Sunday, April 2, 2017

An IPO that Investors "Snapped" up.....

If you've been keeping up with the financial news, you know not too long ago we had a gigantic, really cool IPO hit the streets with a ton of fanfare and a soaring valuation.  The company writes all sorts of cool mobile apps which millennials have become nearly addicted to.  User growth, MAU's, DAU's, MUU's, ARPU and ABPU's and virtually every non-financial metric have skyrocketed. Unfortunately, they continue to lose dump-trucks full of money while they relentlessly build their market presence and hone their business model.....like so many dot.com bubble companies did only seventeen short years ago.  Now that they've gone public they've finally secured a sufficient war chest which will allow them to fully develop their dream and create untold shareholder wealth....and....

Oh my goodness, I just realized that, from the above, you might think that I'm talking about Snap, Inc (SNAP)!  I'm so sorry, I apologize.  I didn't mean to be unclear.  I was actually talking about another incredible, recent IPO from 2012.  I was talking about Zynga, Inc. (ZNGA) 

But now that I think about it, there are a lot of striking similarities between the two businesses.  Let's take a look:

Here are the links to the prospectus filings for Zynga and Snap.

Zynga

Snap, Inc.

I won't bother going through the gory details, but suffice it to say that after the initial love-fest investors enjoyed with Zynga, fueled by skyrocketing pre-IPO non-financial metrics, pushing the stock price up over $15/share, reality quickly set in, confirmed by the flat/declining revenues and the inability to reduce the cash burn to a reasonable level.  The business continues to lose $100 Million plus a year with no reversal in sight.  The stock has been repriced and has languished at about $3/share for years.   

Snap, Inc. is on a slightly sharper trajectory.  They've managed to lose $900 million in the two year period ending December 31, 2016.  The stock price initially jumped to just shy of $30/share generating a $34 Billion Market Cap for a blink of an eye.  The stock has now settled, my guess would be temporarily, in the low $20's in its probable Zynga-esque death march to $2/share.

However, before passing judgement on the merits of this aggressive valuation (Snap, Inc. had roughly the same Market Cap as Southwest Airlines shortly after the IPO), I feel obligated to get to the bottom of the genesis of the excitement and enthusiasm for this company.  Obviously, my starting point was to talk with a few millennials that actually use Snap, Inc. apps.  The following is a direction-ally correct collage of a few conversations I had with some millennial friends of mine.

Me: "So do you use Snap-Chat?"
Millennial: "Of course, everybody uses it..."
Me: "Really?....what do use it for?"
Millennial: "It's like a quick way to say hi...."
Me: "That's it..?"
Millennial: "No....you can do all kinds of things..."
Me: "How often do you use it?"
Millennial: "I don't know maybe 50 or 100 times a day..."
Me: "Huhhh?....100 times a day?...really?  What do you do..."
Millennial: "We send cute little things....."
Me: "I still don't get it....."
Millennial: "Well...here...let me show you...(click)....see....here's a picture of you with a pig face..."
Me: "Well....I guess that's pretty cool....I'm not so sure I like being a pig though....."
Millennial: "There are all kinds of things....you can be a dog or a deer...and you can make it vomit rainbows.....see" (showing me her phone with a picture of me in a pig face vomiting rainbows)
Me: "Ok....but I don't think I want to have a picture of me with a pig face vomiting rainbow-vomit all over the Internet....it's not very professional..." 
Millennial: " That's Ok...it disappears in 30 seconds..."
Me: "But why would I want to spend time doing something that disappears in 30 seconds?"
Millennial: "When it disappears you just send another one...they are called 'snaps'..."
Me: "Is this the 'sexting' thing?"
Millennial: "Well, I've heard that some people do that....but I would never do that..."
Me: "Of course not......I wasn't implying that you would.....but theoretically, I could send you a picture of myself with a pig face, naked, puking rainbow vomit?....I could do that?"
Millennial: "..eeewwww....that's kind of creepy..."
Me: "Of course I wouldn't do that.....but I could?...is that right?"
Millennial: "Well....yeah.....I guess....but it's still creepy...."
Me: "So...since the messages disappear, do you ever worry that terrorists or criminals might use snap to communicate..?"
Millennial: "I'm sure they wouldn't do that....that's just wrong...but I guess it could happen......Snap keeps everything we do a secret....that's why it's so popular...."
Me: "Yes...agreed....it would be wrong for terrorists and criminals to use the app to communicate during crimes.....one more thing, in their IPO materials they proclaim themselves as a camera company, do you ever buy anything on Snap or pay attention to the advertising?....do you ever pay for anything on Snap?"
Millennial: "No....it's great.....it's all free!.....I didn't know they made cameras......There's advertising???"


Based on the financial statements and the above discussion I am absolutely convinced that Snap is a cool little, apparently addictive, app that provides hours of constant enjoyment and loads of fun for millennials of all ages, with possible niche markets for terrorists, criminals, Anthony Weiner-wanna-be's and photo-enthusiasts (once they actually develop a camera).   Obviously, there are also significant monetization and "moat" questions.  What's to prevent Facebook, Twitter, Google, et. al. from developing a competing App integrated with their already dominant platform(s)?  Given the above, I'm equally convinced that the stock isn't worth anywhere near the Current $28 Billion Market Cap.  Again, it's all about the valuation.

        
The Tip of the Iceberg

These Snap/Zynga-like optimist driven valuations (i.e. pessimists don't buy stocks at today's prices) are all over the planet now.  Any business with a pulse, a little bit of hype, some newly invented non-financial metrics and a great story (i.e. Most successful IPOs are started in a garage by a college drop out less than five years ago...I believe it's an NYSE rule) and even bigger dreams is a candidate to become the "next big thing".  These "e-something" businesses are suddenly everywhere. They exist on every stock exchange all over the globe. Some of them are honest buffoonery (i.e. the Zyngas and Pets.coms of the world), but others are outright frauds with financial performance fueled by alternative-facts. Unfortunately, it's impossible for most of us to tell the difference in the beginning ....and it really doesn't matter in the end.  The final, inescapable result is the same.....naive investors are left holding the bag.    
      
Most of these boondoggle/frauds have relatively obvious telltale metrics.
  • Newly invented, skyrocketing, unverifiable, non-financial metrics.
  • Acquisition sprees used to goose earnings and create fictitious/misleading growth.
  • A nearly unquenchable thirst for capital.
  • Potential Accounting fraud through related party transactions.
  • Out-sized growth of Intangible/Questionable Asset valuations.
  • Lots of press releases re: Things that they are going to accomplish but never do.
  • Governance issues

I've discussed the "Magnificent Seven" before in my "Holiday Wishes From a Born Again Investment Banker" post.  These are, in my opinion, the future poster children for Accounting Shenanigans.  As you might suspect, the smaller companies, subject to less investor and regulatory scrutiny, can be even more hilarious.  Here are a couple of my favorite "little guys" for your review.  I'm not going to dig deep into the financials, for fear I'll put you to sleep, but I'll just say that the following businesses exhibit most of the above bullet points  

Kuangchi Science Ltd

This cute little business trades in Hong Kong (HK:439) and sports a modest US$2.4 Billion Market Cap.  It also looks like an incredible, totally fake business.  Here's the verbatim description on Google finance, as provided by Kuangchi Science management. They invent "space flying apparatus", sell paper goods and own/manage apartments.  I was hoping to see a division which specialized in English Literature, but no such luck.  Diversification is apparently the key to their success.  

KUANGCHI SCIENCE LIMITED is a Hong Kong-based investment holding company principally engaged in space flying apparatus, paper and property businesses. The Company operates through three segments. In-depth Space Services segment applies the technology developed in respect of the civil near space flying apparatus to sell the related products and to provide consultancy services related to in-depth space services. Its products include a flying apparatus for space tourism, a solar-powered platform for low-altitude transportation and a flying apparatus levitated in space, among others. Paper segment is engaged in the manufacture and trading of paper packaging products, paper gift products and paper promotional materials. Property Investment segment is engaged in the leasing of properties.

(Authors Note:  You just couldn't make this stuff up.)

Here's their lead product, a "jet pack" that they bought from New Zealander Glen Martin a few years back.....as far as I can tell, it's a really loud drone with enough thrust to lift a guy off the ground...they say up to 5,000 feet.  I'm not sure if the super-cool, irritating "Western-Star-Wars-Disco" music is included in the package.  I'd hope not.   Could you imagine a commercial version of this beast?... swarms of these deafening buzz-saw sounding things taking off in your neighborhood, blowing leaves off of trees and small pets and children into the street, whisking brave commuters off to work, or more likely, near-certain death in "near-space" every morning?  With or without the thumping theme song?  I can't.
  
In minute 1:40 of this video Dr.Liu Ruopeng, the Chairman of this fraud, gives a ringing endorsement of his product saying "I'd even buy one for myself".  At the time of the video in June of 2015, Kuangchi expected "sales to soar" in 2016.  According to the 2016 year end financial statements, they haven't sold any just yet.  Could it be the $150,000 price tag? Could it be that people feel uncomfortable with the prospect of occasionally crashing to Earth during their morning commute? Seems like an awfully expensive first step on a trip to the hospital/mortuary to me.  But surprising?.....not so much.

The photo to the right depicts what looks like a freshly painted garbage dumpster with some aluminum foil and a decorative antenna gizmo, that Kuangchi was reportedly going to use to launch some turtles into "near" space last September. Oddly, it was never reported exactly how this launch (fiasco) went or what scientific data might have been gathered from same.  Am I mistaken or wasn't NASA launching animals into "near" space in the 1950's to see what might happen?  My recollection was that they only launched animals (rather than human beings) into "near" space because the rockets were a.) not powerful enough to reach an orbit ("far" space) and/or b.) would likely explode on the launch pad.  Is this Kuangchi "technology" really 70 years behind the times?.. ...being sold to investors as "state of the art"?  I'm hoping they threw some veggies and chicken broth in this thing along with the turtles before they lit the fuse. At least then, if they screwed up the re-entry, they'd get a nice big pot of turtle soup out of the whole, silly endeavor. 
   
In a nutshell, the only thing that Kuangshi does well is raise capital.......somehow they raised US220 million in 2014 (they had shareholder equity of about US$10 million prior to that)  Their annual report and website are cartoon-ish.  Everything they publish is a never-ending river of non-sensical, vague references to scientific sounding crap.  There are no financial reports available on their website since YE 2014 and there's no investor relations section on the website either.  A friend of mine sent me the 2016 year end statements and as far as I can tell, like so many of these businesses, this whole mess is just a piggy bank for insiders.  Again, this is a publicly traded company.....frightening.



Ebix 

Ebix is a "back office insurance processor" headquartered in John's Creek, GA.  Again, I'm not going to go into the nitty-gritty of the financial statements of Ebix (Nasdaq: EBIX) here.  Like Kuangshi Science, suffice it to say that EBIX also exhibits most of the telltale, accounting scam bullet points I had described above.  

Ebix, as described in their Google Finance blurb:

Ebix, Inc. (Ebix) is a supplier of software and e-commerce solutions to the insurance industry. Ebix provides application software products for the insurance industry, including carrier systems, agency systems and exchanges, as well as custom software development. Ebix conducts its operations through four channels, which include Exchanges, Carrier Systems, Broker Systems and Risk Compliance Solutions (RCS). Ebix operates data exchanges in the areas of life insurance, annuities, employee health benefits, risk management, workers compensation, and property and casualty (P&C) insurance. Ebix designs and deploys back-end systems for P&C insurance brokers across the world. Ebix also designs and deploys on-demand and back-end systems for P&C insurance companies. Ebix focus in RCS channel pertains to business process outsourcing services that include providing project management, time and material consulting to clients across the world, and claims adjudication/settlement services.

Well, that all sounds fine and dandy.  They are clearly global leaders in  "outsourcing-back-end-exchanges-and adjudication/settlement services and RCS-es" whatever the hell that means. According to their financials, they somehow generate $300 million a year in revenue and take $100 million to the bottom line. Other than the questionable financial statements, I base my assessment, that this business is not what it seems to be, on only two things:  a.) The hilarious "Recruitment" video to the right which shows the CEO, Robin Raina in all his glory, providing an oddly uninhabited, mood-lit paradise, suited for just about every recreational activity except, perhaps, putting in a full days work.  I particularly enjoyed the tour of the employee restrooms and the illuminated commodes/urinals; and b.) Since I happen to be in the insurance business and I'm fortunate enough to have a few C-Suite contacts at some of the larger insurance companies in this country,  I made a few informal phone calls and asked a simple question: "Have you ever heard of EBIX?....do you use them for anything?"  The unanimous answer I received, even from executives of companies whose logos are plastered on the Ebix website was "Well....I think I've heard of 'em...but we don't do business with them as far as I know."  (Author's Note: Robin, if you are reading this, please send me a list of company contacts to talk to, along with the annual billing figures to their businesses, so I can retract my presumption and restore my confidence that your client relationship representations aren't total bullshit.) Based on this totally unscientific survey, I have to ask.....who exactly are their customers?  When we look at the Ebix "Case Studies" on their website we see all sorts of goofy little vague references to "Leading Retailer" and "Major Insurance Company".  The actual "named names" are small insurance agencies and the like....not that there's anything wrong with that.....I just have no idea how you can generate $300 million in back office revenue without any large customers on the books.  If they were solution providers for American Family, Allstate, Cigna, Travelers, Liberty, Hartford, United Health, et. al. don't you think they might consider putting those success stories front and center?  ....instead of "we produce insurance certificates for the Dick Durf Agency of Ottumwa Iowa"??  I just can't figure it out.....

Money for nuthin'....

Again, these silly business abound on stock exchanges all over the globe.  Just throw a dart and you've got a great chance of finding some cooked books and financial statements that do a yeoman's job of clouding the real financial condition of the underlying business.  Subsidiaries and "off the books" financing schemes have become the rule, they are no longer the exception.  Value is created with the stroke of a pen and the push of a button.  

If you recall, in my last post, I described how Softbank created $6.6 Billion worth of "Trust Securities" out of thin air, overnight, collateralized solely by the Alibaba ADRs they own.  As you also might recall they represented in a press release to have "sold" these securities.  So $6 Billion of "shareholder value" becomes a $12 Billion leveraged bet in an instant.  Diagram below:

  
Can you imagine the number of these silly, obfuscatory transactions that are hidden in financial statements all over the planet?  Accounting games are everywhere.  It's become much easier (and profitable) to pump up the numbers and presentations than to actually expend real brain-power and effort to improve the economics of the underlying business.  Katie Marriner and Francine McKenna just published a fascinating article and supporting data describing the pervasive use of cutting edge Non-GAAP metrics in the contemporary CFO's relentless quest to boost earnings, or at least divert the focus from business reality.  We might question, if there are non-recurring, extra-ordinary items reported every quarter, aren't they, by definition, recurring?  Why are these disclosures highlighted and GAAP de-emphasized?  Despite the SEC's somewhat half-hearted efforts to reduce the practice, management continues and has actually accelerated their push to prominently display Non-GAAP earnings metrics which, of course, exclude the "bad stuff".  The hocus-pocus "improvement gap" is widening. Optimism abounds.

Today's CFO's, Public Accountants and Investment Bankers are getting more creative and aggressive by the day, making it impossible to compare current macro metrics to historical norms.  Like Major League Baseball, this financial "steroids era" is wreaking havoc with financial batting averages and home run records.  Every former-bench-player-CFO is now fully capable of hitting it out of the park if he/she pops the right financial pills....while the Commissioner looks the other way "for the good of the game".        

Let's Go Macro! 

Last weekend I took some time to try to put together an Excel spreadsheet to help me wrap my head around just how widespread these accounting Shenanigans really are.  

My goal was to accumulate company data (Market Cap, Revenue, Earnings and a calculated P/E) by sector and in total, just to see what we could see.  I collected the data from 7,693 tickers and scrubbed them for inactive stocks, missing data, multiple/repetitive stock classes and duplicates.  That exercise reduced the population to 5,092 tickers which represent the entire population of actively traded, publicly held businesses that you or I (retail Investors) could reasonably purchase by calling our broker or placing an order on E-Trade, Schwab, Scottrade, etc.  Market Caps ranged from several hundred billion dollars down to a few million.  For the sake of brevity I've displayed just two "trimmed" sectors (Energy and Tech).  The schedules are sorted by Market Cap and represent the top ten businesses in the sector, down to the smallest reported Market Cap.  I've also provided the Summary of all Sectors.  




So, we can see that, this data doesn't look too far off from Bob Shillers S&P 500 CAPE Calculations (Cyclically Adjusted P/E).  My 28.4 vs. Bob's 29.1.  At first blush, you'd think that this makes sense.  Shiller's number is a 10 Year Ratio on a population of this country's 500 largest and presumably best run, most dominant businesses, whereas, my calculation is based on current, snapshot values on a much larger population of 5,092 businesses.  In other words, I'd expect the Shiller CAPE to be higher since the 4,592 smaller, riskier businesses, in aggregate, should have a lower P/E.  Investors should not want to pay as high a multiple, again, in aggregate, for these businesses as they would for "blue chips".    


CAPE = Share Price/ [(EPS for 10 years x Inflation Factor for those years)/10]

Interestingly, that's not what's happening.  As we can conclude from the data to the left, when we compare the "Top 50" By Market Cap to "The Rest" of the 5,092 Businesses by Sector we see an interesting divergence.  The smaller, less "blue chip-ish" stocks, with little or no earnings are priced at a much higher multiple than their larger, more established counterparts. These 4,492 businesses represent $8.37 Trillion in shareholder value yet they produce minuscule earnings, yielding a P/E Ratio of 55.8.  The "Rest" of the Energy, Healthcare, Telecom and Insurance Sectors have no earnings at all. Basic Materials and Tech sport P/E's of 98.5 and 73.4 respectively.  One would think that this $8.37 Trillion will have to be repriced at some point.  The Wall Street Journal also reports the P/E for the Russel 2,000 which interestingly, is currently at 126.98, supporting the premise that Mr. Market has unrealistic expectations for these businesses.  (As an aside, a year ago, the entire Russel 2,000 had no P/E posting an aggregate loss.)  Here are a couple of additional, relatively obvious observations on the above now that we have this data in front of us:
  • These are the 5,092 businesses/shares that all/any of us can buy with click of a button or a phone call to our broker.  These are all of the "real" publicly traded businesses/stocks out there available to us.  This is it.  If we want to own "stocks for the long run" as passive investments, most of us have no more/other alternatives.
  • Many of us, when we purchase stocks, accomplish our ownership through some form of collective investment vehicle (Mutual Funds, ETF's, Unit Trusts, Etc.)   
  • Managers of these collective investment vehicles must deploy our cash.  They have little/no choice.  They are forever looking for the next big thing.  That's what they are paid to do, so they continue to plow our money into what they might consider the best of a series of really bad choices.
  • Per the above, broad based equity prices have risen to what seem to be unprecedented levels, if everything else had remained constant.  But, as we shall see below....."everything else" has not remained constant.
Another nice metric which also reflects macro valuation levels is Shiller's Price/Sales (P/S) ratio for the S&P 500, which he's tracked for seventeen (17) years.  I like to look at the P/S ratio since it's a bit more difficult to fudge revenue than it is to monkey around with earnings.  The ratio is as high today as it's ever been.  Today there is $2.07 of share price for every $1.00 of sales/revenue for the the S&P 500.   The average is $1.44 and the all time low is $.80 in March of 2009.  My recollection is that we weren't having too much "financial fun" in March of 2009.  As a point of reference, the current P/S ratio for my 5,092 Businesses is 1.88.  Interesting Sector Valuations are:
  • Banking - 3.53
  • Technology - 3.31
  • Healthcare - 2.58 
The market cap of these Sectors is about $16 Trillion (43% of the $37 Trillion total).  Both revenue and earnings seem to be getting really expensive. 
   




Another Way to Look at it.....

The below data from FRED (Data provided by the St Louis FED) shows a striking divergence between "Earnings" and "Valuation".  


The base year chosen is January 1st, 2007, prior to the 2009 crash, Indexed to 100.  In the chart, earnings, independently represented by GDP and Corporate Profits remain flat, with annual growth just south of 3%.  i.e.) There just isn't that much economic growth and profitable businesses activity going on.  When we compare this anemic earnings growth to what's happened to stock prices (Represented by the Wilshire 5,000 Index) and the money in our bank accounts (M1...for those of us who choose to stay out of "stocks for the long run" ...at least for the time being) we see that the "narrow money" we keep in our checking and savings accounts has more than doubled since 2007.  Our Mutual Funds/Stocks have nearly doubled from the hay-days of 2007.  If we had somehow, through great luck or incredible vision, chose to "get in at the bottom" in 2009, we see that the value of our stocks actually would have more than tripled from the "should I jump out of my office window or not?" days of 2008/2009.  Thank goodness those days are well behind us.

How/Where Do Investors "Own" these Securities?

Since we no longer take physical delivery of our stock certificates, most (if not all) of us invest electronically, keeping our wealth in our accounts at financial institutions and brokers.  All of those Stock, Mutual Fund, ETF, etc. symbols can be viewed and tracked "real time" on our E-Trade, Schwab, Fidelity, et al. client portals. It really is amazing. We can buy, sell and transfer in the blink of an eye.  Today's institutions provide a critical, in fact, essential custodial function.  They hold our Assets Under Management (AUM), keeping our wealth safe from harm, giving us immediate updates as to the value of same, making it incredibly easy to place trades and move things around.  I absolutely prefer (I would think you do too) this system to keeping my Stock Certificates in a Safety Deposit Box, like we had to do in the good old days. Back then, we had no choice.

Conversely, today, the downside is that our aggregate life savings, theoretically, can become "hair-trigger" money, if we or someone we designate, chooses to pull the trigger. That said, lets take a look at where all of our investments in the ($37.2 Trillion) 5,092 businesses described above are kept.

The "How/Where Are These Shares Owned?" schedule describes many/most of the custodial/management locations that our 5,092 individual common stock investments could possibly be hiding.  They could be in brokerage accounts, mutual funds, banks, pledged as collateral unbeknownst to us (Remember "Re-Hypothecation?"....the process by which an Asset Manager or Custodian can use your securities as interest-free collateral for loans?  Pledging the same collateral multiple times?  Isn't that awesome?). Our stock investments could actually be, because we don't understand our ETF contract, fully leveraged or nonexistent, replaced by forward/derivative contracts.  To us, our ticker symbols appear on a screen with a number of shares and a current price, representing the value that we're entitled to per the contract that we have with our brokerage account provider.  Our "shares" could be anywhere.  All we know with certainty is that the few shares of some of the 5,092 ($37.2 Trillion) companies we own are buried somewhere in the $146 Trillion pile of equities, loans, mortgages, CDOs, MBS's, Swaps, counter-parties, relationships and indemnity agreements, etc. that have become our financial system.  Our money is in there somewhere.

You'll also note that the amount of Assets Under Custody have skyrocketed to $85.4 Trillion.  What are these assets?  Unfortunately, nobody (other than the custodial bank and the owner of the asset) really knows.  These are off-balance sheet, non-discretionary assets, of which the custodian has no management/decision responsibility.  There's no GAAP Requirement to disclose their composition. The only GAAP disclosure requirement is to simply report that these assets exist and the manager has "custody" of them.  Envision warehouses filled with stock certificates, mortgages, loans and contracts of every flavor buried deep in the bowels of JP Morgan, State Street or BoNY Mellon.

I suspect there is an enormous amount of "double counting" going on here. Banks having custody of other banks assets, funds managing other funds or "funds of funds", contracts to deliver assets in the future masquerading as full value assets today.  Yet the "assets" rarely, if ever, move.  The "book entry" documenting ownership just changes, perhaps even recorded two or three times on the same "filing cabinet full of assets".  Who knows?

I've always wondered what might happen if we stopped the music and every shareholder on a specific date of record demanded delivery of their shares.....just to make sure they exist.  Do you think there might be a few difficulties cropping up?  In BlackRock's 2016 10-K (pg 23) they spell out the risk associated with physically/electronically "losing track" of what's going on:

For example, in January 2017 BlackRock announced it would be moving custody services on more than $1 trillion of client assets from State Street Corp. to JPMorgan Chase & Co. Any such transfer may be costly and complex, and expose BlackRock to heightened operational risks.  Any failure to mitigate such risks could result in reputational harm, as well as financial losses to BlackRock and its clients. 


Note the "and its clients" reference regarding financial losses.  Are they talking about the moving van tipping over and spilling securities all over onto the Boston Post Road?  Are they worried about missing filing cabinets?  Perhaps they're concerned the movers will grab the wrong boxes of stock certificates and mortgages?  Probably not.....they are worried about record keeping and not being about to match things up.

Is it just me, or is anyone else concerned about the proliferation of all of these unidentified Assets Under Custody (AUC)?  I hope someone somewhere is keeping meticulous records as this stuff flies all over the globe at "Quadrillions of Dollars a Year".















Off Balance Sheet (OBS) Assets at the six largest US custodian banks (AUC)  have increased $17.9 Trillion, roughly the equivalent of US GDP, since prior to the (last) financial crisis.  Financial Assets are flooding the streets.  This expansion is occurring even though GDP/Corporate Profits have been bumping along at a less than impressive pace.

Remember, the value and viability of all of these rapidly expanding, swirling financial Assets relies on the sum of two things.....really, just two.  All of these assets, whether they are loans (requiring debt service) or equity (with expected returns) rely on the earnings/income/growth/wages of this country's underlying 1.) Publicly traded business (described in this post); and, 2.) Privately Held Businesses.

Unfortunately, by definition, we know very little about the macro aspects on the country's privately held businesses.  There is no "Market Cap" calculation nor are there published earnings, thus the reference to "privately held".  We can, however, presume that the US Banking system is just as eager to serve successful private businesses as it is eager to finance their publicly traded counterparts.

Based on the above described flat earnings growth, and rapid financial asset expansion, in my mind it's time to start seriously questioning whether the meager (and probably overstated) $1.3 Trillion of Public Company earnings, plus Private Sector earnings, can possibly support expected returns/ valuations and debt service on $146.1 Trillion (plus) of double/triple-counted financial assets.

Simple math tells us also that a 1% FED promulgated increase in interest rates would require that the $146 Trillion worth of our double/triple counted assets must simultaneously generate an additional $1.46 Trillion in earnings (more than all public company earnings today) to support the current valuation.  The more likely path, as with fixed-rate assets, when interest rates (yields) rise, the asset prices will most likely fall.

To Illustrate, let's just say, hypothetically, that all of the $146 Trillion of double/triple counted securities are 10 year, fixed-coupon bonds (Which they of course, are not.....but humor me for the moment while I make my point). The "rule of thumb" I use (on 10 yr bonds) is that; every 1% increase/decrease in interest rates generates an 8% decrease/increase in the value of the bond (asset). i.e.) a 1% increase in interest rates, when applied to $146 Trillion of 10 year fixed-coupon bonds would lower the value of these bonds (assets) by $11.7 Trillion. (There are tools all over the Internet that we can use to do this math) 

Taking this a step further, if all of these bonds (assets) are 30 year mortgages (which a big chunk of this mess undoubtedly is), the reduction in mortgage (asset) value from a 1% increase in interest rates would be....(gulp)......19.6%....or.....(double gulp) $28.6 Trillion. Remember all of those MBS's?.... ..they've not gone away. 

So, given the above, combined with the easy money around the globe, we can fully appreciate the FED's reluctance to normalize/raise rates. We can argue that they've been way to low for way too long...but that's water over the bridge....or under the dam...whatever. Janet & Co's. very carefully choreographed, several month, advanced notice just to make a 1/4 point adjustment, or a several quarter, advance notice that they are planning on reducing their balance sheet, are all intended to insure (hopefully) that nobody is caught swimming naked. This of course, makes perfect sense. Much more-so than the Volker days, when he'd have a bad sandwich at lunch, get pissed off and raise rates overnight. Luckily, everyone fully understands what the FED is doing and they are perfectly hedged. Yup.....that's exactly the way these things usually play out.

Concentration

As described in the "How/Where Are These Shares Owned?" chart above, US bank
balance sheets have also ballooned to an all time high, $16.874 Trillion, yet according
to www.usbanklocations.com the number of reporting banks has decreased substantially.  













The above table describes total asset levels for all US Banks, the "Top 20" US Banks ranked by assets, and corresponding ratios, pre-crisis, post crisis and current.  The following metrics jump off the page:
  • The number of banks has decreased from 8,661 to 5,922 in ten years,  (32% decrease)
  • Total US Bank Balance Sheet Assets have increased 59% ($5.322 Trillion) in ten years.
  • "Top 20" Balance Sheet Assets have increased 60% ($3.847 Trillion) in 10 years.
  • "Top 20" Balance Sheet Assets have increased to 61% of Total Assets, up from 54% of Total Assets ten years ago. 
  • Average Assets for the "Top 20" Banks are $514.9 Billion, up from $322.5 Billion pre-crisis.
Bank Assets (loans) are now more concentrated in a few of our larger banks than ever before.  Again, it's important to remember how Bank Assets are created.  You and I are both Bankers.  I loan you a Billion (charging a fee), you turn around and loan me a Billion (charging a fee)...and we've created $2 Billion in "Bank Assets" with the initial $1 Billion.  I have my Billion back (less the fees) and I can loan it out again....you and I just have to pay interest on our loans to each other. Of course, this works pretty well in a near ZIRP environment, but it's obvious how increasing interest rates would slow the creation of assets.  The carrying cost becomes prohibitive.   

Despite all of the half-hearted, feigned, placatory "break 'em up" regulatory rhetoric put forth by our post-crisis politicians, the big US  banks have morphed from "Too Big to Fail/Jail" to "Wayyyyy to Big to Fail/Jail".  I'd suggest that this course, if not checked, will eventually conclude with "Destined to Fail".

As I've mentioned in prior posts, this money printing, asset creation and bubble-blowing is happening all over the planet.  The Theory of Financial Relativity is alive and well. Per the Yardini Research chart on the left, the World's Central Banks prime the pump and the worlds financial systems takes over. The FED, PBOC, BOJ & ECB have tripled balance sheet assets since 2007.  All of these asset (loan) purchases represent cash funneling out to bankers just like I had described earlier.  My banker can continue to loan money to your banker and he/she can loan it out again and again, creating multiples upon multiples of financial assets.  The quality and viability of all of these assets (loans) all over the globe is solely dependent, as described earlier, on the earnings/income /growth/wages of the respective economy's businesses.  Keep that in mind as you read through the next section.

   
Value Can Neither be Created Nor Destroyed.....

....but it can easily be disguised, manipulated and misunderstood.

I mentioned above that: "everything else" has not remained constant.

Let's talk about constancy for a moment.  Over the last decade the number of foreign stocks (and associated Market Cap) listed on US Exchanges has skyrocketed.  In and of itself, that isn't a problem.  Some politicians would most likely disagree, but generally, the regulated/monitored flow of legitimate cross border capital is indisputably beneficial to both the US and the global economy.   But again, like my earlier Major League Baseball metaphor, things can sometimes get a bit out of whack.

So let's take a few paragraphs to talk about what's changed

Foreign Equities listed on US Exchanges in "Big Round Numbers" amount to roughly $7.6 Trillion (Today's Values) or 20.4% the aggregate Market Cap of all US Listed, actively traded Equities.  Ten years ago, excluding Canadian and European Companies, that number was "a few billion".

Today there are 486 Foreign Stocks/ADRs Listed on the NYSE alone. Canadian and European Stocks Represent $5.2 Trillion in Market Cap. The rest, $2.4 Trillion are listings from what I'll kindly refer to as "less regulated" countries. (Asian, South American and African Stocks)

If you've been following this blog you'll know that I've long been concerned/critical about the quality of financial data and earnings reported by foreign businesses operating in these "less regulated" environments.  In big round numbers, there are currently $2.4+ Trillion of "less regulated" Stocks listed, about 1/4th of which (By Market Cap) are Japanese companies, the next 1/4th are Chinese, the next 1/4th are Taiwanese; Indian and South Korean.  The last 1/4th is comprised of South American and African Stocks.

I've long opined that Chinese investment in US Assets is simply disguised Capital flight.  Because of the on-shore/off-shore dual currency mechanism, Chinese Investors trade "Monopoly Money" for hard assets denominated in US Dollars (or Euros).  Based solely on the currency imbalance, Chinese companies would be willing to list without regard to price in order to convert the soon to depreciate RMB to a reserve currency.  A dollar today is worth several wheelbarrows full of RMB a few years from now.

So how did this happen?  Why, by marketing foreign access to naive US Capital of course!  Below, I've taken the liberty to post the language from the NYSE web page touting the advantages foreign issuers are availed of when listing their (alleged) "dog-shit-wrapped-in-cat-shit" stocks on the NYSE. I've also deployed our patented, Dick Fuld Banker Speak Translator (BST) to help us determine what this marketing language really means:


INTERNATIONAL COMPANIES LISTING IN THE U.S. CAN CHOOSE TO:
  • Use IFRS (in its original IASB version) instead of U.S. GAAP. While not an option (yet) for U.S. Companies, rule changes passed in 2007 enable international companies to use IFRS reporting language in their filings. 
  • BST: "Feel free to put anything you want in your financial statements. The SEC's in our back pocket. Anything goes. Thank God you don't have to jump through the same hoops US Businesses do." 
  • Follow home country corporate governance practices. Numerous corporate governance requirements adhered to by U.S. companies are not required for foreign private issuers. Among the most notable: U.S. proxy rules do not apply to International Companies. For the proxy process, international companies are only required to solicit proxies from their U.S. holders. In doing so, they do not need to use a proxy statement compliant with the U.S. rules. 
  • BST: "If your home country is a corrupt, kick-back laden, political swamp, no problem!... just keep doing what you are doing! Since US Proxy rules don't apply, you don't need to tell US (minority) shareholders what you are doing or ask them to vote on it."
  • List ADRs or Common Shares (same requirements). A company (whether it is a dual listing or a single listing) is not limited to using only ADRs. 
  • BST: "Again, we're flexible...whatever you want....US Shareholders are clueless. All they think about is 'user engagement' and other fake, made-up crap." 
  • Foreign issuers must abide by the internal control requirements of SOX 404 (Internal Controls). However, continuous cost reductions with the elimination of excessive testing (materiality) and documentation have decreased the burden on listed companies. 
  • BST: "We know SARBOX compliance looks like a pain, but the compliance requirements are going away....there's a new sheriff in town.....and keep in mind, SARBOX really doesn't matter to foreign issuers.  It's irrelevant.  Just make sure the signors have no plans to ever travel to the US.  If things go in the shitter they won't want to have to deal with an FBI/SEC welcoming committee. 
REQUIREMENTS THAT DON'T APPLY TO INTERNATIONAL COMPANIES
  • Report on a quarterly basis. Unlike domestic filers (with their 10-K and 10-Q filings), international companies file their annual report as a 20-F and interim reports (minimum frequency is set by home country requirements) are submitted, like any press release, on a Form 6-K. 
  • BST: "Again, we're really informal folks, just let us know that everything is going ok once a year and we're fine with that! Our primary goal is to make things easier for you, and if we can collect some fat fees and increase trading volume along the way, all the better! 
  • Have a majority independent board. The independence test is focused on the Audit Committee. The Audit Committee can consist of one person. 
  • BST: "We think this is really awesome! Put all of your yes-man cronies on the board with impunity. Better yet, just hire some schmuck who knows nothing about accounting as your 'audit committee' and have him/her sign off on your financial statements. Again, he/she should not plan on stepping foot in America anytime soon." 
  • Have a compensation or nominating committee. The only committee required for an international company is the Audit Committee. 
  • BST: "This is key. No need to tell minority US shareholders how you spend their money on executive comp. or god-forbid, have them vote on it. Since you control the schmuck...uh...I mean audit committee... just classify your bonuses and comp as "office expense". 
  • Receive shareholder approval for equity compensation or other stock issuances. 
  • BST: "Again, office expense is the way to go on this one too." 

Here's the NYSE Link to the above:


The Perfect Storm

So let's recap.  What do we have?

  • All sorts of goofy, nonsensical, money losing, possibly fraudulent new equities (Snap!, Zynga, Kuangchi, Ebix, "The Magnificent Seven", etc.) are trading on US exchanges, and in fact, all over the world.
  • The proliferation and creation of all sorts of hybrid securities, designed to goose earnings and disguise leverage.
  • US P/E ratios are at historic highs.  Most notably, P/Es for "The Rest" (4,692 stocks) of the  , presumably less established publicly held US Businesses, in aggregate, are significantly higher than we would expect at 55.   i.e.) The current share price is equal to 55 years of EPS for this basket of 4,692 stocks.  The Russell 2,000 P/E is currently at a multiple of 127 (127 years of earnings).
  • Some of "The Rest" Sector P/Es are much higher.  Energy, Basic Materials, Healthcare, Telecom and Insurance have P/Es higher than 70 (or non-existent due to losses in the entire sector).  
  • P/S Ratios have never been higher.
  • We've created $146 Trillion plus of "double counted" securities, ($37 Trillion in stocks) all relying on the economic activity and earnings of public ($1.3 Trillion) and private businesses.
  • Of the $146 Trillion, $85 Trillion are "Off Balance Sheet" (OBS) assets.  These Assets (loans) have increased $17.9 Trillion since prior to the (last) financial crisis. 
  • This incredible expansion of financial assets is being duplicated globally through coordinated Central Bank monetary policy.  
  • US Bank Assets (loans) are more concentrated, and growing faster than ever before.  The number of US Banks has decreased by 32% while bank assets have increased 59% since the (last) financial crisis.  Today, the "Top 20" US Banks account for 61% of all US Bank Assets.   
  • Included in the $37 Trillion of actively traded Stocks are 500+ foreign issues ($7.6 Trillion) traded on US Exchanges.
  • Investment Bankers have relentlessly turned over every rock on the planet in search of new listings, products and deals to sell to US money managers and investors.   They've found a gold mine of absurd growth stories residing overseas and eagerly listed these frauds as the "next big thing" with the complicity of US Exchanges.  Not surprisingly, all of this presently undetected, inevitable carnage, of course, was designed and implemented to generate enormous fees.  Same shit....different day.  
  • There's simply too much money chasing too few quality securities, driving valuations up to what will most likely be unsustainable levels.
So, I'll ask, is it reasonable to believe that "quarter point Janet" will be able to somehow slow this train down?  Will she be able to get the worlds Central Bankers on the same page, carefully choreographing a slow, methodical, march to normalized interest rates, carefully reversing and winding down these newly created financial assets?  Will she be able to manage the process as the "smart money" repackages the depreciating assets, giving them time to move them over to the "dumb money"? After all, someone will eventually have to absorb the loss.  If that proves to be impossible, will the FED be able to step in and minimize the chaos quickly enough, if and when the "Theory of Financial Relativity" runs off the rails?

Mary Jo White's SEC did nothing to stop the proliferation of questionable/fake IPO's.  Are we to believe that Jay Clayton's SEC will somehow get tough on Wall Street and decline to keep listing this junk, or at least level the playing field by requiring foreign issuers to play by the same rules as US businesses?

Is it possible that Messrs. Dimon, Blankfein, Fink, Corbat, Sloan, Hooley, Hassell, et. al. will wake up one morning, find religion and unilaterally deleverage?  Is it likely that CFO's and Public Accountants will somehow begin to review financial statements with a conservative eye, writing down/off "investments" that haven't and will never pay off?

Will our well-oiled, pseudo-collaborative Beltway machine have the foresight to see what's unfolding, come together and take coordinated, preemptive legislative, financial and regulatory steps to minimize the damage that a sudden, global asset revaluation will inevitably cause?

Finally, will our current Administration have the patience and strength to work hand in hand with world leaders to limit the fallout, or at least, react in a measured, reasonable manner so as not to make matters worse?

Of course, there's no economic incentive for anyone mentioned above to stop behaving badly. As financial history has shown us.....everything is always peachy-keen....until of course, it's not. The system actually rewards the behavior, we should expect it based on what we've seen over the years.   Everyone in the food chain makes money by any means necessary until the chain snaps under it's own weight...and we pick up the pieces and start over.

For us little old retail investors, to use a combined zookeeper/mariner's metaphor, hoping for all of the usual leopards to change their collective spots would be tantamount to wishing that the school of sharks swimming around us just isn't hungry.  Optimistic, to be sure, but hardly realistic.            

For those of you who are regular readers, you know that I first recognized and began posting about these issues emerging in 2014.  Today, the financial pressure continues to increase.  My conclusion, I'm sorry to say....is that once the coordinated activity of the world's Central Banks fades, as it certainly will, the "Theory of Financial Relativity" provides that equilibrium and consequently, current asset values will no longer be possible.

Like the Kuangchi Science Jet Pack, the higher we go, the worse the landing will be.




Additional Reading

Snap Shareholder Demographic
http://blogs.wsj.com/moneybeat/2017/03/04/who-bought-snap-shares-millennials/

Snap - Non-voting shares
https://www.wsj.com/articles/in-snap-ipo-new-investors-to-get-zero-votes-while-founders-keep-control-1484568034

Snap Key Events
http://www.businessinsider.com/the-life-and-career-of-snapchat-cofounder-bobby-murphy-2017-3/#murphy-whose-full-name-is-robert-cornelius-murphy-was-born-in-berkeley-california-in-1988-his-mother-immigrated-from-the-philippines-to-the-us-and-both-of-his-parents-had-government-jobs-1

Reporting of Non-GAAP Metrics
http://projects.marketwatch.com/2017/gaap-nongaap-earnings-2016q3/

Deep Throat - January 2016 - The Valuation Problem - Revisited
http://deep-throat-ipo.blogspot.com/2016/01/the-valuation-problem-revisited.html

Deep Throat - January 2016 - The Valuation Problem
http://deep-throat-ipo.blogspot.com/2014/12/the-valuation-problem-case-study.html



Companies 1 - 20 of about 469 in Energy
Companies 1 - 20 of about 338 in Basic Materials
Companies 1 - 20 of about 745 in Industrials
Companies 1 - 20 of about 744 in Cyclical Consumer Goods & Services
Companies 1 - 20 of about 277 in Non-Cyclical Consumer Goods & Services
Companies 1 - 20 of about 995 in Healthcare
Companies 1 - 20 of about 883 in Technology
Companies 1 - 20 of about 112 in Telecommunications Services
Companies 1 - 20 of about 166 in Utilities
4,729 total companies

Companies 1 - 20 of about 2964 in Financials
   Companies 1 - 20 of about 773 in Banking & Investment Services   

   Companies 1 - 20 of about 169 in Insurance
   Companies 1 - 20 of about 456 in Real Estate
   
Companies 1 - 20 of about 1491 in Collective Investments
      
Companies 1 - 20 of about 740 in Exchange Traded Fund
      Companies 1 - 20 of about 114 in Investment Trusts       

      Companies 1 - 20 of about 76 in Holding Companies
      
Companies 1 - 20 of about 637 in Closed End Fund
7,693 total tickers


Lots of money chasing finite/limited earnings       
Mutual Funds in the US - $15T Asset Value
https://www.statista.com/statistics/255518/mutual-fund-assets-held-by-investment-companies-in-the-united-states/

Number of Mutual Funds in the US - 9,500
https://www.statista.com/statistics/255590/number-of-mutual-fund-companies-in-the-united-states/

Number of ETFs in the US - 1,707
https://www.statista.com/statistics/350525/number-etfs-usa/

This statistic presents the value of assets managed by Exchange Traded Funds in the United States from 2003 to 2016. The value of U.S. ETFs amounted to approximately 2.47 trillion U.S. dollars in 2016.
https://www.statista.com/statistics/350503/value-of-etfs-usa/

Forbes - Largest Privately Held Compnaies
https://www.forbes.com/lists/2011/21/private-companies-11_land.html

Mutual Fund Asset Growth - $9.6T in 2008 to $15.6 T in 2016
https://www.statista.com/statistics/255518/mutual-fund-assets-held-by-investment-companies-in-the-united-states/

Hedge Fund Assets - $2.3T 2015
https://www.preqin.com/docs/samples/2016-Preqin-Global-Hedge-Fund-Report-Sample-Pages.pdf

Largest Brokerage Firms
http://www.brokerage-review.com/stock-brokers/largest-brokerage-firms-byassets.aspx

Largest Private Banking Businesses
https://en.wikipedia.org/wiki/Private_banking

Yardeni Research - Forward P/E
http://www.yardeni.com/pub/mktbriefsppesecind.pdf

US Bank Assets 12/31/16 - $16.874T
http://www.usbanklocations.com/bank-rank/total-assets.html

Snap - Love from an Analyst
https://www.bloomberg.com/news/articles/2017-03-27/wall-street-is-suddenly-bullish-on-snap

State Street 10-K - p65 - AUC - $15.8T
https://www.sec.gov/Archives/edgar/data/93751/000009375117000249/stt-20161231_10k.htm

JPM 10-K p62 - AUC - $8.3T
https://www.sec.gov/Archives/edgar/data/19617/000001961717000314/corp10k2016.htm

WFC 10-K - p47 - AUA - $1.6T
https://www.sec.gov/Archives/edgar/data/72971/000007297117000278/wfc-12312016xex13.htm

BAC - 10-K - p34 - AUC - $2.5T
https://www.sec.gov/Archives/edgar/data/70858/000007085817000013/bac-1231201610xk.htm

Bank of NY Mellon - AUC - $29.3
https://www.sec.gov/Archives/edgar/data/1390777/000139077717000065/bk201610-k_4q16.htm

Kuangchi Science : Kuang-Chi Near Space Test Flight Set For 2016, R&D Center Open In Haikou 

NYSE List of all Global Stocks with Mkt Cap - 486 stocks & 
https://www.nyse.com/publicdocs/nyse/data/CurListofallStocks.pdf

ICI - Mutual Funds February 2017 - $16.9T
https://www.ici.org/research/stats/trends/trends_02_17

Yardini Research - Central Bank Assets
http://www.yardeni.com/Pub/peacockfedecbassets.pdf



4 comments:

  1. Love your articles, thanks for all the work you put in them!

    ReplyDelete
  2. KUANGCHI, EBIX... why don't short sellers drive their shares down? these seem to be pretty obvious frauds. Need to do some work on both.

    ReplyDelete
  3. Your articles are fantastic.

    That Ebix video tells you all you need to know, and the NYSE page is just unbelievable. How is it that nobody else reports on the nonsense you point out in your BST breakdown?

    ReplyDelete
  4. Deep-Throat; where do u have your money invested? Stocks, bonds, gold, cash, income-producing real estate, farmland, Berkshire Hathaway?

    ReplyDelete