IN THIS EDITION
WHY BANKRUPTCY IS THE NEW BLACK
OK, OK, I’m not exactly one to write about fashion, but fashion is about trends, and investment analysis is frequently about identifying trends early, if possible even before they properly begin, to assume the vanguard position prior to a dramatic outperformance of a given asset, or investment style. And so, in exercise of my modest accumulated wisdom and experience, I am predicting a surge in US corporate restructurings and bankruptcies, if not already in 2012, then in 2013. There is just too much corporate capital being wasted and consumed on bloated, inefficient balance sheets. Investors, normally fearful of bankruptcy, will soon learn that it is, in fact, their best friend. Once a corporation is on the edge, the sooner you push it over, the better. Free up that capital, re-deploy it, run it lean and mean and, when the time is right, leverage it up and score the big returns. How best to invest for a world in which bankruptcy makes the front page of Vogue? Read on.
Truth may be the first casualty of war but semantics is the first weapon of debate. As Sun Tzu observed, to win a war without even fighting is the acme of skill. Well, if you entangle your foes in a semantic net, you can win the debate before it even begins. Just define your terms appropriately.
So it is with the foes of capitalism, some of whom continue to take inspiration, knowingly or not, from Karl Marx. Marx and his sidekick Engels defined capitalism as a system designed to “extract the greatest possible amount of surplus value, and consequently to exploit labor power to the greatest possible extent.”1
Well, to define a system, any system, as exploitative is to stack the rhetorical deck in favour of those who disapprove. What Marx fails to mention in this definition, however, is that the capitalist system seeks to exploit the greatest possible amount of surplus value from ALL inputs, be they energy, technology, the existing capital stock, as well as labour. If, for example, paying higher wages (or granting stock options) to hire skilled workers will enable the capitalist to extract more suplus value from, say, a given technology or, better yet, to develop an entirely new one, well then it is the technology that is being exploited here. But the word ‘exploit’ carries a negative connotation, denoting unfairness. I doubt that technology has much of a problem with being exploited, but semantics being what they are, a sensitive individual can still feel their emotional strings being pulled at the thought.
Luddites aside, most people, including those who rely on the government, or charity, or family handouts, or whatever form of assistance from the labour of others, rejoice daily at the exploitation of technology. Take the plow for example, which greatly improves crop yields. Or fertilizer. Or the food processing, transport and preparation network that practically serves up ready meals on your table, day in and day out. I do not belittle the plight of the poor for one moment, but to continue our semantics discussion, in most of the developed world, recall that, less than a century ago, the poor were referred to as ‘starving’. With over 46mn Americans receiving food stamps today, for example, it is difficult to apply the word ‘starving’ to the poor.
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So yes, capitalism ‘exploits’ all inputs, as mentioned previously. It does so in pursuit of ‘surplus value’, otherwise known as profit. And it does so, and I cannot stress this point more, it does so in a state of competition. Not managed competition. Not controlled competition. Not subsidised or bailed-out competition. Not rent-seeking, special interest, lobbyist enabled competition. No, it does so in a state of essentially pure competition in which underperforming, uncompetitive firms either restructure core operations, shutter their doors voluntarily, or they go BANKRUPT.
There, I said it. That four-letter word of investing, that act of corporate failure, of poor management, or perhaps just bad luck. But the critical point to remember here, in order to understand why bankruptcy is about to become the new black, is that it is a necessary product of healthy, unfettered, dog-eat-dog competition. No bankruptcy, no capitalism. No capitalism, no … well, little if any economic progress. Just ask a historian.2
Within a capitalist system, it is competition that determines just how all ‘exploited’ resources are going to be originated, distributed and redistributed
It could be argued that the Asian economic miracle of recent decades was a product of ‘managed capitalism’ in that most Asian countries have followed a mercantilist (export-led) growth model. However, that can take you only so far, as Japan demonstrates.
dynamically through time. Firms that invest and grow, presumably because they produce products or provide a service that consumers both want and can reasonably afford, will find that they are ‘exploiting’ more workers. And firms that don’t invest or for whatever reason don’t grow, they will find their slice of the ‘exploitation’ pie shrinks over time. Those that do most poorly in the competition stakes and go bankrupt will no longer ‘exploit’ at all.
Now this is going to strike the reader as a rhetorical leap from mere semantics into a trick of logic, but here goes: If what makes a capitalistic system sub-optimal or, in the eyes of some, just plain evil, is the ‘exploitation’ of labour, then it would be desirable for all firms to go bankrupt, as the ‘exploitation’ would thus cease. Workers would, however, find they were out of jobs.
A Marxist might counter that the goal should not be bankruptcy—after all Marxists do desire a general growth of the means of production so as to better provide for all—but rather for the surplus value, or profit, not to accrue to the capitalist, but rather to the workers themselves, hence their desire that ‘workers of the world unite’, rise up, seize the means of production and establish a ‘dictatorship of the proletariat’, that they can then use to satisfy their various needs and wants without an exploiting capitalist skimming off the top. All you need is a revolution. Easy, right?
Not so fast. What is needed following that revolution is some way to determine just what those needs and wants are. Hmmm… now who (or what) should that be? Well, absent a pricing mechanism in a free, objective market in goods and services, it is impossible to know to what extent an individual desires a given good or service in relation to other goods and services. Production and trade that is not free, but rather reflects the edics or preferences of some individual or group of individuals in particular, is not going to determine the true relative prices prioritising everyone’s myriad needs and wants. Rather it will determine something else. Taken to the extreme, where relative prices are simply mandated by a central authority, then all legal fulfilment of needs and wants will reflect nothing more than the edicts of that authority.3
Let’s make the implications of that paragraph crystal-clear: In a large, complex society, with a necessary division of labour, in which the exchange of goods is absolutely essential to even the partial fulfilment of needs and wants, the alternative to a free-market pricing mechanism is authoritarianism, pure and simple.
The word ‘legal’ is used here because, of course, the moment an authority begins to distort prices, enterprising individuals will seek to make an illicit profit by providing goods or services at the prices that people actually want to pay, instead of at those they are forced to pay. Or, alternatively, they will provide goods and services that would not even be provided at all, for example those that are deemed illegal or are taxed so heavily that they can only be provided by a black market.
Now, if you are a fan of authoritarianism, perhaps because you are in a position of authority yourself, then this might rather appeal to you. I, for one, am a father of four. As such, I am in a position of authority with respect to children ranging from 11 years to eight months in age. (That said, my position is subordinate to the head of the household, my wife.)
While I do tire of it from time to time, I regularly exercise my authority. I set rules for all manner of behaviour. And I mete out appropriate (I believe) punishments when I believe these rules have been broken. My household is not run as a free-market capitalist system.
But of course I am hardly omniscient with respect to what goes on under my roof. Indeed, I am a big fan of unsupervised play, in which children interact in the absence of an adult. This requires children to make their own assessment of behaviour, or risks they might take, and to learn lessons accordingly. In the event that the children choose to exchange toys for a time, or to play one game in exchange for playing another therafter, these relative ‘prices’ go unobserved on my part.
The point of this example is to illustrate that there are exchanges taking place in my home of which I am unaware. Yet it is these, and only these voluntary and unsupervised exchanges that can possibly reveal the ‘prices’ that reflect the true preferences of my children. The moment I step into the room, behaviours change, for the better (I hope) or worse. (Physicists call this the ‘uncertainty principle’, in that observed matter necessarily has different properties than unobserved.)
In an authoritarian system, the moment the authority merely takes notice of a given economic activity, that activity changes. Conscious of the attention, and wary that the authority could weigh in with a new regulation, or tax, or whatever, at any time, changes actors’ behaviour. One way in which behaviour might change is that those who are observed start to pro-actively engage the authority, seeking to influence their thoughts, opinions and conclusions in some way. If successful, they won’t be left alone. No, no ‘exploiting’ enterprise would possibly desire that. Much better is to cozy up to the authority, receive subsidies of some kind, or at a minimum restrict competition in some way so as to stack the competitive deck in your favour.4
So-called ‘rent-seeking’ activities pay off handsomely in an authoritarian system. In a purely competitive one, they would be a complete waste of time. It is as if a football team spent its time arguing with the referee rather than playing the game to the best of their ability. No doubt a strategy of arguing
4 While I am no fan of lobbying, there is a huge misconception amongst many of its critics, that corporate lobbying activities are, for the most part, aimed at deregulating industries. Nothing could be further from the truth. The vast majority of the corporate lobbying activity in Washington is aimed at structuring the regulatory environment in such a way that it benefits established firms at the expense of those seeking to compete. Bush’s Medicare prescription drug benefit and ‘Obamacare’ are two recent, prominent examples.
with the referee, rather than playing well, would fail. The team in question would come bottom of the standings, struggle to attract good players and, eventually, be relegated to the minor leagues.
Of course that team’s assets—the players—would not necessarily be so relegated. Talented players would find their way to other teams that were more inclined to compete than to argue with referees. And guess what? Under pressure of competition, the acquisition of these talented players would allow other teams to raise their game, much to the benefit of the consumers, in this case, the fans.
Viewed in this way, bankruptcy is more than just a necessary evil of capitalism that we need accept. It is a powerful driving force of real economic competition, albeit one operating largely unseen in the background. As I argue in my new book, THE GOLDEN REVOLUTION , bankruptcy is also a key enabler of Schumpeterian ‘Creative Destruction’, without which dramatic leaps in economic progress become all but impossible.
So now, let’s move to the catwalk and check out the next trend in corporate fashion. Fortunately, we have no shortage of bankruptcy models. Just think of all the firms that have been bailed out in recent years (financials, autos+parts). Or of those that are subsidised in some way (energy, defence, agriculture). Or that have regulatory protections restricting competition (healthcare, pharmaceuticals, utilities, telecommunications, financials again).
With no bail-out, no subsidy and no regulatory protections, just imagine how many of today’s firms would be exposed as inefficient wasters of capital. How many would find themselves unprofitable? How many would have to restructure dramatically or shut their doors entirely? It is impossible to know, of course, but we are no longer far off finding out.
A recent study by Deutsche Bank points out that the main reason why corporate default rates have not soared in recent years is due to the “unprecedented intervention” of European and U.S. policy makers. Well, with the European economy now slowing and that of the US limping along in what can only loosely be termed a ‘recovery’, without fresh stimulus, the chickens will soon find their way home to roost.5
It gets better. In both Europe and in the US, state and regional governments, the source of a good portion of the arbitrary, rent-seeking distortions listed above, are beginning to find that they are unable to meet their own obligations. While a central European authority and the US federal government may consider offering assistance, as it stands now, it appears that a large wave of fiscal austerity is building up, soon to sweep across the land.
In the US, it is increasingly clear that a range of new taxes and/or higher tax rates are almost certainly going to arrive in 2013. The cumulative effect on 5 An article discussing this study can be found here.
corporate cash flow and profitability is going to be palpable. With subsidies declining and taxes rising, 2013 is going to be a grim year for corporations.
When corporations see things deteriorating, they will consider their options. Some will restructure and downsize. Others will resist, only to find that they stare the risk of bankruptcy in the face. It is investors, however, who are likely to have a complete change of heart. Just as a homeowner underwater on a mortgage can make an entirely sensible decision to walk away from a house, once investors realise that a company is at serious risk of bankruptcy, they are going to force the issue. Why? Because it makes fundamental economic sense. Unless you’re expecting to live off subsidies or protective regulations forever, when you realise that, in fact, you can’t compete, well then the best decision you can make is to pull the plug right then and there.
Don’t forget, for all the talk of corporate de-leveraging, outside of a few isolated pockets, there really hasn’t been much to speak of since 2008. In an Amphora Report from last year, Fighting Solvency Time Bombs with Liquidity Bazookas,6 I pointed out how, while US nonfinancial corporations in general are more liquid than they were in 2008, they are not yet materially less leveraged and, importantly, they are much more highly leveraged than has ever been the case prior to an investment boom. In other words, if you are waiting for investment to lead the way to recovery, a great deal of de-leveraging is required. As it happens, wave of corporate bankruptcies would accomplish that in short order.
On no account do I mean to suggest that, somehow, bankruptcy is a free lunch. Yes, the threat of bankruptcy stimulates competition. Yes, once it occurs, it reallocates capital from inefficient to efficient uses. But there are costs associated with the poor business decisions that lead to bankruptcy. However, it is important to recognise that these costs were incurred in the past. They may be realised in an accounting sense when the legal act of bankruptcy is made. But the costs are sunk costs, never to be recovered and, as such, once a bankruptcy candidate is identified, you want to force the issue as quickly as possible and not throw any good money after bad.
INVESTING IN BANKRUPT FASHION
The greatest investment returns accrue to those who take the greatest risks yet are proven right by events. Nowhere is this more frequently observed than when it comes to investing in distressed assets, that is, those that are involved in bankruptcy: potential, imminent or actual. Indeed, bankruptcy provides the single most effective way for investors to acquire real corporate assets at fire-sale prices.
The way to take advantage of a looming wave of bankruptcies is to eschew stocks in favour of distressed bonds. While it is the bondholders that are defaulted on, that is mere inconvenience when 6 This Amphora Report can be found at the link here.
compared to the shareholders, who are wiped out. Bondholders forgo interest payments but, as senior creditors, they have the first claims on the assets.
For the sake of illustration, imagine that a corporate bond investor buys up the entire corporate debt market. Now imagine that every company files for bankruptcy. Well guess what? That investor will have just acquired the entire corporate capital stock, courtesy of shareholders, who clearly overpaid for their shares. This is a simple way to think about why, anticipating corporate bankruptcy, investors would be wise to reduce stock holdings and to start looking for opportunities in distressed bonds.
But wait a minute. What about cash instead? Why settle for a sub-100% recovery rate for illiquid assets when liquid cash will hold 100% of its value? The problem here is that, unlike the corporate capital stock, cash can be printed and diluted such that it continually loses purchasing power. What is 100% today reduces to a mere 83% after four years of inflation compounding at 4%. (This is the course the UK has been on since 2009.)
However, corporate bonds, paying fixed coupons, also are at risk in the event that inflation rises to the point where central banks begin to raise interest rates. As such, investors in corporate bonds need to consider how they can protect themselves for past, present and probable future money printing. Well, this is in fact surprisingly easy: Rather than purchase fixed-coupon corporate bonds, buy FRNs (floating rate notes) instead. Their coupons will rise along with interest rates such that, in the event that there is a surge in inflation, and central banks eventually raise rates in response, the damage will be limited.
Think of these distressed FRNs as being like options. On the one hand, ‘deflationary’ downside is limited to the recovery rate on real corporate assets in the event of bankruptcy. On the other, ‘inflationary’ downside is limited by the floating-rate coupons.
Inflation and interest rate risk aside, another challenge with investing in distressed assets is that, while they might appear cheap, they are highly illiquid. Indeed, while bankruptcy proceedings are underway, the affected assets are untouchable. Eventually they will be released to creditors, but it is often unclear just how long that process will take. For example, Lehman’s creditors are only now beginning to retrieve their assets from that admittedly highly complex 2008 bankruptcy.
There is no avoiding the illiquid nature of distressed investing any more than one can avoid it in private equity. Indeed, distressed investing can be thought of as ‘private equity on steroids’: The risks, and the potential rewards, are even greater.
For those investors who agree that there is a wave of bankruptcies on the way in the near future and who are interested in taking advantage through distressed investing, care must be taken not to tie up too much capital in such an illiquid form. I thus remind Amphora Report readers that our core recommendation remains to hold a defensive, diversified portfolio of liquid commodities. Not only do these retain their purchasing power better than cash in the event of rising inflation; they also carry no credit or default risk, limiting the downside in the event of a sudden deflation that takes out financial counterparties, including banks.
“John Butler provides much illuminating detail on how the world?s monetary system got into its present mess. And if you’re wondering what comes next, this is the book to read.” —Bill Bonner, author of the New York Times bestsellers Empire of Debt, Financial Reckoning Day, and Mobs, Messiahs and Markets
More Praise for THE GOLDEN REVOLUTION:
“John Butler has written an indispensable reference on the subject of gold as money. His book is a combination of history, analysis, and economics that the reader will find useful in understanding the use and misuse of gold standards over the past century. He breaks the book into a long series of essays on particular aspects of gold that the reader can take as a whole or in small bites. It is technical yet accessible at the same time. The Golden Revolution is a useful and timely contribution to the growing literature on gold and gold standards in monetary systems. I highly recommend it.” —James Rickards, author of the New York Times bestseller Currency Wars: The Making of the Next Global Crisis
“In The Golden Revolution, John Butler makes a powerful case for a return to the gold standard and offers a plausible path for our nation to get there. Enlightened investors who blaze the trail will likely reap the greatest reward. For those still wandering in the dark, this book provides necessary light to keep you headed in the right direction.” —Peter Schiff, CEO, Euro Pacific Precious Metals; host of The Peter Schiff Show; and author of The Real Crash: America’s Coming Bankruptcy—How to Save Yourself and Your Country
“John Butler’s historical treasure trove empowers the reader to understand, prepare, and act. To have a chance to emerge unscathed from financial turmoil, join the Golden Revolution. I have.” —Axel Merk, Merk Funds; author of Sustainable Wealth
“The Golden Revolution is another indispensable step on the road map back to sound money. John Butler?s experience of the modern ?fiat? banking world, combined with his understanding of the virtues of a disciplined monetary system, allow for genuine insight into the practical steps that could, and surely will, be taken to reestablish gold as money.” —Ned Naylor–Leyland, Investment Director MCSI, Cheviot Asset Management
“Ex scientia pecuniae libertas (out of knowledge of money comes freedom).John has used his exemplary knowledge of money to lay out a cogent framework for the transition of society based on fiat money to a more honest society forged by gold. He has taken complexity and given us simplicity. Monetary economics and its interrelationship with geopolitics, finance and society is extraordinarily complex, but he has managed to assimilate a vast array of information and distill it in a simple and thoughtful framework. That is an art many academic writers never achieve.” —Ben Davies, cofounder and CEO, Hinde Capital
AMPHORA: A ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. JOHN BUTLER [email protected]
John Butler has 18 years’ experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, quantitative strategies. Prior to joining DB in 2007, John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences. His new book,
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