Today you’re going to read a Daily Reckoning that’s been five years in the making-that’s if you can manage to get through it. If you do, I’m willing to bet you’ll be a Daily Reckoning reader for the next five years. You’ll want to see how today’s story finishes. But I’m going to guess that less than 10% of all readers today will get to the end. Why?
It’s too long! I’ve been getting that complaint ever since we first began publishing the DR in Australia in 2007. You’re busy. You don’t have time. You want me to get to the point. Blah blah blah. I’ve heard it all before.
But good stories take as long as they take. Do you think Tolstoy’s editor told him that War and Peace was too long? Do you think Shakespeare’s proof reader said, “Bill…I really love this Hamlet guy. But you need to get rid of one of the Acts. Five is too many. People can’t stand and watch a play for five acts. They need to drink ale.”
Today’s story is how the investment world you live in came to be…and how we’re on the edge of a great leap forward…or a great leap into a deep abyss. If you don’t have time to read it, go over to Facebook and tell everyone you’re too busy to read about the most important investment story of your life.
Act One: Globalisation in Retreat and Insiders in Flight
Like any good story I’ll begin in the middle, then show you how we got here, and finish with where we’re headed next. I’ve even chucked in an epilogue on the value of Facebook for storytelling. But let us begin with the facts. And the first fact is that globalisation is in retreat.
Consider the initial public offering of Swiss commodities trader Glencore in mid-May of last year. Glencore is still down 21.6% from its IPO price. It’s up from its lows in September of last year. You can see the woeful state of affairs in the chart below.
When Glencore went public I asked if it was a sell signal for the whole commodities complex. When there’s more money mining the share market than trading the output of mines, you know business conditions have changed. It would have been tempting for long-time Glencore employees to get out while the getting was good.
Nine months later, some of them are starting to. The Financial Times reports that Steven Blumgart, the head of Glencore’s aluminium division and one of its most senior executives, announced his retirement in late January. The FT says, “It’s the first significant departure since [Glencore’s] multi-billion pound initial public offering last year.”
The FT goes on about the IPO and Blumgart’s departure, “The windfall for Glencore employees prompted some investors to question whether the IPO marked the staff’s cashing it at the top of the commodities cycle. The departure, which insiders say was planned months ago, is likely to reignite those concerns.”
Now there are many valid and non-conspiratorial reasons for a person to leave a job after many years. It’s perfectly normal. What’s more, Glencore’s CEO Ivan Glasenberg said he has no plans to leave any time soon. He’s even bought shares. The truth is, Glasenberg can’t cash out without damaging the value of his own equity stake in Glencore.
Glasenberg’s dilemma should remind Mark Zuckerberg of the irony of having your wealth linked to the value of your company: you’re only fabulously rich if you stay with the firm. You can leave the firm and be moderately rich. But to be truly fabulous, you must remain in the service of the customer.
When the CEO becomes the brand (Apple with Steve Jobs, Microsoft with Bill Gates, or even Warren Buffett with Berkshire Hathaway) the investing public associates the performance of the company with the man or woman at the top. If that man or woman leaves, the shares can fall and the paper wealth of the CEO is diminished.
There is a paradox in there somewhere for a graduate student to write a thesis. CEOs have been so successful in making themselves into superstars that they can’t afford to leave! To be fair, it is clearly possible for a CEO to get rich even if he leaves a business.
In fact, these days you can make more money getting fired than you can by keeping your job. For example, Hewlett Packard fired its CEO Leo Apotheker last year. He’d been CEO for just 11 months. The stock fell by 45% during his tenure. Yet he was paid a severance of $7.2 million and received another $2.4 million in performance related bonuses.
As an aside, its stories like this which cause people to wonder if hard work is really rewarded any more. If it’s possible to get ahead by being fired, then why bother working at all? This is partly what the current crisis is all about: loss of faith in the fairness of the economic world. How did we get here?
Act Two: The Cult of Shareholder Value, the Financialisation of the Western World, and the Consumption Boom
Somewhere in the early to mid-1980’s having a telegenic, dynamic, and likable CEO became important on Wall Street. It was probably around the same time that executive compensation became tied to quarterly earnings performance. In fact, it was about the time Jack Welch became CEO of General Electric.
I’m going to spend a little time on Jack Welch. His story coincides with the greatest equities bull market of all time. And though Welch is now often referred to as one of the great CEOs ever, I’d like to make the claim that his success as a CEO is directly related to the expansion of a massive credit bubble. Credit bubbles make everyone look like a genius CEO, just as bull markets make all punters feel like a genius.
You do need to give Welch a certain amount of credit. He started at GE as a junior chemical engineer in 1960. He worked his way up the ranks to become CEO in 1981. At that time, GE had total revenues of $26.8 billion and a market capitalisation of $14 billion. When he retired on September 2nd of 2001, GE had annual sales of $130 billion and a market cap of $410 billion.
You read that correctly. When Welch took over, according to GE’s official biography, the market value of the company was about half of annual revenues. You can only ever buy a company selling at less than one times sales if you’re in a savage bear market, or if it’s a lousy company.
GE wasn’t a lousy company. It was mostly an engineering and high-value manufacturing company. And in 1981, stocks were pricing in the Reagan recession. Stocks were cheap. In fact, they were as cheap as they were going to get for the next twenty years. Welch had very good timing.
In 1981, Welch gave a speech at the Pierre Hotel in New York. It’s a famous speech now. Its title was “Growing fast in a slow-growth economy”. He never used the phrase “shareholder value” in the speech. But this is now widely regarded as the moment when corporations began judging their success by the performance of the share price rather than any underlying metric of value.
Welch gave birth to the cult of shareholder value, although he later repudiated the idea in a 2009 interview with the Financial Times. In the late 1980s, he became famous (or infamous) for his management technique of regularly firing the bottom 10% of his management team. He popularised the six sigma management strategy originally developed by Motorola. And for the next twenty years, GE grew its earnings and its share price by virtue of a record expansion of money and credit in the world.
To understand how GE grew its revenues by 385% during Welch’s tenure (and its market cap by 925%), all you really need to do is look at the consolidated revenues by business segment in GE’s 2000 annual report. That was the last full year Welch led the company.
As you can see below, GE Capital Services (GECS) – the financial arm of the business involved in everything from commercial finance to insurance to mortgage lending – made $66 billion in sales 2000. The old industrial manufacturing part of the business, by contrast, generated $63 billion in revenues.
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Of course, it’s no sin for GE to have a diversified business portfolio. But it is useful to know what was driving the company’s growth. Maybe it was the brilliance of Jack Welch. Or maybe it was something else, like credit growth. GECS revenues doubled between 1996 and 2001, from $32 billion to $66 billion. Meanwhile, total company revenues, which included the plodding industrial operating segment, grew by 63% over the same period.
Now, 63% isn’t exactly smoked chicken either. But even without knowing what GE’s income statement and balance sheet looked like in 1981, it’s safe to say the expansion of money and credit in the United States took GE to new heights by the late 1990s. The focus on shareholder value (management of the share price) led the company to grow earnings (and earnings per share) by expanding the financial arm of the business. This set an example and led to a trend across corporate America: stock price strength through debt growth.
Not coincidentally, the broadest measure of US money and credit, M3, began to expand dramatically by early 1995. M3 is a discontinued money supply figure that includes coins, currency, savings and demand deposits, checking accounts, and institutional and retail money market funds.
In other words, it’s the best measure of the supply of money and liquid credit assets in an economy. That’s probably why the Fed discontinued publishing it in 2005. As you can see, the rapid expansion of M3 from 1995 to 2005 matches the 515% increase in GE’s share price from $9.39 in April of 1995 to $57.81 in June of 2000.
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GE is probably the most visible example of how the credit bubble distorted the business model of major corporations. The credit boom altered incentives in the macro economy and rewarded speculators. It also caused other companies to increase production based on consumption that was boosted by credit. If consumer demand was growing, then the supply of goods and services had to grow to meet it. This process would eventually filter all the way down to the demand for raw materials from Australia. This brings us to the final act of our drama.
Act Three: The Commodity Boom and the Evolving Nature of Chinese Growth
Yes, our story has finally made its way to the Lucky Country. It’s no coincidence the explosion in credit growth that began in 1995 coincided with the bottom in commodity prices. Stocks were peaking as an asset class. Commodities were at a nadir.
But the consumption led boom in the Western world finally led to the great supply shock in commodities. Two decades of under investment in productive capacity plus huge growth in demand led to rising commodity prices. And directly to the current boom, whose future is very much in doubt.
You don’t need me to remind you of how good the commodities boom has been to Australia. I visited Australia for the first time in late 2002. Early the next year I recommended BHP Billiton to the readers of my US newsletter, Strategic Investment. The argument was simple: China was about to undergo a lot of rapid, metals-intensive industrialisation.
This was all part of the plan in China, by the way. China’s economy is managed by five-year plans. The 11th five-year plan featured a lot of investment led growth. This fixed asset investment – roads, bridges, railways, and urban housing – was heavy on steel consumption. This was manna from heaven for BHP and Rio Tinto.
This huge demand for steel was also based on China’s deliberate move to migrate hundreds of millions of people from rural farms to cities, where they could work in factories and be part of China’s export machine – the machine driving China’s growth.
It wasn’t hard to understand this process. Credit growth in the Western world led to an export boom in China. That export boom demanded huge quantities of raw materials. Many of those raw materials came from Australia. Australia’s Treasury Department even recognised this in 2005.
Treasury produced a chart that put China’s steel-based industrialisation into historical perspective. It compared world GDP to world steel production. The great growth periods of the past were matched by giant increases in steel production from newly industrialising nations. China’s industrialisation was just the latest, greatest example of how economic growth is driven by fixed asset investment.
That Treasury paper was published in 2005. By 2007, as you know, the credit bubble had truly popped. And here we are today. We are now at the final phase of China’s metals intensive growth. China’s commodity demand is shifting toward resources involved in an expanding consumer sector. That’s the claim I’m making, anyway. But let me offer you some proof.
My first item of proof is the resignation of Steven Blumgart from the aluminium division at Glencore. Blumgart leaves shortly after aluminium prices neared a two-year low. They could recover, of course. But the weak performance of base metals in general (aluminium, zinc, and nickel) could confirm what I’m suggesting: metals consumption in China is peaking.
Now, it may be more of a plateau than a peak. The 12th 5-year plan urges China to move slowly from an investment led economy to a consumption led economy. This would change the structure of China’s demand for resources. It would slowly demand fewer metals, but more of different commodities.
Mineral sands like zircon, rutile, and titanium dioxide are used in the production of ceramics, glassware, and paint, for example. This is right up the alley of a company like Iluka Resources (ASX:ILU). I profiled Iluka in Australian Wealth Gameplan in 2010 (although to be fair, I talked about it as a potential thorium play). Look at what Iluka has done in the last two years.
This story – how Chinese commodity demand is evolving in 2012 and over the next five years – is what I hope we can explore at our After America conference in Sydney. For the last five years, I’ve written about the collapse of the global credit bubble and how to survive it. This is the year that the story could move beyond crisis and collapse and turn into a real transition in the leadership of the global economy. That is the central idea of the After America symposium.
The good news is that every editor I’ve spoken with has ideas on what opportunities may evolve from China’s plans. And some, like me, think those plans could go awry. If you’re not able to come to the conference, I can assure you this is the story that will dominate the Daily Reckoning over the next year.
Can the world economy make a seamless transition from Western- led growth to BRICS– led growth? Or is this the year we all stumble and fall in the ditch?
On the opportunity side, China’s 12th five-year plan calls for more investment in alternative and renewable energy, IT, and biotechnology. This is a small-cap investor’s dream and something Kris Sayce will be speaking about in Sydney. Now, I’m not convinced the official goal will lead to any real breakthroughs. That’s not how innovation works. But it will spur investment in clean-energy start ups and also other industries like biotech and IT.
Another example is the focus on “Strategic Emerging Industries” in the plan. China isn’t planning on quitting the manufacturing business. It’s trying to move up the value chain by making things that are more sophisticated, complex, and have higher trade value. This should create value for some of the “strategic metals” Alex Cowie is researching in Diggers and Drillers.
All the keynote speakers – Satyajit Das, Dylan Grice, Paul Monk, and David Thomas – will have something to say about the current state of play. And Murray Dawes, Greg Canavan and I will be speaking as well. I can’t promise any consensus. But I can promise a lot of discussion and actionable ideas.
In some ways, the whole purpose of the Daily Reckoning over the last five years has been to prepare you for the bursting of the credit bubble. That aftermath of the credit bubble – huge government debt in Europe, a chronic housing mess in America, and global deleveraging – are still with us.
But I sense the China aspect of the story is evolving (especially in terms of energy). Now is the right time to set aside a few days and think hard on the issues to see what we can come up with. And speaking of thinking, let’s return to Facebook.
Epilogue: Redemption through Relevance
I should clarify my main complaint about Facebook yesterday. It’s not that sharing pictures of your breakfast is evil. After all, breakfast is just breakfast. My main point is that the more information you flood your brain with, the less time you have to distinguish between what matters in this world and what doesn’t.
We live in an age where too much information degrades your ability to make sound judgements. Facebook understands this. For starters, the information you’re presented with on your Facebook page is already sorted by importance.
Granted, the default sorting order is set by Facebook. It tells you which stories from which friends it “thinks” will be more interesting to you. This is kind of aggravating. But this attempt to sort information is in recognition of the fact that some information is more valuable to you than other information.
Facebook also understands the importance of stories. Stories are how human beings transmit useful knowledge. Stories are also how we create or impose meaning on the random events of our life. Telling stories isn’t just how we communicate. Telling stories is how we try and understand the world.
Facebook’s new format is based on the importance of stories. The new format for presenting information is called “Timeline.” Mark Zuckerberg said, “Timeline is the story of your life”.
It’s a fascinating marketing move. Facebook is trying to become the medium by which people tell their stories to the rest of the world. Those stories may or may not actually reflect the real lives of the story tellers. But I should at least give Facebook credit for understanding something important about communication: information has no value if it’s not accessible through a good story.
Communication devoid of content or context is just noise. This is my main beef with Facebook. People are so busy with trivial things they’re failing to see the big things. And there are some very big things to see, if you take the time to look.
for The Daily Reckoning Australia