Frightened Children - Analysts clinging onto the Mother of Guidance

“A mother understands what a child does not say” – Jewish proverb

 We looked at the growing consensus hugging nature of analysts in Japan who increasingly base their forecasts on a +/-5% range within company guidance.

Fig.1 below shows how the trend has climbed in the past 3 years. Whether one blames compliance or a lack of capability, consensus hugging now pervades over 50% of analysts from around 35% prior to 2013.

Fig.1 : % of Companies with Consensus Estimates less than +/-5% from company Guidance

The study gets worse when we look at it by sector. Since Lehman Shock, 75% of financial analysts in aggregate are within 5% of company guidance from 35% in late 2008. Unsurprisingly after the immediate crash, most analysts were way out of line with company guidance. 

When we broadened the study to +/-10% of guidance, nearly 70% of analysts are holding within that range. Has the hollowing out on the sell-side of more experienced analysts caused the trend? Naturally, the compression of commissions has forced many firms to cut overhead and the trend toward less experienced analysts has grown.

Fig. 11 % of All stocks estimates +/10% of company guidance

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The Public Pension Black Hole - Sucked in the vortex of an undiscovered universe

“It’s not what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so!” – Mark Twain

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The beauty of pension accounting is that slight tweaks can make a large unfunded liability seemingly disappear or at the very least shrink it to “she’ll be alright mate” levels. However if a pension fund plays the game of understating its risks for long enough then eventually it catches up, especially if performance is consistently poor. This is what we are starting to see in vivid colour among state and local (S&L) governments in America. Reality is biting. Let’s jump right in.

California Dreaming

To put this in perspective the California Public Employee Retirement System (CalPERS) lost around 2% of its funds in 2015/16. The fund assumes an aggressive 7.5% return. Dr. Joe Nation of Stanford Institute for Economic Policy Research thinks unfunded liabilities have surged to $150bn from $93bn in the last two years. Furthermore suggesting the use of a more realistic 4% rate of return. CalPERS has an unfunded liability of $412bn (or the equivalent of 3 years’ worth of state revenue).  California collects $138bn in taxes annually in a $2.3 trillion economy (around the size of Italy). With over-inflated asset markets and increasingly negative returns on highly rated paper, the growth in unfunded liabilities is even more concerning as any market correction (likely to be severe given such blatant manipulation to date). If the correction is huge it will push the unfunded portion to even more dizzying levels.

US Pension Tracker (USPT) defines its methodology to assess the true mark-to-market value of unfunded liabilities versus actuarial assumptions.

“[We] reflect market pension debt using a discount rate equal to 20-year Treasury yields rounded to the nearest one-quarter percentage point. The yield in 2014 was 3.00%. The use of this discount rate here is intended, as most financial economists agree, to more closely represent market realities and system liabilities.”

USPT assumes that public pension funds have a market based unfunded pension deficit of $4.833 trillion. The actuarial base (using a discount rate of 7.5%) of the pension deficit is approximately $1.041 trillion. This assumes an unfunded portion of $3.8 trillion. Using the 2016 20-year US Treasury bond yield of 1.71% the market based pension deficit explodes to over $8.8 trillion or a $7.5 trillion unfunded portion equating to around $74,000 per American household. For California alone this would push the pension debt per person above $135,000.

This study is a mere snapshot of the state of public pensions in the US. Once again we have a festering problem that is turning gangrenous yet not enough attention is being focused on solutions. The over reliance on authorities to get us out of this economic mess is concerning. Perhaps there is a wish that helicopter money (as B-52 might be more appropriate) will somehow kick off inflation and cut back into these unfunded liabilities. However, we should be careful what we wish for. The risk of duration on the negative yielding debt would wipe out large portions of pension assets making the journey highly challenging not to mention any hyper-inflation risks would reduce the purchasing power of any retirees who got paid their promised distributions. Quite simply there is no easy way out of this and whatever solution is found will involve pain. For all the kicking and screaming in the world, the problem has festered over the past decade and many administrators have chosen not to do anything serious about it. Brace yourselves.

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Methamphetamine Price, Purity & Economic Downturns - Drug pushers are economically rational

Methamphetamine prices and purity and the correlation to markets 

The US Justice Department (DoJ) and the Drug Enforcement Agency’s (DEA) latest report on the trends of methamphetamine prices and purity on the samples they buy from dealers shows some strong correlation. In the last 20 years, methamphetamine prices (US$/gram) have shown a 91% R-squared correlation (i.e. very high) to purity. 

Looking at Fig.1 we can see that the tech bubble collapse in 2000 and 2008 saw purity levels rise consistently several years before the crisis set in and the trend continues for a further 5-6 years. The latest data would suggest that the purity is heading back up, usually a sign that the economy is about to take a 'hit'.

While illicit drugs are no laughing matter there is a silver lining. Medicinova (4875 JP) is well advanced on a cure for drug addiction and is currently being funded by the US National Institute of Health to accelerate the commercialisation. The FDA is also fast tracking its approval.

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Yearning for Yield

The ‘yield’ plays are in the sectors vulnerable to downturn

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Brexit Schmexit. In the uncertain TINA (There Is No Alternative) world we find ourselves, traditional strategies looking for dividend yield security no longer carries the prudence moniker of years past. Especially as the sectors where you would expect to find a healthy cheque aren’t attractive anymore. Transports and pharmaceuticals are traditionally viewed as safe havens. However when Japan Airlines (9201) carries twice the yield of the JRs and the mainline drug companies float in the 2% range you tend to get the idea that these stocks are either fully priced or representative of market uncertainty. Even telecoms are in the mid 2% range. Japanese banks, brokers and auto companies are returning c.4~5%. The traditional defensives may still find a bit more relative gas in them before the market can’t stomach the levels.

Fig.1 highlights US unemployed persons. As America’s population has grown over the decades, naturally the number of unemployed even on a relatively steady state has climbed. What is striking is not so much that unemployment rises when the economy takes a hit but the 66 year linear pattern. We are approaching yet another inflection point and it corroborates the ‘Dire Straits for Central Bankers’ report of June 17th, 2016.

We analyse the relative unattractiveness of yield plays in Japan and conclude that while defensives might still have some gas left in the tank, there are few alternatives where one can really hide in the cyclicals world. Even looking at net cash and equity ratios TINA is not attractive in many cases.

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Dire Straits for central bankers - Money for nothing brothers in arms are out of ammunition

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Executive Summary

Better to sit down. We will be entering some pretty bleak conclusions in this report. The world’s central banks have hit stall speed. They have lost control and do not have enough altitude to recover. How bad can things get? There are two things at play here. One is economic (explicitly monetary) policy. The other is social reality (explicitly hardship). Both have become dysfunctional. Reckless central bank monetary expansion sold behind the banner of ‘nothing to see here’ has backfired. Money velocity (or the power of money) across the globe is plummeting to record lows. While the GFC was easily avoidable the post disaster mop up operation consists of printing our way out of the disastrous debt pile by inflating it away. Even negative interest rates leave inflation well below targets. Deflation still prevails. Poverty and post-GFC destitution has reached boiling point. When people feel robbed of their identity and increasingly their democracy we should not be surprised to see the rise of nationalism and non mainstream candidates and sadly violence, especially in Europe. This social disruption should not be ignored because the experimental financial engineering that was supposed to wiggle us from the bondage of moral hazard has had the complete opposite effect.

Here are 7 things to ponder;

  1. A recent US Federal Reserve survey found that 47% of Americans couldn’t raise $400 in emergency cash were the need to arise. 5% unemployment rate belies financial difficulties.
  2. A bank survey in Australia showed 50% of people wouldn’t be able to meet their financial obligations if unemployed for more than 3 months. Housing price to income ratio almost twice the level pre-GFC. Private debt: GDP ratio at 160%.Credit rating downgrade imminent.
  3. c.60% of ETF purchases in Japan and c. 100% of sovereign bond purchases are bought by the Bank of Japan which now owns 38% of outstanding government debt. 15 year Japanese government bonds now yield -0.004%. Japan’s move to negative rates  has caused a run on sales of mini-vaults as people look to store their own cash.
  4. M2/M3 money velocity has hit all time lows in the US, ECB, Australia, China & Japan.
  5. Italian banks non performing loans (NPLs) are approaching 20% and as high as 50% in the south of the country. The ECB is breaching their own covenants to hide the mess. Belgian Optima Bank has just been shut down for not being able to meet obligations. Many more?
  6. Over 25% of those in the EU live below the poverty line and youth unemployment is c.25% with long term unemployment now 50%. In Greece those numbers are 36%, 58% and 72%.
  7. China’s industrial sector among others shows clear signs of recording sales without much hope of being paid with receivables ballooning in some cases leaping to over 5 years of reported revenue pointing to a sharp uptick in corporate debt insolvency & NPLs to follow

I wish I could be optimistic about the future but I’m afraid there isn’t anything that shows much promise.

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Pinocchio Motors - Imagine if the sell-side had to recall every over-optimistic forecast

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It is clear that a 40% fall looks like the industry standard knee jerk reaction. Ford (F US) and Bridgestone (5108) shares reacted negatively to the Ford Explorer/Firestone rollover/tyre burst cases of 2000. 260 odd people died in the US. At the time many analysts tried to downplay the litigation aspect and consequent impact to Bridgestone. It was so under baked as to be unreal. The US loves a good class action and the shares took a while to take a beating. Ford also marked time in the initial phases until the matter became clearer. Takata (7312) has remained under pressure for its wilful misguidance of its customers. In Ford, Bridgestone & Takata’s case, lives were put at risk. For VW & MMC, this is not the case. However punishments seem to be over-inflated.

Here we go again. The story starved media gets its hooks into a has-been car maker with a mediocre presence and spinning it into the potential for multi-billion dollar fines. Mitsubishi Motors Corporation (MMC) admitted the falsification of fuel economy records. It is never good that a corporate admits to telling porky pies. To April 25, MMC has shed nearly ¥370bn from its market cap since the scandal broke.

In MMC’s defence, quoted fuel economy stats in any automakers brochures are always overly optimistic. The officially sanctioned tests are run on smooth tarmac in ideal conditions. So inflating already inflated numbers in the real world effectively makes no difference. However is this form of advertising any different to the Flab-blaster 1000 helping you lose belly fat or a shampoo that will make your hair silky smooth? Should research analysts be held accountable for every single earnings mistake found to be made through a lack of rigour and due process? One might even argue that in the dating game, interested parties inflate their qualities to such a degree that should the other party fall for it they could be sold goods that might not live up to expectations.

Class actions in Japan will be promulgated in December 2016. There are no cases now. The Consumer Court Special Procedure Act (“The Act”) will only allow qualified consumer organisations (not consumers) to sue against businesses. In many cases such consumer bodies have limited financial resources. Under the current Act certified (by the Prime Minister no less) consumer organisations can file for injunctive relief not damages. From the end of that year it might change but since 2007, 15 lawsuits for injunctive relief have been filed. Interestingly, the 2007 law says that consumer associations must notify any offender corporations to provide a window to fix the problem before engaging in any legal action. 

As it is the Japanese domestic market that is under fire we can only suspect the MMC fine will be paltry compared to the 500,000 car buyback that VW is embarking upon. Let us not forget that one can be an insider trader in Japan and pay a fine of only $700. Pretty light on.

Nissan will expect to be compensated somehow but if the production arrangements via MMC are viewed as long term beneficial to Nissan then perhaps MMC will be forced to accept even tougher terms on outsourced production in place of a fine. The juxtaposition of MMC is simple. Accept slimmer margins on future outsourced production or risk having to close plants and face the prospect of further restructuring. It is unlikely the government wants to see another round of layoffs. MMC employs around 30,000.  Nissan can choose to bury MMC if it so chooses and indeed if it has the will to go to Osamu Suzuki and ask for similar terms which are probably unlikely it could but I suspect it won’t.

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Size Matters - Insider Ownership impact on Japanese Stocks

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Higher ownership by management removes socialist salaryman thinking

Is it any surprise that companies tend to perform better when board members (insiders) have a higher proportion of their remuneration linked to stock performance? Shareholders have traditionally been well down the list of priorities of Japanese companies, much to the chagrin of foreign investors. Stock incentives, especially in larger corporations, are often a miniscule part of total compensation for leaders. So much so that there is little incentive to focus on chasing real returns through more aggressive strategy. Many leaders in Japan would prefer to see out their tenure as CEO without blemish or scandal to avoid the risk of failure and the shame it would inevitably bring. 

In hindsight looking at Sharp’s (6753) desperate long term need for crisis management could we have honestly expected any substantial restructuring when the CEO has $33,000 in stock despite being at the company 36 years? Had Sharp’s board held more skin in the game they might have defended shareholders much better against Terry Gou’s constant renegotiations. Perhaps if Sharp had learnt from Carlos Ghosn style performance based compensation structures, they might have been able to defend their turf from Gou. As it stands now Sharp are mere whipping boys of Hon Hai and they’ll be dealt the wrong end of the Tarot cards and have no power to prevent it.

It also begs the question - do we really even need the rigid adoption of a Corporate Governance Code that encourages a minimum of two independent directors when the real way to drive shareholder returns (as we will discover) seems to be to dangle the carrot of stock options and higher insider ownership to achieve these targets? We have argued that Toshiba having a majority of independent directors will do virtually nothing to resurrect fortunes.

While there is no exact science around the right number what we can deduce is that on 1, 5 and 10 year time frames insider ownership under 1% shows consistently poorer returns than those above. The data speak for themselves. 

To those that worry about boards recklessly chasing short term targets there is no reason to suggest that long term targets are pushed by remuneration committees with clawbacks on failure.

Insiders seem to have a large bearing on share price performance, clearly providing a platform of engagement with the company’s fortunes and seemingly much more effective than just hiring two independent directors.

Enjoy the weekend.

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Crime in Japan - Part 3 - Fraud, Drugs, Murder, Yakuza & The Police

Crime doesn’t pay unless you are a gangster over the last decade…

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In our Crime in Japan series parts 1 & 2  we covered the jump in crime resulting from seniors breaking into prison and the rapid breakdown in the nuclear family leading to a surge in domestic violence and child abuse. In this report we cast our focus on the resources of the police and whether the change in crime is impacting their ability to hunt down Yakuza (gangsters), thwart drug use and possession, prevent murder and stop the leap in financial crime where insurance fraud alone is up 2,000% in 6 years and suspicious transactions breaking new records.

The Japanese National Police Agency (JNPA) has been the victim of budget cutbacks. Some 80% of the ¥3.2 trillion budget is spoken for by staff salaries. There are approximately 295,000 staff (including administration) but actual officer numbers have remained relatively stagnant at around 258,000. With an aging police force, retirees are putting pressure on hiring new recruits. Japan does have a low level of crime on a global basis and 197 police per 100,000 citizens reflects that.

Japan has budgeted approximately ¥232 billion to run its jails in 2016. The cost of incarceration runs to around ¥3.8mn per inmate which is around double what one could get through the welfare system. The theft of a ¥500 sandwich could lead to a ¥8mn tax bill to provide for a 2 year sentence. Courts are dealing out harsher sentences however drug related offences generally range inside 2 years behind bars. Many Japanese have been in the media crossfire for repeated drug offences and the courts have had no choice but to incarcerate them when ‘good behaviour’ probation periods have failed. Prison capacity has grown 50% in the last decade to meet the coming crime wave.

Drugs in Japan are an interesting topic. Meth was originally synthesised from ephedrine in 1893 by a Japanese chemist Dr. Nagayoshi Nagai. 26 years later, a pharmacologist by the name of Akira Ogata managed to turn it into crystalline form i.e. crystal meth.

When World War II got under way Japanese soldiers (especially kamikaze pilots) were given crystal meth (branded Hiropon) which not only kept them ‘wired’ but reduced hunger. As the war ended, Japan was left with excess supplies of Hiropon. Food supplies were few and returning soldiers added to the shortage. However little was known of the side effects and the government had an epidemic on its hands in the late 1940s. Luckily there is a solution being developed by the Japanese biotech company MediciNova (4875) which is in late stage trials in the US with a formula that weans drug users from their addiction.

One of the surprising statistics has been the trend in gangster (Yakuza) incarceration in Japan. While police have seen a surge in consultations (aka complaints) surrounding gangster activity, arrest rates have fallen by 30%. Is it because the police are so tied down by the surge in stalking, domestic violence, child abuse and larcenous geriatrics?

People with mental disabilities committing crime are also rising sharply, up 62% in the last decade. Apart from schizophrenia or medically diagnosed mental health issues, addiction to alcohol or substance abuse can also get an offender classified as mentally disable if they break the law.

Financial crime is becoming far more prevalent. From petty scams to sophisticated insurance and bank fraud, such offences are surging. Reported fraud related to bank transfers has doubled between 2010 and 2014 to 13,400 cases with the amount of money transacted surging 5-fold to ¥56.5bn.

Source: Japan National Police Agency (JNPA)

Murder rates in Japan have remained relatively mute. The homicide rate in 2014 was 938 down from 1362 in 2006. As a ratio, Japan has 0.7 murders for 100,000 people versus 91 for Honduras (the highest) or 4.7 in the US. However Japan has not been immune to home grown massacres.

Foreigners as a percentage of crime in Japan continues its long downward march. Much of the crime is related to petty theft and visa overstays. Chinese, Vietnamese and Brazilians make up 60% of foreigner arrests in Japan. Foreigners as a percentage of inmates has also dropped sharply from 8% of the prison population to 5.5%. Chinese, Brazilians and Iranians make up half of gaijin inmates.

The incidence of crime continues to rise in Japan. As discussed in our previous reports we can see that crime rates (e.g. shoplifting, theft, child abuse, domestic violence, assault, stalking etc.), while small on a global scale, are rising at such a speed it seems to be taxing a police force struggling with worsening manpower issues. It would seem to make sense that despite growing reports of suspicious activity by organised crime, arrest rates are falling. Furthermore retiring demographics in the police force suggest that ‘street knowledge’ gained through decades of leads (e.g. informants) may not so easily be transferred to the new recruits. Throw financial fraud increasingly perpetrated by cyber criminals on top, perhaps the Police need to invest in sophisticated systems rather than just hire more cops on the beat? The face of crime has changed.

Full report available here


Tempting Expeditiously Stupid Legal Action

Would any auto OEM CEO actively look to introduce such a function?

Take a look at the picture above. Isn’t looking at something in psychedelic colours distracting? I could go on for the entire report but your eyes probably took longer to read this far. This text at the very least is static not rolling. OK it is starting to annoy me. Sorry.

Back to the picture. First, the driver is speeding at 70mph in a 65mph zone. Second, the ‘psychedelic cowbell (rainbow) road’ is constantly moving so it could be distracting. Third, the driver (one of many to post videos on YouTube) is using a smartphone behind the wheel to take a video of his/her supposedly Mario Kart function. So two laws have been broken on the back of a CEO actively promoting owners to try it. It should be of concern to shareholders that Musk is letting the potential success of the Model 3 go to his head and is using the current media spotlight to aggressively promote the Tesla brand in any way. Promotion is not a bad thing unless that advocacy potentially leads to danger. Now whether the Tesla’s built in radar guided autopilot system could potentially prevent an accident is beside the point. These auto-braking functions are not 100% fool proof and were an accident to occur (especially one resulting in death) a driver could quickly point to the cowbell function as distracting him/her and put the blame back on Tesla and there is no right of reply if the CEO himself is promoting such optionality of his vehicle. To me it suggests that Musk is grossly underestimating potential legal pitfalls of the automotive industry and the dangers of class action lawsuits that have impacted brand image of major OEMs. Is Musk’s team of legal experts somehow lost on the psychedelic cowbell road themselves to advise that such a mindless function which carries no perceivable benefit to safety, moreover putting owners in harm’s way is somehow smart?

Getting real with orders folks

We would also like to correct our statement of $1,000 deposits in our previous Tesla report. It turns out that deposits are fully refundable which only makes the ability to forecast ‘real demand’ that much trickier. People can order up to two cars. It is unclear how many of the c.400,000 orders made to date have been multiple reservations. Many who have placed orders early on for the Model 3 that may be looking to trade them will find the reservations are non-transferrable except on the prior written approval of Tesla. However there would be nothing stopping early reservation holders from selling their cars immediately after they bought from the dealer to desperate buyers wishing to get their hands on a Model 3 for a premium.  

So much of today’s world is narcissistic. To say one has a Tesla Model 3 on order exudes a certain hip image. I am sure some will laud their early-adopter intelligence. However I’m guessing that if one has to wait 3 years until his/her Tesla Model 3 arrives (by which time multiple reviews will have been written and reliability will be open to all) cancellations could accelerate intentionally. It puts the shoe back on the other foot to what levels Tesla intends to produce at, which we ran through in detail in our previous report. For industries with high fixed costs, finessing production rates to be sustainable and profitable is both an art and a science. If Tesla produces too few, it risks order cancellations from impatient reservation holders and if it produces too many then it risks excess capacity should orders dry up or long term demand fails to grow much beyond 400,000 units.

Ultimately the consumer will be the judge of Tesla’s success or failure. However by trying to appeal to the inner-geek of its owners Tesla may end up kicking an own-goal if they are not careful. It is doubtful that Musk will be able to retreat from championing the customisation of his vehicles by pulling the video gaming functionality without wearing ‘Easter’ egg on his face. Much like the social media frenzy that fuels Tesla, should the tables turn, the company could be dropped like a bad habit. The group think that drives it could well put the brakes on it as well. 

Full report available here


Tesla - Electric Shock in waiting?

Social Media is turning off people’s ability to think, Tesla proves it again

Do not get me wrong. Tesla’s CEO Elon Musk is a marketing genius. Not for one second do I think the feat of taking almost 200,000 Tesla 3 orders in 24 hours was a fluke. There is no question that the social media frenzy of buying something that is ‘doing it differently’ has helped Tesla achieve this task. However I am disturbed at how realities rarely seem to get in the way of a good story.

Are we experiencing a sense of Tulip Mania with Tesla? When we look at the performance in stocks such as Ballard Power (BLD CN), GoPro (GPRO US) and Blackberry (BB CN) that promised to revolutionise their respective worlds in automotive fuel cells, action cameras and mobile communications the share prices in each has failed to reflect the initial euphoria and hype.

In this report we highlight 15 considerations as to why investors should contemplate realities of Tesla within the automotive market. The idea that Tesla is about to revolutionise the automobile industry in similar ways to Apple (AAPL US), Uber or Airbnb have to their respective markets is highly improbable. Mean reversion is one reason. Tesla has a global market share of c.0.15%. It would need to grow 80x to match Toyota Motor (7203) for share. Having said that Toyota has 66x more revenue than Tesla yet only trades at 5x its market capitalisation, not to mention having record operating margins over 10%. Even stacking Tesla on a price-to-sales ratio (as it makes no profits yet) would make it 18x more expensive than Daimler (DAI) the maker of Mercedes-Benz which is in probably one of its healthiest product cycles for decades. 3x more expensive than Apple. Take your pick (there is a selection in a later section).

As we once again look at the group think that pervades the financial industry we conclude that history has at times proven not to be on the side of conventional wisdom, or the consensus view, but on the side of those who dissented from them. More significantly, we see too how the sell-side has failed clients by not being rigorous and questioning enough. We have seen so often that the time of greatest ‘so called’ certainty is, in fact, the time to be most sceptical. If we spent more time on corporate biopsies as financial analysts there would be far fewer autopsies. Let’s jump in.

Full report available here.