Reader Notice: Away until September 12

I will be cut off from the real world again.  It is not for Jedi training this time, but for diving with hammer-head sharks.  I am going to Galapagos.  I will do a week of island cruise and a week of diving live-aboard.  I will also spend a few days in New York (Sep 6 – 10).  If you are in New York and curious what I look like, drop me a line at uprofish(at)uprofish(dot)com.

Hyundai Motor Group (Part 4) – RoIC of Hyundai Motor Group Companies

While all HMG companies businesses are geared toward Hyundai and Kia branded cars growth, they operate very different businesses and this has big implication for investors.  Here it goes.

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Notes for HMC and Kia RoIC calculation: 1) Used cash cost for warranty related expenses.  2) Hyundai’s LT payables are abnormally high in 2004/5, but no explanation could be found 3) 2009 working capital was aggressively at both companies as one-off measure for global financial crisis and unlikely to be repeated 4) Kia 2008 was hit by massive FX loss.

Hyundai Motor

Disclaimer: Hyundai comes with three financial subsidiaries as well as Kia and Hysco.  It is difficult to get clean numbers for Hyundai’s automotive operation only.  Above presented should be used only as a benchmark and should never be considered as a true picture.

To my surprise, Hyundai’s automotive business does not seem to have been value accretive either.  In part, it is because of the fast overseas production capacity expansion.  In the past 5 years, overseas capacity has grown from 20% of total production to over 50%.  And Hyundai’s global automotive operation RoIC has declined in the same period (excluding 2009 which was helped by currency effect and aggressive working capital reduction), while parent-only RoIC has been improving.

In other words, Hyundai has been expanding overseas capacity constantly while it was value destructive.  However, I think there are 2 things in play here.  The first is that as a company tries to build brand power, it is likely to go through a period of lower return.  (Remember this drawing?)  The second is that as a company targets multiple markets simultaneously, it goes through a period of sub-optimal capacity design.  I hope the below drawing helps explaining what I try to convey.

And when I combine this with the rest of what I already said in the Part 1 of HMG series,  I think there is a good chance that HMC’s investments will create decent value.  And I am much happier to bet with Hyundai Motor than Kia.  Hyundai’s RoIC is already near the threshold, and it only needs a tick to generate value for the (debt and equity) investors.

However, Hyundai’s biggest problem is while it has all the reasons to generate much profit, it keeps transferring its share of profit to other HMG companies.

Kia Motor

It is not a surprise that Kia was a value destructor.  However, what is surprising is that it was value destructive even in 2009, its record year by huge margin.  While it is true that 2009 RoIC is understated because of Georgia factory construction, it is still unlikely to be value generative even after considering that.  (Compare with Hyundai which had been in aggressive expansion since 2004.)

Turning around overseas operation is imperative for Kia to create value.  However, given its brand image, achieving similar quick success is a tall order.  It should take Kia shorter time than Hyundai, but it cannot be done overnight.  This means rising marketing cost. If you think about why Hyundai let Kia take bigger domestic market share, it is because with HMG’s monopoly in Korea, it is fat margin business.  And growing Kia into another global brand is important.  At the end of the day, Toyota cannot have 30% market share in the US, but 3 Japanese makers can.

However, Kia’s automotive operation have to improve unit return per capital invested by 2-3x to be value accretive.  In most cases, I would say it is an impossible order, but in Kia’s case, I think it is actually possible.  1) Kia has relatively low capacity utilization that future capital requirement is smaller than revenue growth 2) It gets a lot of windfall from Hyundai’s success

Other things to note are 1) Kia’s RoIC gets a boost from legacy equity method investment in Mobis.  When you buy Kia, it comes with a portion of Mobis.  2) Kia continues to de-lever, and it increases equity holder’s claim faster than Kia business’ growth.  But as you can probably tell from the way I am writing, I find it difficult to believe that Kia will pay off investors in the near future.

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Notes for Mobis and Glovis RoIC calculation: 1) Mobis acquired Hyundai Autonet in June 25, 2009 and acquired incremental 5% of Hyundai Motor in Aug 28, 2009; and .  As a result, 2009 RoIC is depressed due to denominator-numerator mis-match.  2) Glovis had large sales gain of equity method shares in 2004 and 2009.

Mobis

The RoIC level of Mobis really wowed me.  How can Mobis generate such high return per unit of capital?  First, it is because Mobis has very asset-light business model comparing to Kia and Hyundai.  (See the table below.)

Second, it is because Hyundai Motor (and Kia) transfers a lot of profit to Mobis.  I mentioned many times that it is for the illegitimate reason of assisting succession to ES Chung, but I do think it makes strategic sense to grow Mobis.  I think competitive parts maker has longer expected life than competitive auto maker.  Subsidizing Mobis does not benefit HMC shareholders, but if I control Mobis and Hyundai Motor as MK Chung does, then it is a logical thing to do.

What really surprised me about Mobis RoIC was that Mobis is actually value generation capability was not degraded in 2009, when it acquired Autonet and additional 5% stake in HMC.  It was mainly thanks to HMC’s record earning.  However, given that Mobis is not buying stakes in these companies for investment purpose.  In my opinion, if Mobis is really to be a holding company, it will probably try to purchase at least another 10% of HMC.  That is roughly 3T KRW or 1/3 of today’s capital invested.  Will Mobis be lucky again?

On going forward, Mobis RoIC will be determined by 1) the growth balance of Module vs. Service parts.  (There is too little information to calculate RoIC separately, but service parts business has higher RoIC than Module business), 2) profitability expansion, and, again, 3) how much and how many of other group companies Mobis will have to buy.

One thing I am curious about is why Mobis does not lever up.  Its businesses are stable in nature and, in my opinion, it should increase leverage.  But then, I think will increase leverage only when it needs cash to purchase other group companies.  I can’t see Mobis increasing leverage and distributing cash to shareholders. *sigh*

Glovis

I do not have much complaint on Glovis’ historical return on invested capital except that it has carried too much cash on the balance sheet.  (I couldn’t understand why they bothered to list at all.)  But this is about to change with entry into pure car carrier business.  Currently Eukor Car Carriers does 100% for HMC and Kia.  This will change over time, and it worried me because PCC is a asset heavy shipping business and I thought it might be value-destructive business.

However, as you can see from below table, PCC business, at least the one Eukor carries out, is no an average shipping business, and is quite consistently value generative.  Initially, I thought it was because Eukor purchased vessels from Hyundai Merchant Marine more or less solely for Hyundai Motor and Kia that there must have been some understanding between the two.  But then, this is not something that is illegitimate.  In a sense, if this is illegitimate then all operational lease contracts are illegitimate.

Of course, there is no guarantee that Glovis will be able to operate as efficiently as Eukor.  However, given that it is an industry that is quite different from other types of shipping (there are handful of large OEMs in the world, and 6 PCC carriers dominate 2/3 of the market.  in a sense, it is a market of mutual understanding), I think PCC is a good investment for Glovis excess cash.

A few other points: 1) Glovis is the only company in HMG that has sizable overseas operation but has better financial results on consolidated basis than parent-only basis  2) Unlike companies in HMG web, there is no need for investors to worry about the risk of buying equity stakes in other companies for succession issue.  3) As my yesterday service parts example shows, due to its yet small size, there are many ways HMG can subsidize Glovis meaningfully.

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Notes for Hyundai Steel and Hysco: 1) Hyundai Steel 2009 RoIC is inflated as it sold 5% stake in HMC in Aug 28, 2009

Hyundai Steel and Hysco

I do not have much opinion for either of them.  I want to stay away from Hysco, but I think Hyundai Steel can be quite interesting.  However, I am not clear how material Hyundai Group’s help will be.  This is a very competitive market with international price.  The higher the transparency, the more difficult it is to transfer profit.  Then, I understand too little of steel business to say anything about either company.

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For Hyundai Capital and Hyundai Card RoIC is not relevant.  I will write about their RoA analysis some other time.

Hyundai Motor Group (Part 3) – Why Not Let Glovis have Mobis’ Service Parts Business?

One day it occurred to me that if I were MK Chung or ES Chung, I wouldn’t be too happy with the fast growth of Hyundai and Kia motors.  Succession is one thing that they have yet to figure out.  Companies like Amco, Glovis, Innocean are created to let ES Chung make money fast, but they are still relatively small.  They probably had had the best thing planned for Glovis, but after the 2006 prosecutor raid, Glovis’ moves became restricted.  As a result, ES Chung is not as wealthy as he was supposed to be.

On the other hand, I think Hyundai and Kia (and thus, Mobis) are growing a lot faster than they expected.  MK Chung was always aggressive and had high hopes for Hyundai Motor Group (HMG), but I think started rolling a bit faster than they expected especially with 2008 financial crisis.

As a result, the issue of how to let ES Chung inherit control over HMG became very complicated.  What should they do?  They can choose one or more of the below options:

• slow down Kia and Hyundai Motor’s growth momentum
• slow down Mobis growth
• grow Glovis (and Amco, Innocean, etc) more aggressively

They cannot really slow down Hyundai and Kia’s growth.  Not only it does not benefit the family (and MK Chung is that kind of manager), the growth momentum is partly pulled by market forces.  But, they can slow down Mobis’ growth.  At the end of the day, it is Hyundai Motor (HMC) which makes all the money, and decides which company will have how much.  HMC decides how much money Kia, Mobis, Glovis, Hyundai Steel, etc will make.  And they can certainly speed up Glovis growth.  It is already getting a lot of HMG’s logistics businesses.

Then, it struck me, why not give Mobis’ service parts business to Glovis? It is a golden goose business:  it is not sensitive to business cycle, but grows with HMC and Kia’s sales growth, and has over 20% operating margin.  This is how Mobis’ service part business works today: HMC and Kia negotiates price with the parts suppliers, Mobis pays them, collects the parts, and distributes to sales points such as HMC and Kia dealerships, repair shops, and retail shops.  Mobis insists that inventory management is key and they add great value by operating distribution center, to my eyes, this is a simple logistics business.  And isn’t Glovis the logistics company in Hyundai Motor Group? Also consider the following:

• HMG openly admits that it sold HMC and Kia’s service parts business to Mobis specifically to let Mobis make some money so that it can invest to grow module business, but now that Mobis module business has grown and that it is not capital intensive business, why does Mobis still need service part business?
• Glovis already does the “driving” portion of the service parts business in many countries.  It also operates “consolidation centers” for its CKD business and just don’t think it is a difficult business.
• It is not clear whether Mobis has exclusive right for service parts business.  I have asked Mobis, HMC and Kia this simple question, but no one can say if there is a written contract.  For example, it seems that it is assumed that Mobis continue to have monopoly right for HMC and Kia’s service parts business in Korea, but when it comes to whether HMC or Kia can contract another company for the business, no one can say “no.  it will breach the contract.”
• It is a golden goose business, but it is not clear at what price HMC/Kia sold these businesses or if it was sold instead of given or if there is even a contract for why Mobis owns this business in certain parts of the world.

So, really, why not?  What is the reason Glovis cannot buy service parts business from Mobis?

But then, I know I am crazy.  It cannot happen. It cannot happen because service part is 1/4th of Mobis’ consolidated revenue and 1/2 of operating profit.  (Used to account more than 2/3 of operating profit.)  Losing service parts business is a big blow to Mobis, and Mobis is a top 10 company in Kospi.  I am sure there is a good understanding between government/politicians and HMG that as long as HMG does it discreetly and as long as it does not enrage the incumbent government, HMG can help ES Chung establishing wealth.  (Because letting ES Chung having it is better than letting it end up in foreigners’ hands.)  But, a disruption of this scale is an invitation for trouble.  So, this will not happen.

However, Mobis can start by passing the running royalty it has been paying to HMC and Kia, which is slightly less than KRW 100B in 2009, to Glovis instead of keeping it for itself.  This is about 6% of Mobis’ 2009 consolidated operating profit and is material to Mobis, but there is no easy way investors can tell if Mobis is keeping it or giving it to someone else.   On the other hand, this is almost 50% of Glovis’ 2009 consolidated operating profit!

Again, because this is also too big, it cannot happen over night.  But I am sure such value transfer to Glovis will be there consistently, slowly and gradually.

201008 Idea Tracker

Made some progress on JGB and Hyundai Motor group issues.  Hyundai Motor Group writing is coming soon.

Japanese Unlikely to Intervene Strong JPY to Ease Government Debt Financing

So, now you know that I have liquidated my short JPY position, but I didn’t tell you the whole story.  Realizing that have not thought through all opposing arguments and thus have many big blind spots is not one reason for unwinding the position.  I put on the short JPY trade at around 85 JPY/USD because BoJ verbally intervened at the level in late 2009 and with Naoto Kan who mused on weaker yen as prime minister (though in precarious position), I thought intervention was likely.  So, it was a tactical position betting on government intervention, but I no longer think Japanese government will intervene.  Why?  Because strong Yen helps government financing their debt issuance.

There are two main reasons why JGB situation has been sustainable: deflation and high domestic saving.  The first makes JGB real return significant and combined with the the second enables high local funding.  However, as we have examined, domestic funding is likely to run out soon and when it runs out real return doesn’t really help.  When the savings rate is not going to go up (due to aging population), and when foreigners are unlikely to invest in JGB (because they don’t have same deflation expectation at their home and thus JGB doesn’t offer real return to them); asset allocation change is critical for funding JGB.  That is what raising deposit limits with Post Bank and mass market advertisements are about.

Strengthening Japanese yen solves the problem for Japanese government, because Japanese private owns a lot of foreign assets.  If you own a lot of foreign currency denominated assets, but if your own currency strengthens thus reducing the value of your overseas investment, what would you do? It depends on if the return on foreign asset is bigger than the devaluation of the foreign currency.  However, given the global low rate trend, and lackluster property/stock market, the chance of the foreign return being bigger than yen appreciation is slim.  Plus, aging population means that Japanese institutions gradually have to make more payouts than receipts.  So, Japanese private sector brings back foreign assets home when they see strengthening trend of JPY (not just one off strength), and the domestic asset allocation structure is geared toward more JGB investment and this relieves JGB funding pressure.

But, export is a big driver of Japanese economy and strong JPY hurts Japanese exporters, so wouldn’t the government have to intervene?  Not really.  Strong Yen helps Japanese companies for foreign acquisition which seems to be their new choice of growth in the face of sluggish domestic demand.  Also, I tend to believe (without hard evidence) that Japanese exporters were never really cheap labor based that those highly impacted by high JPY have already have factories in other countries.  And the aging population means more consumers and they are better off with strong yen, and these old people have voting rights when people below 18 don’t.

Besides, I tend to think that for a consumption geared economy like US, weak USD can help fixing problems by curbing import and giving temporary boost to export; but for export geared economies, weak currency makes their exporters, the backbone of their economy, lose competitiveness.  One of the reasons why Hyundai Motor Group makes good profit today is because the strong KRW phase of 2006-8 forced them to develop competitive cars.  Now KRW weakened they can get extra benefit.  Had Korean Won stayed weak, the companies would have gotten lazy and wouldn’t have developed competitive cars.   If you are in something for your life, you want to be the best no matter what.  You don’t want to delude yourself.

So, when faced with the question of helping exporters and helping themselves, I think Japanese government will rationally choose to save themselves in their trouble of public debt funding.  In my recent conversation with an investor, he said

The fact that the internal imbalances have gone on for so long tells me that we can wait until we see the change in household behavior before making the call that Japan is melting.

I agree with him.  But, I tend to think (though close to bullshit) that the change in government’s action will trigger Japanese household’s behavior change.  Significant effort to improve fiscal balance, such as actually doubling or tripling consumption tax, can suddenly waken Japanese of the danger their country is facing.  And each small changes of government behavior lead us closer to the point of significant change.  Taxi advertisement, magazine advertisement, Japan Post deposit limit increase, and open contemplation of consumption tax increase all lead us a step toward that point.  And if the government doesn’t intervene JPY/USD at 85 or below, I will take it as another sign of being closer to the point of the tipping point.

However, in the mean time, if I am correct and Japan does not verbally/monetarily intervene (the last monetary intervention was apparently in 2004, and left Japan with paper loss of 5T JPY), that means significant foreign asset repatriation by Japanese private and thus stronger Japanese Yen.  I don’t want to short JPY.

As per why is JPY so strong, I don’t know.  Maybe it is because JGB yield is getting less bad comparing to US treasury.  Maybe it is is because Japanese central bank seemed to less enthusiastic about quantitative easing than the Fed.  Maybe it is because Japan is in deflation.  Maybe it is the combination of all three.  See below graphs.

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By the way, while people often point out Japan’s net external creditor position as a reason for why Japanese government bond situation is sustainable, I disagree.  As we saw in the above graph, it belongs mostly to private sector not public, and as you can see from the below graph, it is tiny comparing to the size of debt.  Of course, Japanese government can seize private assets to pay for its obligation, or impose 100% inheritance tax as reader Warubo once suggested, but then we are walking into another territory.

<Update August 13, 2010>

Yesterday, a day after my post, Finance Minister came out and shows his concern over strong yen.  FT reports:

Yoshihiko Noda said at an unscheduled press conference late in the day that the ministry of finance was monitoring the foreign exchange market “with great interest”, and “would take appropriate action” while watching economic developments.

However, he stopped short of outlining any specific action, such as instigating high-level discussions with his G7 counterparts, which disappointed investors. Instead he said: “We are exchanging information on a working level with the US and other [governments],” which market participants said is normal daily procedure.

Will there be intervention?  Will there be not?  FT seems to think that instead of direct intervention, there will be BoJ-led quantitative easing to counter the yen strength.  I think it makes much sense.  Quantitative easing also helps debt financing.  Weak yen is coming, but not now.

In the mean time, FT Lex had a column that shares many points that I raised in the post.

Keeping Myself Honest

About a week ago, shortly after putting on the short JPY trade, I realized that nobody argues for long JGB in my circle.  This is not good because I don’t think I get quality position unless I think enough about opposing opinion.  So, I started asking friends/strangers if they could tell me if I am missing something.  Then, I struck gold.

Me: Have you heard of any good reasons for not shorting JGB?

DM: Deflation

Me: I know that.  And I know high savings, high local ownership, external creditor position, etc.  Anything new?  Anything I don’t know?

DM: The best explanation is always the simplest

I thought I have examined and refuted all the usual arguments, but have I?  Didn’t I subconsciously assume that these arguments are 2nd-rated and or stale and that, in the face of challenging funding situations, they are nothing but lazy excuses?  I couldn’t answer these questions.  It seemed that I put on the trade because 85 JPY/USD looked cheap.  That is not a good reason to put on a trade especially when the trade has more than a decade of history of burning investors.  So, I liquidated my position at small loss.

Then, yesterday, I had a chance to read what Louis Li wrote about Charlie Munger.

查理这种思维方式是基于对知识的诚实。他认为，这个世界复杂多变，人类的认知永远存在着限制，所以你必须使用所有的工具，同时要注重收集各种新的可以证否的证据，并随时修正，即所谓“知之为知之，不知为不知”。

但即使这样，一个人在一生中可以得到的真知灼见仍然非常有限，所以正确的决策必须局限在自己的“能力圈”以内。一种不能界定其边界的能力当然不能称为真正的能力。怎么才能界定自己的能力圈呢? 查理说，如果我要拥有一种观点，如果我不能够比全世界最聪明、最有能力、最有资格反驳这个观点的人更能够证否自己，我就不配拥有这个观点。所以当查理真正地持有某个观点时，他的想法既原创、独特，又几乎从不犯错。

What he is saying is basically that Munger says it is important to be honest about himself about what he knows and what he doesn’t; and the best way to define the competence boundary is to see if I can refute my argument even better than the smartest person with the best counter argument.  If I can’t my opinion is not worth holding.

It is a tall order, but something I just have to do.  In the mean time, I think it was right decision to sell the short JPY position.  But are my other positions worth holding?  Am I wasting my 20 punches?

When Warren lectures at business schools, he says, "I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all."

He says, "Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better."

Recap 201007

During the month, I started trimming Samsung Life, I added Glovis and Kia and I initiated Hyundai Steel and short JPY positions.  

There is no arguing that my Nintendo timing is wrong.  From the initiation of the position, I constantly questioned myself about the possibility of buying too early and many people told me I should wait until the next product launches.  I defied my own uncomfortable-ness and others’ opinion, but now I can see that for companies like this to it is not too late to ride the upside after the product is launched.  The early establishment of the position is driven by my ego and I am paying the price.

However, I believe that risk is not volatility but whether I will lose money within my investment time horizon, and in this respect, I am positive about my Nintendo position.  I wrote before (here and here) that I would be happier with Nintendo at 10-15% of portfolio than 20%.  I was going to trim the position in early July, but then I got distracted with some guests visiting (stupid, but unavoidable in one-man operation), and then the price became unattractive to sell, especially because the price has already moving to adjust for the June quarter result.  I will continue to look into opportunity to trim the position.

Glovis – I added the position in early July at 134,000, but didn’t add the position when the price corrected to below 120,000 in the mid month.  I generally do not feel comfortable adding position when price is falling for reasons unknown to me, unless it corrects over 15%.  This is likely to be a bull shit rule, and I was very tempted to buy more, but with the trend line in the graph broken (though I do not know how to read graph), I didn’t feel like buying into it.

Ultrashort JPY (YCL:US) – With my view on Japanese Government Bonds situation, I started a small position.  This is 2x levered short ETF.  I would have been a lot happier with unlevered JPY ETF, but that is extremely illiquid so I had resorted to levered position.  I do not see this position growing in any meaningful manner for another 6 months.  On the contrary, I think in the short term, strong JPY can precipitate more repatriation of foreign assets by Japanese people and institution, thus bringing even stronger JPY.  I.e. I think there is a high chance I will lose money (significantly )on this position for the coming 6 months.  And that makes levered ETF even worse instrument that I initially thought.  I really have to think through again about the timing issue.  And more importantly a better way to play JGB theme. 

Samsung life – finally it came to the price level I am willing to sell.  I sold about half of the position at KRW107,000 and KRW108,500.  I will continue to exit from the position.

Hyundai Steel – A new position that I think I should have as part of HMG holding, but I am uncomfortable to have on its own without POSCO short.  I initiated the position at KRW 92,200 and then doubled up at 108,000.  We will see what conclusion I come to.

Hyundai Motor Group – I still do the research.  I think there is chance that I will trim Hyundai Motor preferred, add more Hyundai Motor ordinary and Glovis.  We will see.

BP – I think I will exit the position in the near term.  I do not want to contaminate my portfolio with small positions that I know I will not grow.

Doubting the Sustainability of Google’s Dominance

I must have been smoking something when I wrote “Average life of companies in traditional industry is not that long either and the average life of internet companies are catching up.  That is what I think, but please let me know if I am smoking pot” a week ago.  When I wrote it I actually had Google in my mind.  I had subconsciously assumed that Google’s dominance in search is unchallengeable.  A week later, I am not so sure any more.  I think internet is still at its infancy that a few years out we will look back and laugh at ourselves the way we used internet.  As internet no longer start with Yahoo or AOL like portals, soon it may not start with Google or search.  I do think the average life expectancy of internet company is growing (at least for the survivors), but it is still a long way to go to match that of brick and mortar companies. 

Here I will list the major questions I have about Google, and also share my experience at an on-line start up that hit a jack pot then walked a very rocky road.  Your opinions are welcome, as always.

1. Has Google ever become dominant search provider when there was an incumbent local search provider?  Google didn’t come to dominant position in Korea, China, Japan, Czech, and Russia where there was a local search provider when it entered.  (FYI, Yahoo Japan decided to use Google search a few days ago.)  What does this mean?  Localization is the key for search?  Search site is a habit that is hard to change?  Or Google is just not competitive enough?

2. Is the search as we do it today at its best form?  Search improved significantly with Google, but I doubt it is the best it can be.  I am not only talking about better personalization and deciphering user intent better, but also about the way it is presented.  For example, search would have been nightmare if there was no “tab” function in browser.  (In that sense I appreciate the side window Bing provides.)  Google is great for now, but there are still many ways to revolutionize/greatly improve our search experience.  Maybe someone is already doing it in their garage and Wolfram Alpha is a delightful addition.  Also, can someone bring the leap in user experience as how iPhone wrote it again how phone interface should work? 

3. There was a time when Google got 100% of my search, but not any more.  Now, I go directly to Amazon for books, Tripadvisors and Travel Zoo for hotel, YouTube for video, E-Bay for buying random stuff, Cnet for software, and Spotify/iTunes for music.  I still search Google a lot, but much less than before.  The one event when Google still dominate my search is when I do it for work related research (Wiki and Wolfram takes more of this search these days).  I.e. Google has 100% share of my search activity when I am not searching to make a purchase, but Google’s share is declining fast for my purchase activity, and if I were an advertiser, I want to be with those sites that attract purchasers not just searchers.  Look at Bing.  though it is still very small, Bing is catching up and has higher share of ad $ spending than click share.  (Note: Google.com is not the only page where Google makes money.  It provides search function to other websites, and it has Adsense, etc.  Or I guess it can even sell search service.)

4. Internet advertisement is growing fast and Google is considered to be the unchallengeable super power here.  Many say that Google has best engineers, best computing power, biggest partner network, best datamining skills.  I doubt if the game is over.  If Google is so good, how come I have never encountered an advertisement that I wanted to click?  I’m serious.  I have never intentionally clicked one advertisement.  It wasn’t that I tried very hard to resist the temptation of clicking a very attractive/highly-relevant advertisement.  There was simply no advertisement that I wanted to click. 

5. There are so many Google products, I use 5-6 of them and I’ve heard of 7-8 but I have no idea what the rest are about.  I can give it positive interpretation: “Internet is so unpredictable.  With their engineers investing 20% of time invested in free projects, Google has high chance hitting the next jack pot.”  But, I can’t help thinking about the resources used to fund all these projects.  With so many diversification, how come there haven’t been another big hit?  Should I find comfort that because Google is diversified it will have the next big thing or is Google just losing focus?

6. I enjoyed Old Spice commercial on YouTube a lot.  Google Maps is indispensible for Open Rice website.  I don’t think P&G or Open Rice is paying Google money for their usage, but Google needs to cover the server cost, etc.  Is there any chance that Google became a dumb pipe? 

7. As an investor, I like companies that are focused on generating highest return to shareholders in a sustainable way.  The profit Google generates is not small in any measure, but are they doing their best?  Brin, Page, and Schmidt are the biggest shareholders of Google, but their interest is not aligned with investors.  My father told me once that “what you like is your hobby and what you are good at is your job.”  If you like your work so much that you do it in your personal time, I, as a shareholder, have no problem.  But if you bring your hobby to work, I have a problem.

I do not understand the logic of their pull out from China.  Who benefited from it?  Not even Chinese citizens who they care so much.  Why should Google develop alternative energy?  Why should all these services be free?  Google maps could have evolved (it still can) into many money making applications, but it just lies there for free.  If if the ability to see books online is so important to users search experience as Google says then people would have been happy to pay 50 cents to view 10% of a book for the relevant section.  Why is being free so important?  (Well, I have an answer for this.  It is partly that they wanted to give it for free, but also that people were less willing to pay and it was more difficult to charge then.  But, then the problem is brand image is as a place for free services..)

And this makes me wonder if Google will be able to monetize from the growing Android.  Will Google be focused on how to monetize from their development?  Or is Google’s focus collecting more personal data to think about how they can make Android users life easy?  They are related but different.

8. There are quite a few online services I am happy to pay, but I do not want to pay a penny to Google which does not know how to serve customer.  You know what I mean if you ever tried to get customer service from Google.  I bought 80G of extra storage space at $20 from Google early this year.  I am not complaining about the poor product description (that I can only upload files not folders).  After painstaking effort of uploading my files, I learned that my files couldn’t be downloaded for system error.  They were missing.  But all I could do was leaving a message in online user forum (because Google outsources customer service to self service forums) where there were already more than enough messages complaining about the same problem.  It took 2 weeks for a Google engineer to leave me a reply and another 2 weeks for him to solve it.   Until he leaves a reply on the user forum, all I can do is to wait.  And even though I demanded refund each time I left message, he just ignores that part.  Nothing can be done or contacted.  The lesson was that I wouldn’t pay a dime to Google if a service or product is offered directly by Google.

9. One of the most interesting change Google brought to me is my attitude toward Microsoft.  I not only don’t hate Microsoft as much as before, I now even secretly support it to be a credible competitor of Google.   Part of this is pure human psychology, but part of it is because I really need good alternative.  Naver is my first choice for Korean search and Baidu is for Chinese search, but when they don’t get me what I want, it is nice to have Google to fall back to.  I don’t have that option when I do English search.  It sucks.  One evidence of big change in my attitude is smart phone.  I waited for a long time to buy a good Android phone.  I thought it would be available by this summer, but it seems like I will have to wait for a bit longer.  Then, I saw Windows Mobile 7 phone.  Windows based mobile phone is the last thing I wanted to have, but when I saw the video, I decided I will scrap Android and get Windows 7 phone.  Whereas Android is still only iPhone me-too that is not as good as iPhone, Windows Mobile 7 looks better and different.  Most importantly, while Microsoft brand is still ugly but not as ugly as it used to be.  That matters a lot when you do consumer business.

<My first hand experience at an online game company>

All these questions and what I read in Googled remind me of what I saw at a Korean online game company, where I interned about a decade ago.  I joined them just when their first game became a smash hit.  The game was well made, but more importantly the company re-defined how game companies make money.  It was a revolution in that world, and the company became the place to work for top game designers and engineers.  The company provided “playground” for computer geeks.  The founder/CEO was an engineer himself and he understood what they wanted.  A lot of freedom and authority was given to engineers and there was not much deadline, fixed working hours, cost pressure or any formality.  One of the top engineers proudly told me that he doesn’t work more than 2 hours a day.  (He worked more than that, but he did played a lot.)

My job was to assist them in expansion to web community business, but the business didn’t seem to have much plan or future, and I couldn’t understand why they were spending so much money.  Then, one day, one of the top management confided with me and said “why not?  it is going to burn only a couple of billion won a month.  it is not too much.”   The company grew too fast and got more money than it can handle.  It was a huge organizational chaos.  But nobody criticized them.  I didn’t either.  It was the hottest company in Korea.  Who am I to criticize them?  In fact, such chaos was considered their strength and people tried to learn from them.  For engineering company, you need to attract the best engineers and this is how you do and let them be creative and motivated.  

The year I joined (2000), was the first year they turned to profit.  Comparing to 1999, revenue grew 10x and OP margin was 45%.  Between 2000 and 2004, revenue, operating profit, and free cash flow all grew by c.300%.  It became even hotter company to work for for engineers, but many of the core people started leaving to start their own one, or to retire with stock option, or because they came to dislike the ever bigger organization.  I.e. there were less driven people and more “attracted to its success and glamour people.  CapEx grew to buy more servers and to move to better office, and development cost swell.

However, it failed to bring another hit product.  They spent more money, hired more expensive engineers and designers, and developed more games, but no hit.  Between 2005 and 2008, revenue didn’t grow, profit declined.  Most of the free cash still came from the old hit game that they made that have been in decline.  They were lucky that that old game was so addictive that it still provided much cash to support the bloated organization.  Then, in 2009 finally it made another hit product.  Revenue doubled, profit quadrupled, and free cash flow by 20x. 

Was this rocky road unavoidable?  Should I think that they could have another hit product because they had relaxed engineer-centric culture?  Or, would the company and its shareholders have been better off if it was more disciplined?  (Actually, I haven’t looked or contacted the company for 5 years and it is possible that the company’s culture and operation changed since then.)  I remember reading something like “Is Google’s culture praised because of their success or is it praised because it is a great culture?” in Googled.  I have the same question for this game company I worked at.

How Will Japan Fund Future Government Bond Issuance?

Since FY1995, Japanese government has net issued about JPY 25T of bonds every year and between April 2010 and March 2011, the government plans to net issue JPY 33T worth of bond (JPY 44T gross.)  However, where will the extra funding come from?  Well, looking at the above picture, the first thing that comes to mind is let banks to buy more JGB.  Comparing to insurance and pensions or to Japan Post, banks’ asset allocation to JGB is relatively low.  Also, given the close relationship between banks and MoF in Japan, MoF should be able to persuade or direct the banks to buy more.  However, this does not seem likely.

First, Japanese banks already have more government bonds than other banks.  European banks on average has about 5% of their assets in government bonds, and Greek banks have about 8% of total assets in Greek government bond.  Also consider that the coming Basel rule change is trying to make banks to have about 8% of assets in cash and government bonds.  Well, Japanese banks already have double that amount voluntarily!  (Note: I do not know why BoJ Fund of Flow data and Japan Bank Association data have such big differences.  I think fair value vs. at-cost accounting is one of the reasons, but I don’t know.)

Second, it seems that instead of increasing JGB holding Japanese banks might have to reduce their asset allocation in JGB.  Economist reports:

Kazuto Uchida, chief economist at MUFJ, says he has briefed the government of Naoto Kan about the pressures the banks will face to diversify their assets. …

Mr Uchida notes that under Basel 2 bank-capital rules there are so-called “outlier criteria” for banks with a heavy exposure to interest-rate risk, such as the Japanese banks. This will eventually limit how many JGBs the Japanese banks can hold. Under a stressed scenario in which JGB yields move up or down by two percentage points, the loss the banks would suffer must not exceed 20% of Tier-1 and Tier-2 capital. That would be a big move in yields but, if market sentiment turns, a perfectly possible one. Mr Uchida says Japanese banks are currently well below the 20% threshold (MUFJ does not reveal its level; Mizuho put its at 8.5% in March 2009). But if they continue to increase their holdings at the current pace, in a number of years they may exceed it, Mr Uchida says.

On the other hand, GPIF, the public pension fund was a net seller between April 2009 and March 2010 and is likely to be a net seller on going forward.  Foreigners are unlikely to be a buyer.  Other (financial and non-financial corporate sector, government, fiscal loan fund, and other) is other and I think difficult to move much.  So, unless Japan wants BoJ to print, that leaves MoF household.  Or raising taxes and cutting spending. No wonder unconventional measures are taken/discussed:

• Ministry of Finance put advertisements on taxis (Aug 2009) and magazines (June 2010) to persuade average Japanese people to buy more government bond. 
• Japan Post reform is getting reversed and it is proposed to double customer deposit limit at Post Bank to 20 million JPY and Japan Post Insurance maximum coverage to 25 million JPY (source)
• Consumption tax increase (LDP proposed doubling it from current 5% to 10%) is discussed and seems to get public supporting when economy is dull and there is deflation(source)

Well, as you can see from the below calculation, even these desperate measures is likely to earn Japan only a few more years.

And there is a bigger problem.  It seems that by 2015, there will not be enough Japanese household financial asset to cover Japan’s public debt, even when you assume the savings rate will stay at 2.2%, which is unlikely.

All these point that Japanese government is in deep trouble and aggressive movement from BoJ is inevitable.  The prime minister Naoto Kan (though he may have to step down soon) tried to make BoJ to set inflation target to make BoJ when he was finance minister.  The Your Party is aggressive in making BoJ to target inflation to get Japan out of deflation.  BoJ plans to introduce 0.1% loan for banks if they lend it to certain growth sector.  (I haven’t been able to find report of implementation)  With the understanding of fiscal constraint and the importance of getting out of deflation, the general direction seems to be demanding BoJ to do more.  Well what can BoJ do if it has to do more?

Betting short on Japanese government’s ability to fund is not easy.  Many money managers lost money on the trade in the past decade(s).  Not few investors (including myself) talk about JGB today, and their investment thesis is not too different from their predecessors.  If any, the situation surrounding Japanese government’s funding ability has gotten worse.  Debt/GDP, interest payment/Tax receipt, age of population is all higher and deflation persists.  Yet, JGB yield is lower today than anytime in the past.  Through the years, short JGB trade became death trap for traders.  (And, Japanese Government Bond credit rating, which was once lower than Botswana’s (which seems fair) has actually improved in the past decade!)  That is why I haven’t initiated a position even though every time I look at JGB, I come to negative conclusions.  (Please read my other JGB posts)  But I have initiated a small short JPY strategy recently.  As an individual investor, I cannot buy JGB CDS.  I will examine Japanese bank puts and US treasury shorts.

I just cannot help but to think that some day down the road, we will look back and wonder “what the hell were we smoking thinking that Japan can go on like that?”  Japan is the black swan.  Japan singly changed the way we think about sovereign debt.  We learned to consider domestic saving rate, domestic ownership of government bond, deflation (0.5% 2-yr JGB actually has real yield of c.1.5%), citizen’s risk-aversion, local currency denomination, private sector deleveraging, presence of big domestic institution buying government bond, etc.  (And, I think the reason Italy was largely saved from the PIIGS debt scare this year is (more than) partly because Italy has high domestic saving.)    So, we learned from Japan to think of sovereign risk more benignly.  But what if Japan gets into trouble?  What will that teach us about how we should think of the sovereign risks of US, UK and many other countries?

And, let’s be honest.  Japan is not okay.  The situation doesn’t make any sense.  Japan’s private and public sectors have debt of 460% to GDP.  In the year to March 2011, the Japanese government has JPY 92T budget of which JPY 37T is to be financed with tax revenue and JPY 44T is to be financed with borrowing.  And when average interest rate is only about 1.5%, Japanese government spends more than 25% of its tax revenue in paying interest.

<Reference: Historical Credit Rating Change of Japanese Government Bond>

See here for what each company’s rating means.

<Reference: Japan and Consumption Tax>

Raising consumption tax rate is interesting.  According to OECD, Japan’s tax to GDP ratio is one of the lowest in the rich world but with one of the highest corporate tax rate and lowest consumption tax rate.  So, raising consumption tax seems to be a now brainer for Japan, but Japan has never succeeded tax reform.  Yet, though it might not rise immediately, it seems there is political consensus and public understanding about the need for consumption tax rise. (source) 

Internet and my Changing Behavior

“An eight-year-old today sees the internet with about as much fascination as you see the toilet” is what the Segway inventor said.  I am somewhere in between.  I am the generation who learned BASIC as a kid and connected to Telnet with 14.4K connection (darn, when 56K became available it felt like light speed!), and went exuberant with Netscape Navigator.  I also stayed quite close to internet start-up boom of late 1990s.  I was a member of university computer club and a bunch of friends went to work for or start a start-up helped.  I interned at a successful on-line game company for a few months myself.  That’s all good memories.

Anyhow, cutting to the chase, my attitude and behavior toward internet has changed greatly over time and especially in the recent 2-3 years:

I prefer clean services.  Hulu, Vevo, and Spotify are my favorites.  Being in HK, I had to utilize my friend in UK for Spotify access and set up VPN for Hulu access, but well being geeky I found the effort worthwhile.  Grooveshark is a good service, and I enjoyed it very much but not only it has buffering delay, but there are just too many same songs in search result.  I much prefer to listen to the advertisement and use Spotify.  Same for YouTube and Vevo.  I can’t get explicit version songs on Vevo, but at least it will give me one good quality music video.

I lost my appetite for owning media files.  I collected cassette tapes, then upgraded my collection to CDs then ripped all my CDs to mp3s.  Until recently I bought many songs (either mp3 or CD), but I downloaded more songs illegally than I bought because there were more songs that I wanted to own than I wanted to pay.  (Funny but so often even $0.99 doesn’t look that cheap.)  But with Spotify Premium, I really find no reason to own songs.  The good thing about Spotify is that it stopped me from downloading illegaly, but the bad thing about Spotify is that it also stopped me from purchasing music at all.  I am a big movie fan and I own many real DVDs but I don’t think I will buy anymore because when Netflix becomes available in Asia what’s the point of owning it?  It saves me storage space and it is always available.

I am happy to pay.  I am one of the last person who would pay for online stuff.  Maybe there is something between being geeky and being misery, but I was big fan of Warez sites and P2P file sharing.  We often say illegal downloading is to save money, but honestly as an ex-illegal downloader, it is much more about hobby, habit, and verification than money.  I still do occasionally (will I be busted for writing this?) but mostly I would just pay.  There are many factors, 1) the value of my time is higher 2) search has improved so much that it took away the fun of searching for illegal version 3) files became very cheap, and 4) i am getting old.

I can be small individual investor all thanks to internet.  It is really Wikipedia, Google, Skype, Reuters Knowledge, Bloomberg that let me be today.  Without them, I couldn’t have been a small time investor seating in Hong Kong investing all around the world.  Information and communication was expensive before internet.  My operating cost would have been easily 20-30x more that what it is today and I couldn’t have afford it.  True, that big institutions also use all these internet services, but I, as an individual with small capital, got a lot more benefit than them.  Internet has really closed the gap between the rich and the poor.  It is democracy.

Internet is the biggest enemy of my productivity.  2 big decisions I made 7 years ago really boosted up my productivity: throwing away TV and throwing away MSN and Yahoo messengers.  Without TV, I read more and without instant messengers I concentrated better at work.  Recently I also dropped push e-mail service because it disturbed my sleep at night.  Internet is an indispensible tool for me for work.  Without internet, I cannot find the information that I want.  But at the same time, it is so easy to be distracted on internet.  I started downloading all the information I need first, then block internet with Freedom software.  It is not that good because often I have to search internet in the middle of work and then I have to reboot my computer, but it is still thousand times better than not having one.  I am seriously considering using parental control on myself to block off a few sites.  But what should I do about Wikipedia?  I love Wiki, but it is just so easy to read one more article…

Privacy worries me.  I shared a lot on internet when it was small.  Maybe because I was young, partly because other types of communication was expensive, but I did have big online life.  But today, search has become so easy, I don’t want to put anything personal on the web.  I am not on Facebook, don’t have personal Twitter, and even hate putting photos on Kodak Gallery or Picassa.  I do try to be updated and borrow my friends account to surf those sites frequently but I have little desire to use it myself.  In one interview, Facebook’s Zuckerberg was asked about the privacy setting controversy Facebook caused, and he said something like “people’s perception of privacy will change over time and in a few years we will wonder why we tried so hard not to share those things online”.  I do think he is right, but for now I am happy to be what I am.

Predicting the future of internet business is still very tough.  I used to love Yahoo directory, Alta Vista, AstalaVista, AOL and Napster. I don’t use any of them.  It is Google, Bit Torrent, Spotify that I use.  But then even iTunes that looked very promising last year doesn’t look that promising this year with Spotify.  Will Spotify, Google, Facebook, Groupon be as hot next year?  I don’t know.

I don’t think I will stay away from technology stocks as Warren Buffett did.  I often think that, growing up with internet and being semi-geek, I should be better than the 70-year-old Buffett in understanding internet.  But I know this is bullshit and pure over-confidence.  Yet, it is just difficult to drop it.  I think one thing has changed.  If a stock will perform well for 5 years then miserably for the next 5 years, should you invest (either long/short) or not?  Average life of companies in traditional industry is not that long either and the average life of internet companies are catching up.  That is what I think, but please let me know if I am smoking pot. 

I think I will invest with companies that give productivity boost.  But then, this is not really a sure answer either.  I owned many Palm Pilots, Clie and i-Paq in the late 1990s and early 2000s.  They were productivity devices and once I had them it was impossible to live without them.  There were not many apps but I downloaded many of the few available.  But none of them look that promising today.  Well, they were way expensive at $4-500 per piece, but isn’t iPhone expensive?

Oh, one thing that I haven’t changed is I prefer reading paper.  I do read many things online but I like the freedom of scribbling on the corners of books and papers as I read.  Until the day they let me do that on e-book, the cool looking iBook is not much use for me.