Odd Lots - John Hempton on What's Ailing Bank Stocks

Episode Date: August 19, 2019

We live in a world of generally expensive stock markets and bank equities trading at 30-year lows. So says John Hempton, co-founder of hedge fund Bronte Capital and a former bank analyst, who also calls it "one of the great puzzles of the world." On this episode, we take a special trip to Australia to speak with Hempton about banks and how they fit into the way he evaluates good businesses and promising stocks. He notes that bank profit margins have been declining in places with both positive and negative rates. We also speak about how he picks stocks in a market currently trading at eye-watering valuations, why you shouldn't necessarily seek 'value,' and what investors can learn from the early 2000s tech bubble.See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa, play the podcast Oddlots on Amazon music. Hello, Oddlots listeners, it's Tracy Alloway. Before we get to today's show, I have a bit of news. It's something I'm really excited about. Oddlots is hosting its first ever live event on Thursday, September 19th, in New York City. Join me and Joe Wisenthol as we host. an all-star lineup of guests to talk about everything from white-collar fraud to sovereign debt and much, much more. This will be a group of new oddlots guests plus a few old favorites. We'll also have live finance theme music as well as drinks and just overall great conversation. Details of the lineup are going to come out very soon, so keep listening to Oblots to learn how to sign up to see us live on Thursday, September 19th, in NYC.

Joe and I both hope to see you there. And welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. My co-host, Joe Wisenthal, is away this week. I happen to be on a work trip to Australia. I've never been before. It's fascinating. I have big plans to meet a koala.

But beyond that, I also happen to be in the country for a momentous historic occasion, which is the benchmark Australian bond yield dipping below 1% for the first time. I was also there when the Reserve Bank of New Zealand opted to cut rates by 50 basis points, which was something that shocked the market. And just a couple hours later, we had rate cuts from the Central Bank of India and also the Central Bank of Thailand as well. So clearly we are in another cycle of fresh monetary easing. And along with these lower yields and interest rates around the world, come lower bank stocks. Bank valuations are trading at historic lows, partly because of concern about bank's ability to make profits on lending when rates are this low.

And who better to talk about all of this than John Hempton of Bronte Capital, someone who's been writing about the financial markets for a very long time on his blog and also invests in them through a long and short hedge fund. John, it's so nice to meet you in person finally. Thank you. I'm a little bit in awe of that requirement to speak about it generally because I like to about these things rather specifically. I started my career in financial markets as a bank analyst. So once upon a time I read more or less every bank account for every major bank in the world.

And along the way I decided that they were largely not very good businesses. There are exceptions. There are extremely good oligoplies in some countries, Canada, Australia, Scandinavia. There are a few banks that have large captive businesses that should be very cheap to run. The trust banks come out. But as a general rule, most banks are not very good businesses, but they mask themselves as pretty good businesses most of the time. How do they do that? Well, firstly, they're very powerful because they have access to large amounts of money.

And being powerful means that you just get a lot of press. journalists seem to be too interested in bankers, the world seems to be too interested in bankers. The second reason is that you can deceive yourself for a very long time running a bank. Banks are quintessentially estimate machines. And thirdly, every now and again, they really are very profitable. We're looking at the moment at banks across the world, except in the United States, basically at 30-year low. A lot of the European banks, and it's not just Deutsche at 30-year lows, if you look at Sochgen, it's at a 30-year low. If you look at credit agricole, UBS, the English banks, they're all at 30-year lows. And I live in a world of extremely expensive stocks. And so suddenly I feel like I want to be a bank analyst again, just because, you know, these things look cheap. So I've been puzzling myself a bit about bank margins for a while. Now, I'm going to lead you back to an article that was appeared in The Economist on January 15, 1998.

And the article is just comical when you read it now. It's called the Lloyd's Money Machine. And at the time, Lloyd's TSB, as it then was, was the 35th biggest bank in the world by asset and the biggest bank in the world by market cap. Ten years later, Lloyd's was essentially UK government property. But this was, it wasn't ordinary profitable. It was ferociously profitable. To pick an example, if you look at the banks in the world at the moment and do say revenue to risk-weighted assets. You see the Japanese banks at the lowest end and revenue is sub 1% of risk-weighted assets.

Then there are the German and Italian banks and the English banks get up to about 2% and a bit percent. And the English banks are in the order that you would expect with Royal Bank of Scotland being the and Barclays being the fattest margin, and the margin actually just matches the stock prices. And then sitting in the middle is sort of these American banks at about 4.5%, 5%. And then with an outlier. And the outlier is the one you'd expect, which is the most revenue-focused retail bank in America, the one that would do anything to, including steal from you, to get more revenue. and that's Wells Fargo, which is just the fattest margin better.

And at about the same sort of revenue to risk weighted assets, you see the Canadian banks is about 6%. And then the fattest margin banks in the world are the ones that speak in my accent. And it's just this really good oligopoly. But if I go back to this 1998 article, Lloyd's revenue to risk weighted assets at that time was 8%. Lloyd's in the UK made more money than the Australian banks do now. Wow.

It was just astonishingly profitable. And over the next 10 years, English bank margins went down, and then they went down a little bit more, and then they went down a little bit more. And eventually you had the wonderful institution called Northern Rock, which was the protagonist in all of this. and Northern Rock ran mortgages at about 60 bits of margin and about 25 bits of cost. And eventually they got down to 20 bits of net margin leave at 60 times to produce an 18% REOE.

But they managed to do this in a low but positive interest rate environment. I understand why English bank margins collapsed and why Lloyd's collapsed. the answer was, well, there was a large whack of competition. The banks will blame it on new regulation, right, and the fact they have to hold more capital and they can't eke out that much money per capital plus low interest rates. This predated that, right? This was pre-crisis. Lloyd's was ferociously profitable in 1998.

Its revenue to risk-weighted assets was north of eight. By 2008, its revenue to risk-weighted assets was subdued. You're talking the beginning of 2008 then, not after September 2008. The beginning of 2008, it was sub-two. And the problem is that when your revenue to risk-weighted assets went down that far, even small credit losses blew you up. Now, the beauty of the American banking system was that the revenue to risk-weighted assets never went below about four and a half.

You know, during the crisis, the banking sector had $330 billion, I think was the number of pre-tax pre-provision income, and if you've got a trillion dollars of losses, you can write that off over three years, and as long as you can extend and pretend enough, you never actually go sub-profitable. And they raised a lot of money, and they sort of came through.

The English banks didn't have enough revenue, and the German banks spectacularly didn't have enough revenue, right, because the German banks are the thinnest in the world. But all of this margin collapse happened in a positive interest rate environment. it. Recently, the most interesting thing I've seen is by a guy called Shannon McGonachie, who runs a fund for Horseman Capital, a Japan-focused fund. He's an Australian. I'd never heard of him before this interview. But he was running through Japanese regional banks,

which are the lowest margin banks in the world. And he says, and I haven't verified the number, but I believe him because it sort of matches my on-the-ground observations, that the average interest rate achieved on a new loan in a Japanese regional bank this year so far has been 68 basis points. And it costs more than 68 basis points to administer the bank. You've got to have branches, you've got to have staff, etc. And so on increment, on current business, the Japanese banks are loss making before credit losses. They don't even need a credit loss to lose money. If they have credit losses, that's just sort of extraduce to the capital. It doesn't show in their accounts, and the reason is that they have a bunch of reason,

ways of turning capital gains into interest income, the most obvious of which is that they've held a lot of JGBs because they have loan deposit ratios of sort of 0.6.7. They've held a huge number of JGBs. As rates have come down, they've got huge capital gains, they've been clipping those capital gains all the time and calling it interest income. Right. So they look like they're marginally profitable at the moment, but they're in fact, marginally loss making before credit losses. So instead of making money on actually extending loans to customers or corporates in the way that they used to, they're making most of their money through asset price increases that then get booked as interest income.

That will run out, and then they will make losses on extending loans. Here's simple view is there's no price that you can buy these at. They're 0.2 book, and that's a value trap. So is the banking business just broken at interest rates that low? That's what is clearly the case in Japan and is what the market is telling you about the big mega banks in Europe. The flip side is that, you know, there are banks in Europe in oligopolistic markets that are still got fairly fat margins, which have also come down.

So, you know, if I'm going to, beat myself up, the stock on the portfolio, the two stocks that I own that have bugged me most, have been Svenska Handels Bank, which is a very well-run, highly oligopolistic Swedish bank, and Allied Irish. And Allied Irish is a less well-run, but even more oligopolisic Irish bank. And Irish banking margins are very nice, right? They're about the same as US banking margin. They're not as rich as Australian banking margins, but they're many times, you know, a big French or a big German bank or even a big English bank. Yet they're still drowned to trading at 0.6 book. I'm trying to work out why I'm wrong.

We've had a demonstration of margins collapsing even in a positive interest rate environment, and that's called English banks. And we have a demonstration of margins completely and utterly collapsing in a negative interest rate environment. and that's called Japanese regional banks. And I'm wondering whether I'm just insane or not. But that's my little frustration at the moment. So how would you explain it then? Is the market wrong? That would seem to be the simple explanation.

Every time I've been confident that the market is wrong, it tends to beat me in the head. I think it's wrong. I rang up Shannon McGonicky after this, and I tried to go through just because I want to work out whether any of the margin collapse and the methods of hiding it that he could see in Japan were applicable to my Irish banks. And the answer was no, but that doesn't mean that I'm not wrong. I'm enough of a stock picker to know I can be wrong any day of the week.

And believe me, the moment I think I'm wrong, and if any of your dear listeners will tell me why, then I'll sell these positions. I'm not allergic to them. But they are very tempting. And the reason they're very tempting is that almost everywhere you look in this world, particularly in North America, you see assets at extreme prices. Right. Right. That we have a situation where the market really does believe that low interest rates are here to stay

and that economies are going to be relatively weak. So things that have highly deterministic cash flows that you can value off the low interest rates are priced at very high level. My favourite example of this is Visa. Visa trades last time I looked at 17 times revenue. I think the market's down a bit this week, so it might be only 16 times revenue or 15 times revenue. Only 15.

Yeah, there's a famous quote from Scott McNally at the end of the, it's one of the quotes that I almost should pin on my wall at the end of the tech bubble, which said that, you know, at the height of the tech bubble, Sun was trading at 10 times revenue. And dear readers, what were you thinking? You know, at 10 times revenue, in order to get a 10% return, I've got to return 100% of revenue to you in cash,

which means that I don't have any stuff, which is kind of hard when you're running a tech company. And I don't have any inputs, which is kind of hard when you're selling computer boxes. And I don't pay any taxes, which is kind of illegal. and that I can maintain all the revenue without any R&D expense, which seems a little improbable. What were you thinking then? You know, 10 times revenue was the sort of number that said, this is insane. Now, here I have Visa, which is a very fat margin business.

I'll admit it's a very fat margin business, trading it 16 or 17 times revenue. And yeah, it's got two-thirds margin. Half of Visa's revenue drops to P&L. And all of that is spent on either dividends or buybacks. It's an incredibly cash generative machine. But it is 1.7 times the price that Scott McNally said was insane. Is the difference between now and past markets, that in past markets, valuations used to be self-limiting. At some point, someone would go, you know what, this stock is far too expensive and I'm not going to buy it.

Whereas now, because so much of the profit that you're going to buy it, you know, because so much of the profit that you make by investing is basically momentum and a price increase. No, that's just got to be wrong. Nothing is as expensive as the worst as second tier tech stocks were during the tech bubble. If you go have a look at the biggest five or six tech names during the tech bubble and you bought them now and you held them to now, you've actually made an acceptable return. If you went and looked names 20 to 30 in March 2000. And you held them to now, the result is an unbelievable, spectacular wipeout, right? There are names that were hugely important then that don't mean anything to you now,

like I2 Technologies. There was a period where the two hottest tech names in the world were I2 technology and JDS uniface. and I2 Technologies had a market cap of 220 billion, and JDS Unifase was 280 billion. Now the various parts of JDSU are still available, and if you actually add them up, there's probably 20 or 30 billion market cap there, so it's not a complete insane wipeout. I think I2 Technologies was sold at the end for 700 million. if you go back to the second tier tech names, they were just insane. That is, if you actually had revenue like Cisco,

Cisco was one of the first ones to break, and the reason it was one of the first ones to break is that it actually had revenue, and it told you the world wasn't quite as good as you thought, and so the stock went down a lot. There was that period where profits were, you know, in a really good bubble, profits are a bad idea because then you have a fantasy about it.

But the tech bubble got to the point where revenue was a bad idea, right? Because then you'd have a fantasy. You couldn't, right? What you really wanted to measure was something like eyeballs. Right. Potential growth. Potential growth. And if you bought the stuff that was the second tier then,

the wipeout was far more spectacular. That was much more overvalued than anything I'm seeing now. That said, the old economy was priced at seven or eight. times earnings then. The years 2000 to say 2006 were the years in which the naive champion bearded self-righteous value investor outperformed. I know a few of these. I'm sorry, the bearded self-righteous value investor. Is that their official name? No, but that's what they are. You see them, they're just cheap. And they liked by cheap stocks. And they're very obsessed by PE ratios. several of them owned things that looked cheap like Jose Bank and, right, they also wear cheap suits.

They'd like to be Buffett Acolytes and they all meet up at the Berkshire meeting. I've been, you know, been to this Berkshire meeting, several of these people are my friends, right? They're almost a cliche of they start with the valuation and they'd buy almost any old economy stock at seven or eight times earnings. And for the next five to seven years, they just did. wonderful, right? They outperformed like crazy. And a lot of the things that they owned were cheap and bad. So the same people often, you know, if I take a look at Longleaf, which is a fairly decent, well-known mutual fund, I don't think they have beards, but it falls into the same camp. Longleaf owned a whole lot of things that looked cheap and went to zero, right? The sort of general motor stuff.

and, you know, sometimes cheap is cheap for a reason, but at that time, the whole old economy was cheap. And if you just bought the old economy, you did really well. And, you know, some of the misvaluations then were crazy. You go have a look at the New York Times or any other newspaper, and newspapers hit their highest valuation ever in 2000, just as their business model was about to dismantle. And I actually asked somebody at one stage,

sort of tech analyst, why all these newspapers were valued so highly. And the answer came back looking at me weirdly as if, well, they have websites, don't they? People look at their websites. Right. They were tech plays at that time because all of them were going big on the internet in some way or the other. The overvaluation this time is not as bad as that time. It's just broader, right? In that time, if you just did the naive thing and, the 10 times earnings or nine times earnings old economy stocks, including, dare I say at Wells Fargo, you just did fabulous, right?

And the most naive, self-righteous value investor, the one that, you know, seems to think that any growth stock is risky, but value stocks are not, right? Did great guns for five years. This time, you know, I want to be a self-righteous beard and value investor, I really do, but the only things that look cheap are banks. And I've just given you,

you know, my angst feeling about them. My own two banks. I also own a little slither of a company called Power Corporation of Canada. None of this I've ever disclosed for, but they'll, they look really cheap and I don't think they're problematic. The problem with cheap stocks is cheap stocks are often problematic and you can get yourself very trapped as every bearded value investor is once discovered. Okay, so talk to me about how you actually go about selecting companies in an environment of ultra low interest rates, as we've discussed, but also generally broad, high, expensive valuations. Actually, I tend not to start with the valuation at all. My general view is I start with the business. And there are some business models that you just want to own at some

stage. The best business model in the world is we'll develop global scale. We will share the better scale with their consumers. And it's also the hardest business model in the world to own, especially as a bearded value investor. And the reason is, well, the iconic example of is, of course, Amazon. But if you look at Amazon in 2002, it just sold books. It made small losses. It was growing very fast. And if Jeff Bezos had told you where he was going, he would have sounded insane. Now, it wasn't in Jeff Bezos's interest to tell you where he was going, because if he told you he sounded insane to 98% of people and to some weirdo out there, they might think, oh my God, I want to get there too. And so he'd induce competition. If your Jeff Bezos in

in 2002, the job is to grow as fast as possible subject to the constraint you don't run out of cash and you want to get big before your competition get there. And the problem with that from a value investor's perspective is the optimal profitability is zero. So what you're you have to do is buy a high-growth, zero-profit company that doesn't tell you what its direction is. This is the hardest thing in the world to do. But I'm always on the lookout. The problem is I don't have any. Well, I have a few, but I don't want to talk about them. And the other thing is, if I told you what I thought about them, I'd sound insane. The other thing is that if they're not going that direction, I want to sell them before they de-rate. So it's not in my own. It's not in my

interest to tell anybody for the same reasons it wasn't in Jeff Bezos's interest to tell anybody. The second sort of model that I look at all the time is what we call the trifecta. If you are a small bit important part of a big thing, you're a consumable and you have a high switching cost. You make a packet of money. The problem with these trifectors, and I'll give you a nice example. There's an English one called Crowder, right, which we own. And Crota makes active ingredients for cosmetics. It does a lot of other things, but the original product was active ingredients for cosmetics. It turns out there are recipes, almost every face cream that can answer the medical question visibly reduces the appearance of wrinkles.

Has it in it ingredients that are extracted from wool grease? Now, there are Egyptian recipes for wool grease, makeups or cosmetics, and they all stunk. And so the woman would put this really smelly face cream on and sleep somewhere a long way away from her husband. Helena Rubinstein, you may not know, was an Australian. She grew up in sheep country in western Victoria, and she originally started making cosmetics from grease she extracted from sheep sheds in Australia. It also all stunk. The first company that pulled out the active ingredient was Crota, which was a little company in Gould East Lancashire and sheep country in the north of England.

And you all know the name of it, it's lanolin. But there's about 70 derivatives of lanolin. And lanolin is the basis of the modern face cream industry because it made a face cream that worked and didn't stink. Now, Crota has a fairly high switching cost. Sheep do things that are nasty. They walk through paddocks, which have herbicides and pesticides in them. And if you are not careful, you'll get the herbicides and pesticides into the face cream.

And a sort of bad day for a L'Oreal brand manager might be recalling your product because it has pesticides in it. So if you're the L'Oreal brand manager, you want to be really sure of the provenance of your supply chain. Croda buys almost all the wool grease from all the sheep in Australia and New Zealand. It buys it in China and it's small batch processes it and it does the chaos monkey type testing where it puts contaminants in it to make sure that the tests find the contaminated batches as well. Right? So that it knows and it's never had a product recall and its testing procedures are extremely rigorous.

And if the question is, do you pay 25 cents for the commodity one or 50 cents for the Crota ingredient in your $50 L'Oreal face cream, it's a no-brainer for the L'Oreal brand. Right. They're going to buy the Crota product. It solves a problem for you, or a potential problem. Right. So you have a small part of a big thing. It's the critical ingredient.

It has lots and lots of pricing power because the brand manager doesn't want to change. The other thing is the brand that it's selling to is an incredibly fat margin product. So when you're selling a fat margin ingredient to a fat margin product company, you just sort of make double margin. And Crota may be the best chemical company I've ever seen. I start with a model like that. The only problem is that Crota also trades at five times revenue and revenue is not growing very fast.

And it is a chemical company, right? It's not quite the 10 times revenue that Sun was at the height of the dot-com bubble. But it ain't a valuation that should make you comfortable. Now, the way we choose stocks hasn't changed, which is that we start with the business model. I'm not interested in owning a bank, but I am interested in owning a bank in an oligopolistic market, right? Because there's something that it's got. I'm not interested in owning a commodity chemical company, but I am interested in owning a specialty chemical company that has something that makes you not want to change to the competitor. We start with that, and then we go to the value.

And the problem is at the moment that every time I go to the valuation, I start getting this slight queasy feeling in my stomach. I used to get uncomfortable buying specialty chemical companies at two and a half times EV to sales. And I now get uncomfortable buying them at four times EV to sales. Specialty chemicals is an area that I know a lot about. And I can't find anyone that I like that's trading at less than four times EV to sales. And this is true of business after business in area that I have genuine expertise. Now, I know that there must be some cheap sector out there, but it's not one that I have expertise in except for banks.

And banks are a scary one because with banks when you're wrong, you're really, really, really wrong. If I go back to that article in The Economist, which basically described Lloyd's as having the problem. of just generating way too much capital, making way too much profit. And it had so much profit that it didn't know what to do with it all. And so it was buying back stock or giving it to shareholders in huge gobs. If you'd told me that 10 years later that bank would be bankrupt, I would not have believed you. If I'm wrong about Crota, it's going to derate by half. If I'm wrong about a bank, I'm going to get a big fat zero. The other thing is that, that change. That's a trade. changes the risk management. You know, there's a Warren Buffett saying that if you liked at

$10, you should really love it at $6, so you should buy more. And every hairy-faced value investor does that, right? That is, they buy on the way down. There's a famous photo of Paul Tudor Jones. There's a young guy, he's a trader, and in the back of his picture is the, it's just stenciled on a piece of paper hanging crooked in the office is the phrase, losers average losers. And at one end of the world, you have Warren Buffett that says if you loved it at $10, you should be buying more at six. And at the other end, you have Paul Tudor Jones saying, losers, average losers. And they're both right in times. Hairy-chested value, hairy-faced value investors, also hairy-chested ones, get themselves into trouble by doubling down and doubling down and doubling down again.

most famous example of course is Bill Miller, who doubled down on AIG many times to bankruptcy. Right. And Bill Miller had a record where he outperformed the S&P, I think, for 18 straight years and then gave back all the excess performance in one year. Now, I don't want to be Bill Miller. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday. and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini. We'll bring you the latest

headlines, in-depth analysis, and big interviews, all the stories that hit home on your days off. And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays, we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. Watch us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and

Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. John, you mentioned buybacks. Yes. And I want to ask you about this because it does feel like at a time, when there is ample liquidity in the system and people talk about money essentially being free and at the same time you have sluggish global economic growth, you do see a lot of companies doing buybacks or raising dividends because they don't know what else to do with their money apparently. Well, not knowing what else to do with your money is actually the sort of half of the course for really good companies. And, you know, if you have a look at Crowder, it's ROE is 30, 40,

whatever it is. It's a very big number. Its return on assets is enormous, but it can't grow. So what's it do with its money? It either does an acquisition or returns it in a dividend or a buyback. It is very rare that you find a really good business with really fast growth prospects. Right. So in fact, historically, the companies that I like buy generally generate excess cash and they generally return it. Collectively, the market's insane at this. If you look at aggregate buybacks over the last 30 years, buybacks are highest when the market's high

and their lowest when the market's low. The stock market went into net issuance mode during the GFC when the stock market was at its all-time low. And at the moment, it's at all-time record buy-back levels. So whilst I like companies that do buybacks, I'm quite aware that on average buybacks are done very badly. And they're done badly by some of the companies I like as well. At this time, I'd be very jaundiced about a company that's incurring debt to buy back stock

because, you know, you could have done that a lot more rationally a while back. I have examples of companies that have bought back stock beautifully over the years. If you have a look at the tobacco companies, the tobacco companies for years and years and years traded at a very sharp discount because people thought tobacco was a bad idea. They're right. Tobacco sales halved. The number of American smoking has halved over sort of 25 years. And Philip Morris is like a 10x or 15x, some big number. And the reason essentially is that they got some pricing power and they bought back lots of stock at cheap prices. And that works all day. At the other end, you have a company which was very admired one.

and made the mistake of buying back $130 billion of stock over a decade and a half. Who is that? General Electric. Oh, of course. Had General Electric only bought back $100 billion of stock, not 130, we wouldn't be having this discussion about General Electric. It would still be a perfectly okay company. It would certainly be a less good company that was,

and it's clearly made missteps along the way, the biggest of which is probably buying Ulston. But, you know, you can argue about what the missteps are. One of the missteps, for instance, is selling all the brands. And, you know, once upon a time there was a GE appliance in every household pretty well in the Western world. And that was a pretty good branding exercise. And now those GE appliances don't exist. And they just got rid of them because they were low margin businesses, but it got rid of mine shit.

There are all sorts of little mistakes that they made along the way. But the biggest mistake by far was that they just bought back way too much stock. right and gee is my poster child for a company that has impaled itself on stock buybacks and you can go back to that um trian i've got it it's a wonderful document the trian activist pitch for g e when g e was about thirty dollars a share essentially the pitch was the same as every other activist pitch which is that they should lever up and buy even more stock right well had they followed that advice g e would be a big fat round zero. G.E. is your poster child for bad buybacks. I've got a longish list of companies that have brought themselves back to a balance sheet which I would consider single B.

And often they're rated single B. If you go back through long periods of history, the 10-year cumulative default rate for companies rated double B is about 35%. The 10-year cumulative of default rate the company's rated single B is about 50%. And, you know, the rating agent, and I'm going to get the exact words here, the rating agency definitions are kind of interesting. Its investment grade if under the wide range of circumstances, it's going to repay you. It's junk or double B if there are reasonably likely circumstances in which it won't repay you. In other words, you'll get repaid if something doesn't go wrong. At the C's, they invert that, which is under the wide range of circumstances,

you won't get repaid. And the short hand is you will get repaid if things go right. And the credit market is almost always open at the triple B level. When the credit market closes at the triple B level, the economy has very real and very sudden problems. The credit market is sometimes open historically at the double B level, and it's almost never open at the triple C level. This cycle, I have seen triple C's issue debt many times and single B's issued debt a lot. Now the maths of it historically, and again, these are very rough numbers because the junk debt people will probably laugh at my naivety here, but the maths of it is that triple B's used to trade at about 300 basis points spread over treasuries. So you got paid 300 310 basis points a year for holding it.

But you had a 35% cumulative default over 10 years, so you'd lose 3.5% of them a year, but you'd get a 50% recovery on that. So the cost of it of owning the junk debt in credit was about 1.7% a year, and you've got about 3% a year, so there's a 1.3% carry for owning junk debt. That's a reward on a diversified portfolio, it makes some sense as a banker. You got to the point here where looking just at historic numbers that Carrie went to zero. This is, of course, irrational because the defaults all happen at the wrong time. If you held triple B, double Bs for a very long time, you got that 1.7% on average, but you got all your defaults selectively in 2002 and 2009. Cash in 2002 and 2009 is worth more than cash in 2006 and 2019 because you can turn that

cash into money into the market at very low valuations. So whilst you've got a premium over very large periods, the premium wasn't well timed. You really want to make money at bare markets so you can use that money to buy things. It's really important. You know, one of the problems with businesses that lose money in bad times is that they lose money at the wrong time. Liquidation businesses, by contrast, make money at the wrong time. So, you know, the extreme version of that is Charlie Munger's company, the Dow Newswire, and it publishes bankruptcy notes.

It's a legal publisher in the U. And Charlie owns, Charlie Munger, not Berkshire, owns a very large amount of the company, and Charlie is the chairman of the board. and he has an annual meeting where all the hairy-gested value investors go and, you know, hairy-faced value investors go. And they all listen to Charlie, and Charlie doles them out wisdom. But the real trick with that company is it makes OK money over a cycle, but it makes it all when bankruptcies are. Right. It's like a hedge for the macro economy. Yeah, but then you've got Charlie Munger as your investor.

Right. So they made a whole lot of money when the markets were really low, and Charlie went and bought it. things with it. Right? And in fact, if you go look at it, it bought almost all of its Wells Fargo on a single day, one day from the absolute bottom of the Wells Fargo stock price. And the real trick to that business is not only does it make money at the right time, but you have a really wise guy who invests money at the right time. The dollar doesn't care much how you make it. It cares like crazy when you make it. So talk to me about excesses in the debt market, which you just described, and how that impacts the stock market, which you invest in. And I'm thinking of one of your

most famous calls here, which would be Valiant. Valiant was a series of opaque accounts. It had all the famous adjusted earnings. And you could not. work rationally from the adjusted earnings back to gap earnings. You just had to trust them on that. The other thing about Ballard was that it was trading at 10 times sales and it was buying companies at 10 times sales. And 10 times sales is my favorite magical number. You really, really need to be good to justify 10 times sales. That Scott McNally quote is just burned in. into me. You had this thing trading at 10 times sales, buying things at 10 times sales with accounts that made no sense. The first thing we did was we tried very hard to reconcile the adjusted

EBITDA number to the EBITDA number. And we found instances where they were like. There's no if or buts about this. The first one we found was a trivial one. It was the Galderma royalty. They'd bought a business essentially from Nestle from memory. And they were selling stuff that goes in women's lips to make their lips puffier. But at every dollar of sale, they had to send five cents of that. Just a small amount back to Nestle because they owed them a royalty. When they were working, they're adjusted a bit throughout. They didn't include that.

Now, it's an expense, right? Every dollar you sell, you have to send five cents back. If you sell an extra dollar, you have to send five cents back. Now, they capitalised their estimated value of that and excluded it from their adjusted edictor. Right. Then we found another one that was like that and another one that was like that. Can I ask you on this point, though? Because whenever I have a conversation about adjusted earnings, what some people will say is,

well, what does it matter because you have the gap numbers there anyway? Valiant wasn't making gap profits, right? In fact, I always feel like pulling them up right now. But the first gap profit that Valiant made was after it blew up. And in fact, it was writing off deferred tax liabilities and writing off earnouts. Right? There were no gap profits. Without adjusted earnings, Valiant looked unprofitable and would have been judged as such by the market.

There are times that adjusted earnings make sense. I'll go right back to the very beginning of my stock picking career. This was a very, very much bearded value investor thing that a 22-year-old might think about. There was a company in Australia called Byron, and Byron invented the process for making synthetic emeralds. In fact, these things have turned up to be kind of useful. If you could make them large enough, you might make a synthetic sapphire as a screen. for a mobile phone, which would make a sort of unscratchable screen. They are used for the nose cone of cruise missiles.

And the reason that they're work is they're extremely hard and abrasive, and the military doesn't care what they pay for them, but you can run the guidance system through the nose cone of the missile, so you can see through it without putting, you know, it's a sort of unbreakable window on a missile that's going extremely fast. but these were originally jewels and I can only remember the numbers in price per share but they'd spent about a dollar 80 per share

building this whopping big plant and they were amitising the plant off which was about 20 cents a share a year they had these enormous projections for how much money they were going to make about selling these synthetic sapphires and that didn't work out that way Firstly, the Russians copied the plants so you could buy synthetic sapphires from other places and the military establishment copied the plants and they also started selling synthetic sapphires.

And then women started looking down their nose at synthetic sapphires anyway and so you didn't get a big price premium for them even though they were flawless, you got a discount for them. In fact, a sort of flawed natural sapphire traded at a premium to a flawless, beautiful synthetic one. So the company was never going to recover. In fact, it was going to lose money, but it was making about eight cents a share of operating cash flow, offset by the amortization of this plan, so it was declaring losses. But it had built up about 20 cents a share of cash after all the debt, was trading at 20 cents, and was making seven cents of cash flow a year.

It was going to make losses forever. Now, the first adjustment was just adjust out the depreciation because it was a plant that I didn't pay for. I was paying 20 cents a share. The people who paid for the plant paid a dollar a share. From my perspective, the earnings were seven cents a share, right, for the next 10 years. And that's roughly how it turned out, except some rich guy bought control of the company and diverted the cash flows for his own use. But there was a perfect instance where I should ignore the gap accounts. and I should just look at what's really going on. And the world is full of those instances, right?

But it's also full of people who, like Valiant, will ask you to ignore the Galderma royalty. Now, the Galderma royalty is absolutely patently obvious that you shouldn't ignore it. And, you know, when you're late in a bull market and people are hyping things, they'll ask you to ignore the most silly things ever. Byron was the example of a company

which was loss-making as far as the eye could see and were still worth a lot of money. So what would you, this is probably going to be the last question, but what would be your one piece of advice for people who have to put money to work in the market right now, with all this going on?

You're asking someone that's finding it extremely easy to find shorts at the moment and extremely hard to find longs, how I invest long at the moment. This is not an easy to, question. If you go back to the height of the tech bubble, if you bought the top five names and you held them to now, you did okay. If you bought names 20 to 35, you did terrible. It feels bad to pay a big price for quality, but in retrospect, it's worse to pay an even bigger price for junk. Right? So my

that reaction is probably leave half the money to do something else with. Right. And in some sense, rebalance a 60, 40 portfolio would be a reasonable assumption. And actually pay up for quality because I think you'll, not because you'll do better paying up for quality, but you'll probably lose less, which is as, you know, and you know, over very long periods of time, my guess is the quality stocks will still produce returns that are adequate. if your idea of adequate is low single digit. Well, on that happy note,

John Hempton, Bronte Capital, thank you so much for being on Allthons. Thank you for having me. This has been a special edition of the Odd Thoughts podcast Down Under. You can follow me, Tracy Alloway, at Tracy Allaway on Twitter. You can also follow my co-host, Joe Wisenthall at The Stalwart. And you can follow our guest for the episode on Twitter, Mr. John Hempton at John underscore Hempton.

You can also follow his blog, Brontecapital.com.com. You should also follow our producer, Laura Carlson, at Laura M. Carlson. And you should follow all of Bloomberg Podcasts at Podcasts on Twitter. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report. report on the day's top stories.

Episodes are published throughout the day with the latest information and data to keep you informed. Yes, there are other products like this from a variety of news organizations, but they usually rerun their radio newscasts throughout the day. That's not what we do. We create

customized episodes that can only be heard on Bloomberg News Now. And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News

Now on Apple, Spotify, or anywhere you listen. What separates good leaders from transformational ones? I'm Jessica Chen, and in season two of Leading By Example, we'll sit down with executives like Grace Chen of Bertie Gray to find out. It's important to understand. It's important to understand. where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to leading by example, executives making an impact on the IHeart radio app, Apple Podcast, or wherever you get your podcasts.