Archive for the ‘Analysis – Business’ Category

The dark side of rising bank profits

Tuesday, August 12th, 2008

On Monday, the financial press reported in Bendigo Adelaide Bank profit surges that

Bendigo and Adelaide Bank, Australia’s seventh-biggest lender by market value, reported a 40% rise in full-year net profit, but said financial markets remained a challenge.

That sounds like good news right? Well, we do not know enough about Adelaide Bank to give any informed comments. But for those who want to dig deeper, here is one factor you may want to think about.

First, how does a bank make money? As we explained in Banking for dummies,

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates.

One way to make more money is to increase lending. In order to do so, the bank may borrow more (from depositors, for example). But the problem with this is that this also increases the risk of default for the loans. Therefore, in an effort to increase profits, the bank may increase their loans by lowering their lending standards. In a booming economy, bad lending practices can be masked by rising asset prices (e.g. stocks, property) as the banks can easily recover the full amount of bad debts by selling the assets used as collaterals. But when the economy tip into a bust, unemployment will rise along with falling asset prices. That’s when bad lending practices will lead to trouble. If the bank is highly leveraged, bad debts can quickly lead to a more than proportionate hole in its balance sheet (see Effect of write-down on bank balance sheet).

Rising bank profits may sound nice, but watch out for its dark side. Some cynics reckon that it is in the interest of current bank CEO to raise profits, collect millions in payout and then pass the mess of future bad debt problems to the next CEO to handle.

Effect of write-down on bank balance sheet

Sunday, July 27th, 2008

On Friday, National Australia Bank reported a $830 million write-down on their assets. As this news article, More NAB bad debt revealed reported,

National Australia Bank’s senior management has been castigated by banking analysts after the bank released a fresh $830 million writedown of its investments in US housing mortgages.

The stock market reacted by plunging 3.5% at the time of writing. Will there be more? We will leave it to the mainstream media chatter to talk about it. Meanwhile, we will show you how a write down will affect the bank’s balance sheet. For this, we continue a simplified bank balance sheet from Introduction to banking corporate accounting:

Asset: $98.50 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

Let’s say 2% of a bank’s non-performing assets is being written down. That means $1.97 of the asset will be gone. In that case, the asset part will look like this:

Asset: $96.53 (Loans), $10.50 (Cash)

But what about the liabilities and equity side of the balance sheet? The liabilities side remains intact because they represent the saver’s deposit. Therefore, it will be the equity side that gets deducted:

Equity: $2.03

The balance sheet now looks like this:

Asset: $96.53 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $2.03

In one write-down the bank’s capital ratio gets reduced to 2.03/96.53 = 2.10%. It’s reserve ratio is still 10%. Will it get into trouble? As we explained before in Banking for dummies,

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

Let’s say the bank pays 9.5% interest rates to its depositors (liabilities) and receives 10% interest rates from its loans (assets)- assuming interests-only payments. That means it will have to pay $105 * 9.5% = $9.975 to its depositors and receives $9.653 from its loans. In this case, the bank is in trouble.

Or let’s say banking regulations says that the capital ratio cannot go below 4%. Currently, it is at 2.10%, which means it is in trouble. It has to either sell its assets or raise cash (via equity raising) to bring the ratio up again.

No matter what, the bank’s profit will fall.

Introduction to banking corporate accounting

Thursday, July 24th, 2008

Today, we will go deeper in depth on corporate accounting for banks. Without a proper understanding of this, it will impair our ability to appreciateĀ a bank’s financial position. Back in Banking for dummies, we explained that

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

Today, we will go deeper into that.

First, we will introduce the basics of accounting:

Assets = Liabilities + Equity

So, let’s say you deposit $100 into the bank. In this case, the highly simplified bank’s balance sheet will be:

Assets: $100 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

In this example, the bank is losing money because it is borrowing $100 from you which it has to pay interests on. But its $100 of cash is sitting there idle. Therefore, the bank has to lend out, say $90 at a higher interest rate than it borrows the cash from you. The balance sheet will now look like this:

Asset: $90 (Loans), $10 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

Let’s say it pays 5% p.a. interest rates on deposits and receives 10% p.a. interest rates on its loans. At the end of the first year, the bank balance sheet will be (assuming interest-only payments on loans):

Asset: $90 (Loans), $19 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

Now, there are 2 ratios that you need to understand. First, government regulations require that banks keep a certain ratio between equity and risky loans (in the assets) that it makes out to others. We shall call this the capital ratio. In this example, the capital ratio is 4 (Equity)/90 (Loans), which gives 4.44%. That is, its leverage is 22.5 times. There is another ratio called the reserve ratio, which is the ratio of cash and deposits. In this example, the reserve ratio is 19 (Cash)/105 (Deposits), which gives 18%.

Now, let us assume that the reserve ratio has to be, by law, a minimum of 10%. In that case, this bank has an excess reserve of 8% (see 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?). It can lend out an additional $8.50 to give a balance sheet of:

Asset: $98.50 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

In this case, its reserve ratio is $10.50/$105, which gives 10%. Its capital ratio is 4/98.5, which gives 4.06% (leverage of 24.6 times).

Economy in downsizing phase

Thursday, May 29th, 2008

Recently, we noticed a trend in some housing neighbourhoods. Large four bedroom houses are sprouting out “For Sale” signs. At the same time, the “For Sale” signs for smaller and cheaper three bedroom houses disappeared much quicker than their four bedroom counterparts. What is happening?

Our theory is that as the Australian economy slows down, people are downsizing. As interest rates rise, the mortgage debt burden for the more expensive four bedroom houses increases. In order to cope, some owners decide to sell them and downgrade to cheaper three-bedroom houses, which will lighten their mortgage repayment burden. Meanwhile, less and less people are able to afford the more expensive four bedroom houses and as a result, their sales slow down. It is also possible that people more from more expensive suburbs to cheaper suburbs. That explains why these three bedroom houses sell much faster then their four bedrooms ones due to competition from ‘outsiders.’

If you look around, you will find the same for cars. People are downsizing from the more expensive petrol guzzling fast cars to smaller and petrol-conserving cars.

When it comes to retailers, the same principle holds. As the economy slows, retailers in the upmarket and more luxurious end will suffer slowdown in their sales as consumers feel less wealthy (see the negative wealth effect on The Bubble Economy), cut costs and reduce their discretionary spending. At the same time, retailers in the bargain end (e.g. the Everything-$2 shops) may experience an initial upsurge in their sales as consumers who used to spend in the upper end downsize to the cheaper end.

So, what is the lesson here for investors?

In the initial stage of an economic slowdown, stock prices of upmarket retailers will decline as their sales fall. But stock prices of the bargain retailers may see their sales rise initially. If the economic situation remains in limbo, this may be a case for selling the stocks of upmarket retailers and switching to bargain retailers.

But there is a potential trap here. What if the economy deteriorates further into a severe recession (or touch wood, depression)? Then it will be very likely that even some bargain retailers will not be spared as consumers’ spending powers evaporate through rising unemployment.

In short, during the initial downsizing phase of the economy, there will be winners and losers. But if the economy worsens further, even the winners may still lose.

Discern what they do, not what they preach- Daily Reckoning Australia case study

Saturday, February 9th, 2008

One of the most important ‘soft’ skills of successful investors is the ability to discern whether there is any contradiction between the actions and stated or implied philosophy of an entity (e.g. business, organisation, government, etc). Obviously, as the old adage says, actions speak louder than words. If the contradiction occurs in a human, then there is a very stinging word for such a person: hypocrite. For long-term investors, when it comes to analysing a business, it is important to discern whether such a contradiction exists. No business (in the context of a free market) can exist in the long haul while bearing a tension of mismatch between its actions and underlying philosophy. Such mismatch engenders feelings of distrust which can only grow if it is not rectified.

We will now give you an example of such a contradiction from our most recent experience with Daily Reckoning Australia (DRA). Please note that DRA is pretty independent from its parent organisation Agora Financial. Therefore, not want to lump all of them together, which may be unfair.

First, what is the underlying philosophy of DRA? If you go to their web site, you can see words like “libertarian” and “free-wheeling.” Like us, they adhere to the Austrian School of economic thought. Basically, the Austrian School in a libertarian movement believes in the free market, and non-intervention (note: not anarchy) of government. But as you can see from our experience with them (see Dispute with Daily Reckoning Australia), this is just where our similarities end. In reality, although they proclaim liberty and non-intervention, they practice censorship and draconian control. It is similar to the situation that we described in Analysing Web 2.0 businesses: Shoutwire vs Digg case study about Shoutwire,

  1. Their staffs perform the role of the police and arbiter. We see a significant weak point in such business policy. Firstly, staff members are people who have their own personal bias, prejudice, predisposition and perspective. This implies that any news that can make it to the voting gallery are already ?censored?. That is why some people think that Shoutwire has an ?agenda??their very policy of ?management? (in the name of quality) doomed their stories to possess a slant.
  2. Such ?management? (censorship) implies that subjective judgements of their staffs will inevitably override some of the collective viewpoints of the community. This defeats the entire purpose of having community-based news in the first place.

For example, they accused us of ‘spamming.’ But their readers thanked us and complimented us for our comment contributions. Who is right? The answer depends on whom you ask. If you believe in totalitarianism, then DRA is right. If you believe in liberty, then the free market is right. Clearly, you can see what DRA believes in through their actions. The problem is that on one hand, they preach liberty. Yet on the other hand, they practice control.

We understand that in every web-based publishing business, there is a need to control spams. There is a libertarian way to solve this problem and a totalitarian way to do so. For us, this experience with DRA (see Dispute with Daily Reckoning Australia) made us think about the best way to solve this problem. We decide to solve the problem from a free-market perspective (see Installed a new comment feature: comment rating)- we let the community (i.e. free market) censure those whom they do not like. Of course, this system works best if contributors are not anonymous. As a side note, all our comments contributions in DRA are never anonymous. If our intention is to spam, then it does not make sense to do it on our own name.

Had DRA approached the problem from the free-market perspective, it will benefit everyone. For us, if the free market despises our comment contribution in DRA’s web site, we will get instant feedback about it and think of ways to take the better route. But if the free market loves our contribution, then it benefits because everyone is given access to quality content. DRA would benefit too because such a system tells them what their customers want.

But alas, Daily Reckoning Australia (DRA) chooses the totalitarian way, which contradicts their underlying philosophy. How is it possible to trust them?

Analysing Web 2.0 businesses: Shoutwire vs Digg case study

Thursday, December 28th, 2006

The advent of the Internet heralds the Information Age, which brings in radically different ways of doing business from the preceding Industrial Age. Unfortunately, the Information Age is relative new and many business people have yet to fully grasp and understand the implications of this paradigm shift. With the proliferation of Web 2.0 businesses (e.g. Digg, Youtube, Google, etc), how are we to comprehend the significance and viability of each one of them? Hence, we will look at the art of analysing Internet businesses for their investment merits, using Shoutwire as a case study. For today?s topic our recommended reading is New Rules for the New Economy, which among the books in the Recommended Books section.

Before that, let us give a quick introduction to the idea of community-based news. The philosophy is very simple. An individual in the community will submit news stories to be voted (in favour of or against) by the rests of the community. Through voting, the community express its collective view on the value of the submitted story. Popular stories will be promoted to higher visibility whereas unpopular ones will be demoted to obscurity. Thus, the power of the community?s collective wisdom is harnessed to do the bulk of the dirty work of promoting, editing, filtering and censoring. This is a very powerful concept. A few web businesses emerged to implement this concept. To name a couple: Digg and Shoutwire.

However, not all businesses are created equal. Some will survive and others will wither and eventually die. In this article, we will look at Shoutwire as a negative example of how not to do a web business. As Graeme Philipson said in this article, The coming digital showdown:

We are not even a decade into the digital millennium and already the battle lines have been drawn. Two camps have emerged, each with widely divergent views on the nature of information, who owns it and how it should be distributed.

The forces are at this stage evenly matched, and it is not apparent from the day-to-day squabbling which side will emerge victorious. But one side must, because their views are diametrically opposed and can’t coexist in the long term.

On one side are those who believe information is a commodity that can be owned, bought and sold, and its distribution controlled. This naturally leads to a restrictive view of information. This group comprises most of the music, publishing and film industries, and most hardware and software companies.

On the other side are those who believe that information by its nature should be free, and that its distribution should be uncontrolled. This viewpoint naturally leads to an expansive view of information.

It would be clear from this article that which camp Shoutwire belongs to.

First, we look at their submission policy, which in our view is detrimental to the long-run viability of their business: ?Remember that ShoutWire is primarily a news site and submissions which have little or no news value are more likely to be deleted than those that are news. It might seem like we delete a lot of stuff, but remember that ShoutWire is your site after we give you our brand of quality; besides that, all links that make the front page are decided by ‘you’. We?re just trying to ensure that the selection of links you have to choose from when looking for stories to shout is of the highest possible quality.?

We have quite a number of criticisms on their submission policies because they contradict the original philosophy of having a community-based news. On one hand, they deemed that the ?the front page are decided by ‘you’?, yet on the other hand, they play the role of police and arbiter in deciding which news are worthy of be voted by the community. Our views are:

  1. Their staffs perform the role of the police and arbiter. We see a significant weak point in such business policy. Firstly, staff members are people who have their own personal bias, prejudice, predisposition and perspective. This implies that any news that can make it to the voting gallery are already ?censored?. That is why some people think that Shoutwire has an ?agenda??their very policy of ?management? (in the name of quality) doomed their stories to possess a slant.
  2. Such ?management? (censorship) implies that subjective judgements of their staffs will inevitably override some of the collective viewpoints of the community. This defeats the entire purpose of having community-based news in the first place.
  3. At this point in time, they have enough staffs to play the roles of police and arbiter. But how can they possibly continue to do so without being overwhelmed in the long run when the number of submitted stories grows in magnitude?
  4. There is no way for Shoutwire staffs to be an expert in all fields of human knowledge. As such, how is it possible for them to be competent judges on the quality of technically specialised stories? For example, this site holds contrarian investment viewpoints. Does that mean we are conspiracy theorist lunatics? Or are we independent thinkers? The only way to tell the difference is to study the merits of our arguments, reasoning, logic and the origins of the school of thought that influence us. A person without specialised technical knowledge is in no position to make such a judgement.

We can see that Shoutwire?s insistence in controlling the quality of their news stories will be the cause of their decline in the long run. The whole point of having community-based news is to harness the collective power of the community to do the quality control. As such, do you think they have a cause to worry about angry teenagers, conspiracy theorists, spammers, advertisers, parasites, self-promoters and so on from ruining the quality of their stories? Such policies of theirs weaken the whole philosophy of their business model in the first place.

Next, we look at the possible long run result of Shoutwire and their rival, Digg. As Kevin Kelly?s book New Rules for the New Economy says:

Mathematics says the sum value of a network increases as the square of the number of members. In other words, as the number of nodes in a network increases arithmetically, the value of the network increases exponentially.* Adding a few more members can dramatically increase the value for all members.

By frustrating their users through deleting their submissions and locking their accounts, Shoutwire is driving their users away to their rival, Digg, which adopt a more laissez-faire and liberal approach. As a result, Digg will grow more and more in size as their members and the number of news stories increases. This in turn will increase the value of Digg?s network exponentially (e.g. more members means that there will be more pair of eyes ensuring the quality of stories), which in turn will attract even more members and news stories submission. That in turn will further increase the value of Digg?s network exponentially. The curious nature of the network gives rise to what is called a ?natural monopoly? in economics.

So, if Shoutwire continue such a self-defeating policy, we believe that the long run feasibility of their business will be put in serious question. So, after reading this article, if you are given a choice to invest in either Digg or Shoutwire, which one will you choose?