The Weekly Distillation No.42
When Markets Collapse; Facebook; Cohorts; Heineken; Mosquitoes; Book
Photo by Sean Robertson on Unsplash
Welcome to The Weekly Distillation. This is a newsletter that seeks to distill the noise and help you be informed, provoked to think, and inspired to create as you lead in life and in your organisation.
This week’s newsletter is sponsored by Thought Collective
Since 1999 our team of eleven thinkers, designers, and developers have been creating brands, websites, and Apps that communicate effectively, create value, and delight customers.
Recently we have been collaborating with: the hospitality sector to address the crippling fees commanded by online ordering aggregators (www.dishup.app); a health startup that is harnessing non-competitive group activity to improve health and efficiency in the workplace (www.oopla.app); and the family of Seamus Heaney to expand the brewery branding we developed with them into a range of apparel and yoke (www.heaney.ie).
Thought Collective is led by a great friend of mine in Belfast, Northern Ireland. Really honoured to have them sponsor the newsletter this week. Great business and great people.
People once said…….
“Those who compare Bitcoin to the great bubbles of the past need to check the historical books. This moment is very different.” - Joakim Book
“All we have to decide is what to do with the time that is given us.” - J. R. R. Tolkien
“I was in Balmoral when I was told that my mother had died. Still in shock, I found sanctuary in the service at Crathie Kirk that very morning and in the dark days of grief that followed I found comfort and solace in the Scottish outdoors.” - HRH Prince William
“The Palestinians want a state, but they have to give peace in return. What they're trying to do in the United Nations is to get a state without giving Israel peace or giving Israel peace and security. And I think that's, that's wrong. That should not succeed. That should, that should fail.” - Benjamin Netanyahu
“Learning never exhausts the mind.” - Leonardo da Vinci
Skim it in a minute
Here’s how Facebook is using AI to remove posts it doesn’t want on the platform
The first genetically modified mosquitoes released in the US are now hatching
Heineken might be moving into selling whisky and wine
Maven, a startup focused on being a platform for creators of cohort based courses (CBCs) raised $20m in a Series A round, following on from a $5m in seed rounds. It is now backed by an investor in Andrew Chen who also backed Clubhouse and Substack. Really interested to see where this one goes. The trend to future learning in cohorts rather than mainly individual asynchronous learning seems clear.
Deep Dive into When Markets Collapse
Deflation - when financial assets collapse
I feel for anyone who held Bitcoin in the last week, I really do. That must have hurt a lot. I spent 10 years working for fund managers and a hedge fund and had more than a few days where the investment thesis I had argued for came to naught. When the market moves against you these days, it can be brutal. But did Bitcoin really lose 30% of its value in a day, or was it just a knee jerk reaction and the trend will come back to favour Bitcoin?
(Caveat - Although I work in the finance industry, I’m not legally allowed to give investment advice to the general public (in case I cause you to lose money you can’t afford to lose) so none of this is investment advice and if you are ever trading, you should take your own advice).
The trades I remember most were those that went horribly wrong. There’s something in our psyche, probably it’s a British thing, that we feel the pain of the defeat more than the joy of the victory, and it is considered uncouth to celebrate our own wins. Despite the images of champagne quaffing bankers, the sad reality is most of us sloped home more often to mope in our suffering of when we’d had a sharp reckoning with the reality that financial markets are not a simple place to make money! (There were a few champagne days too).
I remember in the 2004-2006 period there was a terrible period for car demand - costs were rising, demand was rubbish and the currency was going the wrong way. I wanted to find a company we could short and I chose Fiat - based in Italy, models were out of date, distracted off into making combines and tractors, high cost base, heavily unionised, loaded with debt - this was a company that would suffer more than others if the market turned down.
Its price seemed too high to me for the coming downturn and it was likely to fall. (As part of a healthy financial market, shorting shares can be a good tool to bring prices back to reflect the reality of the company and lead to assets not being mis-priced for as long). So I argued for a short (we borrowed the shares from a holder (via a “prime broker” who acts as a middleman), paid a fee to the holder via the prime broker for that borrow (allowing the holder to generate income from an asset they were just holding) and then sold those shares in the market. Our plan was to buy them back later, at a lower price, and then return them to the prime broker, closing out the trade and having made a profit. Sell at 4 EUR, buy back at 3.5 EUR.
I even met Sergio Marchionne - the new CEO, I remember he smoked and he wore jumpers to business meetings and didn’t impress me. (Note - I was blinded by my thesis). Turns out the guy was a business genius. My thesis was broadly true - the market did turn down, Fiat was badly positioned - but Marchionne turned the company around, created new models, restructured, did deals with the unions, did a deal with Chrysler - and the markets loved it. Marchionne sadly died in 2018 - here’s a great insight on the man.
My trade was c.30-40% wrong within about 2 days. When you invest $50m plus leverage into a trade, that becomes painful very quickly. When you are in a team that is bonused off the performance of that one fund, and the $ made or lost on each trade is circulated around the team every TEN MINUTES that is even more painful.
In the 18th century, there was a craze to buy shares in the South Sea company, a British Joint Stock company that was given a monopoly to trade slaves to the south sea islands and South America. Because of war, the slave trade was diminished and the company made no profits - and thus the shares eventually collapsed, after a frenzy of bidding had driven the prices to incredible levels.
Better than that, in the early 17th century, there was a craze for tulips. In February 1637, the price to buy a single tulip at a set point in the future, reached 10x annual wages. Eventually the market awoke to realise that one tulip was not worth this - and prices collapse, thus creating the end of the first known speculative bubble, now known as Tulip Mania. You can be pretty certain that people were saying “it’s different this time” back then too.
Duration - when what matters is beyond a visible horizon
There has been a lot of noise about China blocking the use of crypto currency this week, leading to a 30% decline in the price of Bitcoin. Without wanting to diminish that factor, let me take a brief tangent off into the simple end of financial math. If you ever buy a whole company, you are entitled to all the surplus cash that that company generates through its business.
However, there has always been a case that money in the future is rarely worth more than money now. If I offer you £1,000 now, or the same £1,000 in ten years time, what would you rather have? The £1,000 now - because of inflation meaning that that £1,000 in ten years will buy you less. So the real value of a compay (or asset) you buy, is the total of the future cash you would receive, adjusted for when you receive it.
That formula is the sum of the cashflows of the future (CF in the picture above), discounted back (the 1+r’s). However, rather than extrapolate out a calculation to eternity, there is a shortcut that approximates the final value - it simply looks at cash, divided by the required rate of return (what an investor needs to make to invest in an asset, or the cost of money) less the long term growth rate in future cash from that point on. I could go on, but I suspect you are bored. Bear with me.
This is where the tech company, or the steel company, look very different. For a steel company, much of its cashflows are in the early part of that value calculation. For a tech company, many of the early cashflows are negative or minimal, and the value is way out in the future (“jam tomorrow”). So the calculation of value is very weighted to the required rate of return versus growth. For example, if 99% of the cashflows of Facebook is further out than 10 years, then a required rate of return of 10% and a long term growth of 5% means you divide that cashflow by (r-g) or 10%-5% i.e. 20x. If g increases to 6% and required return goes to 9%, that divider of cashflows goes to 9%-3% of 16x - and you have just increased the value of Facebook materially.
You can see how these so called long-duration stocks can be 1) highly sensitive to growth assumptions and 2) investor required rates of return. You can also how ridiculously impractical financial theory is and how there are the most amazing guesses/estimates on companies with this profile of cashflow.
Inflation - what happens when inflation expectations increase?
What drives an investor’s required returns? There are many factors but often it is inflation (what return will enable me to hold the value of my money flat in “real” terms rather than “nominal”), appetite for risk and level of debt in the investment. Any of these going in an unfavourable direction leads to the “r” rising and the long duration asset having a significant decline in price.
Which brings us back to the real world. We have had decades of falling inflation as structural changes have taken effect - automation, technological advances, efficient management, move to flexible labour, corporate power, the decline of collective bargaining, China entering the WTO and bringing its low-cost labour force to the Western world’s use, the internet, global supply chains.
1) Inflation expectations are now rising
Interest rates have been the policy makers tool of choice and central banks around the world have become independent of politicians too. As inflation fell, so too did interest rates, leading to a structural decline in investor’s required returns. However, we now find ourselves at a point where inflation is rising, temporarily or permanently is unknown, and therefore r begins to hint at creeping up again. Which means that many of the long duration assets are extremely sensitive to inflation expectations. Markets are becoming worried about inflation on a regular basis.
2) We have added an incredible amount of money to the system that has driven asset prices up
Secondly, we have added the most unbelievable amount of money to the financial system in the last 18 months. Below is a great chart (from early 2020 so very dated given the increase in money supply) that shows just how much money flows around the world. In January 2021, global broad money (the best approximation of how much real money is in the global economy) stood at $106.7 trillion, up 13.2% on a year earlier. That is an increase of $12 trillion….much of which has gone into chasing financial assets. In finding a home in financial markets - bonds prices rose, stockmarkets rose, private equity saw a rise of VC investment in tech companies and new highs in valuations, property saw house price rises, even while structurally commercial property declined due to permanent shifts in where we work (no pun intended), stamps, cars, wines, spirits, luxury goods, cryptocurrencies all rose also.
3) We are building a pyramid of cards
We have created a system where high leverage, automated trading and lowered expectations for long-term inflation have all come together to boost financial assets. This has been backed up by the last few financial collapses or economic slowdowns being met with quantitative easing (“printing money”) by central banks. This leads to a fascinating psyche - if assets collapse too far, the governing authorities will bale us out. The financial system is too big to fail.
Even in these times, assets can continue to rise. The thesis for cryptocrrency seems solid to me - even though in the near term the asset was being driven more by speculation and unsophisticated investors rather than any real fundamental trend. I’ve had friends who don’t invest asking for views on how to get in on crypto - I haven’t seen this since the peak of the dotcom boom in 1999.
I doubt we are heading for a massive financial collapse in 2021. The economy is booming in recovery, global trade is reopening and central banks are keen to be accommodating for some time by keeping rates lower than they should be.
However - if inflation remains high, eventually rates will rise and the longer duration assets and higher risk assets will suffer the most. Also - where is the marginal buyer coming from as the Government / Central Bank supply of $ around the world is fully distributed? This week was a slight hint about the underlying sensitivity in those assets on the fringes, where lots of money has been piling in. Caveat emptor my friends.
What I am reading
This is gripping. Not technical, nor academic, it manages to capture the evolving nature of the threat and how we reached our destination unintentionally. As bugs were discovered by hackers, the initial response of software vendors was to threaten to sue, or to ignore the claims of a breach. Eventually firms grew up where they would buy the bugs from hackers and sell patches to the clients of the vendors. Alongside that, a raft of 3 letter agencies realised these hacks into public and private applications could be very useful - and so began to outbid the companies seeking to sell patches.
And then you ended up with false flag situations - you are a hacker, you sell to what you think is the CIA, but is an American for a company registered in Delaware and is actually acting on behalf of some evil nation or group. No controls, no monitoring, no ethics and lethal power. You can see why the book got its title. I’m really enjoying this one.
Thanks for reading. A special welcome to the 13 people who signed up in May to the email list for the newsletter - if you read this regularly I’d love you to join the email list. I’ve been pushing out of my comfort zone this week, seeking new sponsors. That has led to some rejections and to some great encouragements and opportunities also. Looking forward to sharing some exciting ventures with you in coming weeks.