Perhaps more surprising than the results itself was the market’s reaction to Britain’s exit from the European Union: for such a momentous event, it was very mild, not getting materially out of recent trading ranges, and with the FTSE100 (though a poor proxy for the British economy) back where it was before the vote at the time of writing, with only the rather modest GBP re-rating remaining material.

Portfolios almost unchanged

I couldn’t find any noticeable distressed prices in my watchlist(s) and only sold Panmure Gordon, in the Stamp collection, on the grounds that being a small broker focussed on the London small cap market may not be very promising, as business is delayed or shifts to other places. Companies I hold are are biased towards exporters and  otherwise not UK-centric stocks, which has worked reasonably well despite the London listing bias.

Is the market right?

Is the market dominated by trading noise, or is it successfully predicting that Brexit will have little negative impact? Uncertainty will certainly be there but the outcome is hard to predict. Negative scenarios are all other the press, but one can imagine a few positive ones as well:

  • On consumer confidence, ex-UK consumers will probably ignore it, or plan holidays to the UK. UK consumers might prove stoic, optimists perhaps balancing pessimists. It’s hard to imagine that it wouldn’t at least slow down the housing market (in transaction volumes if perhaps not prices).
  • Business investment should be down, from some plans being frozen or moving elsewhere, though the outlook seemed pretty positive before the vote, down a bit from there may remain positive.
  • Sterling devaluation, if it persists, which is not a given, may help a bit. It could also remain at a sweet spot: big enough to help but small enough not to trigger enough inflation for the Bank of England to have to tighten monetary policy. Indeed, business investment slowing down may be all the tightening that’s needed.
  • Last but not least, there may be positive impact from EU re-focussing (see below).
Doc Marteens with Union Jack toe

Britain kicks arse? (credit: I Ransley via Flickr)

The European Union becomes the Eurozone

A potential positive side-effect of Brexit is that it might help refocus the European Union on improving its institutions, in particular finishing off building the Eurozone.

The United Kingdom was perpetually only half-way in, making the whole system an unwieldy variable geometry construction, both adding complexity and slowing down integration as exceptions piled up, and other member states had a strong incentive to get their own special case deals. When membership was irreversible this made sense, but if it turns out leaving has a precedent, that is not an unmitigated disaster, then there’s a way out. Then, variable geometry need not be inside the EU but between EU membership and the various forms of association around it (e.g. Norway or Switzerland style deals).

This enables the EU to become the Eurozone: the Eastern European states are committed to join; Denmark is de-facto in economically as they operate a fixed exchange rate system with the Euro; Sweden entry seems permanently suspended due to a failed referendum, but then they, or other reluctant members, could choose to either come in or leave and get a UK style deal.

So we have both a simpler and clearer framework institutionally, and an incentive to escape the current deadlock on Eurozone construction, as the choice between further integration or dismantlement becomes clearer and clearer. If this works out, it could be of great benefit to everybody, including the UK, which would be (much) better off with prosperous partners.

As a short term little bonus, if some business, financial or otherwise, moves from London to the continental financial centres, it’s a mini-Keyneysian stimulus programme for the Eurozone, which may help accelerate the recovery process.

Maybe the whole world will in the end need to thank UK voters for their selfless, if unwitting, sacrifice.

The various basic income proposals floating around are often criticized for being unrealistic, and let’s face it, they often are. In a recent column, John Kay is asserting that “either the basic income is impossibly low, or the expenditure on it is impossibly high.”

This includes an implicit dismissal of the Keynesian arguments — that the basic income would create demand that would snowball into economic growth — of some basic income proponents. I happen to agree that this aspect is unlikely to deliver miracles, so let’s assume no such effect here.

Too high

It’s easy to agree that spending half of GDP on basic income would not be acceptable, but it’s also a good problem to have: humans are scarcity animals and do not work well when too far from need, as can be seen in the often sorry state of people benefiting from windfalls (third generation heirs, lottery winners, small “first nations” in rich and guilty countries, etc). Thus a basic income should probably be high enough to remove fear of survival (food and shelter) but not to so high as to remove the need to get out to the world to improve one’s lot.

Impossibly low is desirable…

In Western countries what some would describe as “impossibly low” does provide pretty decent survival standard. The Ikea/Lidl/Primark lifestyle is pretty okay, and way more comfortable than what the richest slice of society could afford a century or two ago. So a basic income in the region of say $500 a month for a tier 1 developed country would probably do the trick (assuming social housing and healthcare are not subsumed into it).

… and possible

Would simple arithmetic work for that? To design a realistic basic income we need some premises:

  • Assume the net expense on welfare remains constant, because it reflects what a society is ready to accept in redistributive pressure. This allows isolating the effect of the basic income as a redistribution technique from other ideas about changing the amount of redistribution (which can be done through any mean).
  • Assume the wealthier members of society (say the top half) do not get richer out of it, that is the (income) tax system is adjusted to increase the tax they pay by the amount of basic income they receive.
  • Some existing welfare mechanisms are abolished (such state unemployment benefits, child benefits) or restricted (e.g. pension age could be pushed forward) as the basic income replaces them.

Then what basic income is possible? It’s simply equal to:

basic income = removed welfare services budget + tax equalisation

Detailed number crunching would be required, but I’d expect it to come to $300-$600 per adult, again for a tier-1 developed country.

The main variable here is what services get replaced (and to what extent) by basic income so it computes at all times.

Radical realism

A realistic scenario is probably better thought with social housing, public education and public healthcare arrangements untouched, but the basic mechanism also applies should someone wish to privatise some or all of these services: then the fewer services are left, the closer you get to a basic income equal to the tax take, though the higher basic income might then buy less, depending on the distributional profile of each service (a most tricky issue on its own).

What are the benefits of a survival income?

A survival basic income wouldn’t abolish poverty, in so far as this is more or less defined as inequality — how much less one has than others, rather than the absolute level of what one has — but still have some interesting properties:

  • Improve the bargaining power of low-paid workers not forced to work for mere survival
  • Remove net tax discontinuities (being a net loser when taking a low paid job)
  • Simplified administration (some)
  • Increased acceptability of redistribution

The welfare illusion

The latter point is perhaps the most neglected while the most powerful point in favour of basic income. It makes no difference in pure economic terms whether the cash flow between the state and the citizen is done through tax or benefit payments, it’s the net that matters.

But, like with the money illusion in the monetary realm, optics matter. This can be observed today in the difference in perception between universal benefits (like child payments and some healthcare in many developed countries) and means tested ones (typically unemployment and safety net income). The former are often popular and well accepted, even by net payers, while the latter are seen as prone to abuse, and divisive. A basic income, even if compensated by tax, would probably quickly become part of the societal furniture.

Even if it was the only benefit, it’s probably worth doing for that alone.

The recent discussion about high denomination banknotes has extended into the merit of paper cash.

In so far as paper cash is needed, does it need to be done the old school way? For buying goods in legal market, probably not, an alternative would be to use “bearer numbers” (implemented as QR-code or barcode) that could be printed on paper if people want that.

The way it would work would be something like:

  • ATMs are replaced by an online banking facility that debits the client’s account, credits the bank’s account at the central bank (or whoever is the barcode cash clearer), which in response issues a new random number associated with the amount. The number is printed in computer readable form on a ticker the punter puts in their wallet.
  • In a shop the punter shows the number (the ticket) which the cash register redeems with the central bank computer. A new number is issued for change and printed on the receipt. These numbers can then be spent at other shops.
  • People can also simply give away the printout to others, as long as the recipient trusts the giver not to spend a copy before them.
  • Splitting a ticket would require an online app similar to the shop’s cash register.

This reproduces something similar to paper cash but without the need for actual ATMs with a stock of high value banknotes, or a banknote printing and processing infrastructure.

The principal disadvantage is that it requires all non-trusted-parties transactions to be online, to check the value and validity of the number with the centralised issuer/redeemer computer system.

The issuer could be a Bitcoin-like system — you can indeed do all of the above with Bitcoin — though current blockchain technologies add a delay to transaction authorisation that’s impractical for most shop-style settings.

It could be argued this is less anonymous than paper-cash because all redeeming transactions are logged (like in Bitcoin).  Technically that could be done with current cash as well: banknotes have serial numbers that could be tracked to produce interesting meta-data — a government could easily mandate the use of some scanner widget in the cash registers of all legal businesses.

Monetary policy’s impact is made relevant by sticky prices. The stickier nominal salaries and fixed prices for products and services are, the greater the impact of changes in nominal money quantity.

Thing is, prices are getting less and less sticky.

Long gone is the time where the price of flights was printed in a paper catalogue updated once a year. Dynamically priced flight can include changes in fuel cost, or demand and supply pressures, every few minutes, and people got used to it. You have a ballpark idea of what a flight cost, but known that the exact price will only be known at the time of booking.

Anyone who buys tech gadgets and shops around using internet comparison engines will end up paying the producer country price, as lean distributors with little stock and tight margins pass through currency impact, and this model dominates — sticky price competitors are structurally more expensive because they need  to add a buffer to both hedge currency risk, and to prevent adverse selection (people buying from them only when the exchange rate has moved favourably since the last sticky price was set). Even supermarkets now have dynamic price labels that can be updated in seconds.

What’s left of sticky prices? Wages and property are perhaps the main markets where stickiness still applies, though this too is challenged by short term rental contracts and short term employment (be it old school or gig-economy style), or variable compensation (bonus or commission based long term employment) where the net wage becomes decoupled from the notional sticky base salary. This is still a strong force, but for how long? I suspect the writing is on the wall: prices will get less and less sticky.

A possible danger for monetary policy is that backward-looking simulations use datasets from olden times, when prices were stickier than they are today, and thus unless a gradual decrease of stickiness is embedded in the model, will make increasing false predictions. More generally, monetary policy may become less and less important as nominal effects reduce, as changes to nominal quantities get absorbed by reality faster. Another reason to give fiscal policy a greater role in macro-economic management.

Despite having a notional check list for small caps, I’ve not been very careful with checking it formally. It’s also a good time for a review as my small cap investment style is maturing.

Picture of earthquake survival checklist

Earthquake survival checklist (credit: David Pursehouse on Flickr)

Owner business

As a replacement for the vague “useful business”, I’ll now try to answer the question: “would I like to own, and possibly run, this business as a private company?” However preposterous for a pint-size armchair investor, the idea is that it’s a business I must be interested in and understand enough, and would be happy to be stuck in (swapping CEO roles or even a majority stake in a private business is considerably illiquid compared to flipping listed stocks). This should eliminate a whole class of scams, and encompass classic criteria like “do not invest in things you don’t understand” or “invest like a businessman”. Besides, if one likes a business it’s much easier to weather price weakness, as one can emotionally compensate for (potential) financial failure with satisfaction from higher purpose (within reason).

Takeover potential

I’ve realised that since starting the portfolio many of my small cap exits are companies being taken over by larger groups. This is a pretty nice way to manage small cap exits: no transaction costs, usually a price premium, and no decision to take. And it makes a good sanity check new investment, as a company must be in some shape to be worth taking over.

The wallet test

As a simplified version of the executive character test, I have to ask myself “would I lend my wallet to the CEO for safekeeping?”, trying to guess that from hints in CEO interviews, reading reporting narratives between the lines, or interviews by trusted third-parties. (Idea first seen on the Value and Opportunity blog.)

Access to bank lending

This is about finding out whether a conservative banker would lend to the candidate business. This implies a solid balance sheet and somewhat predictable cash flow. It can be inferred from regulatory reporting on credit lines or covenant updates, or guessed from the balance sheet and business model.

Minimum (expected) profitability

Is this business making at least £1 million (or equivalent) profits annually, or, for recovery situations, can it be expected to reach that within the next 3 years? This takes out things that are too small to be listed, or too far away from break-even. Most story stocks (notoriously disastrous as a class) should drop out here.

The pass rate should be at least 4 out of 5.

In the spirit of the obliquity principle there’s no price or valuation test (other than that implied in the takeover test). Looking at the price too closely is probably counter-productive — I’d expect buying blind based on the above checklist should already give appreciable outperformance compared to small caps as a whole. And in any case I can’t help doing it, which is not incompatible with passing the check list, which is just a minimum standard.

A review of the existing Obliquity London Stamps portfolio holdings is now due.

Private equity shops are known for buying businesses on the cheap, taking them out of public markets (if they were listed), trimming costs, often throwing the baby with the bathwater by eliminating investment and cutting beyond what makes the company’s product valuable, then loading with debt and then reselling the thin equity slice at a premium based on inflated valuations based on short term accounting effects, which is rarely a good deal.

I think a mirror strategy could work well, as well as being compatible with virtuous and constructive investment:

  1. Buy the minimum stake required to control (change management) a distressed but salvageable listed company
  2. Change management and/or business plan (as normal)
  3. Cut dividends if any, announcing no dividends until turnaround
  4. Reinvest all the cash flow into repaying debt and/or reinvesting in the business
  5. Book capital investments as expenses as much as accounting regulations allow to reduce earnings
  6. Watch the price sink as earnings are zero or negative for the few years that the turnaround requires
  7. Buy more shares at depressed prices (ideally below price paid at #1)
  8. When turnaround complete, watch earnings go positives, reinstate dividends, etc
  9. Sell the fit business at a premium when price as converged with fundamentals

(Inversions from classic private equity shown in italics.)

It’s a form of arbitrage of both classic investor expectations and statistical arbitrage automated strategies that both (over)value short term earnings maximisation, to whom the business will look worse than it really is during the “buy more shares” phase. And as a long term strategy it should be pretty good to other parties like customers and employees.

Much has already been said about the Greek “deal”, most of it unsurprisingly negative. No question it’s a sorry deal in many ways, but I’ll skip that today and try to cover some of the positives.

The Eurozone’s future is now on the table

It has been long known that the euro can be seen as two very different projects: one is a building block on the way to some kind of Federal Europe, the other is a purely technical shared currency, which is doomed to be a form of synthetic gold, because the strength of such a currency is the binding factor — otherwise the stronger members will leave.

Deciding where to go has been procrastinated since 1999 and absent any crises looked like it would be forever. But this crisis has put the debate back on the table. It could still simmer for a while, but I think the debate has advanced more in the past few months than in the last decade.

The historical track record of loose currency unions is abysmal, so if federalism doesn’t progress, we’re probably in for an implosion, if possibly a slow one. I would still bet on (some form of) federalism winning the day in due course.

The Greek debt sustainability debate is over

Today’s Draghi comment that a Greek debt write-off or some kind or other is “not controversial” reflects the speed at which the official consensus has changed. It’s striking that everybody, from the IMF to Schäuble, now agrees on that, despite being a total taboo at least in official speech a few short months ago. Varoufakis has at least comprehensively won the argument here, if not yet a solution.

Defaulting on the IMF was very useful

The catalyst for the above may have been the default on the IMF. Funny how now that the option is full default or a write off by other official creditors, the latter has become their top priority.

Also the silly long term GDP extrapolation modelling methodology has flipped to Greece’s advantage. Now they extrapolate 2 weeks of capital controls to an exhaustive disaster for the next umpteen years.

As such I don’t think a few weeks of capital controls are that bad. No actual production capacity is destroyed, people can go back to work doing whatever they were doing before when it’s over. It could push a few marginal businesses to bankruptcy but I don’t think you can project much out of that. Out-of-model factors will surely have an order of magnitude greater influence on the final outcome. The good thing is IMF models will now probably tend to underestimate Greek recovery, pushing for a better (than otherwise would be) deal.

The deal is technically pretty open

The deal is actually quite open. Everybody seems to expect Greece to get smashed, and it could, but if the politics follow it’s also possible for the deal to produce a reasonable outcome, e.g. the open-end negotiation on debt rescheduling going somewhere decent.

The deal does buy time

As a 3-year deal, if it doesn’t fall on some technical hurdle or outright sabotage, it does leave time for European politics to mature. It would get a bit easier if Tsipras’ Greece wasn’t the only unorthodox (in being of a Keyneysian and somewhat federalist inclination) government in power. In a positive scenario you could imagine both a shift in PIGS and greater tolerance in the Northern countries. It is still pretend and extend, but if we can pretend and extend until the next treaty, and that’s in 2 rather than 20 years, good.

Here and in its open-ended character, it is better than the “referendum question” deal.

Merkel has still not spent any political capital on this

Merkel’s approval rating hasn’t been dented at all and she has effectively not used any of her large stock of political capital, indeed may have again increased it. That can be seen negatively — reward for being tough — but also positively — the “kick the Greeks out of the Euro” constituency may be losing out in Germany.

It also means she’s got capital left for an actual compromise and or federalist steps. Not a given she will use it, but the outlook could be worse.

Benefits of capital controls

As a parting shot I’ve noticed a few positive side effects of capital controls:

  • people with some savings allegedly accelerated paying off debts or taxes, as a bail-in risk mitigation, thereby improving the position of the state and banks, contributing to offsetting some of the negative impact
  • nearly everybody in Greece now has an ATM card (some bank branches were open for that issuing cards) and greater access to online banking
  • it shows how an emergency (semi-)exit could work in a currency union: keep the union currency for paper cash, and use trapped banking currency as a new digital-only currency, by just replacing the exit/ATM limits with an auction system, aka a forex rate between the trapped digital deposits and the union currency