2102 revisited: stock commentaries

We reviewed a few stocks this year.  So far, our take has been mostly right.  Our current scorecard is provided at the top of each section.

YPF (+33%) and Telecom Argentina (+16%)

Last April we noted that the nationalization of YPF and the expropriation of its then controlling shareholder, the Spanish multinational Repsol, was part of a long standing pattern of misbehaving by the Kirchner governments. 

Last month, with surprise developments affecting its unrestructured sovereign debt (impounding of the frigate Libertad in Ghana, adverse New York court judgment), with massive street demonstrations against the Kirchner government and the evident difficulties that YPF had in closing joint-venture deals with the likes of Chevron and others, we surmised that change may soon become inevitable and we started to invest in Argentina, just a little.  We thought that YPF would be a good start, with Telecom Argentina as a less speculative second choice.  At the time, their ADR prices were $10.46 and $9.82 respectively.

Today, they are $13.90 and $11.41.  While Repsol’s legal pressure is continuing, the Spanish government has made it known that it was in regular contact with its Argentine homologue and that a resolution of the dispute was likely.  After initial difficulties, YPF was able to raise substantial sums by issuing bonds on the local market; ironically, the repressive financial controls made YPF bonds the best deal in town.  It also helped that the government could force its Social Security system to buy half of the company’s debt offerings.

Negotiations seem to be continuing with Chevron and now Bridas, and they are very difficult: how could it be otherwise given the Repsol expropriation precedent and the unrealistic energy pricing system?  In the end, I think that Argentina has no choice but to pay Repsol for its stake in YPF and to adopt economically sensible oil and gas prices.  After all, its shale deposits are among the richest in the world, it will control and benefit their exploitation and it doesn’t want to be too dependent on Bolivia and Brazil for its energy needs.

Even though it gears to become the energy national champion (by taking control of Metrogas and with its expected bid for Petrobras Argentina),YPF continues to be priced for disaster (see peer comparisons in our September post). I do believe that the current strategy consisting in copying the Brazilian energy model is wrong and terribly costly; but even then, if the Repsol dispute is settled, as I expect it will, the YPF stock should rise very appreciably.

Telecom Argentina is well managed, profitable and carries a large net cash position.  Price controls and high inflation have squeezed its profit margin, but it too is priced for disaster.  Its stock may not pop up as much as YPF’s, but it is offers lower risks.

The other big risk factor for US investors is the continued listing of these companies’ ADRs in New York, as this provides liquidity and attractive economics given the overvaluation of the Argentine peso.  One would think that, unable to tap international bond markets, Argentina would be anxious to maintain access to international equity markets. 

JP Morgan Chase (+19%)

In May, I commented on the London Whale travails of JP Morgan which had pushed its stock price down to $36.96 on the day of my post.  I advised prudence, cautioned that the loss on its derivatives could well exceed the initial estimate of $2 billion (it did) but took the view that buying below $36 would result in a profitable trade.  The stock price spent two months below that level, bottoming at $30.70.  Today it is $42.81.

The bank management was extensively reshuffled.  Yet markets have responded without enthusiasm.  Although the stock price should appreciate further next year, my view of the company has evolved.  I have come to the conclusion, partly through personal experience and partly through industry review, that the bank has grown too big and diversified to provide superior customer products and services and to be effectively controlled. 

Warren Buffett once said that he wanted to invest in businesses that even fools couldn’t sink, because sooner or later fools would be in charge.  JP Morgan’s top management is very smart, even if it may suffer from some hubris; but I wouldn’t want to own the stock if fools were at the helm.  Admittedly, this is a remote possibility in the case of JPM.

Standard Chartered plc (-6%)

Last August, I wrote about Standard Chartered plc.  I expressed disbelief with their decision to continue doing business with Iran through their US facilities despite clear prohibition imposed by their host country.  I questioned the bank’s decision-making and the oversight exercised by its Board of Directors.  I also felt that its market value failed to reflect the inherent risks of its business model.  I elected to pass and wait for another day to invest.  The stock price then was 1,418.5p; today it is 1,497p.

Since then, little has changed. Of its twenty-one Directors, only two new have joined the Board following disclosure of the Iran saga.  No top or senior manager has paid the price for this fiasco.  The bank settled the outstanding charges with the US federal authorities for $327 million.   However, its latest quarterly results were satisfactory and, had I bought the stock back then, I would have made a 6% gain to-date.  I remain a skeptic but I admit that I may have been wrong.

 

Apple (+26%) and Research in Motion (+87%)

Last September, I argued that Apple was not a cheap stock despite its modest p/e multiple, the reason being that such multiple resulted from a very high gross margin.  I noted that reverting to 2006 gross margin levels would push the p/e above 23, even after deducting Apple’s large cash balances from its market value.  I also expressed some doubt that Apple could maintain its growth rate and gross margins by targeting emerging markets such as China.  Interestingly, Apple’s latest quarterly results showed a small drop in margins which the company put on the concurrent launches of new products.  The stock price, which was $691 on the day of our initial writing, has now fallen to $510. 

Irrespective of its fundamentals, Apple, once buoyed by client adoration and investor exuberance, seems to have lost some of its magic:  Steve Jobs passed away; it stumbled with its handling of Google Maps and Youtube; it continues to rankle with its refusal to support Adobe Flash; Apple TV remains an undefined possibility.  That said, relative to its peers, it remains a unique company; it is just very difficult to keep beating extraordinary expectations and to have to add $50 to $70 billion a year to justify current market valuation.   

On September 28^th, I argued that Research in Motion, the maker of the Blackberry, was a buy as it was priced for extinction, which didn’t seem likely. Today, a consensus has emerged that its new Blackberry 10 will come to market early next year.  Carriers and large corporate clients are testing it.  Besides its reported merits, the BB10I is benefitting from telephone carriers wanting to break the Apple/Android duopoly.  On the other hand, RIMM is faced with patent litigation from Nokia and has a very steep hill to climb in Europe and North America to regain market share. 

How will RIMM look like in two years, will it have succeeded in regaining critical mass, I don’t know.  But it has a sporting chance thanks to a meaningful client base (80 million), strong technology and good finances.  Back on 9/28/12 the stock price was $7.50.  Today, even at $14.05, its stock price continues to discount a somber future.

We should remind ourselves that extrapolating in a straight line is always dangerous; that was true when I wrote about these stocks back then and that is true now.  Market valuations are right most of the time, but when consensus reaches 90% or more, it is usually worth our while to investigate.

 

2102 revisited: the weight of culture and the risks of destabilization

In my post of last January, I quoted excerpts from a 1932 article that journalist Paul Scheffer wrote for the Berliner Tageblatt.  It painted an audience’s expectation and attitude ahead of a speech by Adolf Hitler.  What struck Scheffer was that most of these people were what he called ‘de-classed” middle-class, that is, people who had lost both their standard of living and their self-esteem, and who were waiting for a miracle.  My conclusion was that, as momentous as the impact of the current crisis had been on European economies, it would hit politics even harder.  I argued that the explosive development of social media would be a key contributing factor.  I stand by this assessment.

Subjected to an abrupt increase in unemployment, taxes and cuts in social benefits, Europeans are looking for miracles, and this situation provides fertile ground for demagogues and extremists.  In Greece, Holland and Hungary, we have seen the rise of extreme-right movements; in Spain we have seen the rise of leftwing, nationalist parties.  In France, while a moderate socialist won the presidency, there has been an unprecedented fragmentation of the political scene: splinter groups on the Left led by the likes of Mssrs. Mélanchon and Montebourg are increasingly at odds with the government as are the Greens; on the right, the UMP is splitting as it cannot decide if it should follow a centrist but unimaginative path or one of assertive populism.  In Italy, the anti-establishment party of Beppe Grillo is the second most popular political party and center parties have receded the most.  As the fortunes of Europe are unlikely to brighten any time soon, I expect an increase in centrifugal forces.

Faced with mounting pressure from the markets, most governments delayed taking corrective measures, giving the unfortunate impression that, in the end, they succumbed to outside pressure.  This in turn contributed to weakening them and the prospects for a consensual EU solution.

The need to tap outside rescue programs also contributed to reviving long standing regional frictions, witness the North-South divide in Italy, Catalonia and the Basque region in Spain and Scottish independence in the UK.

If, as I believe, the European economies do not rapidly improve, I expect that the above mentioned stresses will increase.  At first, populism is likely to rise; after all, it is easier to deflect popular anger towards the rich or large corporations (witness the 75% tax or the skirmishes with Peugeot and Arcelor-Mittal), but as these do not have bottomless pockets and are more mobile than the rest, new tactics will be needed.  The temptation for governments to intervene ever more deeply into the economy may become irresistible.  This would buy peace for a while, but it will also bring the center of gravity of politics into a no-man’s land: no longer liberal democracy, not yet illiberal democracy.  One can think of Argentina and Venezuela as the ultimate “models” for such a drift.

Pervading this debate is the unrecognized influence of culture, a major interest of mine, and something I touched upon in my post of last March.  It is an issue that most commentators avoid as they view it as politically incorrect.  That may be so, but it doesn’t mean that it is irrelevant.

Culture is the glue that keeps groups of people together and in relative harmony.  Think of the IBM or the Marine Corps cultures.  It is also what defines nations, and so, by essence, it changes very, very slowly.  Why would we still read about Tocqueville’s America or Custine’s Russia otherwise? 

In the context of the current crisis, it is worth noting that there is a longing for but not a strong European culture; rather, there is the appearance of one when dealing with other very large nations such as China or the USA.  There are however very strong national cultures in Europe; these have had a significant impact on the management of the Debt Crisis so far, and I believe they will be play a major role in determining the survivors.

A great divide has been the so-called Recovery-Through-Growth proposition, i.e., that countries should first seek accommodating monetary and fiscal policies to overcome the current crisis, postponing tax increases and spending cuts for later.  President Hollande has been its most vocal advocate.  The other side of the proposition is No-Pain-No-Gain, which is that the bitter medicine won’t taste sweeter next year and problems are best tackled early before they snowball.

It is interesting to note that France and Hungary are in the first camp while Ireland, Portugal, the UK and Germany are in the second[1].  Spain and particularly Italy are in the middle, leaning perhaps towards the latter group.  Ireland is showing progress; Portugal is still struggling but is in a much better shape than Greece.  The UK was widely criticized for choosing austerity and indeed paid the price with a slight contraction in GDP.  What is remarkable is that these countries chose to endure sacrifice – quite big in the case of Ireland and Portugal - yet their populations didn’t rebel.  They may have paid a higher price in terms of GDP loss than others, but they will come out of the crisis faster.

Italy, led by its Northerners, also took the path of some reforms, although this may not be enough to avoid debt restructuring.  There is no clear prospect for a majority government next year.  As for Spain, it finally seems to have accepted the need for its intervened banks to face reality (merger for some, assumption of losses by creditors and shareholders).  Its government is trying to take unpopular measures but it enjoys spotty popular support and it must deal with internal regional issues.  As to France, and as I noted in previous posts, it is so rich as to being able to delay the day of reckoning.  At the same time, it suffers from an ill shared with others – the weakening of its political center – as well as home-grown cultural idiosyncrasies – such as the inability to do evolution when revolution is an alternative.

To my mind, national culture had a lot to do with the choices nations have made and it will have a lot to do with the outcome(s) of the current European crisis.  This is particularly so since unemployment is expected to rise and economic activity is projected to be lackluster in 2013: national cohesion and resilience will thus be painfully tested.

In sum, while economic progress has been made in Europe, more hardship is on the way.  This in turn will put further stress on political systems which already show signs of fragmentation and polarization.  Politics rather than economics will likely determine the outcome of the current debt crisis.  So will national cultures; they help explain the choices that countries have made and they will play a major role in mapping the future outline of Europe.

 

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[1]  Germany is not (yet) in crisis but it did take some pain under Chancellor Schroeder.

21012 in review: Greece revisited

As the year comes to a close, I feel that it is healthy to revisit the posts written so far and to assess how events have tracked our expectations and predictions.  This is the first installment of the series.

It has been our view that Greece would not be able to fulfill its commitments to the rest of EU and that the adjustments it needed to make were so great that it should and would leave the eurozone, at least temporarily, if not this year at least next.  We have also felt that the single most effective tool at its disposal to correct excessive debt loads was privatization of public assets, which it has refused to implement: of some €300 billion in privatizable public assets[1], only €50 billion were earmarked for sale, and to-date, cash proceeds to the Greek government have been €1.8 billion only. 

So far, Greece remains in the eurozone despite having spectacularly failed meeting its targets and carrying unsustainable debt loads.  Last March, the Greek government agreed to a series of targets with the Troika (European Commission, ECB, IMF), such as bringing its debt-to-GDP ratio down to 120% by 2020; despite a severe “haircut” imposed on private creditors, that ratio stood at 150% by mid-year and was budgeted to rise to 189% by 2014.  Such huge “miss” was due to both a collapsing economy and rising debts.  The budget deficit target will be missed as well.  Further adjustments include more cuts in public sector salaries, pensions and other social transfers, and of course, better tax collection.

Faced with unattainable goals, the Troika decided to fudge, increasing the 2020 debt-to-GDP goal to 124%, reducing interest rates on loans to Greece, returning realized profits on previous ECB financial aid operations and requesting Greece to buy back debt[2] (at a discount) before disbursing the next aid package.

This next disbursement of €34.4 billion is not assured yet.  It is also huge as it represents 17% of Greek GDP[3].  It is worth noting that Germany has become increasingly skeptical of the viability of the Greek rescue, and not without reason: Greece keeps missing its targets, its debts remain very high and the above mentioned budget cuts are likely to stoke further political instability and push an ever larger share of the economy underground, reducing tax revenues and distorting further the economy.

Having forced private creditors to take a €106 billion loss without putting its debt on a realistic recovery path, Greece will ask the same from its public creditors next.  Despite the IMF insistence, the eurozone has so far adamantly refused, although chancellor Merkel recently acknowledged the inevitable, sort of.  Large scale privatizations continue to appear out of the question.

The problem is that, while another round of debt haircuts appears necessary, it is not sufficient to get Greece back on track.

Nowhere in Europe has the pain been greater than in Greece:  Nominal GDP dropped 7.6% from €232.9 billion in 2008 to an estimated €215.1 billion in 2011.  It is expected to drop close to 7% this year.  Labor costs have been greatly reduced and external accounts have adjusted considerably, although in large part because of low internal demand: the trade deficit[4] for the first nine months of 2012 was €10.1 billion compared to €18.6 billion in 2009 and €32.7 billion in 2008.

For the period 2009-2012, the Greek GDP will have fallen as much as that of Chile did in the early 1980s, yet the comparison stops there.  Chile carried out profound structural economic reforms during its depression years while Greece hasn’t.  Unless Greece invests massively to become more productive and to shift its output towards greater value added products, unless it shrinks its public sector, unless it designs a tax system that is efficient without being confiscatory, the above adjustments will prove to have been cyclical rather than structural.  So far, the situation is grim: for example, total investment as a percentage of GDP has gone from 23.7% in 2008 to 14.5% in 2011 and is likely to drop further this year.

At this stage, the odds of Greece remaining in the eurozone are slim although less dismal than they were last March.  To remain, it is necessary that Greece get a large debt reduction, but it is not sufficient.  Besides reforms it also needs the European Union, which absorbs over 62% of its exports, to recover too.

So far, it seems to me that Greece’s condition has gone from desperate to critical; perhaps there is room for further improvement.  The eurozone countries are starting to acknowledge that they can’t fully collect their loans to Greece.  They have yet to decide which avenue is best for them: granting a large haircut as the final boost to a recovering country and fellow eurozone member, or cutting their losses to a country exiting the eurozone.

I remain in the camp of the skeptics.

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[1]  As per former ECB Board member J. Stark.

[2]  Essentially directed at the new bonds which Greece issued as part of its private debt restructuring.

[3]  Source: UBS.

[4]  Excluding oil products which are not included in the official time series.

Argentine inflections

Anticipating inflection points is the Holy Grail of investing: we all know that past trends, up or down, will not continue indefinitely; at some point, the curve will bend and change direction.  But when? 

When will the fundamentals of a company start to show an improvement after sustained restructuring efforts by its management?  When will financial markets start assigning to a company a stock price that is closer to its intrinsic value?  And more challenging still, when will a country abandon failed policies to save itself from chaos?

Argentina is the perfect – some may say terrible – example of a country that has followed bad economic policies for much longer than deemed possible.  Indeed, how bad these policies have been remains unrecognized abroad: not so long ago, I recall some reputed economists stating that the 2005 Argentine debt renegotiation was a model for Greece, that the Argentine economy was growing at a healthy clip.

That is nonsense, but the question remains as to why Argentina seems to defy gravity, and why it has done it for so long?  Two reasons may be given.

One is that Argentina’s growth is illusory.  Measured in US dollars, it is greatly exaggerated because of an “obese” official peso/dollar rate which stands today at 4.78.  This is to be compared with the implicit rate of around 7 when one compares the stock prices of Argentine companies on the local and New York exchanges.  In other words, the peso is overvalued by some 45%; this led the Colombian minister of finance to brag that, measured at true exchange rates, his country’s GDP had overtaken Argentina’s.

The other is that the Argentine government has picked the pockets of everyone in sight:  foreign creditors were squeezed in 2005 in a restructuring in which they lost 75% of their money; private pension funds were nationalized and their resources used to finance the public deficit; energy prices were frozen to subsidize consumer spending; official inflation calculations were fudged, defrauding everybody (and independent economists were heavily fined when their findings departed from the official ones[1]); more recently, insurance companies were forced to finance government-designated projects, foreign exchange controls were implemented to try and stop capital flight and the largest oil and gas company, YPF, was expropriated and no compensation has been paid to date.

As Mexican president Calderon said shortly after the YPF grab, anybody thinking of investing in Argentina should have his head examined. 

Despite grabbing other people’s money, Argentina is paying a very steep price for its policies. 

The refusal by Argentina to pay holders of non-restructured sovereign bonds has kept it from international financial markets since 2001.  After announcing an ambitious investment program, YPF, unable to tap these markets for billion dollar issues can only raise $100 million at a time locally; it is also unable to attract international partners to develop the vast Vaca Muerta shale oil deposits[2] because of the uneconomic pricing of hydrocarbons and pending lawsuits from Repsol[3]; electric utilities are on the verge of bankruptcy; and the ubiquitous intervention of the government in the economy has led to widespread corruption.

Starved for money and growth, Argentine companies carry low valuations.  That, plus the limited remaining number of pockets to be picked has led sophisticated investors to bet on a policy inflection point.  Eton Park, one of the most prominent US hedge funds, built a substantial stake in YPF between September 2010 and March 2012.  I estimate their average purchase price at around $40[4].  The stock closed today at $10.46.  When rumors of expropriation started to surface last April, I was tempted to buy the stock as I thought the government wouldn’t have the money to take the company over.  I just couldn’t imagine that they would just grab it, but they did.

Yet I think that we are getting close enough to an inflection point to dip a toe in Argentina.  I see three reasons for that. 

One is that having taken control of YPF, officially because its former controlling owner (Repsol) didn’t invest enough, the government now “is it”.  In other words, it must show it can succeed where others failed; it needs to attract deep-pocketed oil and gas multinationals as partners, but for that it must (1) improve hydrocarbon pricing, (2) settle with Repsol and (3) regain access to international debt markets.  This looks to me like a chicken-and-egg situation as to what comes first, a major oil joint-venture or the above three-point policy change.  Meanwhile, the clock is ticking because Argentina, once an energy exporter, is now an importer.

Second, the 2005 restructuring saga is turning sour.  Having the Navy frigate Libertad seized in a Ghanaian port is acutely embarrassing for the Argentine government and begs the question: what next? If Ghana is not safe, what more restrictive measures will the government have to apply to its movable assets?  Furthermore, the recent decision by a US judge that Argentina must pay interest on all of its external debt, including that portion which was not restructured, raises the pressure as it carries the threat of escalation in case of non-compliance.  Granted, Argentina has so far been able to delay the execution of court decisions, but it can’t expect to do so forever.  Justice may be slow but it is not dumb.

Finally and perhaps more importantly, the Argentine people are showing growing signs of opposition to the government policies.  The harsh measures taken to effectively prevent them from buying US dollars have been received , and this is understandable in a cvery badlyountry where there is little faith in the willingness of the government to pay its debts, and where real inflation is on the order of 25% p.a.  High profile corruption cases, where government members appear to have enriched themselves illegally, are especially grating when popular unemployment is high.

A large currency depreciation may be the next step, rather than better economic policies.  However this would only diminish people’s savings and living standard, which would hardly be helpful in president Kirchner’s bid to amend the Constitution in order to run for a third term.

As the above diagnosis may still be a bit optimistic - after all, Peronism in its current incarnation still has many followers - one has to look at valuation and to what extent it mitigates the risks to be undertaken.

In the case of YPF, the main risk is really that of full nationalization, a close second being delisting from the NYSE (since one buys the ADR at a 45% discount to the local share price).  Looking at its ADR stock price, YPF looks pretty cheap compared to its government-controlled peers:  Ecopetrol (Colombia) and Petrobras (Brazil):

 

	Ecopetrol	Petrobras	YPF
Market value (bn)	$115.3	$131.1	$4.1
Proven reserves (bn barrels)	1.9	12.9	1.0
Daily production (‘000 of  boe)	719	2,463	467
EV/boe of proven reserves[5]	$61.6	$15.28	$6.36
EV/boe of daily production	$162,880	$80,007	$13,615

 Of course, the above calculations are very rough and do not take into account non-upstream assets such as refineries, pipelines and other long term investments.  But they are informative nevertheless.  For example, while Ecopetrol and Petrobras have similar market values, the former has zero net debt while the latter is burdened by excessive debts.  Still, YPF looks quite cheap.

 YPF faces two specific challenges: as an oil champion under government control, it is in the quasi permanent threat of having its management and strategies politicized; it also faces a very onerous investment program.  Another, less politically risky way of playing the “Argentine inflection point”, is Telecom Argentina (TEO).

The controlling shareholder is a holding that includes Telecom Italia and the well regarded Wertheim group from Argentina.  TEO is well managed and has strong financials.  It is the second largest telecom company in Argentina after Claro (controlled by Carlos Slim’s America Movil).  Its investment needs are more modest than YPF’s on a relative basis. It has a lower profile than YPF.  Finally, its ADRs enjoy a similar discount to local shares.  On a per mobile subscriber basis, it is worth less than one tenth of America Movil.

As history shows, populist governments rarely act in an economically rational way; when they control rich countries, and when they resort to reprehensible policies, they can endure far longer than orthodox thinkers imagine.  But even they cannot repel the laws of gravity forever.  They usually don’t see the light or change their ways; their rule generally ends when they can no longer afford handouts and resort to heavy handed policies to stay in power.

I have started to build small positions in YPF and Telecom Argentina.

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[1]   It is ironic that one of them was the former minister of finance who had presided over the heavy-handed foreign debt renegotiation.

[2]   Which YPF estimates to hold 23 billion barrels of oil resources.

[3]   The Spanish company whose controlling shareholding of YPF was seized by the Argentine government this year.

[4]   Based on the average prices during the periods in which Eton Park reported building its stake.

[5]  EV: Enterprise value, i.e. market capitalization – cash and equivalents + debts.  For YPF we have used the official exchange rate to convert debt amounts to US dollars since most of these are dollar denominated to begin with.

 

 

 

The Gallois Report

One learns from experience at any age.  Look at me.  Having calculated that the odds of two consecutive once-in-a-century mega-storms were close to zero, I declined to purchase a standby generator.  Wrong.  The generator guy is coming by tomorrow.

In France and the US, politicians have become experts at kicking the can down the road, until they hit a wall and need to come up with Plan B.  In this country, we had the Simpson-Bowles Commission; its report was quickly buried but, within the next twelve months, it will likely resurface as the US margin of maneuver is squeezed and public finances are in dire need of fixing.  If our politicians succeed, they should send their French brethren a copy of their recipe, because France could learn from it.

Likewise, France commissioned a report on industrial competitivess from Louis Gallois, one of its most prominent grand patrons[1].  Mr. Gallois just delivered it today.  Having lamented the decline of the US industry, our politicians would do well to read his report, for even if our problems are not quite the same as the French, there is enough commonality to make it required reading.  The diagnostic of the French industry’s weaknesses and falling from grace is particularly instructive, because we could be next on that slippery slope. 

Generally, Mr. Gallois recommends a “competitiveness shock” where key measures are applied quickly rather than being diluted over a decade.  He also stresses that French society must debate the reforms and come together on a plan which will carry the conviction that sacrifices and benefits will be fairly shared.  Indeed, the plan is as much about mutual confidence as it is about specific measures.  

Such convergence of efforts and ultimate rewards (you think of Reagan’s motto “trust but verify”) calls for lower social charges for both employers and employees (1.5% of GDP), greater participation of employees and union representatives in the policy deliberations of large corporations and a robust support for small and medium-sized companies.

Although Mr. Gallois is reputed to be left-leaning, he sees a key contribution of the state as doing no harm.  In his view, any significant new law or governmental decree should be accompanied by a document estimating its impact on industrial competitiveness, and recommendations as to reduce adverse consequences, if any.  The state should also refrain from changing key provisions that affect such areas as R&D investment tax credit, incentives affecting the formation of new companies, among others.  But in typical French manner, the ghost of Five Year Plans of yore would return in the much milder guise of Commissariat à la Prospective.

There are twenty two recommendations made in the report, ranging from broadening and codifying employee participation on corporate boards to ways of fostering innovation, rewarding long term portfolio investors, developing shale gas resources, etc.  Many of these recommendations should be studied in this country because we could benefit from them.

On a higher level, the Report is daunting.  It calls on the government to reduce public spending and it aims at reshaping the French industrial fabric: creating more mid-size companies (think of the German Mittelstand model) and pushing the sector up market where higher quality products permit higher profit margins (think LVMH, Sanofi- Aventis and, I wish, Delage and Delahaye instead of dreary Peugeot).  That is a very tall order, hence the deliberate step-by-22 steps approach.

Equally instructive, and courageous, is Gallois’ call to stimulate capital investment in industry, which in turns necessitates toning down overregulation and the demonization of executives.  This capitalization drive also requires greater stability in the relations with stakeholders which Gallois hopes to achieve by (1) offering greater employee participation in corporate decisions (up to four but in any case less than 1/3 of the board of director seats at companies with over 5,000 employees) and (2) stronger voice for long term shareholders (doubling of their votes after two years).

The initial French government reaction was typical: countering Gallois’ 22 recommendations with 35 proposals, yet watering and complicating the proposed key reduction in social charges.  As the Shadoks[2] of my youth used to say, GA BU ZO MEU, why make it simple if you can make it complicated.

France like the US is faced with mounting pressure to reform itself, yet neither country is on the cusp of the abyss.  Their respective governments have been divisive so that there is no popular consensus on the necessary reforms and shared sacrifices. Yet well connected outsiders (Gallois, Bowles, Simpson) have started to speak up.  In the days of instant communication and interconnected economies we should and need to pick what they have to say, wherever they may be domiciled.

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[1]   Louis Gallois is a former CEO of Airbus, EADS, SNCF.

[2]  A popular and off-beat French TV series in the 1960s.

Revisiting privatizations

Over the course of last year and this year, I have advocated that European countries facing excessive indebtedness and sub-par growth should consider selling public assets.  In the case of Greece, I noted in 2011 that ex-ECB board member, Juergen Stark, had estimated Greek public assets available for sale at around €300 billion; this was to be compared with a national GDP of €240 billion and an overall sovereign debt of €320 billion.

I also advocated the same course of action for others, such as Italy, Spain and France.  The benefits of such a policy would be to increase overall economic efficiency and to raise funds to reduce national debt.  It could also help develop a large and stable pool of savings for future retirees.

I also noted that the best example of what this policy could yield was the Chilean experience in the 1980s.  This is one in which I was closely involved as a banker and investor.  Back then, Chile received no outside financial help, in stark contrast to the current European situation.  Yet, thanks to well conceived debt-to-equity and debt prepayment programs, it managed to reduce its external commercial debt by one third without alienating international markets.

Therefore I was happy to read an interview of Mexican billionaire Carlos Slim in which he too advocated the sale of public assets as a necessary although not sufficient condition to get European economies back on track.

Countries are often reluctant to part with public assets, for very human reasons:

1.      Bureaucrats will lose a sinecure and a power base while employees may see their benefits cut back and even be terminated;

2.      Selling assets during a crisis is bound to bring less than optimal prices;

3.      Deep pocketed foreigners will take advantage of their momentary weakness to take control of national assets;

4.      Public services, once privatized, will be rationalized, resulting in higher tariffs and smaller geographic coverage.

 Indeed, reducing bureaucracy is one of the benefits of privatization.  In many instances, public employee benefits are far more generous than those accruing in the private sector, and the difference represents a subsidy which is unfairly borne by the latter and should be eliminated.  Privatizations often result in job cuts, but the resulting hardship can be controlled and reduced with compensatory and retraining policies and by the opening of new private job opportunities in a resurgent economy.

It is obvious that, at least in the beginning, public assets will be sold at depressed prices, but getting optimum prices is not the name of the game, putting the economy back on track is.  Besides, the cost of a weak economy with a depressed job market is far higher than the money left on the table, so to speak, by selling assets early.  And experience in Brazil and Chile has shown that, if privatizations are accompanied by sound fiscal and economic policies, markets soon adjust and subsequent asset sales command higher prices.

Rich multinationals or vulture funds are often the bugaboos that discourage countries from privatizing.  The reality is that it all depends on how privatizations are structured.  In Chile, most privatizated companies were bought by local entities, sometimes operators, sometimes financiers, sometimes by consortia which included local pension funds; in the case of the largest privatizations, special financing was made available so that local households could buy into blocks of shares that had been reserved for them (the so called capitalismo popular).  In Mexico, it is worth remembering that the largest privatization was won by a consortium of Mexican, American and French interests led by Mr. Carlos Slim who retained effective control.  I might also add that, in my experience, foreigners who have bought local companies on the cheap in times of great national stress end up paying a fair price over time, as governments find ways to extract more money or consideration from them.   One can only look at the electric utility sector in Brazil where the current government is trying to force through a new tariff regimen.

One large and apolitical source of funds to tap in order privatize public assets would be national pension funds.  These were instrumental in similar projects in Latin America and some Nordic countries.  Unfortunately, countries such as France, Italy and Spain largely rely on pay-as-you-go pension schemes, and their pension funds control very small pools of funds (0.2%, 4.6% and 7.9% of GDP respectively).   By contrast, pension funds in countries such as Chile (67%), Finland (82%) and the Netherlands (135%) are much larger and offer far more strategic flexibility.  It would be highly controversial in France in particular, but just imagine if it had a pension pool of 1 trillion euros!  If Italy had €900 billions and Spain €600 billion!  Such funds would dwarf the much maligned hedge funds and vulture investors; they would also match their long term investment horizons with the government desire to find stable institutional investors.

Finally, there is the fear that privatized public services will no longer serve the public, or that tariffs will be raised too high.  With sound regulations, the former concern can be allayed.  The real question is whether essential services should be subsidized, and if so how, or not.  If a country decides that the provider of such services should subsidize them, then privatization may not be appropriate.  Witness the continuing frictions between Telmex and the Mexican government on this issue, or worse, the case of the energy sector in Argentina or even EDF in France.  Countries can’t have it both ways: they can’t privatize and then control prices.  Ultimately though, tariffs may initially increase and then gradually decrease as most of the efficiency gains are passed on to customers.

The current debate in Europe has little chance of bringing about a workable solution to the prevailing financial and fiscal problems:  drastic austerity, be it via spending cuts or tax increases, cannot work because it is socially and politically unacceptable; fast growth is unrealistic because, in the absence of other measures, it is equivalent to Northern member countries subsidizing their Southern fellow members and cosigning their debts.

Austerity is necessary, but its focus should be a combination of shrinking the public sector and making the economy more efficient.  Privatizing public enterprises should be the key driver of this effort.

Growth based on EU subsidies and wealth transfers is a non starter; but growth based on a leaner, more flexible private sector is possible and sustainable.  Indeed, examples of this are easy to find in recent history.  Part of the privatizations proceeds should be earmarked to retrain downsized employees and to help them bridge a conversion period leading to new jobs in the private sector.

Finally, privatizations are essential to reduce sovereign debts in a manner which doesn’t disrupt markets, encourages new investments and keeps financing costs affordable.

At the end of the day, return to fundamental financial equilibrium and economic growth is possible but no single silver bullet exists that will do it all.  Rather, European democracies will need to find a workable balance of some austerity, some tax increases, gains in efficiency and delayed but better quality growth.  To that end, a broad privatization program is essential to help achieve many of these goals in a sustainable and socially acceptable way.  It would also provide the opportunity to establish a modern and potent retirement pension fund industry.