I have to shake my head in disappointment at the headlines this past week in the world of finance and money. It makes me wonder why I even periodically come to the defense of the industry when in weeks like this, it seems like a fruitless exercise. Here’s a tasting of this past week:
1. LIBOR manipulation settlements. LIBOR is the benchmark interest rate that impacts hundreds of trillions of dollars worth of financial contracts. Everything from mortgages, student loans, car loans, derivative contracts, and many others are pegged to LIBOR. LIBOR is calculated daily based on the submissions of some of the largest banks in the world. And, in 2005-2009, it was apparently manipulated by some those contributing banks for their own personal gain. This week, one of the chief offenders, Barclays, reached another settlement with a regulators over their behavior in this period. How is it possible that one of the most important metrics in the global finance industry is manipulated over many years? I guess it’s entirely possible.
2. The stock market is “rigged” – according to author Michael Lewis. His claim is that high frequency traders front-run stock trades all day and every day so that both institutional and retail investors alike pay what amounts to artificially expensive and manipulated prices on routine stock trades. This is apparently legal, for now. But, its potentially wide-ranging impact on the US stock market is coming to light.
3. Alleged IRS corruption hearings proceed. Claims of the IRS abusing power are came back into the forefront this week. This has unfortunately become a purely partisan issue. But, further information about the IRS suggests there’s potentially a bigger issue at hand than even what’s presently going through the House.
4. SAC Capital pays largest insider trading settlement in history. $1.8 billion is what it takes to settle one of the longest running, widest ranging insider trading scandals in history.
So, in one week, the headlines are about THE benchmark interest rate being manipulated for years, the entire stock market being rigged, the largest taxing authority in the US potentially corrupt, and the largest ever insider trading investigation being settled. Clearly, this has not been a proud week for the world of finance. Let’s hope better things are in store next week.
Yesterday, I had the unexpected opportunity to speak with a former executive of a major fruit and produce company. I always find it really fun to talk with someone about something I know nothing about – and in this case, the topic was bananas. So, I asked him about the economics of bananas, and this is what he said:
- Depending on location, retail price is ~$0.70 per pound.
- That retailer buys them by the box which is 40 pounds. So $28 is the retail revenue per box.
- The producer charges the retailer $12 for the box.
- The retailer also incurs additional costs for 7-days of storage and refrigeration at 56 degrees for ripening.
- The producer pays $10-$11 in costs for that box ($6-$7 for pick and pack, $1 for packaging, $2.50 for shipping, and $1 of marketing/sales overhead)
- Within a few hours of picking, the bananas are stored and shipped in refrigerated containers at 56 degrees. Shipping can take 7+ days.
- The picker probably makes ~$12/day and is paid per stem picked.
It’s always interesting to look at a supply chain of a product and decipher where in the chain you’d want to be. In this case, I’m happy to be the one eating the banana.
I believe this could be a true statement by the end of 2011 if it was Groupon’s intent to do so (which it may not be).
It’s very simple math. Many industry sources put the number of Groupon sales reps at 3,000+. The high end of the range is 4,000.
A typical rep using an auto-dialer will probably call 250–300 companies a day. You have to use an auto-dialer to get those kinds of numbers, which I have to presume Groupon uses.
Usually of those calls, the rep connects with a live person 40–50 times per day. Most of the calls result in a short conversation leading to a hang-up, but that’s the life of an inside sales rep.
Figure that there are 225 business days in a year when you subtract out weekends and holidays.
So the math is: 3,000 reps x 40 connects/day x 225 business days = 27 million businesses called.
According to business databases like Cortera and the US Census, there are about 27 million business establishments in the United States. This is a generous number as only about 7.4 million businesses have payroll – but either way you look at it Groupon could very well call every company in the US this year, if they wanted to.
There is a great divide taking place in the land of technology stocks. The “New Guard” of technology companies have a cloud computing, recurring or transactional revenue story with promotional leaders and great spin. The “Old Guard” of technology companies have big brands and huge presence among customers, but are viewed by some as stodgy and tired. Here’s how the public markets are valuing these two sets of companies from a P/E ratio perspective:
The New Guard
- Salesforce.com – 259
- VMware – 136
- Rackspace – 107
- RedHat – 91
- F5 Networks – 77
- Amazon.com – 74
- Netflix – 72
- Akamai – 60
Median P/E ratio of “New Guard” Companies: 84
The Old Guard
- Oracle – 23
- Cisco – 15
- eBay – 14
- IBM – 13
- Dell – 13
- Microsoft – 12
- Intel – 11
- Hewlett-Packard – 12
Median P/E ratio of “Old Guard” Companies: 13
Is it fair for the New Guard to trade at a median P/E ratio that is 6.5 times higher than the Old Guard? I don’t think so – it will not last. It’s not to say that the Old Guard is undervalued, but eventually, the New Guard will come back to earth. Eventually, the New Guard companies will trade at less than a 25 P/E ratio – it’s the law of gravity in stocks (consider that even Apple trades at a 23 P/E). Given that, in the case of Salesforce.com, that means its P/E ratio will decline by 90% from where it is today. The question is whether that multiple compression happens because earnings actually grow by 10 times, or because investors get more valuation conscious, or both. Only time will tell.
This topic was raised to me today in a meeting, and after thinking about it, doing some research, and trying to put aside my biased interest in stocks – I think a stronger case can be made that the bond market is more important than the stock market. There are a number of reasons for this, most notably starting with size.
The global bond market is about $82 trillion. The global stock market hovers around $40–$50 trillion. So, on pure size alone, the bond market is almost twice the size of the stock market. That’s a substantial difference. Point – bond market.
The bond market has a broader set of issuers as you have different segments: corporate, government & agency, municipal, mortgage backed, and funding. Whereas the stock market is a construct for a limited set of corporations – for example, the US has 17,000 public companies. Point – bond market.
The stock market is arguably more influential on sentiment. What’s the key indicator of the stock market? My guess is most would say S&P 500 or Dow. What’s the key indicator of the bond market? Probably most don’t know (e.g. indexes like Merrill Lynch Domestic Master). That, in and of itself, gives the stock market a broader reach and voice. Point – stock market.
That being said, and this may be a reach, but I think the bond market is more influential on the stock market than the other way around. The primary reason is that the returns on bonds are more predictable due to the fixed yields. If yields are very high, there’s no reason to invest in stocks. The comparative risk-reward isn’t there. But, if yields are low, that’s an incentive to move into risk assets like stocks. It doesn’t work as seamlessly the other way around because returns on stocks are less predictable and more volatile. Point – bond market.
This is hardly a scientific analysis, but based on just off the cuff research, what’s more important – the stock market or bond market? I’d probably have to go with the bond market.
After reading this blog post on healthcare and hearing the rising volume against healthcare insurers – I wanted to understand more clearly the profitability of healthcare insurers. So, I went to Google Finance, searched for Aetna, got a list of their competitors – and researched their net profit margins. Here they are:
2009 Net Profit Margin of Healthcare Insurers
- Aetna: 3.7%
- Wellpoint: 7.3%
- Cigna: 7.1%
- United Health: 3.7%
- Humana: 3.4%
- Healthnet: -0.3%
- Healthspring: 5.0%
- Coventry Health Care: 2.3%
- Molina Healthcare:0.8%
- United American Corp: 2.7%
- Unum Group: 8.4%
- Median: 3.7%
I’m not here to defend or attack healthcare insurers. But, 3.7% median net margins seems relatively pedestrian to me – not obviously indicative of an industry gouging its customers. For example, if you look at the profitability of Google and its competitive set, here’s what it looks like:
2009 Net Profit Margin of Internet/Tech Companies
- Google: 27.6%
- Yahoo: 9.2%
- Microsoft: 24.9%
- Baidu: 4.8%
- Apple: 19.2%
- AOL: 7.6%
- Nokia: 3.0%
- Adobe: 13.1%
- Sohu: 28.6%
- Median: 13.1%
Given all of the noise around healthcare insurers being the bad actor in the healthcare delivery equation – I would have thought they’d be more profitable. But, to be fair, profitability margins are only one variable in the complex analysis on our healthcare challenges. We hope that our portfolio companies like Redbrick Health and Ventana can help be part of the solution.
How well have US stocks performed?
With another decade in the books, here’s the quick compounded annual return of the S&P 500 for 50 years:
- Last 10 years: -2.9%
- Last 20 years: 6.1%
- Last 30 years: 8.3%
- Last 40 years: 6.5%
- Last 50 years: 6.2%
Here’s the compounded annual return of the Dow Jones Industrial Average for 50 years:
- Last 10 years: -0.5%
- Last 20 years: 7.0%
- Last 30 years: 9.0%
- Last 40 years: 6.7%
- Last 50 years: 5.8%
And finally, the compounded annual return of the Nasdaq Composite over 30 years:
- Last 10 years: -5.7%
- Last 20 years: 8.4%
- Last 30 years: 9.5%
People used to say that stocks generate about 8%+ annual returns over the long-run. It seems fairer now to say that stocks generate 6%+ annualized returns over the long-run. That type of return doesn’t blow my mind given inflation and capital gains tax though it’s still better than a lot of things. I also have to think that the next 10 years will be better than the last 10 years.
I thought this was a poignant observation by Fareed Zakaria in his book, The Post-American World:
“Hyperinflation is the worst economic malady that can befall a nation. It wipes out the value of money, savings, assets, and thus work. It is worse even than a deep recession. Hyperinflation robs you of what you have now (savings) whereas a recession robs you of what you might have had (higher standards of living if the economy had grown). That’s why hyperinflation has so often toppled governments and produced revolution. It was not the Great Depression that brought the Nazis to power in Germany but rather hyperinflation, which destroyed the middle class by making its savings worthless.”
I’ve been looking unsuccessfully for an article that succinctly lays out both sides of the debate on whether gold is a good asset to own. So, I’m here to ask for your assistance in pulling together an article that outlines the key points on both sides of the debate. I have some ideas, but I’m sure you have more. Just leave any points of view, good articles or predictions in the comments an they will be added to the article. I hope that this article proves to be useful to readers regardless of your current point of view on the topic. If you’re formulating your own opinion on a given topic, hopefully it’s helpful to get the full spectrum of opinions on the topic. And, if you already have a strongly held point of view, surely it’s good to pressure test your convictions with an opposing view every once in awhile. So, here we go:
The Case For Gold
- The devaluing of fiat currencies around the world through unprecedented fiscal stimulus will cause an increase in the price of gold.
- Gold is a safe haven currency that tends to rise in precarious economic times like these.
- International governments will diversify out of their US dollar reserves and buy gold thereby driving demand.
- Hyperinflation is on the horizon – and that drives gold prices.
- The growth of institutional and retail investment demand for gold.
- Lack of growth in the supply of gold from mines.
- Fiat currency has no intrinsic value.
The Case Against Gold
- Gold doesn’t pay interest.
- Gold goes up when there’s inflation, and deflation is the far greater risk today.
- A safe haven asset like gold goes up when Armageddon hits, and we have avoided that.
- Over the long run, history shows that gold is not an appreciating asset.
- Asset prices are inflated by the dollar carry trade – gold will come crashing down
- Too much hype – sell high, buy low.
- Gold has no intrinsic value.
The Price of Gold/Oz.
- $1,141.70 (11.19.09 – date of post)
This is the purest business idea of all time – give me a dollar and I’ll give you 90 cents (or something less) back. Ridiculous, right? Yet, it happens in so many different forms that it’s somewhat surprising. Why would anyone in their right mind give someone a dollar just to get less money back? And, I’m not talking about you giving someone a dollar so that they give someone else 90 cents back. That’s money movement. I’m talking about a direct trade – you give someone money just for the privilege of getting less money back. It happens a lot and we’ve all participated in it.
Here are some ways this model exists in business – and I’ll rank order them by the models that give you the most money back to the ones that give you the least. I’m going to spend a little extra time on the last business which I think is the most onerous of them all. Here we go:
1. ATMs. The most obvious model – you give the bank a dollar, and they give you 98%-100% of it back every time you withdraw it from the ATM. Their service: accessibility and interest.
2. Travelers Checks. We all know that companies like American Express have made a great business in taking your money, and giving you 96%-99% of the value back in the form of a less liquid travelers check. What’s the embedded service? Insurance.
3. Check Cashing. Companies like Western Union will take your check and give you cash worth about 95%-99% of the value. Their value: liquidity, especially to the unbanked.
4. Currency Exchange. Companies like Travelex have made a great living taking your money, and giving you 90%-98% of the value back in the form of another currency. The implied service: local purchasing power.
5. Coinstar. These guys own the kiosks you see at the grocery store where you put in a bag of coins and they give you 90% of the value back in the form of cash. It’s an amazing business to say the least. What’s their underlying service? Money portability.
And last but certainly not least:
6. Gold Buyers. These companies allow you to trade in your gold jewelry, and they give you cash for the gold. Not a fair example you say? I think it’s very fair – gold is a currency and so are the dollars you’re getting in return. Their true service: liquidity.
Here’s why I think the gold buying services are truly the worst economic deal of them all. There are two compounding issues. First, these companies are not giving you anywhere close to value of your gold, dollar for dollar. While the above businesses give you 90%+ of the value of your dollar, some people who have used these gold buying services have calculated that they have received 17%-18% of the value of their gold. That’s an 80%+ tax right there. (UPDATE: This CNN report that came out today says gold buyers pay between 18%-60% of face.) But, let’s not stop with that. There’s a second compounding issue that can be material. Gold is an appreciating asset. The US Dollar is a declining asset.
Here’s the historical price of gold:
Here’s the strength of the US Dollar over the same time period:
[UPDATE: Just a note – past performance is not indicative of future returns. Either currency could go up or down from here. It’s unlikely that any currency fluctuation up or down would make up for the initial 80% tax though.]
Here are the real economics: let’s just say you sold your gold jewelry in 2003 where the actual gold value is $100. Let’s say you got $18 for that $100 of gold. And then let’s just say you held that cash until now. The purchasing power of that $18 has declined to ~$14 since 2003. Meanwhile, if you just held the $100 of gold in the form of the jewelry, it would now be worth over $350. I’m not exactly sure how to properly index two bifurcating currencies, but in a nominal sense, you traded something worth $350 for $14. You got paid 4 cents for your dollar. Instead of saying “We Pay Top Dollar” – these companies should say we pay you cents on the dollar.
[UPDATE: This is what happens when you whip together a blog post late at night. Since the gold is priced in dollars, the depreciation of the dollar is embedded in the gold price. So, I didn’t need the second chart so I double counted the impact of the dollar depreciation.]
Now to be fair – most gold sellers probably don’t hold their cash so the separation from gold’s appreciation and the dollar’s depreciation may not actually have time to play out. The seller gets the value of instant liquidity and they probably use it. In addition, the gold buyers do need to have infrastructure to appraise, melt, and monetize gold if they do it themselves. Nonetheless, the tax these companies charge to give you your money back is pretty onerous no matter how you cut it. But, it just goes to show, there’s always ways to get people to give you money in exchange for less money back.