How hedge funds use debt

An article arose recently from Hedge Fund Research (hedgefundresearch.com) with a study stating that 23% of hedge funds with capital (money put in the fund by investors) over $1 billion used leverage of between two and five times. Leverage is calculated as: the value of the firms assets, divided by the value of its equity (equity for a hedge fund is just the money put into the firm by investors). To give this number (five times) some meaning: for every one dollar of money put into the hedge fund by investors, the company has five dollars worth of assets. The fund has $1 billion put into it by investors, and it owns $5 billion in assets that it has bought. And the answer to the obvious question, “where did the fund get the money to buy the other assets?”: it borrowed money. We’ll keep the leverage ratio at five for the purpose of this article’s example.

To show how important borrowing is to a hedge fund, it helps to show how they use it. Trading on margin is a common way for hedge funds to borrow and amplify returns. The hedge fund might want $1000 worth of exposure to gold. If they use the $1000 that was put into the fund by investors, and then gold rises by 5% to $50, they make a 5% profit for investors ($50/$1000). But that’s a suckers game (sarcasm by the way). The hedge fund could just as easily ask its brokers at Goldman Sachs (or any investment bank) to buy gold, but ask to do it on “margin”. The fund gives the bank $200, and Goldman might let the fund borrow $800 (charging a small interest fee for the use of its funds) and $1000 of gold is bought for the fund. Now if gold rises by 5%, the fund still makes $50 profit, but only used $200 of its funds, hence its return is now 25% ($50/$200). And this (ignoring the fact that a small interest fee charged to the fund will the lower the profit marginally) is the magic of leverage. When the hedge fund is leveraged to this extent, the original money put in to the fund by investors is not so much invested, but it is used as collateral for the fund to borrow against to make trades. In our example the firm put up $200 collateral to borrow $800.

Magical as this may seem, there are no free lunches. Leverage is just as powerful a stimulant  on the way down. If the gold falls in value by 5%, the non levered fund (who didn’t borrow from Goldman) just loses 5%.  But the levered fund finds that its $1000 of gold is worth $950 (same as the non levered, but here’s the difference) the $50 loss as a percentage of the $200 is a 25% loss, five times the loss without leverage (no coincidence with respect to the fact that their leverage ratio was five times). Once again, as we always find in finance, to access greater reward you must take on greater risk. If the fund had decided to put all of its $1000 capital up as collateral, and borrowed $4000 to purchase $5000 of gold (giving it a leverage ratio once again of 5) a 5% decrease in the price of gold would result in a $250 loss, or 25% wiping out one quarter of the capital put in by investors.

So what does this mean when your deciding which financial wizard to put your money with?

And the scary part is...

The good news is that the whole process also tends work in reverse. If we can jump straight to higher prices, we can jump straight to lower prices (this article follows on from What's the scariest thing out there at moment?). One way for the Chinese central bank to lower prices is to lower the money supply, which lowers spending, so less production occurs in businesses (a recession occurs). Finally firms lower prices to induce more people to buy their goods.

But who wants a recession? For most countries, painless disinflation (or lower prices in our example) is all about controlling expectations of inflation. If the central bank can convince the public they are going to lower the money supply, then rather than risk lower demand for their products, firms can immediately lower their price in an effort to avoid the recession, and induce more spending. However China is not most countries. Controlling expectations is for suckers and democracies. If the Chinese want businesses to lower their prices, they can just force them to. They don’t need to convince the public lower inflation is coming. They have a whole bag of weird and dare I say wonderful tricks to help them lower prices without a recession. Where leaders get it wrong is when they forget that this must be coupled with a lowering of the money supply for sustainable deflation (lower prices) to occur. The temptation is for governments to continue printing money to stimulate growth, while holding prices down artificially with controls.

Of course any economist will tell you the consequences of this: shortages and black markets, plus indirect inflation. If prices are artificially low, people will demand more of the product than businesses are willing to supply; simple demand and supply analysis, which any first year economics student could tell you about (but apparently not some politicians). Black markets tend to appear because suppliers realise that they can easily find buyers willing to pay a higher price than that stipulated by the state, so they take their product off the shelves and sell it in secret. You can bet that these sales aren’t reported to the tax department either, so real tax receipts tend to fall. Finally, indirect inflation occurs because firms realise they can’t raise their prices on a product, but they might be able to lower the quantity of it in each unit. Beer stays the same price but there is less in each bottle. Tissue boxes contain fewer tissues, candy bars weigh less, condom packets… well, you get the idea. Inflation continues to erode efficiency and productivity. The scariest part is that all we have learnt since the eighties is that there is no shortcut to reducing prices (or slowing price growth). The Chinese should have an unmatched ability to reduce inflation without inciting a recession; a so called hard landing. As inflation continues to creep higher, the risk of this hard landing seems ever more likely. And slightly scarier again; the higher inflation rocking the democratic Indian economy with less options next door.

What's the scariest thing out there at the moment?

There are many things out there at the moment scaring markets, and sometimes it’s hard to know which direction to be scared in. During the 1970s and early 1980s what was eventually termed the great inflation gripped America, and double digit price increases wiped out productivity and hindered efficiency. Price controls were put in place to stop companies raising prices. Wage controls were erected to keep companies costs down. Many tricks were played by the government to try and lower inflation without slowing the growth in the money supply, but in the end the only way to slow inflation was a cold hard recession, brought about by higher interest rates and slow money growth. There are many things to be scared about at the moment, but the scariest might be rising inflation in China.

When the Chinese increase the money supply, people find they have excess reserves of cash so they spend more. Business are then selling more, which makes them happy because their incomes rise (this is generally the central bank’s intention). Eventually firms realise they can’t keep up though, and they decide to raise prices to curb the demand. Higher prices do what they always do, and people buy less. Production falls to its original level (but now with a higher price level).

Firms today however are wise to the central bank, and try to predict when there will be general inflation. Why go to all the trouble of increasing production (that’s hard work!) when you can just raise your prices when the central bank prints money. In this way inflation expectations become very important for the central bank. If businesses expect the central bank to print money, no increases in production occur. We’ll just jump straight to higher prices.

Furthermore, because of inflation expectations no actual money printing need occur in China for inflation to take hold. Higher inflation expectations mean firms expect higher costs as input material suppliers raise their prices, plus higher wages negotiated by their employees who think prices will rise. In expectation of these cost increases firms increase their prices. The point is inflation expectations are very important determinants of where inflation is headed, and expectations tend to become self-fulfilling prophecies.

Jump to And the scary part is...

When politicians masquerade as economists

What a brilliant opportunity to point out a stupid policy put in place by politicians with short term outlooks, to try and solve one problem, but at the same time making another problem worse. It’s the perfect example of politicians trying to be economists, but forgetting that economics isn’t about spending, it’s about incentives. Let me explain.

The housing market on the Gold Coast has been hit especially hard. Its economy is dependant to a large extent on tourism, and holidays are the first thing to go when people run into financial trouble in recessions, especially when the Aussie dollar is at record highs, making it more expensive to come here. With less tourists coming and spending money, businesses have lower sale, hire less workers, who then have less money, blah blah blah… demand for housing falls. It is suffering at the moment from an oversupply of housing which could take years to work through. This oversupply depresses the price of houses, and hence the price that construction companies can get for their finished product. Construction companies who are unprofitable at these prices go bankrupt, and the ones who can stay afloat build fewer houses at the lower price, a painful adjustment. What’s the obvious solution? Either reduce supply by knocking down houses, which I wouldn’t recommend (but I wouldn’t put it past some politicians to suggest it) or keep supply relatively constant and let demand catch up.

What’s the government’s solution? The government is deciding today whether or not to offer increased subsidies aimed predominantly at first home buyers purchasing, wait for it… new homes. When what the market needs is people to purchase existing homes which have already been built, the government is looking at construction companies crying out that there is no demand for new houses (a symptom of the problem of an oversupply of housing) and throwing money at the symptom instead of solving the problem of oversupply. Not only are they not getting at the root of the problem however, but they are exacerbating it by giving incentives to build new homes, increasing supply. And just to show how short term they are, the politicians are only offering these increased subsidies for six months, at which point demand goes back to where it was, except that we now have a greater supply of houses.

This is a fantastic example of a politician trying to think like an economist. And completely blowing it.

It is also a fantastic example of the government distorting the free market economy, and disturbing the Darwinian process which is supposed to guide our economy towards strength and efficiency. “Creative destruction” is this Darwinian idea; that by allowing fierce competition in the market, and letting weak companies fail, only the best will survive and the economy will be stronger for it. Of course this requires short term pain in recessions as weak companies who made bad decisions, aren’t nimble enough, or simply offer a product (like a house for example) that no one wants, go bankrupt. But in the long term a stronger, more nimble economy arises. Of course the government isn’t a fan of any short term pain, because it doesn’t win votes. When the government gives money away to people to keep a flailing industry alive, it is diverting resources towards an industry the free market is trying to say that no one wants.

The free market scenario, when allowed to play out, also snuffs out the stench of moral hazard, which no one will talk about but hangs quietly in the back of people’s minds. In the extreme moral hazard occurs when companies say, “I won’t worry about the fact that I’m building too many houses and that there is an oversupply, because if I am going to go bankrupt the government will bail me out,” and the government either does this explicitly by giving the company money (like the US government did for AIG) or it can do it implicitly in a number of ways, like offering people incentives to purchase a company’s product. Either way it gives a company the incentive be less careful when making decisions because it believes the government will bail it out. This mindset becomes an issue when it spreads throughout the whole economy. A construction firm under the influence of moral hazard in 2006 might have seen an oversupply of housing on the horizon, but thought I’m going to continue building houses while the going’s good and when the housing market hits the fan the government will bail us all out.

The government is keeping a flailing industry alive, when what the economy needs to do is to restructure. People need to go through the painful process of losing their jobs and finding new ones in booming industries. Unfortunately the long term good of the economy has a small voice, few lobbyists and no vote, and is often on the other side of a spike in short term pain, so policymakers rarely take note of it.

Is the Australian economy “diseased?”

Sorry people time for something bearish. A phenomenon in Australia normally associated with low income developing countries is becoming more and more obvious. “Dutch disease” refers to the de-industrialisation of an economy that tends to happen when natural resources are found. In the late nineteen fifties in the Netherlands large deposits of natural gas were found and exploited, and the ensuing decay of its manufacturing sector resulted in the term “Dutch disease”. Here’s how the story goes.

When a resource is found the demand for it raises the real exchange rate as overseas countries scramble to buy the gold; silver; iron ore; coal; oil; you name it, we’ve got it. To do so they must first use their currency to “buy” (exchange for) ours, and then they use this Australian currency they’ve bought to buy our resources from us (well actually, most of these commodities are traded in US dollars, so they buy US dollars, give us those in exchange for the resources, and then we exchange them for Australian dollars, but the result is the same). Just like most goods, as the demand for Australian currency skyrockets, its price soon does too. This increase in the price of the Australian dollar has the familiar effect of making overseas goods cheaper. As overseas countries begin to offer more and more of their currency for each Australian dollar (as they clamber to get at our resources) you can jump in and get some overseas dollars at favourable rates making overseas shopping cheaper. However just as other countries goods become cheaper for us; our goods become more expensive for other countries.

All else being equal Australian exporters are hurting from the high Aussie dollar. Companies like National Australia Bank, QBE Insurance (I’m sure I’m not drumming up a whole lot of sympathy here, but come on people; CSL, Billabong!?) suffer as their products either become more expensive or their margins suffer (see How will high Aussie dollar hit retailers). These sorts of companies shed workers, reduce production and investment, and in the worst case scenario fail. Meanwhile mining companies spend up big playing in the dirt, and an economy’s investment funds and labour (think of that mate who quit his high skilled job as a carpenter or manager to go to the mines to watch rocks go by on a conveyor belt) are diverted towards pulling rocks out of the ground and away from other businesses who survive by innovating, adding value, cutting costs, and producing goods and services. It is in this manner that innovation (and all these other desirable qualities in an economy) is stifled and the economy is said to deindustrialise, doing less of the aforementioned innovating and value adding, and more of the simple digging up of dirt out of the ground.

However the model also talks about a third sector, the so called “non tradable” sector. This is the part of the economy that isn’t mining, and isn’t exporting overseas. This sector supposably booms because the influx of spending in the mining sector trickles down through to the rest of the economy. It does this through the same process described in paragraph three of Is gold a good hedge against inflation except this time the initial increase in spending comes not from the government printing money, but from the mining investment.

This boom in the “non tradable” sector is likely to be tepid however, because mining is a very capital intensive business and employs few workers, and a lot of the "non tradable" sector like JB Hi Fi and Woolworths are having problems of their own (the internet is making these guys more tradable by the day) as described in How will high Aussie dollar hit retailers. And the model acknowledges this! Unfortunately the RBA doesn’t, at least not until the last monetary policy meeting.  The RBA has been, as described by some analysts, trying to “make room” for the mining boom by crushing growth in other industries. Higher interest rates in Australia certainly doesn’t decrease the Chinese (and others’) demand for Australia’s resources, but it does decrease Australian residents’ demand for other products like computers, cars, televisions etc. It does raise the real exchange rate and make our exporters products even more expensive. In this way demand is driven away from retailers, car dealers and pharmaceutical companies (basically anything that isn’t a resource company) and towards resource companies. Many argue the RBA has in effect been doing everything it can to exacerbate the Dutch disease!

The other reason the spending affect is mitigated is the trend towards foreign ownership of Australian mining investors. The profits of the mining companies are increasingly going overseas to foreign investors to be spent there instead of here. But this in itself is not bad; it simply reflects the decisions made by people about how much to save. Ironically, the fact that the miners are owned by overseas investors can alleviate the Dutch disease in a small way, because as the Australia dollar profits are sent back overseas to foreigners, they convert the Aussie dollars back to their home currency, which alleviates some of the upward pressure on the aussie dollar (they’re effectively doing the opposite of what pushed the Aussie higher in the first place. However because of the capital intensive nature of mining, a large proportion of the profits are kept in Australia and reinvested in the company to build and maintain the assets required to carry out their business.

On its own it’s hard to argue that this type of process is even bad. Australia has a comparative advantage in natural resources and it benefits us to specialise in this industry. This comparative advantage is amplified by the well developed infrastucture in Australia (minerals like coal and iron ore are so abundant that having a profitable mine is not about finding minerals, but about getting them to a port cheaply). However the deadweight loss comes in the drying up of innovation. This innovation isn’t completely lost; as Australia has become one of the preeminent mining services providers to the world, but one day the minerals will be gone, or at least the insatiable demand for them will be. Currently about fifty percent of China’s GDP is investment. As china transforms to an economy more consumer driven this demand for our minerals will fall (consumers don’t have much use for iron ore). Mind you this could take a while, we’ve been waiting for the Japanese to do it for about thirty years, and large portions of Africa are yet to industrialise. This one day will provide significant headwinds as we end up with lower mining exports and uncompetitive export industries.

Are the banks excesively profitable data

This is an explanation of the numbers used in Are the banks excessively profitable?.

To leverage up JB Hi Fi’s balance sheet I simply used the Dupont model, which breaks a company’s return on equity into five parts:

-Sales/assets

-EBIT/Sales (operating profitability)

-Pre-tax profit/EBIT

-Profit/pre-tax profit

-Assets/equity

Sales/assets is about how much revenue the company can generate from its assets. For Tanz THIS IS THE LOANS IT has on its books, and for JB Hi Fi it’s the shops it operates. The next three are about how much of this revenue falls to the bottom line as profits, and isn’t eaten up as costs. Finally the last ratio measures leverage. Equity is the amount of money put into the business by owners, and if the amount of assets the company owns is much larger than this then the money to buy them must have come from debt issues (or to be more precise, liability issues). To apply leverage to JB Hi Fi’s business it’s simply a matter of working out how much debt has to be raised to equate JBH’s leverage ratio (assets/equity) with ANZ’s, and then using it to buy assets, which you assume it gets the same return on as the currently owned assets, and then keeping all the other profitability ratios constant on the way down. But it’s even simpler than that, because the five ratios of the Dupont model are such that when multiplied together they conveniently show the return on equity. So keeping all of them constant, and just increasing the leverage ratio to equal ANZ’s, the numbers are:

Leverage ratio:                  15.57

Return on assets:             3.82

EBIT/sales:                          6.46%

Pre-tax profit/EBIT:         96.06%

Profit/pre-tax profit:      69.96%

Which when multiplied together show a return on equity of a whopping 258% and change. But if you don’t believe me (or DuPont Corporation) here are the numbers:

	Actual	Leveraged
Revenue:	2,731,320.00	17,444,483.51
EBIT:	176,558.00	1,126,913.63
Pre-tax profit:	169,601.00	1,082,513.24
Profit:	118,652.00	757,326.26
Equity:	293,296.00	293,296.00
Assets:	714322.00	4,566,618.72
Profit/equity:	41%	258%

The share buyback calculations are just working out what JB Hi Fi needs to have in debt to ensure a net debt to equity ratio equal to ANZ's:
=equity*ANZ's net debt to equity+cash and cash equivilents
=293 296*10.6+51 735
minus already existing debt:
=3 160 672.60-69 624
to show the amount of money they raise. divide* by the share price on 8/7/2011
=178776668.59/17.29
which shows that they could buy back at the market price 178 776 668.59 shares, 182% of their 108 118 000 shares outstanding according to their 2010 anual report. take that ANZ.

*the amount shown in the next equation is multiplied by 1000 because the values shown are directly from the balance sheet and are divided by 1000.

Are the banks excesively profitable?

A widely used measure of profitability in business, particularly for shareholders, is return on equity. This is because it measures the return on all the money that shareholders have put into the business, including their profits that the company has made and reinvested into itself. It is often preferred to ratios like return on assets because it takes into account the advantage of leverage which can increase returns: when making an investment it is not the return on the asset you bought which matters, it’s the return on the amount of money you put into the investment (your equity).

The return on equity ratio also makes it easy to compare companies in so far as seeing how well they can use the cash they were given to generate profits, which is after all what the shareholder wants them to do. Return on equity is also generally positively related to debt to equity ratios. A firm that utilises more debt than equity to fund its assets will simply have less shareholders with equity to spread profits over, so more profits for each shareholder. The amount that the firm must pay a debt holder in return for giving the firm his funds (the interest rate) is generally less than the amount that the firm must give a shareholder (in the form of dividends) due to the fact that debt is a senior form of funding relative to equity. This simply means that in the event o bankruptcy, the debt holder will get paid back his money before a shareholder who will generally rank last in this queue (assuming there’s anything left for either of them). The lower return also stems from the fact that debt has a fixed, unchanging return in the interest rate, whereas dividends can go up, down or ceased altogether. This reduces the risk for a debtholder by providing certainty of cashflows, and hence lowers the required return. This equates to more profits left over for the company if it chooses debt over equity. Interest payments on debt are also tax deductible, whereas dividend payments on equity shares are not. The tax reducing properties of debt also mean higher profits if a firm chooses debt over equity. Largely due to these three points debt tends to reduce the amount of equity and increase profits, which increases ROE (profits/equity) and results in more profits for you and me.

These are the same reasons property investors borrow to buy a house. They don’t have to put in as much of their own money (less equity to spread profits over), the bank only wants at the moment about eight percent or so return on the money it gives you in the form of a loan whereas people often like to think they’ll make around twenty percent per year on the money they put into an investment property (lower return on debt than equity), and finally the interest payments on loans come straight off people’s taxable income.

So what stops people from leveraging up to the hilt to maximise profits and returns on shareholders’ equity. Unfortunately not a lot if the GFC is anything to go by, but it should be obvious to most that having debt is a risk. Debt must be paid before the owners of the company (equity holders) get paid, so if there isn’t enough profits to go around equityholders get burned. So companies can generate higher returns by taking on more debt, but this increases risk.

Now to the point. There’s a lot of political “debate” at the moment (I don’t think the rubbish politicians talk, deserves a word with quite so much intellectual “feel” to it but that’s what they call it on the telly) about how obscenely “profitable” the banks are at the moment, and you’re hearing a whole lot of big numbers going around like 5.66 billion dollars and even bigger phrases like “record profits at Australians’ expense”. $5.66 billion dollars sound like a lot of money, but that’s right, I’m gonna tell ya it’s not (sometimes ya gotta be mainstream to be contrarian). Now here’s why.

Equity holders and debt holders have put an extraordinary amount of capital into the business to generate it. Particularly debt holders. A simple return on assets for National Australia bank, commonwealth bank, Westpac and ANZ are 0.62%, 0.88%, 1.04% and 0.85% respectively. What’s more their ROEs are 11%, 16%, 16% and 13%. Their debt to equity ratios are 1112% 1457%, 1240% and 1060%. Are these numbers big or small?

Compare them to JB Hi Fi, who has a return on its assets of 17% and a return on equity of 40%. But as discussed a firm can engineer high ROE with high debt levels and hence higher risk. Is that JB’s secret? No. It manages to generate such high returns for shareholders with a debt to equity ratio of just 6%. These figures are reproduced below for easy comparison.

METRIC	NAB	CBA	WBC	ANZ	JBH
ROA %	0.62	0.88	1.04	0.85	17
ROE %	11	16	16	13	40
NET D/E %	1112	1457	1240	1060	6

A bank by the very nature of its business is always going to be very highly leveraged; it borrows money from people and then lends it out. This is a very important function that ensures that borrowers can find savers easily, and it is unlikely that similar rates of economic growth could be achieved without our complex financial system. But it doesn’t change the factors that make debt a risk for an equity shareholder in a bank, namely that the debt gets paid back first, whether there’s enough profits to go round or not. For the astonishing leverage that banks take on they are miserably unprofitable for their shareholders. This can be seen by applying ANZ’s leverage to JB’s balance sheet (ANZ being the bank with the lowest net debt to equity ratio).

If JB Hi Fi leveraged its balance sheet to the extent that ANZ did, and was able to deploy all the raised capital (from issuing all that debt) at the same rates, it would have a return on equity of 258%! And this doesn’t take into account the positive effect on margins of the deductibility of interest payments for tax purposes (for an explanation of where this and other numbers in this blog came from see Are banks excessively profitable data).

Companies who want to leverage up can also issue debt and buyback shares to dissolve with the proceeds, which is simply good because it means there are less shares to distribute profits over. If JB Hi Fi were to leverage to a level similar to ANZ’s they would have to issue $3,091,048,000.60 worth of debt, enough to buyback all the shares, and then nearly enough to buy them all back a second time (if that were possible). Of course they’d have to buy them all up because no-one in their right mind would invest in JB Hi Fi, it’d be too risky!

JB Hi Fi and ANZ are completely different businesses and this is an extreme example to illustrate the point. Comparing ratios across industries like this is a dangerous game and is no basis for an investment, but the point is that banks aren’t that profitable, and when you take into account the amount of debt they use, they are anything but. Next time you hear someone screaming at you that banks make obscene profits (and people do scream when it comes to this topic) you can tell them that banks are a far cry from the most profitable entities on the ASX, and if they think it’s such a great deal then they should buy some shares themselves. They’ll probably tell you that all their money’s tied up in their house.

How will high aussie dollar hit retailers

JBH’s relentless growth has managed to bulldoze any apparent effect from the fluctuating AUD. However, now that there are signs that JBH’s business model might be maturing, and that growth might be slowing, the question is how JBH might be affected.

To isolate the (AUD) effect, and neutralise the effect of JBH’s growth, the margins can be analysed. The rising dollar has two competing effects.  JBH‘s COGS, denominated predominantly in foreign currencies, becomes cheaper, which should fatten GPMs. Without the jargon this means that the goods that JBH buy overseas to sell in Australia beome cheaper for them. If they sell them in Australia at the same price they make larger profits. However overseas goods become cheaper not just for JBH to purchase for resale, but also for Australians to purchase directly from overseas. Overseas businesses selling into Australia have two options. They can raise prices to increase their own margins, keeping prices constant for Australians, but in these markets with low barriers to entry this will entice new firms to enter the market, driving down prices until all but a "normal" profit (just say "low" if your not an economist) erodes. More likely, online retailers exporting to Australia will cut prices to gain market share, and without the fixed costs of a bricks and mortar retailer, they can operate with razor thin margins, and will be much more effective at passing on the savings to Australian customers. The resulting deflation as prices fall around JBH puts downward pressure on gross profit margins.

The question is which one of these competing forces is stronger, resulting in a net benefit or loss.

JBH’s GPM has been negatively correlated with the exchange rate over the last seven years. Admittedly to increase the strength of the model one has to omit an outlier in the data. In the 2008/2009 financial year, even though the aussie dollar was low (which should have made it easier to compete with overseas retailers) JBH’s GPM was still low shedding yet more doubt on the ability of the retailer to cope with competition (during this time the AUD plunged and then climbed very rapidly, pushing the average down even though people perhaps didn’t have time to adjust their purchasing behaviours, however this is purely speculation). The following graph plots the average value of the AUD TWI in each financial year against the GPM resulting that year.

The graph strongly suggests that the net effect of a rising AUD is negative for JBH. 81.08% of the variance in GPM is explained by variance in the TWI. The model predicts (assuming the exchange rate remains at current levels) a GPM of 20.98% in 2011 (this research was conducted at the beginning of the year and the exchange rate rate input hasnt been updated since then).

More concerning than the competition from online retailers is JBH’s push to become an online retailer itself. In the twentieth century being a good retailer was about being able to most effectively get products from manufacturers to consumers at the least cost so as to be able to price competitively. The competitive advantage of these retailers has been their state of the art distribution systems within business models which are otherwise not hard to replicate. If they become predominantly online retailers mailing products out to customers, these distribution systems could become less relevant, and they run the risk of losing this competitive advantage. If one pictures a retailing environment as a purely online affair, it is a fiercely competitive market with low barriers to entry, small firms relative to the now global market, with consumers who can easily compare prices. It’s unlikely that even large retailers would have the scale to exert sufficient bargaining power over suppliers to dig out any sustainable competitive advantage over other firms. The ability to try on clothes, the appeal of instant gratification, and the intrinsic enjoyment people derive from the shopping experience itself will obviously provide friction to such a complete transition, but the more the line is blurred between online and physical retailers the more the market will resemble "perfect competition" (just say "price to earnings ratio of nine" if your not an economist).

What’s more Australian retailers have more to lose than those in other parts if the world. In general they have enjoyed margins much thicker than their overseas counterparts. Costco, which has relatively recently entered the Australian market, had only 1.67% of its revenue fall to the bottom line in 2010, whereas Woolworths saw a net profit margin of 3.91%. Wal-Mart operates on a similar margin of 3.89%, but JB Hi Fi enjoys a royal 4.34%. If JB Hi Fi was to operate at Costco’s margins, it would have to earn revenues of $7 104 910.18, 160% higher than they currently are, to maintain current profit levels. Woolworths’ revenues would have to grow by 134%.

Anyone who tells you they know what is going to happen is lying, but there is no doubt things are going get tougher for retailers in Australia, and it’s very tough to see who the winners will be. This trend is certainly one to watch as the next decade unfolds. Myer has taken the first step down a dangerous path for retailers, which could render them just another online agent, right when they should be diversifying the shopping experience they offer.  They run the risk of becoming more like brokers between manufacturers and consumers, collecting fees along the way.

So what’s the best way to hedge against inflation?

So what’s the best way to hedge against inflation? It’s not some exotic derivative or shiny metal that has been used for thousands of years as money and has who knows how many other nice stories to go along with it. It won’t earn your broker any commissions or fees, and it won’t cost you anything to store, but it will tirelessly maintain the value of your money as inflation continues its never ending assault. And the magical investment is… the humble bank account of course! Interest rates are inherently linked to expected inflation and consistently fluctuate with it over time. In fact, if you had locked your money in for one year in a term deposit (I used the average of the term deposits at the five largest banks, available on the RBA website) each year, over fifty percent of your return would be explained by the ebb and flow of inflation. The correlations for more liquid savings accounts are even higher (I chose not to use online savings accounts even though they would have suited the study better because there was only data going back six years).

Now THIS is what a plot of two positively related variables should look like! You can clearly see that as the inflation rate in a year (on the horizontal axis) gets higher, the average one year term deposit rate at the beginning of the year (vertical axis) gets higher too. To heck the numbers out see Comparing inflation to term deposits.

This is partly due to the RBA’s countercyclical manipulation of the interest rate to slow the economy. When inflation is too high the RBA will raise the interest rate to slow lending, which will automatically increase the return you get on your savings. However the mechanism which ensures that your return’s increase when inflation increases are somewhat subtler and more beautiful than this. At the beginning of the twentieth century Irving fisher said that interest rates provided people who saved with a “real” return or reward for forgoing their spending until a later date (because as intrinsically greedy human beings we would generally rather spend our money on a new toy now rather than wait) plus a little bit more to compensate people for the fact that everything was going to be a little bit more expensive by the time they got their money (inflation). And since then not much else has been said. But people need to be compensated for these two things to be induced to save instead of enjoying their money now. If savers (in particular large businesses) feel that the interest rates are not sufficiently compensating them for the increases in prices over the coming year (the "expected" inflation) they will take their money out of banks and spend it now, before the price rises. This leaves banks with less money than they require, so they put up their interest rates to coax money back in. A savvy investor like yourself has just hedged your return against inflation without doing anything, and more importantly with paying anything.

Many famous investors, most notably Warren Buffett, have commented on the fact that gold is a boring, inert metal with little industrial use, and which pays no dividends or interest (I now add myself to this illustrious list ;-). A bank account is easy and free to invest in, require no analysis to identify suitable entry points, and it pays you, like any good investment should.

How will high aussie dollar affect retailers? 

The evil, ever present, value eroding effect of inflation on...Gameshows

A lot of people know about inflation in the economy, and many people know, and may even remember, the damage it can cause a country. The “Great Inflation” of the 1970s was a period of stagnant (real) corporate earnings and share prices, sluggish at best GDP growth, and could only be halted by the severest recession that America had seen since the great depression.  The hyperinflations of Germany and Hungary rendered it more economic to burn money than to burn wood to keep warm because any amount of money would burn longer than the amount of wood you could buy with it. In order to avoid such catastrophes the RBA each year aims to neatly engineer a price increase of about 2.5% on average throughout the whole economy (it actually aims for between 2% and 3%). But this begs the question: why aim for any at all? Why not just have stable, unchanging prices? The truthful answer is, because they’re not very good at it. What the RBA really doesn’t want is deflation, that is, prices falling in the economy (the opposite of inflation) and it tries to bring about a little bit of inflation each year, just to make sure that prices don’t fall. Since the inflation target was introduced in 1993 the RBA has been able to keep the inflation rate (year on year for those interested) within the target band just 39% of the time, so it makes sense for it to give itself a bit of a buffer*. Now the next question is always “What’s wrong with falling prices?” We all like cheaper things don’t we? Well the RBA doesn’t. What it doesn’t like specifically is for you to “expect” lower prices. If you expect the price of your new shoes (or whatever) to be lower in the future, you won’t go out and buy them now. You’ll wait and spend in the future. For those not familiar with the circular flow of goods, your spending is somebody else’s income, so if you don’t do it then income in the economy declines, and the government and the RBA certainly don’t like that. Deflation also does some funny things with interest rates that make it very hard for the RBA to get you (and businesses) spending again.


While the RBA likes to induce small amounts of inflation each year, it does its best keep it nice and low, inside that 2-3% range. It does this for one simple reason, so you don’t notice it (specifically so that it will not “materially distort” your economic decisions). While the RBA has decided for you (and it’s still a controversial topic) that a little bit of inflation is good, it will still slowly but surely erode your wealth. And governments know that you won’t stand for this, so they try to keep inflation just low enough so you won’t consciously feel it gnawing away at your savings.

Last night Rob Mariano received a million dollars after winning the 22^nd season of survivor, a prize whose nominal value has not changed since the show first aired in 2001. Not bad for a months work, although rob had in fact been on the show several years earlier, where he met his bride to be who herself won the million dollars. Since then he has returned twice unsuccessfully, and finally in his fourth attempt went all the way to claim the same prize his wife won in 2004. Or did he? It turns out that, based on inflation data found on the Bureau of Labor Statistics website, Rob’s prize is worth 16% less than his wife’s only six years later? Yet Rob’s excitement is no less jubilant than his wife’s, who actually received, in “today’s money”, $1,196,308.51, nearly $200 000 more! A testament to the RBA’s skill at eroding the value of the currency over time. In fact, going further back, Rob’s prize gets even smaller! Richard Hatch received the same $1 000 000 in 2000 for winning the first ever survivor, and measured in “2000 dollars” Rob received the slightly less appealing sum of $761 651.53.

Another way of saying it is that Rob’s wife could buy more “stuff” with her million dollars (specifically she could buy more of a representative basket of “stuff” as described by the all-knowing RBA). $196,308.51 more worth of stuff. These values measure not nominal amounts of money, but “purchasing power” and they reveal alot about the true value of the currencies which underpin our economies. Because the price of goods has slowly risen over the last seven years, Rob and his wife can receive the same amount of money, but what he can buy with that money has fallen significantly, so it is to say that his purchasing power has decreased along with the value of the currency.

So what’s the best way to hedge against inflation?

*The target the RBA follows is actually the "underlying inflation rate" however since the CPI is what your worried about when you buy gold thats what I've focussed on. What's more it should be said that the target that the RBA sets itself is the average of inflastion over the medium term cycle. Since the inflation target was instituted the inflation rate has had an average of 2.7%, so by this metric its possible (depending on how long the medium term cycle is) the RBA hasnt done too bad. However the point of the paragraph still stands. The RBA incities a small amount of inflation to ensure that deflation doesn't take hold.

What else explains the movement in the gold price?

The argument regarding gold and inflation stems from the notion that throughout history gold has been used relatively consistently as currency to facilitate transactions. Gold does this well because it is portable, hard to forge, is highly resistant to corrosion (so it won’t rust on you) and has a relatively stable supply. This means it performs the functions of money quite well, and makes gold a prime candidate for an alternative currency, should an economy lose faith in the present fiat one. Inflation has crippled many, if not all fiat currency regimes in the past, hence the idea that if we have inflation gold should become more valuable. But inflation is just one of the phenomenon that can lead to the loss of faith in a currency. Does this imply a one for one increase in the gold price as inflation rises? Probably not. If prices rise by three percent over 2010, is your gold worth three percent more? In fact the gold in your portfolio isn’t worth anything (ignoring the few industrial uses it has) until the day the world throws away its paper money and goes back to using gold for transactions. Holding gold is about waiting for this day, and gaining a huge return, rather than trying to hedge against the steady rise in inflation.

The inflation hedge argument breaks down where people decide what to do with their increased holdings of money. It assumes that a little bit of the new money finds its way into everything you buy. You buy a little more food, a little more television, and a little more gold. When the money supply increases, people buy goods and services from the storeowner because they want to use them.  But why buy gold? Why not put your money in a bank account and earn interest if you don’t want any goods and/or services right now? The only answer is because you fear that the fiat currency system that your money would be part of (in a bank account) is going to fall apart, and gold will become the new medium of exchange.  This is likely what explains the other 87.38% of variation in the gold price (as well technical traders chasing trends, herd mentality etc). The jury is still out on exactly how damaging inflation is for an economy or financial system, but a three percent increase in prices over a year is probably not going to tear it apart and result in an increased risk of holding money, resulting in people demanding gold and pushing up its price. Consistent increases over time? Perhaps, however some economists are adamant that a little bit of inflation is good for the economy. But that too is an article for another time (and a controversial one at that).

So does the data support this conclusion? Below is a chart showing the price of gold with a blue line, and the inflation rate with red bars. It shows that the price of gold increased quite dramatically from 1971 to 1980. Over this time inflation was quite high. Yet from then on until 2000 the gold price did little, hovering around $500 for twenty years, even though inflation over this period persisted (albeit at a reduced level). The gold price then took off and was just under fourteen hundred dollars by 2010, rising sharply throughout a period of moderate inflation.

Two things need to be remembered about the 1970s. The first is that a significant portion of the inflation is cost push inflation (against which gold cannot be a hedge) attributed to the energy crises scattered throughout the decade. The second is that 1971 was the year of the “Nixon shock” where conversion of US dollars into gold was abruptly suspended. Under the Bretton woods exchange rate system every country could, at predetermined rates, exchange their currency for US dollars, and then their US dollars for gold. When central banks and citizens alike became suspicious of the US’s ability to do this (due to large scale increases in the US money supply) they began to lose faith in the global monetary system, and demanded their currency be exchanged for gold at the federal reserve. As the US began to run out of gold to exchange for its currency it announced it would cease to do so and the demand for gold (and its price in the private market) skyrocketed. Excluding the war years, money had been backed by gold for centuries, and the evaporation of this backing left nations not worried about inflation, but about the legitimacy of their currency.

The parabolic increase in the gold price between 2000 and 2010 occurred when average inflation was just 0.86% higher than the decade before, where gold did nothing. In fact towards the end of the decade deflation was the greater concern as the world plunged into recession. This event did however shake the globes confidence in the financial system and its currencies, as did the dot com crash and the World Trade Centre attacks in the early 2000s. It is these types of events that shake the confidence in the current financial system and the unbacked paper currencies it rests upon that give gold a fundamental value. Gold is not a hedge against inflation, but a hedge against the possibility of people seeking an alternative to their fiat currency.

Of course history is always up for interpretation, and this is mine. There are bound to be others. But just remember that blindly investing in vesting in gold as a hedge against inflation blindly goes against all logic. Know exactly what your investment goals are with every trade. Now I know what you’re thinking: I’ve read this whole boring article on inflation. You’ve told me what not to invest in. Tell me something I can use! The answer might be more boring than you think.

The evil, ever present, value eroding effect of inflation on...Game shows!

­­Is gold a good hedge against inflation?

It is commonly stated that gold is a good hed­­ge against rising prices. People keep gold in their portfolio with the expectation that as inflation rises, their gold will rise in value too, shielding them from the erosion of purchasing power that is inflation. So does this relationship hold? Does gold protect against inflation? First let’s look at the data.

This chart plots the inflation rate against the return on gold (in AUD) in that particular year. For example the point right up at the top tells us that when the inflation rate was 10.10%, the return on gold was 129.55%. Using a simple yet powerful statistical technique called the coefficient of determination we can measure the portion of variance in the return on gold which is explained by the change (rise or fall) in inflation. First the good news. The trend line predicts that in general higher inflation coincides with a higher gold return that year and there is strong statistical evidence that this positive relationship exists (this is measured using a [only slightly] more complex statistical technique incorporating sampling distributions and t scores). However only 13.03% of the variance in gold’s return can be explained by the variance in inflation. In three different years when inflation was between 10.10% and 11.27% gold returned 130% (1979), -30% (1981)  and 29% (1982). Blindly investing in gold and ignoring the other factors that would have contributed to 86.97% of your return over 1971 to 2010 seems a bit risky doesn’t it?

Two things complicate our analysis. The first is that with gold you can only hedge against one type of inflation. Demand pull inflation occurs when there is an increase in aggregate (total) demand for goods and services in the economy relative to the aggregate (total) ability of the economy to supply said goods and services. Increased demand from people for the goods and services produced by the economy is by no means a bad thing. When people decide to spend more money on another person’s goods, the seller’s income increases. Everybody’s happy. The problem is where the government (or more specifically the central bank) decides to print money. There are a number of reasons that they might do this, but most often throughout history it is because the government cannot collect enough tax to finance its spending. They print money and use it to buy what they need, whether it be defence, infrastructure… whatever. The problem is the economy can only produce so much, this amount being called the natural rate of output. There are only so many workers, so many machines, and so many hours in a day to produce goods and services. The problem can compound itself after the government spends the money with suppliers, who then spend this money again, and the cycle continues. Suppliers (newsagents, mechanics, everyone) who were happily producing at their natural rate of output, now find people banging down their door if the government plays this cheap trick too often. Businesses may initially be happy to produce more, but they will only be able to maintain this for so long, and eventually realise that it is just as easy to raise prices as it is to work overtime to try and meet the demand. As prices go up people tend to buy less of stuff and eventually businesses find themselves producing at the natural rate again, no better off because even though they’re charging higher prices for their goods, everything else is now more expensive too.

If the government does this a little you might not notice. The reference to people banging down doors may seem like a little bit of an exaggeration, but this is precisely what excess money printing leads to in large enough bouts, and anyone who’s seen pictures of German waiters auctioning off meals atop a restaurant dining table will understand this. It is precisely this kind of abuse of power by the government that gold is supposed to hedge against. The idea is that gold as a currency cannot be cheaply printed by the government for it to spend. To increase the supply of gold many years of exploration and development must take place at great cost, and most governments don’t seem to have that kind of patience and long term vision anyways. Your gold is supposed to rise in price with the rest of the goods in the economy, leaving you “unexposed” to inflation, as opposed to someone who has held cash over the same period which has not risen in value (your ounce of gold is worth more but their ten dollar note still has a ten on it). It is a commonly known fact among economists that, in general, an increase in the money supply relative to the supply of goods and services in the economy causes inflation.

“Cost push inflation” occurs because of an increase in the cost of producing a good. When the Queensland floods wiped out much of the grain produced there, this supply reduction resulted in increases in grain prices, which ultimately flows through to food prices and gets counted in the consumer price index and inflation. Gold cannot be a hedge against this type of inflation. A good becoming scarcer will cause its price to rise regardless of the type of money used (assuming its demand remains constant). So somehow we need to separate the effects of demand pull and cost push inflation if we are to compare against gold returns. No easy feat.

The second problem we have is that super-efficient gold markets price in future inflation as soon as they get a whiff of it and increase their demand for gold immediately (throwing up its price).

The second problem we have is that professional gold traders jump into gold (increasing its demand and hence its price) as soon as they get a whiff of any inflation that might occur in the future, trying to beat the rest of the market. This happens well before inflation hits the average man down the street talking about how he used to be able to buy a cup of coffee for ninety cents, and well before the inflation shows up in the data. So comparing the gold return to inflation in the same year may be pointless! One way to account for these problems is to compare the gold return to increases in the money supply, which signals to the market future demand pull inflation. The following chart does just that.

Although the trend line predicts very mild increases in gold returns as money growth (represented by Broad Money, but that’s an article for another day) increases, this time there is no statistical evidence from the sample that a positive relationship exists between the two, and only 2% of the variation in gold returns is explained by variation in the money supply growth. So what else explains the movement in the gold price?

What else explains the movement in the gold price?