to read a balance sheet. You have to understand the parts and what they do. “Property, plant and equipment” is a system, not a number. Just because long term debt isn’t due now, doesn’t mean it will never be due. It’s not enough to discount earnings. You must analyze what “Property, plant and equipment” will be producing when the debt is due.
Pensions are allowed to amortize losses over long periods of time. Like debt, that doesn’t mean the liability isn’t due, only that it’s put off. Pension repayments for investment losses is not a deduction.
In other words, “Property, plant and equipment may become redundant when the debt is due, and companies have to fund prior investment losses with earnings they do not have and taxes they’d have to pay if they did have earnings. In other words, the 2009 General Motors bankruptcy. The financial media said their bankruptcy was unpredictable.
Life in a frog pond.
Every system be it political, cultural, or economic is a frog pond. In other words, a closed system that few frogs can ever escape. As much as CSX would love to spread its wings and fly, in the end it’s stuck with 10’s of thousands of miles of tracks, hundreds of trains and delivery contracts.
Every time their senior management returns from an Awaken the Power Within seminar, they face the same reality. “Oh shit, we’re still running a railroad.
A railroad is a frog pond with rails.
In fact, probably the best example. The structural rigidity is what makes it so.
In systems engineering, systems become rigid because of their inability to change quickly. But this should not be confused with management failure. In the frog pond, the frog has water, bugs, the weather, animals that eat them and disease. In other words, the rigidity comes from the environment.
Of course, unlike the frog, a railroad can defend from rigidity by, say, saving money, prepaying its pension, or buying a company that’s not a railroad.
But railroads have debt covenants, investors, and greedy short-term executives. (The carnivores in the railroad frog pond)
Low rates and structure.
Low rates are great… providing you are borrowing money.
If you own a shoe store and have been slaving to add inventory over the years (Inventory build is an after-tax item.) and a guy can borrow at 1% and fill up a store with new shoes, you’re screwed.
In other words, low rates destroy equity.
This destruction of equity is usually hidden from sight. Let me give you an example.
After the great rate transformation of 1997 and onwards, low rates allowed US corporations to offshore production to China. They closed their US operations and reopened in China.
From an accounting standpoint, these moves were nearly “cost” free. Many if not most of their US operations were already written off, like GE’s huge Schenectady operation.
The new operations were more often than not owned by surrogates. Apple does not own Foxconn.
How is the move hidden?
Imagine a company makes blue jeans. The retail price in the US is $75. In a US factory, the cost is (say) $30. There is another $20 in retail costs, leaving a margin of $25.
The US company offshores to Pakistan. The cost in Pakistan is $10 a pair. (That’s an overestimate, the real cost is probably lower.)
Unlike the US, Pakistan has cheap labor, no real labor laws, comical environmental standards, and slave management.
From a balance sheet and income statement perspective, most of what you see is the profit. There’s no change is Property, plant, and equipment. You go from it was written off (zero) to it doesn’t exist. (Also, zero)
In inventory, you don’t even have in process inventory… materials, labor, etc. It comes in the door as jeans.
There’s typically an increase in selling costs because mall space is expensive, but these gaudy, classless retail casinos are also leased. (No building, no debt to purchase it)
How did that destroy equity?
At balance sheet glance it doesn’t, but in reality the US operation HAD value. That value was hidden. What made the move work was low rates. (Among other factors)
Most of the railroad tracks in the US have been here since the 19th century. The tracks have been replaced and new trains purchased, but the intrinsic value of the railroad remained.
But, as we know, a railroad is in a frog pond. How do low rates ruin the frog pond?
The cancer in the system.
To understand the cancer in the system, one must learn to think in duration space.
The best way to imagine duration is in mortgage pools.
Imagine you have a pool of 30-year fixed rate mortgages all pooled at the same time. The initial duration is 30 years, but mortgage pools never have 30-year durations. Houses are sold or the loans refinanced, and the mortgages paid off.
This means although the initial pool is 30 years, the underlying mortgages don’t last that long.
Mortgage pools live in dynamic space. When rates are falling and prices rising, real estate becomes hyper liquid. People upgrade or refinance to add new kitchens and swimming pools. That original duration can go from 30 years to under 10.
Duration in processes is the same as mortgage pools.
Because money is cheap, or free, any process can be easily replicated by a competitor. So, as rates fall, more competitors emerge. Armed with free money, they recreate processes they believe will make them money, and ordinally they do.
Look at coffee shops and micro-breweries. These “businesses” have a life expectancy of a fruit fly. Here in Vietnam, I walk by a dozen empty coffee shops on the way to the coffee shop I frequent. The same is true in the US where we operate Landon Fillmore Systems.
Since 2010, microbrewery closings have increased 600%. These closings are nothing compared to malls. Hundreds of billions of dollars of mall space have been bull dozed down. Ditto for office space.
In other words, corporate duration is collapsing.
They also create zero duration businesses.
These “businesses” are those that are never profitable and in fact, didn’t have a rats ass chance when they were started. These include lab grown meat, loony energy companies, pot farms and the like.
Any duration these fart factories may have had was always a fantasy.
Chemo can hurt the host also.
If the water freezes all the frogs die. But if it cools, only some do. The rise in rates will hurt entities that rely on low rates but help certain frog pond companies that didn’t get invited to the free money party.
It has already trounced 401k investors in bond mutual funds. In my opinion bonds are still absurdly overpriced based on current short rates and potential bond defaults. (1)
Just as rate reductions cause mortgage pools to lose duration, real estate prices to rise, and real estate become hyper liquid, the opposite is true when rates rise.
These rate increases eventually cause retail sales to fall, which makes the entire transportation sector lose money. The S&P transport sector peaked in 2021 and has been looking for footing ever since. (2)
Further danger in the system.
Corporate taxes.
In our opinion, this is a bigger danger than people realize. With the average CEO living like Caligula pissing away their Trump corporate tax cuts on greedy share buybacks, the writing is on the wall.
The average US corporation pays about 20% in corporate taxes. It’s hard to argue that you can’t afford $300bn in taxes when you spend $1 trillion on share buybacks. I believe the top corporate bracket will go to 39% initially, to match the top personal bracket.
The end of share buybacks
This will be a train wreck to companies share prices.
When rates were near zero, companies borrowed heavily to fund share purchases. The increase in taxes and interest rates will make most of the $1 trillion in buybacks non-economic. (They were, frankly, not economic when rates were near zero.
There is no process in a share buyback. It would be like the frogs draining water from the frog pond and eliminating living space for the tadpoles.
The end of 401k’s.
The corporate purpose of the 401k was to remove the (large) permanent unfunded liability from a companies balance sheet. (This was what blew up GM and GE.)
Given their penchant for share buybacks it can be assumed that companies could care less about large unfunded liabilities. But there are two huge problems with 401k’s.
First and foremost, they are extremely expensive. If you pay an employee $100,000 a year and have a (effective) 7.5% match, which is what we have, your cost is $7,500 per year plus the cost of administration. A defined benefit plan’s annual cost for a young employee is perhaps 15% of that.
The reason is you are funding a discounted future benefit of (say) 40% of their average preretirement salary at age 65 with at least 30 years of service. These plans typically do not allow lump sum distributions. In other words, more than half of this cost will come due 10 years (on average) after the company ceases to exist. (Talk about amortizing costs)
Second is that one of the huge challenges to companies today is employee retention. How can you retain an employee if he can walk away with your $7,500 15 minutes after you put it in his account by quitting his job?
Never underestimate how much an Ivy League B-schooler can fuck up a company.
An associate of mine once worked for a company riddled with top heavy Ivy League grads. They had taken in and pissed away $2 billion and still didn’t have a product!!
David Iger’s destruction of that which could not be destroyed (Disney) is case #1, front and center. But the mother of all B-school losers was Jack Welch of GE. (3)
Hundreds of these new generation companies are run by people who couldn’t run a corn dog stand if they had to cut a profit. The common theme is that they “ran out of capital,” as if making a profit was somehow not a part of business.
What to look for in valuable businesses.
Look for businesses that can invest in themselves.
Great examples today are mining and oil companies.
These companies typically use free cash flow to expand. In other words, they can invest in themselves without outside funding. Much, if not most of the cost will show up in the early years as losses because these processes are written off at the rate they are purchased. (Providing it’s a long-term investment strategy.) Good examples are Kinross gold, Rio Tinto, etc.
Don’t just look at financials.
They can be highly deceptive. If you look at the fracking industry, they were written off as dead 20 years ago. But oil companies constantly innovate their processes.
Recovery rates in fracked wells are in some cases double what the estimates were even 10 years ago, let alone 20. From the standpoint of systems engineering, oil is the most innovative industry in the world.
Pay close attention to senior management. If you’ve followed Elon Musk’s takeover of Twitter, like him or not, it’s staggering how fast that man can innovate.
Look to foreign shores.
It would be silly to think the US market is where the value is. Most US companies are insanely overpriced.
Foreign companies may be hard to understand. They don’t always use standard US cost accounting principles, especially in countries like South Africa.
In addition, you have to have a good handle on geopolitical risk. To do this you must take off your political blinders an imagine yourself a CEO. You’re trying to make money, not run Myanmar. Put yourself in their shoes. How do they think? What do they want? Where do they hire their engineers. What is the CEO’s background.
We use a number of services but one you may be familiar with is Marc Faber’s “Boom, Doom and Gloomreport.” Faber, a Swiss, has been working out of Chiang Mai, Thailand for several decades. He has enormous Asian resources but is also good with value, especially resources and mining.
Use the options market.
When rates rise, interest becomes enticing. So why not take 90% of your money and get that 5.5% and put 10% in long term call options on deeply discounted companies?
In other words, why risk a 50% loss on all of your money when you can get the same (or greater) return risking all of 10% of your money. There comes a point where average guaranteed sex once a week is better than great random sex once a year. So why not do both!!
That said, we don’t suggest you play the options market. We typically buy long dated calls. The bid ask spreads on these things are typically high, (say 0.90 to 1.5) for an option 20% out of the money. We usually put in an offer a bit shy of the ask.
Again, we’re buying a deeply discounted company with a PE of 5-8. We’re looking for the shares to double in price, so we want a lot of cheap shares.
We also shy away from shorting, but keep in mind, Landon Fillmore Systems is not primarily an investment company. We make investments because we have to. Given our deep dive into integrated financial systems and international tax, we’re in that space anyway.
To Summarize…
Keynesian economics is like communism. It’s not an economic system based on either science, logic, or predictable results. It’s just an excuse for what countries and banks want to do to make money.
Democracy works? Show me where? There isn’t a democracy on the planet that isn’t unraveling.
To better see this, imagine the world in duration space. Think of everything in a space-time continuum. Break companies down into processes, not earnings. What is their frog pond? How does a change in the water temperature affect their ability to survive? Are the managers draining their own pond. (Share buybacks) Can their process outlive the debt they used to create it?
Thinking of investing in Brazil? Hmm, where in Brazil? Is Amazonas as safe as Rio Grande do Sul? You might want to read up on that. Hong Kong? Perhaps Kuala Lumpur has less geopolitical risk. Vietnam? I’m here right now. Come on over.
You might find the change in paradigm refreshing.
