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European Investing Summit: How Superinvestors are Navigating the EU Crisis

Last week, in addition to attending in person the Santa Fe Institute conference, I also “virtually attended” the European Investing Summit put on by ValueConferences and the Manual of Ideas.  It too was quite the experience, in terms of the quality and quantity of content and its groundbreaking format for connecting global value investors.  These days it’s nearly impossible to amass the brainpower and experience of informed presenters in one conference room over the course of two days in any physical sense.  That’s why the Manual of Ideas had the idea to orchestrate a virtual conference, with a blend of live streaming and pre-filmed interviews, replete with presentations and interactive conference rooms to connect with fellow attendees and presenters alike.   Many thanks to John and Oliver Mihaljevic for conceiving and executing on an outstanding idea, and for gathering some of the foremost talent in the industry.

I spent a whole lot of time last week and over the weekend listening to and absorbing as much as I could from the videos.  I particularly liked the fact that nearly all of the videos offered great lessons on the process and philosophy side as much as they did on the ideas front.  I went into the conference with plenty of thoughts on Europe and where I saw the crisis inevitably leading to, plus I had already deployed capital strategically into four distinct European investment opportunities, but I really wanted more considering the vastness of opportunity amidst crisis. (Be sure to check out my post connecting Europe today to the Articles of Confederation USA entitled The Answer to the Eurozone Crisis was Written in 1787).

I “left” the conference having learned of several very intriguing ideas that are queued up for immediate further inquiry, but maybe even more importantly, I “left” feeling like I made important strides in continuing the evolution of my own investment philosophy.  In this blog post, I would like to share some of the more macro ideas from the live sessions on day 1 of the conference, including perspectives on the European markets and some important philosophical points on value investing in this present environment.  Anyone who finds these ideas remotely intriguing would extract considerable value from attending these online sessions at ValueConferences.com.

Guy Spier, Managing Partner, Aquamarine Capital

The live portion of the event kicked off with Guy Spier’s keynote address on “Investing in Europe in the Face of Crisis and Uncertainty.”  Spier started his analysis with some very informative charts on the debt-to-GDP ratios of the various EU entities, including a breakdown between public, private and corporate debt.  There were some interesting observations on the charts, including just how troubled Greece is from a public debt perspective, how much greater Ireland’s aggregate debt burden is compared to the rest of the EU and US, and how much actual private wealth exists in Italy.  Obviously we all know about Greece’s woes, but I think in valuing investing circles, the troubles of Ireland stand in stark contrast to conventional wisdom, and Italy’s wealth is often overlooked (this is something I’ve covered on my blog in the past in a post called Why Italy Doesn't Worry Me).

In my opinion, one of the more important points Spier made off of these charts is that “fear-mongers try to make money off of selling fear, but the globe has a whole lot more wealth than is ever talked about.”  This is exactly how crises go.  People get caught up in the negative emotion and willfully look past some crucial realities. 

We then turned to a chart on the odds of a country leaving the EU, which has greatly decreased since ECB President Mario Draghi’s aggressive late summer statements and actions.  This segued nicely into how Guy in the recent past thought the Euro would in fact break up, however, politics, not economics paved the way for Draghi to bypass the rules in practice, and keep the currency union together.

Next Spier broke down the two lenses through which people view this crisis: the Anglo Saxon vs. the Continental.  Anglo Saxon countries are more individualistic and place a greater degree of value on personal freedom, whereas the Continental lens is more collectivist.  This creates a dichotomy whereby those who adopt the Anglo Saxon perspective view the crisis through an economic lens, while Continental people take the political view.  Each perspective has its own unique consequences; however, it’s clear that today the Continental approach is winning. 

Spier himself asserted that he has moved his understanding in the Continental direction.  This then evolved into a discussion on how the crisis itself is a catalyst for further integration to the point where without crisis, integration itself stagnates.  That raises the question of whether crisis is desired amongst those integrationists like Draghi, for without it they cannot continue the mission of Jean Monnet.

Please note: Spier then gave some very interesting investment ideas, but again, my focus here is to outline the European perspectives and what I learned philosophically about value investing.

Charles De Vaulx, Chief Investment Officer and Portfolio Manager, International Value Advisers

Right off the bat, De Vaulx continued on this theme of an Anglo Saxon/Continental divide: “Investing has always been an Anglo Saxon endeavor…it’s mostly those countries that have relied on capital markets to advance capital formation, while other countries saw their capital formation financed in other ways.”  De Vaulx then launched into a great history of value investing, and how it had predominantly been an American, and then British phenomenon.  Starting with the early 1990s recession, great American investors like Tweedy Brown and Michael Price ventured into global capital markets for value, mainly Europe.

Why did these investors turn to Europe? De Vaulx argues that this is due to some of the competitive advantages offered by European reporting.  Before the adoption of international account standards in Europe, man companies made it easier for some equities to get mispriced, or they ended up undervalued due to very conservative accounting practices (the opposite of many other places in the world).  In many of these cases, true economic earnings were thus understated.  Likewise, many companies had hidden assets on their balance sheets that were booked at historical cost, rather than present value.

Previously, the abundance of family owned and controlled businesses had been thought of as a risk in Europe, yet on further analysis, it became clear that these families were true stewards of investor capital, with their risks aligned in an advantageous way.  Further, many were open to the idea of takeovers and/or mergers as a means through which to realize value. 

Right now, International Value Advisers has 10% of the fund invested in France and only 0.4% in Germany.  This sits in contrast to much conventional wisdom, which holds that Germany is the safest, and France’s regime will crush capitalism.  Many companies across Europe, and particularly in France are in actuality global businesses, with a plurality of income generated overseas (De Vaulx used Vivendi and Total as examples here).

Over the course of the Euro Crisis there has been a big distinction in stock performance between the quality businesses and the cyclical ones.  Right now, many of the high quality businesses have performed very well, and thus are not cheap, while the cyclical businesses have become increasingly depressed.  Because of this contrast in performance, De Vaulx has been selling some quality businesses and allocating more capital towards the cyclical ones.  Because of this dichotomy, if you look at Europe in aggregate, the markets look very cheap; however if you want to buy quality you have to be willing to pay up.

Interestingly, De Vaulx had two impactful statements which contrast with typical value investing theory: first, he said that “gold has a lot to do with value investing and has a lot to do with Europe” as a hedge against problems; and second, he said that “buy and hold should not be part of the value investor’s vocabulary right now” due to the heightened volatility, which will be with us for a while.  This is an interesting adaptive change for a long-time value investor. 

Alvaro Guzman de Lazaro Mateos, Managing Partner and Portfolio Manager, Bestinver

Bestinver is a long only, no derivatives value investing group that follows macro, but doesn’t invest it.  Guzman de Lazaro focuses much attention on the reasons why a security has become cheap, and when an answer is readily identifiable, he invests so long as the reason for cheapness are acceptable.  In Europe, much of their attention is focus on family owned companies, companies with weird share structures, long-term projects and under-the-radar small caps.

Guzman de Lazaro observed that by and large, “Europe is a less efficient market” and in my opinion, this is music to any value investor’s ears.  For without inefficiency, there cannot be value, and the greater the degree of inefficiency, the greater the opportunity.  Guzman de Lazaro continued that in the US there is far more competition amongst the various value investors, and competition drives down return.  With European family owned businesses, there is a unique opportunity to engage with the families in order to develop a synergistic relationship over the course of years.  These families start to see their big investors as partners, and take their input in capital management.

Typically, Bestinver will look for companies with high barriers to entry, trustworthy management, little or no debt, and the stock already down quite a bit, all the while value itself should be growing.  What they prefer is a stock to drop solely due to concerns about the European Union itself, and not the fundamentals of the business.  Guzman de Lazaro emphasized the importance to their margin of safety of the increasing of intrinsic value while the price either stagnates or drops lower.  This creates a situation where over time the company has gotten cheaper.  Because a breakup of the EU cannot be taken off the table, Guzman de Lazaro models each company accounting for a 40% devaluation in their respective domestic businesses. 

Guzman de Lazaro also presented two excellent ideas, one of which is now on my immediate research list, and I urge you all to check out the European Investing Summit to learn more.

Jochen Wermuth, CIO and Managing Partner, Wermuth Asset Management

Jochen Wermuth is an investor focused on Russia and his presentation was appropriately titled, Russia: Klondike or Eldorado?  I went into the presentation disliking Russia and wanting to dislike it more.  Everything we hear about the country is of government and corporate corruption alike, with a near dictatorial leader imposing his well as he sees fit.  While there is certainly much merit to these complaints, Benjamin Graham certainly would still invest in a cigar butt were the valuation cheap enough, with little regard to the quality of the business itself.  And it does seem like Russia has some impressive numbers working in its favor, and we’re talking verifiable, not corruptly skewed numbers here too.

Wermuth started with the assertion that valuations are extremely depressed, and the reasons are twofold: the perception issues cited above, and a dose of truth.  The government has been increasing its share in the economy, and extracted significant value from the oil sector in order to build a substantial sovereign wealth fund.  To that end, there have been rollbacks in the pace of privatizations, and more dangerously, people in the country have been deeply upset by corruption to the point where they want to leave.  As a result, the country’s equity risk premium now sits at 17%--all-time highs, and a 36% discount to its average PE over time, and a 58% discount to the rest of the BRICs.

That starts us on the good stuff—the country is priced for the worst case scenario.  Importantly, government debt, as it stands right now, is at 10% of GDP and the country has zero debt denominated in foreign currencies.  This is in stark contrast to many other countries around the globe.  Plus, Russia has $520 billion of its own FX reserves, the 3rd largest stash on the planet.  This is a very different Russia than the one which defaulted in 1998.

As it stands right now, market infrastructure is not very developed, with foreign capital the primary “bid.”  Pensions in Russia are small and cannot invest in equities, therefore the market really just moves along with the flow of international capital.  When the tide rides in, valuations rise, and when it leaves, they decline.  Further, speculative flows focus on only a few sectors (i.e. the love for emerging market consumers) to the point where there are substantial valuation gaps between the sectors.  Liquidity (or the lack thereof) compounds these problems, are brokers only push their international clientele into the most liquid vehicles, not the cheapest, best investments.

John Gilbert, Chief Investment Officer, General Re-NEAM

Although this was dubbed the European Investing Summit, John Gilbert focused his really thorough presentation on the present state of the US economy and its implications for long-term investors.  Gilbert posted some outstanding charts highlighting the state of the economy today and how it has changed over time.  One of the first observations was that both household net-worth to disposable income and household net worth to debt have both improved since the crisis began, albeit not very much overall.  Plus the savings right, while higher now, has to potential to get even more elevated.

Financial sector debt-to-GDP has risen from “virtually zero” in 1952 to a peak of 120% of GDP in the bubble days, back down to about 90% now.  Deleveraging has been particularly rapid in this sector of the economy, but it “may have considerably further to go.”  Leverage in the shadow banking arena (mortgages, ABS and other) is greater than in the traditional financial sector now, and this can be attributed to the financialization of the economy.

Gilbert then asked rhetorically, “how far along are we on deleveraging, and how much further do we have to go?”  In 2011, the Bank of International Settlements presented a paper at Jackson Hole called the “Real Effects of Debt.”  The BIS outlined how in each of the 3 sectors, levels of 85-90% of GDP correlate to slower subsequent economic growth.  We are still in this danger zone.

Many optimists point to the debt service as a percent of disposable income in order to say thing are getting better, and the Fed does this too (for my Twitter followers, you know I’m guilty as charged here too…see the chart for yourself here).  Gilbert says “it is quite encouraging” and certainly has some merit, and says the reasons behind this are the Fed’s zero interest rate policy (ZIRP) and what that has done to create low mortgage interest rates.  However, Gilbert would caution that the balance sheet itself remains quite stressed and this leaves the household sector vulnerable to any subsequent shocks.

Historically, the largest source of deleveraging has been from increases in nominal GDP, most specifically inflation.  While there are no imminent signs of inflation, this is a good template through which to expect future deleveraging to take place and its worth looking at where inflation might come from.  Plus, the aid of inflation in decreasing debt burdens can be quite large even when the overall inflation rate is low.  Policymakers are aware of this, but there problem is that it’s tough to get inflation started in the short run. 

Housing is typically a good source of inflation, although it “won’t surge anytime soon.”  It is clearly off the bottom today, and we’re heading in the right direction.  Single family rental rates (or the bond equivalent value of owning a home) has diverged sharply from the price of actually owning a home.  This makes renting more expensive relative to housing and pushes would be renters into homeownership.  This is a good positive for housing.

As for Fed policy, QE3 is different from its predecessors both in terms of conditions in advance (they’re a bit better now) and in the way it’s done (open-ended purchases of MBS instead of fixed amounts of Treasuries).  This marks an important “cultural change in the Fed” that is moving towards unanimity in the dovish direction.  We can see this in how certain members have changed their positions to align with Chairman Ben Bernanke.  Since QE3 is tied with the Fed’s goal of “maximum employment” we must then examine what that term means.  Gilbert defines it as “the rate when the economy is at potential and not exerting pressure on inflation.”  The problem is that this rate shifts over time, and is not observable.  It therefore “must be inferred from the condition of the labor market.”

One way that policymakers try to figure out “maximum employment” is through using the Beveridge Curve.  This plots the unemployment rate against the job opening rate.  There are two problems with this analysis: the natural employment rate is subject to error, and there is a big spread between the real-time data and revisions down the road.  Right now it’s too early to form any strong opinions about the labor market, as to whether there has or has not been structural change in the economy.  The Fed is inclined to say there is not; however, Gilbert is a bit more skeptical and wants to wait to make any judgments.

Everyone today is looking for more yield, but it’s important to remember that these are troubled times and more yield involves more risk.  We are approaching tight corporate bond spreads on high quality stuff, but not quite yet on high yield.  There are many anomalies in markets due to this chase for yield, including: electric utilities trading at their highest P/E relative to the S&P ever, the Schiller CAPE/Tobin Q are not all that cheap right now; Gold has outperformed the S&P despite not being a good long-term investment in its own right.  Gilbert elaborated on gold saying that once in a while it acquires option value, but doesn’t pay off very often.  It is “only in the money when people lose faith in the existing monetary standard” and considering that faith has not broken, gold “is a candidate for a bubble.”

In conclusion, Gilbert explained that it’s too early to say whether there has been a permanent behavior change following the recent crisis, but it’s significant that most people alive today have never seen anything other than credit inflation.  Lehman itself upended 200 years of lender of last resort behavior, and this in and of itself could have far- reaching consequences down the road, leading people to take on less debt for a long time, and/or possibly inducing central banks to be more aggressive than they have been.

I had the opportunity to ask a question, and I asked: “you referenced the connection of maximum employment to NGDP and the Fed’s new form of QE2 as a more forceful push towards maximum employment.  Do you then view QE3 to be the fed’s adoption of NGDP targeting?”  Gilbert answered that it’s not quite there, because there are technical problems with targeting NGDP.  He does however expect the idea of NGDP targeting to get more attention, because it would allow the Fed to let inflation rise without actually saying so. 

Gilbert continued to explain that If we end up in a world where the US is not a real growth economy, but a 2% real GDP growth state, and you set an NGDP target of 5%, this lets your target inflation rate rise from 2% to 3% without actually doing anything.  Further, he said that it’s hard to see QE3 having the transmission mechanism to support such a substantial change in their targeting.  They’re solely resorting to increase the quantity of money right now, rather than the cost of money, which is what NGDP would do.  For that reason, the Fed might have to take more radical steps were they to actually adopt NGDP targeting as its policy.


The Answer to the Eurozone Crisis was Written in 1787

When I last focused on the EU in this blog, I took a look at why Italy doesn't worry me too much.  I omitted Spain from this analysis purposely, because what placated me with regard to Italy just did not exist in Spain despite Spain's lower overall stated sovereign debt-to-GDP ratio.  Since that time, the Eurozone had calmed down, but during my blogging hiatus things once again flared up.  Now, I think it's time to take a much deeper look at the EU and what it all means, because this has become far bigger than an economic question.  More specifically, I am firmly in the camp that sees the Eurozone crisis as a constitutional crisis, not an economic one.  

Since World War II, the European Continent has moved towards a unified economy, without unifying any of the institutions necessary to manage and enforce a centralized currency.  As a political philosophy guy, this is seriously fascinating stuff, as we are witnessing history in the making, while as an investor it's skewed to the scary side of things.  The uncertainty is great, however, for you history buffs out there, the clearest parallel to Europe's present predicament is the United States under the Articles of Confederation.  

As a refresher, the Articles of Confederation governed the United States in the time period between the American Revolution and the Constitution, where States existed as de facto sovereigns and no strong centralized power existed.  In response to growing economic and political failures, and rising social tensions, the leading intellectuals and political figures in young America gathered in Philadelphia to "form a more perfect Union."

Unfortunately, and contrary to the linear path with which history is narrated, the Constitution was not instantly greeted with excitement and acceptance.  As a result, the Founding Fathers had to go to great lengths to ensure its passage, especially in the "core" states of New York and Virginia.  Alexander Hamilton was a particularly important architect of our form of American Federalism and was a key emissary for the State of New York (in fact, he was the only New Yorker to sign the document).  To help get New Yorkers and Virginians to vote "yay" for the Constitution, Hamilton and James Madison wrote what are now known as The Federalist Papers under the pseudonym "Publius."  It's amazing how relevant these papers remain today.  

To be clear, I did not originally conceive of this idea of the EU as the pre-Constitutional US.  I first encountered the parallel in some of Bridgewater's excellent economic research available on the WWW.  Instantly the parallel resonated with me, and as a result, I started re-reading some of the relevant American History.  No one document struck me as more important today than Federalist #15.  It's as if Alexander Hamilton wrote each and every word directed at the powers that be in the EU today. 

Hamilton so adeptly incorporates the political, economic and ultimately the human emotional element into constructing a deeper understanding of the failures of a weak, centralized confederacy of interests.  Interestingly, Hamilton briefly gets into the history of failed attempts at confederation in Europe and their collapse at the hands of individual constituency interests.  Ultimately, he makes it abundantly clear why no sovereign interests can unite without unified institutions that have real powers of enforcement.

Below are a few excerpts from  Federalist Paper #15, entitled "The Insufficiency of the Present Confederation to Preserve the Union" but I urge all interested parties to read the whole thing:

In pursuance of the plan which I have laid down for the discussion of the subject, the point next in order to be examined is the "insufficiency of the present Confederation to the preservation of the Union." It may perhaps be asked what need there is of reasoning or proof to illustrate a position which is not either controverted or doubted, to which the understandings and feelings of all classes of men assent, and which in substance is admitted by the opponents as well as by the friends of the new Constitution. It must in truth be acknowledged that, however these may differ in other respects, they in general appear to harmonize in this sentiment, at least, that there are material imperfections in our national system, and that something is necessary to be done to rescue us from impending anarchy. The facts that support this opinion are no longer objects of speculation. They have forced themselves upon the sensibility of the people at large, and have at length extorted from those, whose mistaken policy has had the principal share in precipitating the extremity at which we are arrived, a reluctant confession of the reality of those defects in the scheme of our federal government, which have been long pointed out and regretted by the intelligent friends of the Union.


It is true, as has been before observed that facts, too stubborn to be resisted, have produced a species of general assent to the abstract proposition that there exist material defects in our national system; but the usefulness of the concession, on the part of the old adversaries of federal measures, is destroyed by a strenuous opposition to a remedy, upon the only principles that can give it a chance of success. While they admit that the government of the United States is destitute of energy, they contend against conferring upon it those powers which are requisite to supply that energy. They seem still to aim at things repugnant and irreconcilable; at an augmentation of federal authority, without a diminution of State authority; at sovereignty in the Union, and complete independence in the members. 


There is nothing absurd or impracticable in the idea of a league or alliance between independent nations for certain defined purposes precisely stated in a treaty regulating all the details of time, place, circumstance, and quantity; leaving nothing to future discretion; and depending for its execution on the good faith of the parties. Compacts of this kind exist among all civilized nations, subject to the usual vicissitudes of peace and war, of observance and non-observance, as the interests or passions of the contracting powers dictate. In the early part of the present century there was an epidemical rage in Europe for this species of compacts, from which the politicians of the times fondly hoped for benefits which were never realized. With a view to establishing the equilibrium of power and the peace of that part of the world, all the resources of negotiation were exhausted, and triple and quadruple alliances were formed; but they were scarcely formed before they were broken, giving an instructive but afflicting lesson to mankind, how little dependence is to be placed on treaties which have no other sanction than the obligations of good faith, and which oppose general considerations of peace and justice to the impulse of any immediate interest or passion.


Government implies the power of making laws. It is essential to the idea of a law, that it be attended with a sanction; or, in other words, a penalty or punishment for disobedience. If there be no penalty annexed to disobedience, the resolutions or commands which pretend to be laws will, in fact, amount to nothing more than advice or recommendation. This penalty, whatever it may be, can only be inflicted in two ways: by the agency of the courts and ministers of justice, or by military force; by the COERCION of the magistracy, or by the COERCION of arms. The first kind can evidently apply only to men; the last kind must of necessity, be employed against bodies politic, or communities, or States. 


There was a time when we were told that breaches, by the States, of the regulations of the federal authority were not to be expected; that a sense of common interest would preside over the conduct of the respective members, and would beget a full compliance with all the constitutional requisitions of the Union. This language, at the present day, would appear as wild as a great part of what we now hear from the same quarter will be thought, when we shall have received further lessons from that best oracle of wisdom, experience. It at all times betrayed an ignorance of the true springs by which human conduct is actuated, and belied the original inducements to the establishment of civil power. Why has government been instituted at all? Because the passions of men will not conform to the dictates of reason and justice, without constraint. 


From this spirit it happens, that in every political association which is formed upon the principle of uniting in a common interest a number of lesser sovereignties, there will be found a kind of eccentric tendency in the subordinate or inferior orbs, by the operation of which there will be a perpetual effort in each to fly off from the common centre. This tendency is not difficult to be accounted for. It has its origin in the love of power. Power controlled or abridged is almost always the rival and enemy of that power by which it is controlled or abridged. This simple proposition will teach us how little reason there is to expect, that the persons intrusted with the administration of the affairs of the particular members of a confederacy will at all times be ready, with perfect good-humor, and an unbiased regard to the public weal, to execute the resolutions or decrees of the general authority. The reverse of this results from the constitution of human nature.


All this will be done; and in a spirit of interested and suspicious scrutiny, without that knowledge of national circumstances and reasons of state, which is essential to a right judgment, and with that strong predilection in favor of local objects, which can hardly fail to mislead the decision. The same process must be repeated in every member of which the body is constituted; and the execution of the plans, framed by the councils of the whole, will always fluctuate on the discretion of the ill-informed and prejudiced opinion of every part. 


In our case, the concurrence of thirteen distinct sovereign wills is requisite, under the Confederation, to the complete execution of every important measure that proceeds from the Union. It has happened as was to have been foreseen. The measures of the Union have not been executed; the delinquencies of the States have, step by step, matured themselves to an extreme, which has, at length, arrested all the wheels of the national government, and brought them to an awful stand.


Why should we do more in proportion than those who are embarked with us in the same political voyage? Why should we consent to bear more than our proper share of the common burden? These were suggestions which human selfishness could not withstand, and which even speculative men, who looked forward to remote consequences, could not, without hesitation, combat. Each State, yielding to the persuasive voice of immediate interest or convenience, has successively withdrawn its support, till the frail and tottering edifice seems ready to fall upon our heads, and to crush us beneath its ruins.


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.