John Hempton on What's Ailing Bank Stocks

plus a few old favorites. Will also have live finance, the music, as well as drinks and just overall great conversation. Details of the lineup are going to come out very soon, so keep listening to add blots to learn how to sign up to see us live on Thursday September in NYC. Joe and I both hope to see you there. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. My co host Joe Wisenthal is away this week. I happened to be on a work trip

to Australia. I've never been before. It's fascinating. I have big plans to meet a koala, but beyond that I also happened to be in the country for a momentous historic occasion, which is the benchmark Australian bond deald dipping below one percent for the first time. I was also there when the Reserve Bank of New Zealand opted to cut rates by fifty basis points, which was something that shocked the market. And just a couple of hours later we had rate cuts from the Central Bank of India

and also the Central Bank of Thailand as well. So clearly we are in another cycle of fresh monetary easing. And along with these lower yields and interest rates around the world come lower bank stocks. Bank valuations are trading at historic lows, partly because of concern about bank's ability to make profits on lending when rates are this low.

And who better to talk about all of this than John Hampton of Bronte Capital, someone who's been writing about the financial markets for a very long time on his blog and also invests in them through a long and short hedge fund. John, it's so nice to meet you in person. Finally, thank you. I'm a little a bit in ore of that requirement to speak about it generally because I like to speak about these things rather specifically. Um I started my career in financial markets as a

bank analyst. So once upon a time I read more or less every bank account for every major bank in the world, and along the way I decided that they largely not very good businesses. There are exceptions. There are extremely good oligopolies in some countries Canada, Australia, Scandinavia. There are a few banks that have large captive businesses that should be very cheap to run. The trust banks come out.

But as a general rule, most banks are not very good businesses, but they mask themselves as pretty good businesses most of the time. How do they do that Well, Firstly, they're very powerful because they have access to large amounts of money, and being powerful means that you just get a lot of press. Journalists seem to be too interested in bankers. The world seems to be too interested in bankers. The second reason is that you can deceive yourself for

a very long time running a bank. Banks are quintessentially estimate machines. And thirdly, every now and again they really are very profitable. We're looking at the moment it banks across the world except in the United States, basically at thirty yellows a lot of the European banks. And it's not just Deutscher thirty year lows. If you look at sock Jan it's at a thirty year low. If you look at credit agricol ubs, the English banks, they're all

at thirty year lows. And I live in a world of extremely expensive stocks, and so suddenly I feel like I want to be a bank analyst to give just because you know, these things look cheap. So I've been puzzling myself a bit about bank margins for a while. Now I'm going to lead you back to an article that was appeared in The Economist on January and the article is just comical when you read it now. It's

called the Lloyd's Money Machine. And at the time, Lloyd's TSP, as it then was, was the thirty five biggest bank in the world by assets and the biggest bank in the world by market cap. Ten years later Lloyd's was essentially UK government property. But this was it wasn't ordinary profitable, it was ferociously profitable. To pick an example, if you look at the banks in the world at the moment and do say revenue to risk weighted assets, you see the Japanese banks at the lowest end and revenue is

sub one percent of risk weighted assets. Then there are the German and Italian banks, and the English banks get

up to about two and a bit descent. And the English banks are in the order that you would expect, with Royal Bank of Scotland being the thinnest and Barclays being the fattest margin and the margin actually just matches the stock prices, right, And then sitting in the middle is sort of these American banks at about four and a half five percent, and then with an outlier, and the outlier is the one you'd expect, which is the most revenue focused retail bank in America, the one it

would do anything to, including steal from you, to get more revenue, and that's which is just the fattest margin bank, and at about the same sort of revenue to risk weighted assets you see the Canadian banks is about six percent. And then the fattest margin banks in the world are the ones that speak in my accent, right, and it's just this really good oligopolic. But if I go back to this article, Lloyd's revenue to risk weighted assets at that time was eight c Lloyd's in the UK made

more money than the Australian banks do now. It was just astonishingly profitable. And over the next ten years, English bank margins went down, and then they went down a little bit more, and then they went down a little bit more, and eventually you had the wonderful institution called Northern Rock which was the protagonist in all of this.

And Northern Rock ran mortgages at about sixty bits of margin and about twenty five bits of cost, and eventually they got down to twenty bits of knit margin leave at sixty times to produce an eighteen centirow it. But they managed to do this in a low but positive interest rate environment. I understand why English bank margins collapsed and why Lloyd's collapsed in the answer was, well, there

was a large whack of competition. The banks will blame it on new regulation, right and the fact they have to hold more capital and they can't eke out that much money per capital plus low interest rates predated that, right. This was pre crisis lloyd Lloyd's was ferociously profitable in its revenue to risk weighted assets was north of eight by two thousand and eight. It's revenue to risk weighted assets was sub you're talking the beginning of two thousand.

It that night after September two, two thousand and eight, it was subject. And the problem is that when your revenue to risk weighted assets went down that far, even small credit losses blew you up. Right Now, the beauty of the American banking system was that the revenue to risk weighted assets never went below about four and a half. During the crisis, there was the banking sector had three thirty billion, I think was the number of pre tax

pre provision income. And if you've got a trillion dollars of losses, you can write that off over three years, and as long as you can extend and pretend enough, you never actually go sub profitable. And they raised a lot of money, and they sort of came through the English banks didn't have enough revenue, and the German banks spectacularly didn't have enough revenue, right because that the German banks are the thinnest in the world. But all of

this margin collapse happened in a positive interest rate environment. Recently, the most interesting thing I've seen is by a guy called Shannon mcgonachy who runs a fund for Horseman Capital and japan focused fund. He's an Australian. I've never heard of him before this interview, but he was running through Japanese regional banks, which are the lowest margin banks in

the world. And he says, and I haven't verified the number, but I believe him because it sort of matches my on the ground observations that the average interest rate achieved on a new loan in a Japanese regional bank this year so far has been sixty eight basis points, and it costs more than sixty eight basis points to administer the bank. You've got to have branches, you've gotta have staff, etcetera, and so on increment on current business. The Japanese banks

are loss making before credit losses. They don't even need a credit loss to lose money, right If they have credit losses, that's just extroduced to the capital destruction that it doesn't show in their accounts and Lorea's and is that they have a bunch of reason the ways of turning capital gains into interest income, the most obvious of which is that they've held a lot of jgbs because they have loan deposit ratios of sort of point six point seven they've held a huge number of jgbs. As

rates have come down, they've got huge capital gains. They've been clipping those capital gains all the time and calling it interest income, so they look like they're marginally profitable at the moment that they're in fact marginally loss making

before credit losses. So instead of making money on actually extending loans to customers or corporates in the way that they used to, they're making most of their money through asset price increases that then get booked as interest income that will run out, and then they will make losses on extending lines. His simple view is there's no price that you can buy these at their point to book, and that's a value trap. So is the banking business

just broken at interest rates that low. That's what is clearly the case in Japan, and is what the market is telling you about the big mega banks in Europe. The flip side is that you know there are banks in Europe in oligo baalistic markets that are still got fairly fat margins which have also come down. So you know, if I'm going to beat myself up the stock on the portfolio, the two stocks that I own that have

bugged me. Most have been Spensker Hundle's Bank, which is a very well run, highly oligobalistic Swedish bank, and Allied Irish and Allied Irish is a less well run but even more oligo ballistic Irish bank. And Irish banking margins are very nice right there, about the same as US banking margins. They're not as rich as Australian banking margins, but there are many times you know a big French or a big German bank, or even a big English

bank yet that they're still drowned to trading. At point six book, I'm trying to work out why I'm wrong. We've we've had a demonstration of margins collapsing even in a positive interest rate environment, and that's called English banks. And we have a demonstration of margins completely and utterly collapsing in a negative interest rate environment, and that's good in Japanese regional banks. And I'm wondering whether I'm just insane or not. But that's my little frustration at the moment. Well,

so how would you explain it? Then? Is the is the market wrong? That would seem to be the simple explanation. Every time I've been confident that the market is wrong, it tends to beat me in the head I think it's wrong. I rang up Shannon mcgonicky after this, and I tried to go through right just because I wanted to work out whether any of the margin collapse that and the methods of hiding it that he could see

in Japan we're applicable to my Irish banks. And the answer was no. But that doesn't mean that I'm not wrong. I am enough of a stock picker to know I can be wrong any day of the week, and believe me the moment I think I'm wrong, And if any of your dear listeners will tell me why, then I'll sell. These positions. Are not allergic to them, but they are very tempting. And the reason they're very tempting is that almost everywhere you look in this world, particularly in North America,

you see assets at extreme prices. Right that we have a situation where the market really does believe that low interest rates are here here to stay, and that economies are relatively are going to be relatively weak. So things that have highly deterministic cash flows that you can value off the low interest rates are priced at very high levels. My favorite example of this is Visa. Visa trades that last time I looked at seventeen times revenue. I think the markets down a bit this week, so it might

be only sixteen times revenue or fifteen times revenues. Yeah, there's a famous quote from Scott McNally at the end of the It's one of the quotes that I almost pin on my wall at the end of the of the tech bubble, which said that, you know, at the height of the tech bubble, Sun was trading at ten times revenue, And dear readers, what were you thinking, you know,

at ten times revenue. In order to get a ten percent return, I've got to return a hundred percent of revenue to you in cash, which means that I don't have any staff, which is kind of hard when you're running a tech company and they don't have any inputs, which is kind of hard when you're selling computer boxes. And I don't pay any taxes, which is kind of illegal. And that I can maintain all the revenue without any

R and D expense, which seems a little improbable. What were you thinking that ten times revenue was the sort of number that said this is insane. Now Here, I have Visa, which is a very fat margin business. I'll admit it's a very fat march in business, trading at sixteen or seventeen times revenue, and yeah, it's got two thirds margin. Half half of Visa's revenue drops to the P and L, and all of that is spent on either dividends or buybacks. It's an incredibly cash generative machine.

But it is one point seven times the price that Scott McNelly said was insane. Is the difference between now and past markets That in past markets, valuations used to be self limiting. At some point someone would go, you know what, the stock is far too expensive and I'm not going to buy it. Whereas now because so so much of the profit that you make by investing is basically momentum and a price increase. No, nothing, that's just

got to be wrong. Nothing is as as expensive as the worst as second tier tech stocks were during the tech bubble. If you go have a look at the biggest five or six tech names during the tech bubble, and you brought them now and you held them to now, you've actually made an acceptable return. If you went and looked at names twenty to thirty in March two thousand and you held them to now the result is an unbelievable,

spectacular wipeout. Right, there are names that were hugely important then that don't mean anything to you now, Like I two Technologies. There was a period where the too hottest tech names in the world, where I too Technology and JDS Uniphase and I two Technologies had a market cap of two hundred and twenty billion and j D s

Uniphase was to eighty billion. Now, the various parts of j DS you are still available and if you actually add them up, there's probably went to your thirty billion market kept there, so it's not the complete insane way about. I think I two Technologies were sold at the end for seven million. If you go back to the second tier tech names, they were just insane, right, That is,

if you actually had revenue, like Cisco. Cisco was one of the first ones to break, and the reason it was one of the first ones to break is that it actually had revenue and it told you the world wasn't quite as good as you thought, and so they stop went down a lot. Right, There was that period where profits were about you in a really good bubble. Profits are a bad idea because then you have a fantasy about it. But the tech bubble got to the point where revenue was a bad idea, right, because then

you'd have a fantasy. You couldn't write what you really wanted to measure with something like eyeballs, potential growth, potential growth, And if you bought the stuff that was the second tier, then the wipeout was far more spectacular. That was much more overvalued than anything i'm seeing now. That said, all the old economy was priced at seven or eight times earnings. There the years two thousand to say two thousand and six were the years in which the naive champion bearded

self righteous value investorout the FORMT. I know a few of them. I'm sorry, the bearded self righteous value investor. Is that their official name? No, but that's what they are. You see them. They were they're just cheap and they liked buy cheap stocks, right, and they're very obsessed by pe ratios. Several of them owned things that looked cheap, like Jase Bank and right. They also wear cheap suits. They'd like to be buffet acolytes, and they all meet

up at the Berkshire Meeting. I've been been to this Berkshire meeting. Several of these people are my friends. Right, they're almost the cliche of they start with the valuation and they'd buy almost any old economy stock at seven or eight times earnings, and for the next five to seven years they just did wonderful, right, They outperformed like crazy. And a lot of the things that they owned were

cheap and bad. So the same people often. You know, if I take a look at long Leaf, which is a fairly decent, well known mutual fund, I don't think they have beards, but it falls into the same camp. Long Leaf owned a whole lot of things that look cheap and went to zero, right, the sort of general motors stuff, and you know, sometimes cheap as cheap for a reason. But at that time, the whole old economy was cheap, and if you just bought the old economy, you did really well. And you know, some of the

misvaluations in were crazy. You go have a look at the New York Times or any other newspaper. And newspapers hit their highest valuation ever in two thousands, just as their business model was about to dismantle. And I actually asked somebody at one stage, a sort of check analyst, why all these newspapers were valued so highly. And the answer came back, looking at me weirdly, is it? Well,

they have websites, don't they? People look at their websites. Right, There were tech plates at that time because they all of them were going big on the internet in some way or each other. The overvaluation this time is not as bad as that time. It's just broader. Right in that time, if you just did the naive thing and bought the ten times earnings or nine times earnings old economy stocks including there, I say at Wells Fargo, you

just did fabulous, right. And the most naive, self righteous value investor, the one that seems to think that any growth stock is risky but value stocks are not, right, did great guns for five kids? Mhm this time? You know I want to be a self righteous beard and value investor, I really do. But the only things that look cheap, thanks, And I've just given you you know my angst feeling about them, my own two banks. I also earn a little slither of a company called Power

Corps Corporation of Canada. None of this I've ever disclosed. For that they they look really cheap, and I don't think they're problematic. The problem with cheek stocks is cheap stocks are often problematic, and you can get yourself very trapped, as every beard and value investor is once discovered. Okay, so talk to me about how you actually go about selecting companies in an environment of ultra low interest rates as we've discussed, but also generally broad high expensive valuations.

Actually I tend not to start with the valuation at all my general view, as I start with the business. And there are some business models that you just want to own at some stage. The best business model in the world is will develop global scale, will share the better scale scale with their consumers. And it's also the hardest business model in the world twine, especially as a hit as a bearded value investor. And the reason is well,

the iconic example is, of course Amazon. But if you look at Amazon in two thousand and two, it just sold books, It made small losses, it was growing very fast, and if Jeff Bezos had told you where he was going, he would have sounded insane. Right now, it wasn't in Jeff Bezos's interest to tell you where he was going, because if he told you, he sounded insane. People and to some weirdo out there, they might think, oh my god, I want to get there too, and so he'd induced competition.

If you're Jeff Bezos in two thousand and two, the job is to grow as fast as possible, subject to the constraint you don't run out of cash, and you want to get big before or your competition get there. And the problem with that from a value investors perspective is the optimal profitability is zero. So what you have to do is buy a high growth, zero profit company that doesn't tell you what it's directions. This is the hardest thing in the world to do, but I'm always

on the lookout. Right. Problem is I don't have any right um that that. Well, I have a few, but I don't want to talk about them. And the other thing is if I told you what I thought about them might sound insane. The other thing is that if they don't not go in that direction, I want to sell them before the d rate. So it's not in my interest to tell anybody for the same reasons it wasn't in Jeff bezos Is interest to tell anybody. The second sort of model that I look at all the

time is what we call the trifecta. If you are a small but important part of the big thing, you're consumable, and you have a high switching cost, you make a packet of money. The problem with these trifectors, and I'll give you a nice example, is an English one called Crowda right, which we own and Croda makes active ingredients for cosmetics. It does a lot of other things, but

the original ingredient product was active ingredients for cosmetics. It turns out there are recipes almost every face cream that can answer the medical question visibly reduces the appearance of wrinkles, has it in it ingredients that are extracted from war Greace. Now there are Egyptian recipes for war Greace makeups or cosmetics. And they were stuck, and so the woman would put this really smelly face cream on and sleep somewhere a long way away from her husband. Helena Rubinstein, you may

not know, was in Australia. She grew up in sheep Country and western Victoria, and she originally started making cosmetics from Greece. She extracted from sheep sheep sheds in Australia. It also all stunk. The first company that pulled out the active ingredient was Croda, which was a little company in Ghoule, East Lancashire and sheep Country in the north of England. And you will know the name of it.

It's Landlord, but there's about seventy derivatives of Lanoline and Landeline is the basis of the modern face cream industry because it made a face cream that worked and instink. Now Crowda has a fairly high switching cost. Sheep do things that are nasty. They walk through paddocks which have herbicides and pesticides in them, and if you are not careful, you'll get her decides and pesticides into the face cream.

And a sort of bad day for a Lorreal brand manager might be um recalling your product because it has pesticides in it. So if you're the Loreal brand manager, you want to be really sure of the provenance of

your supply chain. Croda buys almost all the war grease from all the sheep in Australia, in New Zealand, ad buys it in China and it's small batch processes that and it does the chaos monkey type testing where it puts contaminants in it to make sure that the tests final the contaminated batches as well, right, so that it knows and it's never had a product recall, and it's

testing procedures are extremely rigorous. And if the question is do you pay twenty five cents for the commodity one or fifty cents for the crowd for the Croda ingredient in your fifty loreal face cream, it's a no brainer for the lore L brand. Actually, they're going to buy the Croda product problem for a potential. Right, So you have a small part of the big thing. It's the critical ingredient. It has lots and lots of pricing power

because the brand manager doesn't want to change. The other thing is the brand that it's selling to is an incredibly fat margin product. So when you're selling a fat margin ingredient to a fat margin product company, you just sort of make double margin. And Crowder maybe the best chemical company I've ever seen. I start with a model like that. The only problem is that Crowder also trades at five times revenue, and revenue is not growing very fast.

And it is a chemical company, right, It's not quite the ten times revenue that Sun was at the height of the dot com bubble, but it ain't evaluation that should make you comfortable. Now, the way we choose stocks hasn't changed, which is that we start with the business model. Right. I'm not interested in owning a bank, but I am interested in earning a bank in an oligobalistic market, right

because there's something that it's got. I'm not interested in owning a modity chemical company, but I am interested in owning a specially chemical company that has something that makes you not want to change to the competitor. We start with that, and then we go to the valuation. And the problem is at the moment that every time I go to the valuation, I start getting this slight queasy

feeling in my stomach. I used to get uncomfortable buying specialty chemical companies at two and a half times EV to sales, and I now get uncomfortable buying them at four times EV to sales. Specialty chemicals is an area that I know a lot about, and I can't find anyone that I like that's trading it less than four times EV to sales. And this is true of business after business in the area that I have genuine expertise.

Now I know that there must be some cheap sector out there, but it's not one that I have expertise in except for banks, and banks are a scared one because with banks, when you're wrong, you're really, really, really wrong. If if I go back to that article in The Economist which basically described Lloyd's as having the problem of just generating way too much capital and making way too

much profit. And it had so much profit that it didn't know what to do with door right, and so it was buying back stock or giving it to shareholders in huge gobs. If you told me that ten years later that bank would be bankrupt, it would not have believed you. If I'm wrong about Crowder, it's going to d rate by half. If I'm wrong about a bank, I'm going to get a big fat zero. The other

thing is that changes the risk management. You know, there's a Warren Buffett saying that if you liked at ten dollars, you should really love it at six dollars, so you should buy more. And every Harry faced value investor does that, right, That is they buy on the way down the As a famous photo of poor Tutor Jones, there's a young guy, he's a trader, and in the back of his picture is that it's just stenciled on a piece of paper hanging crooked in the office is the phrase loses average losers.

And at one end of the world you have Warren Buffett that says, if you loved it at ten dollars, you should be buying more at six. And at the other end you have poor Tutor Jones saying loses average losers, and they're both right. In times, Harry chested value Harry faced value. Investors also Harry chested Ones get themselves into trouble by doubling down and doubling down and doubling down again. The most famous example, of course, is Bill Miller, who

doubled down on a I G many times to bankruptcy. Right, and Bill Miller had a record where he outperformed the S and P I think for eighteen straight years and then gave back all the excess performance in one Right now, I don't want to be building You're right, John, you mentioned buy backs, yes, And I want to ask you about this because it does feel like at a time when there is ample liquidity in the system and people talk about money essentially being free, and at the same

time you have sluggish global economic growth, you do see a lot of companies doing buy backs or raising dividends because they don't know what else to do with their money. Apparently, well, not knowing what else to do with your money is actually the sort of half of the course for really good companies. And you know, if you have a look at Crowda, it's roes whatever it is, it's a very big number. It's return on assets is enormous, but it

can't grow. So what's to do with its money? That does an acquisition or and it in the dividend or buy back. It is very rare that you find a really good business with really fast growth prospects. Right. So, in fact, historically the companies that I liked by generally

generate excess cash and they generally return it collectively. The markets insane at this If you look at aggregate buy backs over the last thirty years, buy backs are highest when the markets high and their lowest when the markets low. The stock market went into net issuance mode during the GFC when the stock market was at its all time low, and at the moment it's at all time record buy

back levels. So whilst they like companies that do buy backs, I'm quite aware that on average, buy backs are done very badly, and they're done badly by some of the companies I like as well. At this time, I'd be very jauned us about a company that's incurring debt buy backstock, because you know you could have done that a lot more rationally a while back. I have examples of companies

that have brought backstock beautifully over the years. If you have a look at the tobacco companies, the tobacco companies for years and years and years traded at a very sharp discount because people thought tobacco was a bad idea. They're right. Tobacco sales have the number of Americans smoking has halved over twenty five years, and Philip Morris is like a ten x or fifteen x, some big number.

And the reason essentially is that they got some pricing power and they brought back lots of stock at cheap prices, right, And that works all day. At the other end, you have a company which was very admired once and made the mistake of buying back a hundred and thirty billion dollars of stock over a decade and a half. Who is that General Electric? Of course, had General Electric only bought back a hundred billion dollars of stock, not a

hundred and thirty. We wouldn't be having this discussion about General Electric. It would still be a perfectly okay company. It would certainly would be a less good company that was, And it's clearly made missteps along the way, the biggest of which is probably buying Alston. But you know, you can argue about what the missteps are. One of the missteps,

for instance, is selling all the brands. And once upon a time there was a g appliance in every household pretty well in the Western world, and that was a pretty good branding exercise. And now those g appliances don't exist, and they just got rid of them because they were low margin businesses. But to got rid of mind ship. There are all sorts of little mistakes that they made along the way, but the biggest mistake by far was

they just brought back way too much stock. Right, and G is my poster child for a company that has impaled itself on stock by backs. And you can go back to that tree and I've got it. It's a wonderful document. The three and activists pitch for G when G was about thirty dollars a share. Essentially, the pitch was the same as every other activist pitch, which is that they should leave her up and by even more stock. Right. Well, had they followed that advice, G would now be a

big fat round zero. G is your poster child or bad buy backs. I've got a longish list of companies that have brought themselves back to a balance sheet which I would consider single B, and often they're often they're rated single bit. If you go back through long periods of history, the ten year cumulative default rate for companies rated double B is about thirty. The ten year cumulative default rate the company's rated single B is about and you know the rating agent, and I'm going to get

the exact words here. The rating agency definitions are kind of interesting. It's investment grade if under the wide range of circumstances it's going to repay. It's junk or double B if there are reasonably likely circumstances in which it won't repay you. In other words, you'll get repaid if

something doesn't go wrong. The CS they invert that, which is, under the wide range of circumstances you won't get repaid, and that the shorthand is you will get repaid if things go right, and the credit market is almost always open at the triple B level. When the credit market closes at the triple B level, the economy has very real and very sudden problems. The credit market is sometimes open historically at the double B level, and it's almost

never open at the triple C level. This cycle, I have seen triple cs issue debt many times and single

bs issued debt a lot. Now, the maths of it historically, and again these are very rough numbers because the junk debt people will probably laugh at my naivity here, But the maths of it is that triple bees used to trade at about three hundred basis points spread over treasuries, So you've got paid three hundred three ten basis points a year for holding it, but you had at cumulative default over ten years, so you'd lose three and a half percent of than a year, but you'd get a

recovery on that. So the cost of it of earning the junk debt in credit was about one point seven percent a year, and you've got about three percent a year, so that there's one point three percent carry for owning junk debt. That's a reward on a diversified portfolio. It makes some sense as a banker. You got to the point here where looking just at historic numbers, that carry went to zero. This is of course irrational because the

defaults all happen at the wrong time. If you held triple B double B is for a very long time, you've got that one point seven percent on average, but you've got all your defaults selectively in two thousand and two and two thousand and nine. Cash in two thousand and two and two thousand and nine is worth more than cash in two thousand and six and two thousand and nineteen because you can turn that cash into money

into the market at very low valuations. Right, So whilst you've got a premium over a very large periods, the premium wasn't well timed. You really want to make money at bear markets, so you can use that money to buy things. It's really important. One of the problems with businesses that lose money in bad times is that they lose money at the wrong time. Liquidation businesses, by contrast, make money at the wrong time. So you know, the extreme version of that is Charlie Manger's company, the Dow

News Wire, and it publishes bankruptcy notes. It's a legal public share that you and Charlie owns. Charlie Manger, not Birkshire, own's a very large amount of the company. And Charlie is the chairman of the board and he has an annual meeting where all the hairy jested value investors go and hairy faced value investors go and they all listened to Charlie and Charlie dolls them out wisdom. But the real trick with that company is it makes okay money

over a cycle, but it makes it all when bankruptcies art. Right, it's like a hedge for the macro economy. Yeah, but then you've got Charlie Manger as your investor. So they made a whole lot of money when the when the markets were really low, and Charlie went and bought things with it, right, And in fact, if you go look at it, it brought almost all of its Wells Fargo on a single day, one day from the absolute bottom

of the Wells Fargo stock price. And the real trick to that business is not only does it make money at the right time, but you have a really wise guy who invests money at the right time. Right the dollar doesn't care much how you make it. It cares like crazy when you make it. So talk to me about excesses in the debt market, which you just described, and how that impacts the stock market which you invest in. And I'm thinking of one of your most famous calls here,

which would be Valiant. Valiant was a series of opaque accounts. It had all the famous adjusted earnings, and you could not work rationally from the adjusted earnings back together. You just had to trust them on that. The other thing about Valiant was that it was trading at ten times sales, and it was buying companies at ten times sales. And ten time sales is my favorite magical number. You really really need to be good to justify ten times sales.

That Scott McNally quote is just burned into me. You had this thing trading at ten times sales, buying things at ten times sales with accounts that made no sense. The first thing we did was we tried very hard to reconcile the adjustedy adjusted a bit the number to their bit the number, and we found instances where they were like, there's no if saw butts about this. The first one we found was a trivial one. It was

the Galderma Royalty. They had bought a business essentially from Nestle from Memory and they were selling stuff that goes in women's lips to make their lips puppier. But every dollar of sale they had to send five five cents of that just a small amount back to Nestle because they owed them a royalty. When they are working their adjusted A bit throughout, they didn't include that. Now it's an expense. Every dollar you sell you have to send five cents back. If you sell extra dollar, you have

to send five cents back. Now they capitalize their estimated value of that and amatize and excluded it from their adjusted dedicta. Right. Then we found another one that was like that, and another one that was like that. Can I ask you on this point though, because whenever I have a conversation about adjusted earnings, what some people will say is, well, what does it matter because you have the gap numbers there anywhere? Valiant wasn't making gap profits right.

In fact, I always feel like pulling them up right now. But the first gap profit that Valiant made was after it blew up, and in fact it was it was writing off deferred tax liabilities and writing off earnouts right, there were no gap profits. Without adjusted earnings, Valiant looked unprofitable and would have been judged as such by the market. There are times that adjusted earnings make sense. I'll go right back to the very beginning of my stock picking career.

This was a very very much bearded value investor thing that a twenty two year old might think about. There was a company in Australia called Byron, and Byron invented the process for making synthetic emeralds, which is in fact that these things have turned up to be kind of useful. If you could make them large enough, you might make a set synthetic sapphire as a screen from mobile phone,

which would make a sort of unscratchable screen. Um. They are used for the nose cone of cruise missiles, and the reason that their work is they're extremely hard and abrasive and the military doesn't care what they pay for them. But you can run the guidance system through the nose cone of the missile, so you can see through it without putting. You know, it's a sort of unbreakable window

on a missile that's going extremely fast. But these were originally jewels, and I can only remember the numbers in price push in per share, but they'd spent about a dollar eighty per share building this whopping big plant, and they were amortizing the plant off, which was about twenty cents a share a year. They had these enormous projections for how much money they were going to make about

selling these synthetic sapphires, and that didn't work out that way. Firstly, the Russians copied the plants, so you could buy synthetic sapphires from other places, and the military establishment copied the plants, and they also started selling synthetic sapphires. And then women started looking down their nose at synthetic sapphires anyway, and so you didn't get a big price premium for them, even though they were flawless. You've got a discount for them.

In fact, a sort of flawed natural sapphire traded at a premium to a flawless, beautiful synthetic one. So the company never was never going to recover. In fact, it was going to lose money. But it was making about eight cents a share of operating cash flow, offset by the admortization of this plant, So I was declaring losses, but it had built up about twenty cents a share of cash. After all, the debt was trading at twenty cents and was making seven cents of cash flow a year.

Was going to make losses forever now, the beau. The first adjustment was just adjust out the depreciation because it was a plant that I didn't pay for. I was paying twenty cents a share. The people who paid for the plant paid a dollar radia ship from my perspective of the earnings for seven cents a share right for the next ten years. And that's roughly how it turned out, except some rich guy bought control of the company and

diverted the cash flows for his own years. But there was a perfect instance where I should ignore the gap accounts, right, and I should just look at what's really going on. And the world is full of those instances, right, But it's also full of people who, like Valiant, will ask you to ignore the Galderma Royalty. Now, the Galderma Royalty absolutely patently obvious that you shouldn't ignore it. And you know, when you're late in a ball market and people are

hyping things, they'll ask you to ignore the most silly things. Ever, Byron was the example of a company which was loss making as far as the eye could see and was still worth a lot of money. So what would you And this is probably going to be the last question, but what would be your one piece of advice for people who have to put money to work in the market right now? With all this going on, you're asking someone that's finding extremely easy to find shorts at the

moment and extremely hard to find longs. How I invest long at the moment? This is not an easy question. If you go back to the height of the tech bubble, if you've bought the top ten five names and you held them to now, you did okay. If you bought names five, you did terrible. It feels bad to pay a big price for quality, but in retrospect it's worse

to pay an even bigger price for a junk. Right, So my gut reaction is probably leave half of the money to do something else with right, and in some sense rebalance A sixty forty portfolio would be a reasonable assumption and actually pay out for quality, because I think you'll not, because you do better paying up for quality, but you'll probably lose less, which is as you know, and you know over very long periods of time. My guess is the quality stocks will still produce returns that

are adequate. If your idea of adequate is low single digit. Well, on that happy note, John Hampton, Franti Capital, thank you so much for being on offline. Thank you for having this has been a special edition of the Odd Thoughts Podcast down Under. You can follow me Tracy Alloway at Tracy Alloway on Twitter. You can also follow my co host, Joe Wisenthal at The Stalwart and you can follow our guest for the episode on Twitter, Mr John Hampton at

John Underscore Hampton. You can also follow his blog Bronti Capital dot blogspot dot com. You should also follow our producer Laura Carlson at Laura M. Carlson, and you should follow all of Bloomberg Podcasts at podcast on Twitter, st