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The London Brief - September 30th, 2020

The London Brief

September 30th, 2020

Value investing hit a new low as a man decided to sue Ben Graham’s dead body for losing his money. “I read the Intelligent Investor over 20 times. What a complete waste of time.” He had invested in newspapers, movie theatres, radio stations and oil and gas stocks.

This month’s brief will go over developments at the Fed and possibly why value isn’t working, some thoughts on virtual currencies, an initial assessment of Japan’s new prime minister, thoughts on a recent hedge fund fee study and a run-down on M&A activity for the month.

The Fed

Stanley Druckenmiller said, “I think the merging of the Fed and the Treasury, which is effectively what’s happening during COVID sets a precedent that we’ve never seen since the Fed got their independence, and it’s obviously creating a massive, massive raging mania in financial assets. For the first time in a long, long time, I’m actually worried about inflation because we actually have the Chairman of the Federal Reserve with a three and a half trillion dollar deficit lobbying Congress to do more spending and guaranteeing those of us on Wall Street that he’ll underwrite it.”

Perhaps because of this desire to print, Judy Shelton, the controversial nominee to Fed did not yet[1] get support for her nomination by key Republicans. “Ms. Shelton’s views are so extreme and ill-considered as to be an unnecessary distraction from the tasks at hand” said a group of former Fed officials including Alan Blinder, ex-Vice Chair. In the past she has said, “I don’t see any reference to independence in the legislation that has defined the role of the Federal Reserve for the United States.” She advocated going back to the gold standard in a 2009 editorial. She favours virtual currencies competing against government issued currencies. She wanted a new Bretton Woods style conference to reset the monetary system. “If it takes place at Mar-a-Lago that would be great. We make America great again by making America’s money great again.”

The worlds central bankers and many Republicans fervently disagree.

Reserve and Virtual Currencies

The Kipling Doctrine suggests that if you hold your money supply constant while everyone else is printing money then reserve currency status can be yours.

Virtual currencies satisfy this principle of constancy, but they partly suffer from a dependence on illicit trade. For instance, the dark web spawned the Silk Road marketplace, a combination of Amazon and Ebay for drugs. Sellers were ranked for product quality and service. Although this site has now been shut down and its youthful founder controversially serving an almost life-long sentence, several copycat sites have popped up. The sites offer product 24 hours a day, seven days a week and apparently the customer service has gotten better. One way to shut down the dark web drug trade would be to co-opt virtual currencies into the financial system where exchanges would have to report on who was using it. This could frustrate the use of these nascent currencies.

I listened to an interesting podcast with Cleo Paskal, an Associate Fellow at Chatham House in their Asia Pacific program as well as a Resident Senior Fellow for the Indo-Pacific in the Center on Military and Political Power at the Foundation for the Defence of Democracies (her business cards must difficult for printers). She spoke about China’s Strategic National Power initiative where points are awarded by the party for various initiatives that enhance China’s global power. A key reason why China has taken a hard line in Hong Kong, Xinjiang and India is that the world is distracted by Covid and election politics. It’s able to use the distraction to implement strategic policy initiatives. When nations take countermeasures then China steps back, but its policy initiatives haven’t changed; they instead revert to playing a longer game. But China cannot realize its imperial ambitions if it’s latched its monetary system to the dollar.

China’s political incentives to break away have never been higher. Carrie Lam of Hong Kong has credit card issues due to U.S. sanctions. The former colony’s police union had to relocate $1.4 billion of assets to Chinese banks. The dollar is used for 40% of SWIFT transactions versus 2% for the RMB. The U.S. has the power to direct action against Chinese banks. China still needs FDI from multinationals. Ding Shuang at Standard Chartered Bank says, “The danger of [sanctions against Chinese banks] occurring is one of the key reasons that China may accelerate the renminbi internationalization.”

As part of China’s National Power objectives, it launched a digital currency last April. Consumers and businesses will download a digital wallet onto their mobile phone and then use the Digital Currency Electronic Payment like cash. The digital money’s value is tied to the yuan. It’s currently being tested in major cities at places like ride hailing apps, food delivery services and McDonald’s. The currency was designed by former PBOC governor Zhou Xiaochuan, who wanted to protect China from someday having to adopt a standard like Bitcoin or Facebook’s Libra, which would be designed and controlled by others. China’s digital currency is not like other cryptocurrencies in that there is no anonymity and it doesn’t use the blockchain.

On the surface, it does not look like China’s virtual currency really changes all that much domestically. However, as China expands via its Belt and Road initiatives, it may make and receive payments in yuan as countries in Africa, the Middle East and Asia utilize this digital currency to buy goods from China or potentially as an exchange currency with each other. Because there is no anonymity and everything is digitally tracked, for a Chinese domestic holder, it probably would still not be very feasible to expatriate your money.

Japan’s New Prime Minister

Yoshihide Suga, won a landslide victory, to replace Shinzo Abe to lead the LDP Party. Elections may be called in October to give him a popular mandate so he can make substantive changes. He was credited with driving domestic reforms such as visa changes that created a boom in Chinese tourism. Mr. Suga has highlighted the inefficiencies of small and medium sized companies. He also wants to promote the digital economy.

Suga is the son of a strawberry farmer. He is known for his work ethic and pragmatism. He has pledged continuity. His only known business stances are the need for more competition amongst mobile providers, reducing the number of regional banks and introducing casino reforms.

According to Zuhair Khan of UBP, Suga is keen on further measures to empower shareholders. Certainly, Warren Buffett with his significant investment into Japan’s trading houses last month thinks the change is sustainable.

More thoughts on this to come.

Hedge Fund Fees

Pictet cut out UCITs strategies from its fund of fund portfolios last month. They believe the strategies are primarily long/short funds with risk and performance characteristics that are more moderate than the offshore world. In other words, they didn’t like the returns. I expect many are grappling with the same issues around performance.

The National Bureau of Economic Research put out a paper called “The Performance of Hedge Fund Performance Fees”[2]. They analysed 6,000 hedge funds from 1995 through 2016. The funds produced gross profits of $317 billion, of which they kept $202 billion ($88.7 billion of management fees and $113.3 billion of performance fees). The negative skew is created from asymmetric performance fees in that during a good year, investors pay but when there are losses hedge funds do not share in the losses or claw-back past performance fees.

Investors who invest in multiple funds can face netting issues where maybe Fund A and B earn positive returns, but Fund C is negative. As a result, the investor pays the performance fees on A and B without an offset from Fund C.

Another behavioural characteristic is that when a hedge fund manager is substantially below the high-water market, some managers choose to quit and lock in losses and the loss of the performance fees. Other managers tend to create families of hedge funds. When one of the smaller funds goes negative, the parent may shut it down rather than try to earn back the losses, which also crystallizes losses.

The study points to two pieces of advice that could augment returns by avoiding this asymmetry risk. First, it’s important that hedge funds go the duration. If a manager is distracted with other ventures or potential successors choose to launch their own funds rather than keep paying the original founder, there is a reasonable probability they stop the fund and liquidate when they are below the high-water mark potentially locking in losses. Second, the smaller entities of fund families are risky. Not only are there the usual risks of focus and allocation, but if that part of the fund family is in the red, there is an incentive to shut down the fund and focus on the larger performing funds instead. As an example, Echo Street Capital Management was down 10% in its hedge fund and had a waiting list of investors allegedly. They decided to shut the hedge fund last month, continue with the larger long-only strategy they had and then launch a new long-only focused vehicle that sounds like a hedge fund. The idea is that they no longer wanted to sell a ‘low volatility’ product, because that product was not really low volatility. All investors in the fund though paid performance fees when things were good but have now locked in a 10% loss. Avoiding fund carve-outs and focusing on the main fund might be more prudent.


Frank Aquila, global head of M&A at Sullivan & Cromwell, said, “A coalescence of deals on hold coming back to life, central banks providing copious amounts of cheap liquidity and companies seeking growth has led to an M&A boom as deal makers have returned from pandemic enforced seclusion. Unless there is a significant economic shut-down in the coming months, M&A activity will likely remain at near record levels through at least the end of 2020 and likely into 2021.”[3] Despite a flare-up in coronavirus cases, M&A activity held firm in September broadly bearing this comment out.

Shareholder activism may get more difficult if the U.S. Department of Labor has its way. The potential news rules would prohibit pension funds from voting at annual meetings, “unless the fiduciary prudently determines that the matter has an economic impact on the plan.” ISS blasted the plan. It could make life more difficult for shareholder activists who have benefitted from ISS recommendations.

Long-awaited European banking consolidation transpired. Caixabank and Bankia announced a €4.3 billion merger. From the 2008 crisis the number of major banks in Spain went from 55 to 12; now it may go to single digits. Italy is trying to find a buyer for Monte dei Paschi by year-end. UBS and Credit Suisse are exploring a potential deal. Credit Agricole is looking for mergers in Italy. There should be more European banking M&A to come.

Japanese firms continued their overseas diversification with Orix buying a 20% stake in Indian renewables developer Greenko Energy for $980m. Domestic consolidation continues. Regional banks are looking to consolidate with an announced deal between Michinoku Bank ($181m) and Aomori Bank ($422m). Yamada Denki made a partial tender offer to Hinokiya Group in a $229 million transaction. Hitachi Capital and MUFJ Leasing are merging in a $3 billion deal. But the big deal in Japan was NTT buying in the rest of NTT Docomo in a $40 billion tender offer.

Private equity continued to be active and seems to be benefitting from recent debt issuances allowing for ‘portability’, where the debt transfers to a new PE buyer in a sale. Blackstone bought Precision Medicine Group from TPG and Berkshire Partners for $2.3 billion. Cambium Learning, a company backed by Veritas Capital, acquired the Rosetta Stone for $792m. Pacific Equity Partners bought Citadel, a cyber-security software firm, for $340 million. KKR bought 1-800 Contacts from AEA for $3.2 billion. AEA had bought 1-800 Contacts from Thomas H. Lee in 2016. Bain and a Finnish consortium bought Ahlstrom-Munksjo for €2.1 billion. The company makes specialized fibre-based products like high-tech engine filters, release liner (underneath stickers) and décor products, like laminate papers for modern kitchen cabinets. It also makes fabrics for medical facemasks. PE-backed Ivanti acquired MobileIron for $870m.

DCP Partners made an approach to 51job. DCP is an Asian private equity firm. 51job provides recruitment, employee retention and personnel-related services in China. The firm has a Wuhan call centre and sales and service locations. This is continuing the potential theme of Chinese listed companies on U.S. exchanges being privatized or relocated. Sina Corp. also received an improved offer for its founder to go private. And Tencent acquired Sogou. There was a $840 million deal for Macau Legend by a large junket operator. The company had been negatively impacted by the coronavirus and China’s crack-down on money laundering. The buyer will help the company with liquidity during this cash burn period. Deals was on the smaller side in Hong Kong and greater China, but there continue to be transactions. The Chairman of Cross-Harbour Holdings looked to buy out his $672m Hong-Kong listed motor school and Western Harbour Tunnel company. The holding company was almost a cash shell. The company had been subject to an activist push. YuanShengTai Dairy Farm announced that China Feihe made a voluntary offer for $380m. Whirlpool China received a partial takeover bid from rival Glanz Electrical Appliance. Whirlpool welcomed the offer. The company has a RMB 9 billion market cap.

Patrick Drahi took advantage of low valuations to make an offer to take his holding company, Altice, private in a €5.2 billion deal. Iliad bought Play Communications for €1.6 billion as Iliad enters the Polish telecoms market. Altice made an unsolicited $10.3b bid for Cogeco, a Canadian cable operator. The stock is controlled by the Audet family, which owns 69% of the voting rights of the company.

Outside of these key industries and regions, there was a widespread number of deals in various industries. Veolia made an approach to Engie to buy its 29.9% stake in Suez in a hostile takeover. Nvidia acquired ARM from Softbank for $40 billion designed to transform the semiconductor sector. This deal will not be an easy one from a regulatory perspective with customers likely to complain on the antitrust side and China worried about a neutral player becoming U.S. controlled. Gilead bought Immunomedics for $20 billion as it seeks to diversify into oncology. Microsoft bought a private gaming company called Bethesda Studios for $7.5 billion. The gaming company makes such environmentally prescient titles as Doomed. Caesars tried to make a $3.7 billion bid for William Hill. Caesars (formerly El Dorado) was a company back in March the market thought was going under due to excessive debt. Six months later it’s able to mount a cash unsolicited offer. A division of Nestle acquired Aimmune, which is a pharmaceutical acquisition for peanut allergies, for $2.6 billion enterprise value. MetLife agreed to acquire Versant Health from an investor group led by Centerbridge Partners for $1.7 billion. A consortium led by Paradigm Capital made a €293 million bid for Sverige Holding which operates as an education institution focusing on the mastery of the English language worldwide. E.W. Scripps agreed to buy ION Media Networks for $2.65 billion with help from Berkshire Hathaway. It will double its roster of TV stations. Illumina bought privately held company Grail in a $8 billion deal. Grail specializes in cancer detection and was originally founded by Illumina who still owns a 12% stake. WPX and Devon Energy merged in a $3.5 billion deal in the oil space. Baring Private Equity acquired Virtusa in Sri Lanka for $2 billion. The deal is contested by some shareholders who think Virtusa sold too cheaply. Euronext made an offer to buy the Borsa Italiana from the London Stock Exchange; it was given exclusive negotiating rights. EPGC made an unconditional offer to buy the rest of Metro AG. It looks opportunistic. The increased stake should enhance the ability for EPGC to pick the next CEO. Farm Bureau Property & Casualty made a $440m offer for FBL Financial. Altor made a $300m offer for Gunnebo, which provides security solutions.

End Notes

A poll by the Pew Research Center said that 52% of young Americans from 18-29 are still living with their parents. There was a significant spike since February due to the coronavirus. A Bloomberg article, “Workers Keeping Americans Fed are Going Hungry in the Heartland” had some disturbing statistics. One-third of those relying on emergency food distributions are doing it for the first time. Before the pandemic, the U.S. had the highest number of people who couldn’t afford a basic energy-efficient diet among the world’s 63 high income countries at around 1% of the population versus 1% for Italy, 0.5% for Greece and 0.2% for Norway. During the pandemic 10% of American households reported they did not have enough food in a given week. There is no shortage of food. In fact, farmers have ploughed over excess crops and dumped milk. But the lockdowns entrapped supply chains. In 2016, 2.8m Americans or 13% of American food workers were food insecure.

In such challenging times, it’s good to have a story that is uplifting. A friend recommended A Gentleman In Moscow by Amor Towles. It’s a fictional story of a count who is “imprisoned” in his favourite hotel in Moscow at the start of the Bolshevik Revolution. He suffers numerous indignities but does so with a spirit that tries to see the bright side in everything. By the end of the story you realize he has been lucky as he didn’t have to go through the chaos and paranoia of Soviet-directed society outside. This book was a refreshing lesson that often the greatest hardship to overcome is within the mind itself.

Cobham, Surrey, September 30th, 2020

[1] This could change by the next London Brief though!

[3] “Six of the Largest 10 Deals Announced Globally During August Involved Tech Sector Targets”, Marketwatch, September 2nd, 2020

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