Why Italy Doesn't Worry Me

With Greece once again making front-page headlines, the attention, as it often does, is seeking the “next crisis.”   Just like this Summer, to many the next phase involves the inclusion of Italy in the Euro-induced panic.  Why Italy?  Many of the reasons are obvious: Italy is carrying a $2.1 trillion budget deficit accrued over years past (all dollar figures cited throughout are Euro’s converted into dollars at today’s $1.324/€1 exchange rate), the country is infamous for a perpetually corrupt economy, and the nation’s politics are equally dysfunctional.  In many respects, Italy remains a pseudo-fascist state, where government and business are largely intertwined and collectively unproductive. Yet despite these notorious problems, Italy does not concern me, as much of the crisis argument for the country hinges on the manipulation of numbers while willfully ignoring the rich assets the country possesses. 

This past summer, yields on Italian bonds surged above 7%.  This forced long-time Silvio Burlesconi, a man who survived numerous scandals, to finally depart leadership, and drove the European Central Bank (ECB) to buy Italian debt on the open market to help drive down yields.  In fact, it was the spread of contagion to Italy that provoked the more acute phase of this Summer’s Euro crisis that ultimately drove the European Union to embrace a fundamental rethinking of the Maastricht Treaty.  Italy entering the crisis faze was (and remains) concerning because of its size relative to Greece.  To make matters worse, Italy needs to refinance over $300 billion of its legacy debt in 2012, an amount which in and of itself is nearly as large as Greece’s entire deficit.  By that token, as the Forbes article linked to above suggests, “Italy is too big to bail out.”  Fearmongerers love using size to their advantage as it relates to the Italy “problem,” but they equally love ignoring size when the topic becomes the relativity of Italy with Greece, so let’s take a deeper look.

Let me start with this caveat: this is not an argument for or against privatizations in Italy, or anywhere else for that matter.  I am merely going to lay out a few of the assets that the Italian government positively owns, in order to highlight my belief that this is a crisis of liquidity and not one of solvency, and as such, it is very much a transitory event  as it pertains to Italy.  In the future, I will be sure to discuss my beliefs on the Euro as a currency in more depth, for that will shed further light on my argument that Italy is not a concern in the first place.

Italy vs. Greece—Some Relativity

What makes matters appear far worse than they actually are for Italy is the frequency with which people are stacking the country’s $2.1 trillion deficit against Greece’s $456 million deficit to highlight the “greater magnitude” of Italy’s problem.  To the lazy eye this looks frightening, yet it’s not— the fearmongerers are intentionally aiming their appeal towards the lazy eye.  What they don’t want you to know is that Italy’s GDP dwarf’s Greece’s (Italy’s is greater than $2.1 trillion, while Greece’s is a mere $329 million).  Further, these numbers are solely looking at accrued deficits from years past and in no way reflects the fact that Italy is running a SURPLUS (yes you read that right) of approximately 0.8% of GDP this year, while Greece is in a tailspin.  Quite simply, the situations are not analogous.  It is merely the size of Italy combined with the “what if” that drives the fear, whereas in Greece the problem is fundamental and existential as it pertains to the country’s continued inclusion in the Eurozone. 

A Wealth of Assets in Italy

Let me start with a question: which country in the world has the third largest gold reserves after the U.S. and Germany? 

Clearly the answer I’m getting at is Italy.  Italy has immense gold reserves that serve no functional purpose for the country at this point, especially since they themselves are not sovereign over their own currency.  At today’s price of ~$167/ounce, Italy owns $14.4 billion worth of gold.  This alone accounts for 6.9% of Italy’s budget deficit.  The concern that Italy’s deficit will persist in perpetuity is a core argument of the fearmongerers, therefore the value of using that gold to pay down the deficit is far greater than the value of the actual gold itself.  Viewed as a perpetual obligation at Italy’s present 5.5% interest rate on the 10 year note, the paying down of $14.4 billion of debt amounts to a net present value of a $262 billion gain.  I like to think of the benefit this way because Italy is carrying a primary surplus right now, and as such, dropping its perpetual debt burden substantially alters the country’s present and future outlook for the better.  The cost-to-carry of the debt instantly drops, as should concerns over refinancing 14% of the country’s outstanding debt during the course of 2012. 

Now let’s get to where Italy really has substantial wealth—public ownership of corporate enterprises.  In the time leading up to World War II, the fascist regime of Benito Mussolino used the government as a means through which to build corporate Italy.  While fascism was defeated in World War II, the legacy of government intertwinement with business in Italy never ceased.  In fact, it was the primary method through which Italians rebuilt and moved forward in the aftermath of the War, with some generous help from Uncle Sam in the form of the Marshall Plan.  Largely due to this history and a dose of corruption, the Italian government continues to own substantial business interests within the country.  Below is a select sample of a few of these interests.

First up is Poste Italiane, the Italian “post office.”  I say post office in quotes, because while the company does postal services, it is not your run-of-the-mill post office.  Poste Italiane operates several lines of businesses including logistics (which does have a natural connection to package delivery), financial services, insurance, phone calling cards, and even semi-conductor manufacturing.  In 2011, Poste Italiane brought in $28.9 billion in revenues and had nearly $2.5 billion in operating income.  Further, the European Union has rules and restrictions on post offices, and is trying to liberalize and even phase out some of the government postal services themselves.  As is typical for Italy, the country has been slower than slow in pursuing these liberalizations, as evidenced by this quote from the Consumer Postal Council: “The target date for full liberalization had been postponed several times [by the European Union], and Italy took full advantage by refusing to liberalize its market ahead of schedule.”  Why does this matter?  Well again, an interest in a profitable business like Poste Italiane could easily be worth $25 billion on the private market (this is a rough earnings power valuation of a company generating $1.5 billion in sustainable EBIT). 

Luckily for Italy, Poste Italiane is just the tip of the iceberg for government ownership of industry.  The Italian government is also the full owner of Fincantieri, the largest ship-builder in the Mediterranean.  While the company is not nearly as profitable as Poste Italiane, the state ownership is notable, for why does the Italian government even have the full ownership of a company that today is known for being the premier manufacturer of luxury yachts in the world?  At one point in history, Fincantieri served a purpose for the government in manufacturing military vessels, yet now the company is better known for building super-yachts for Europe’s elite playboys to cruise the Italian Riviera and the Amalfi Coast.  Fincantieri suffers from government’s inability to efficiently manage the business as is evidenced on its 4% operating margin on over $3.5 billion in revenues.

One of the prizes of Italy’s ownership interests in corporations is Eni, a publicly traded conglomerate with a market cap of $91 billion today.  The government owns 30% of the company, a stake worth $27.3 billion on the open market.  Eni, an integrated energy company involved in exploration and production and the delivery of oil and natural gas, makes $21.3 billion in operating profit and over $8.3 billion in net income.  As of today, the company is valued near the low-end of its five year trading range, and outside a crisis environment could be worth far more down the road. 

Lastly, let’s briefly talk about Italy’s public interest in broadcast and media.  In my opinion, this is a pretty big no-no for a liberal democracy to begin with, especially in light of the fact that the recent Prime Minister owned the largest private media empire in the country, while pulling the strings at a substantial state-run enterprise.  In essence, the media and the government were inseparable, and this helped Burlesconi consolidate his grip on power for so long.  This is a greater than $3 billion in revenue business, that includes ownership over Cinecitta, the largest cinema studio in Europe, and the crown jewel of Mussolini’s propaganda initiatives during World War II.  Many a great Sofia Loren films, and more recently Gangs of New York and The Life Aquatic were filmed there  It’s no wonder that outsiders view Italy as helplessly corrupt.   Needless to say, there is tangible asset value here, that given the need, Italy could monetize in order to bring their debt burden under immediate control.

In Sum:

I have outlined approximately $73.2 billion dollars of tangible value (or 3.4% of the deficit) that Italy could monetize should the need arise, and this is far from an exhaustive list (please note that the $73.2 billion figure counts Italy’s gold value at $14.4 billion, and not the more generous $262 billion benefit the country would gain from removing a perpetual liability from its balance sheet, as would be the case with any of these other valuable assets).  In addition to gold and corporate interests, the country owns billions of dollars worth of real property. While this would not extinguish all liabilities entirely, even the most gloomy of observers doesn't think that is what's necessary.  The key is to restore the debt to what the market perceives to me a manageable level, which in and of itself will drive down yields and make the cost of carry that much less.

Despite these facts, fear itself is contagious and that is clearly evidenced by the concern over the country in debt markets today.  Italy is not running a deficit as of today, and as I have highlighted above, the country owns substantial assets.   I cannot help but think that one catalyst for the contagion of fear is the market trying to force the country’s hands into privatizing these aforementioned lucrative assets.  In past debt crises around the globe (Latin America serves as an outstanding case study), substantial state owned assets were privatized in order to cover public borrowings.  In the process, many profited directly by positioning for a crisis and then deployed their gains along with those who stayed on the sidelines in order to make substantially more money in scooping up newly private assets at dirt cheap prices.  To many, a crisis is an opportunity and that is precisely how Carlos Slim became the wealthiest man in the world.

Links for Thought -- February 10th

Warren Buffett: Why Stocks Beat Gold and Bonds (CNN Money) -- Warren Buffett gives a preview from this year's shareholder letter and explains why the long-run returns from equities will exceed those of stocks and Gold. As always with Mr. Buffett, the reasoning is presented in a clear and simple manner and the timing is impeccable considering the Gold vs. everything else discussion in the media this past year.

Credit Suisse Global Investment Returns Yearbook 2012 (Credit Suisse)-- This is an outstanding presentation from Credit Suisse that covers 112 years of market history as it pertains to inflation vs. deflation, currency investing/hedging, and panic vs. euphoria sentiment in markets.  

@Google Presents Daniel Kahneman (YouTube) -- In this gem, one of the fathers of Behavioral Economics and author of Thinking, Fast and Slow (a must read) discusses how and why our brain succumbs to cognitive biases, and what we as humans can do to adequately recognize and adapt to this reality. He does so by distinguishing between System 1, our "automatic" thought mechanism in the brain, and System 2, our "deliberate" one.

The Housing Bottom is Here (Calculated Risk) -- Calculated Risk, a site which rose to prominence for its early and frequent calls of a bubble in housing, dating back to 2005, this past week declared that the bottom in housing will come at some point in 2012. This is a big call for a site that is known for sharp analysis. Further, it's notable that this call comes just a few months after the rent vs. ownership cost gap in housing reached equilibrium for the first time since the late 1990s.

Bernanke-Led Economy Proving Critics Clueless About Federal Reserve Policy (Bloomberg) -- Fed Chairman Ben Bernanke gets some props from Bloomberg for masterfully navigating a challenging economic landscape.  Those who have followed me before this blog was born know that I have been a proponent of Bernanke's and as such, I'm happy to see a mainstream publication take some shots at the wrongness of conventional wisdom as it pertains to Fed policy.

New RGA Investment Advisors Market Commentary

It's official, I'm Managing Director at RGA Investment Advisors!  Here's our first commentary with some of my input, be sure to check it out:

RGA 2011 in Review and a Top Down Plan for 2012

For years many professionals in finance have been touting the benefits of diversification, however there remains a long-standing debate about how best to pursue the objective—should investors have a concentrated yet diverse portfolio, a diverse portfolio, or should they just index and buy as broadly as possible?  2011 was a year in which we saw all kinds of problems with  the pursuit of diversification and it highlights exactly how and why we like to approach this problem a little differently.  First, the important math.  The theoretical reason behind diversification is to eliminate single-stock risk to the point where a problem with one portfolio company or holding does not overly infect the entirety of the portfolio.   Joel Greenblatt, a Columbia University professor, hedge fund manager and author did some interesting work to quantify this factor of risk. Owning two stocks eliminates 46% of the risk associated with individual stocks, eight stocks eliminates 81% of the risk, sixteen stocks eliminates 93%, and thirty-two stocks eliminates 96% of the risk.  In order to mitigate 99% of the single-stock risk one most own 500 holdings.  The clear point here is that mathematically speaking, the benefits to diversification continually diminish when the portfolio holds more than sixteen total stocks.

Why do we bring this up now?  Well in 2011, correlations were as high as they ever were.  In other words, every stock, and just about every asset class moved in the exact same direction.  This implies that what was a risk to one stock, was also a risk to another.  While in aggregate that statement appears to be true, it’s not entirely true.  Directionally, stocks moved consistently in tandem, but in terms of magnitude of the move, there were vast differences.  Plenty of stocks finished the year up nicely, while others finished the year down badly.  Many diversified portfolios took substantial hits and the key factor lies in how diversification had been pursued. 

Simply diversifying holdings is not enough.  Importantly, 2011 highlighted the fact that people need to diversify their correlations.  That means that investors must expose their portfolios to as many different catalysts as possible.  It means buying quality companies in a variety of sectors, with a variety of strengths and weaknesses, which should overlap as little as possible in aggregate.  Some might say, well why not just index then and achieve ultimate diversification?  And that question, while a legitimate one, further confirms the initial point.  An overly broad, diversified portfolio is exposed to nothing other than just economic growth.  Without economic growth it’s nearly impossible for the market in aggregate to move higher, but that’s not entirely true for a well-selected, diversified basket of stocks, bonds and cash that are rebalanced tactically with layered and stratified correlations.

The Information: A Book Review Meets the Facebook vs. Google Debate

In The Information: A History, A Theory, a Flood, James Gleick traces the history of information from Claude Shannon working in Bell Labs through the modern day proliferation of information on the World Wide Web.  Not long ago, former Google CEO Eric Schmidt controversially proclaimed something along the lines of: “every two days we create as much information as we did in the history of the world up until 2003.”  While not necessarily controversial on its face, many perceived this as a slight on the accumulated knowledge of mankind up until that point. 

What Schmidt meant by was not to diminish the accomplishments of his ancestors, but to laude the proliferation and compounding power on which information works.  Information over time itself becomes a facilitator of faster and swifter growth in new information.  Gleick’s book provides us all with the framework through which to understand what Eric Schmidt meant and why it is consequential and important. 

Few would deny that today is the Information Age, and as such, any author who titles his book “The Information” is undertaking a self-acknowledged daunting and maybe impossible task.  As humans, it is perhaps our ability to create and manipulate information (and not our opposable thumbs) that distinguishes us from the rest of the Animal Kingdom, and that certainly factors into the intrigue and import of this book. 

By and large, despite its length and depth, the book reads like a novel with robust character development and seamlessly interwoven and entertaining narratives.  In reading The Information we learn about how the telegraph, telephone and Internet each came to vastly accelerate both academic and economic growth in due to the efficiencies gained from packaging information in novel ways.  We learn about the history of “coding” from African mountain-top drum beats, to World War II era code-breakers to web page development and the quantities and depth of information required to transmit each message across their respective medium.  And we learn about how today, as the Information Age just may more aptly be labeled the age of Information-overload.

The book is a multi-disciplinary take covering information from fields including physics, engineering, statistics, biology, English, and history, all at different points.  Through this vast lens, people from any background can extract significant value from reading this book.  In order to understand modern times, and how and why things work as they do, we need to take a step back and attempt to understand yesterday first.  Why this would be important to a computer programmer or entrepreneur is self-evident.  Its import to investors should be equally so.  We need to have a framework through which to understand the evolution of information-based services in order to understand what may be a value-trap and what may be the next big thing.

As I was reading the book, I couldn’t help but decipher in my head how it relates to today’s debate about whether Facebook is the next Google.  While reading The Information, I came to thinking that many miss what I perceive to be a key point: one of the most essential elements of Google is that it is THE catalogue of information for the Internet.  Google’s dominant position as the search engine of choice and its first-mover advantage in building out its own information storage infrastructure has helped cement that status.  Facebook may (and does) have an advantage as it pertains to social connections, yet Google’s advantage is far more robust and deeper. 

Google’s advantage is “information” in the most general and abstract sense.  The company figured out not only how best to store said information, but also learned how to catalogue and index the information in the most accessible manner.  Social is but one facet of information and it will never be more than that.  While just about anyone with an interest in information can extract value from Google, that’s distinctly not the case with Facebook.  Quite simply Google holds the keys to the information that the Internet facilitates.  Information is ubiquitous, and Google is your catalyst.

This is far from my complete analysis of the Facebook vs. Google debate (which I really think is an illusory debate founded solely on the premise that everyone likes an either/or proposition these days), but I think it is particularly relevant given the history outlined by Gleick in The Information.  I would recommend this book to just about anyone interested in learning about how the Internet came to be, for without information theory there is no Internet, but in particular, I would recommend it to anyone involved in either the development of new information-based services or any investors in media or technology companies. 

Author Disclosure: Long GOOG

My Reflections on Steve Jobs, by Walter Isaacson

As soon as I heard there was an authorized biography of Steve Jobs in the works, I knew I would be reading it ASAP.  As a semi-"fanboy" of Apple products, I had a special affinity for Jobs' ability to create beautiful, yet simple products that so clearly surpassed the competition.

Steve Jobs is inspirational to me as an innovator and businessman, and I always looked forward to his next Apple event.  Not many people could successfully earn the respect bestowed upon him by both the hippiest of the hippies and capitalist of the capitalists out there today like Jobs has.  The first iPod I got (a gift from my Mom for my college graduation) was a semi-spiritual event and shortly thereafter Apple was my first really good Tech investment in the dot.com bubble's wake.

I say a semi-fanboy, because while I prefer Apple products, and recognize their superiority, the closed ecosystem and lack of hardware scalability consistently pisses me off.  No product exemplifies my feelings more than the iPad.  I knew the concept was in the pipeline for a while, and I "knew" that I would be buying one rather quickly.  I even bought a large external hard-drive/hub and built my own internal home network in anticipation of the iPad as my computer replacement.  My vision was clear--with my newly created home network and hard-drive, a tablet (I was expecting the name iSlate, not iPad), and a tablet dock, I could theoretically build my own cloud-computer at home.  The tablet would be my CPU and monitor (the brains and eyes), while my network would be the memory (the central nervous system), enabling the liberation of my computing experience into my personal cloud.

Unfortunately, it wasn't meant to be.  The iPad, required adding an additional device to one's computing infrastructure, rather than liberating the user to do something new altogether.  Sure the iPad was new, and incorporated some amazing and groundbreaking features, but there was a major disconnect between my expectations and the level of enthusiasm that ultimately greeted the device.  Here's what I said at the time.

Needless to say, I felt let down.

After spending much of this past Thanksgiving weekend messing around on some family and friends iPads, I still want one despite my disappointment, and despite the fact that Apple never fully came around to the features I want.  Perhaps that's just my impatience about the fact that neither the iPad 2 nor any of its clones have come close to offering what I am looking for.  But really, I think it comes down to how amazingly awesome the iPad is to use, and in the context of what I was looking for in a tablet, if I settle, I better settle for the best (the Ipad).

I start my "review" of Steve Jobs, by Walter Isaacson with this little anecdote, because it is in some ways the perfect metaphor for my feelings towards the book, as well as my feelings towards Steve Jobs.  Reviews of the book are a dime-a-dozen, and therefore, I would like to focus my review not on the book itself, but on elaborating on my personal feelings towards the subject--Steve Jobs.

Immediately upon the book's release, all the juicy tidbits about Jobs personality and personal life were plastered all over the Internet. Before the book came to light, I was generally aware that Jobs had a prickly personality, and before reading much of the book, I learned a good chunk of the most shocking details from his childhood post-adoption to his intimate relationships to his business rivalries.  Much of the "drama" was conveniently extracted by a media blitz as one website after another attempted to beat their rivals at revealing the most shocking plot lines first.  And let me be clear from the start, the "juicy" stuff is interesting because it is what we already did not know; however, as I kept reading the book I became more annoyed (albeit not surprised) with how much of the focus in the press was on Jobs' personality and his private life rather than his ethos and achievements.  With that in mind, I purposely will forego reciting and commenting on many of these facts better left for the tabloids.

The media blitz forge an initial bias on my part: there was more to Steve Jobs than meets the eye, and he is not exactly the saint he was idolized as in the public eye.  My bias was further confirmed as I began reading the book.  The early parts moving from Jobs' childhood in Silicon Valley, through his college days and the founding of Apple don't really paint too attractive a picture of the man.  Jobs' genius clearly stands out from early on, but all of the striking parts in the beginning pertain primarily to demystifying Jobs role in the creation of Apple (Isaacson confirms the oft-stated critique that Wozniak was the brains behind Apple's technology) and highlighting the nature and depth of Jobs thorny personality.

As I kept reading, I said to myself, "sure he's done some great things and all, but what an asshole!"   Then something happened along the way.  It started even before the revelation of Jobs' cancer, at which time he became more of a sympathetic figure.  Where I really felt my inner transition in emotion towards Jobs was the sequence in which Isaacson takes us through the early days of Pixar and its rise.  I can't put my finger on what exactly it was, but in this context I really started understanding Jobs as a guiding visionary, who can almost will innovation to happen, rather than just someone who got lucky being around the most brilliant computer geek of his time.

Visionary probably isn't even the right word, but I said it there intentionally.  It wasn't as if Jobs set out to create something new altogether with Pixar.  Actually, he was navigating down a different path altogether when the CGI movie idea came to him, but it was he who recognized the promise and allowed the ship to steer itself towards its manifestation.  Where most other CEOs would never let the project get legs in the first place, Jobs encouraged the creatively inclined workers among him to embrace and indulge in their creativity, nurtured the project, and saw to it that at each step of the way success would be maximized.  Opening doors was not enough.  Nothing short of perfection was.

Maybe it's just that Pixar itself sounds more fun, but as that episode of Jobs' life played out, my personal Steve Jobs impression reflated rather quickly.  This accelerated as the story evolved into Jobs' return to Apple and eventually his battle with cancer.  The return to Apple contains much of the folklore we already know, but also in the context of Isaacson's narration, it turns Jobs from someone whose bubble had popped and builds him back up into the man we know today.  There are some clearly delineated self-improvement stories in there, but also we finally get the clear articulation of Jobs' brilliance--his ability to take something amazingly complex and make it beautiful and simple.  This holds true on the macro and micro levels, as Jobs built the company and each of its products around this principle.  Don't get me wrong, these elements were there from the beginning in Apple, but they are much more well-rounded and central to the plot at this point, probably because they are clearer in Jobs' own personal vision by then.

As for the battle with cancer, many have taken this as a real critique of a brilliant man.  The question "why would someone so smart do something so dumb" was asked throughout the blogosphere, and I very much see why people want to ask this question.  Yet, I think that view can only come when that fact is encountered in isolation from the rest of the book. While many have derided Jobs for failing to adequately treat his own cancer, and to a large extent, I agree, he wouldn't be Steve Jobs were it not for his ability to ignore hindrances while focusing steadfastly on his personal priorities--EVEN TO A FAULT!

Although the outcome sucks, it's hard to blame the man for it.  In fact, it makes him into more of the tragic hero I think he has become, in that the source of his strength, his so-called essence itself, was also the source of his downfall.  Therein lies the real source of my once-again reflated opinion.  Steve Jobs is your prototypical tragic hero in the Aristotelian sense, and this is exactly what humanizes his brilliance in the end.

The real climax of the book, and what pulls it all together are Steve Jobs' own words on what he thinks his legacy should be.  Whether one can truly ascribe each word to his life or not, the message in and of itself is one that all should take to heart.  To maximize one self, people need to be well rounded and have an understanding and connection to the humanities, but also knowledge of the technical.  People need to be hyper-honest, even to the point of being critical, while also being able to push aside their ego in order to accept criticism and use it constructively.  Lastly, people need to build things out of passion, aiming for the highest of quality, rather than for profits alone.

Be sure to read the book for yourself, it's well worth it.   What is interesting in the book goes well beyond what's juicy and leaves many lessons to learn for just about anyone.