Monday, 29 September 2014

A not so #disruptive lunch? Disintermediation, integration and maintaining a cadre of thinkers in a changing world.

Sometimes a disruption comes in different forms and a lot of times as I've said previously it can take the form of a slight tweak on conventional thinking. Thursday's disruptive lunch at BBY (twitter: @BBYltd) in Sydney was rather dichotomous in that it presented us with a truly radical disruption in the form of a Bitcoin pioneer and an old world firm that was looking to transform itself by acquiring disruption by acquisition.

When Ted Pretty stepped up to the podium at last Thursdays Disruptive Lunch at BBY, he looked like anything but a disruptive force in Australian business. In fact, Mr. Pretty looked like your favourite uncle taking a break from tinkering with machinery in the garden shed just long enough to lecture you on some esoteric subject. Instead of 30mins on the virtues of a good torque wrench and lawn mower maintenance we got an insider look at the reshaping of Hills Ltd. (ASX: HIL).

For my non-Australian readers Hills came to prominence in Australia on the back of the post-war housing boom with its ubiquitous Hills Hoist clothes line. Every house seemed to have one and this enabled Hills to prosper and grow into a conglomerate centred around various products that leveraged   the metal fabrication core that drove the company. Today Hills is a much different beast and Mr. Pretty went through his management team's current thought process:
  • Economic numbers in Australia are of concern and likely to point to a downturn in the next 18months. Given this the challenge for Hills is to decide whether to buy bolt-on businesses now or wait for the economic cycle to reduce the entry cost of such acquisitions
  • Focus on security and health as these sectors are growing at 6 - 8%  per annum. The investment case is compelling with the demographics of an ageing society being the main driver. Security leverages similar metrics with some extra twists (see below)
  • On the "hardware" side margin compression remains the one constant. Race to the bottom requires a shift to value-add via back-end software enhancements and a move into smart overlays to connect the on the ground sensors
  • Security is the ultimate disruption concern for the world. This divides up into the now well-documented areas of terror, global crime, social behaviour and economic terror 
  • The challenge for Hills is to leverage their existing "foot in the door" and increase the revolving revenue stream possibilities
  • The business is already in a better position to track product trajectory by knowing more than what and when they sold a product, but also to know where in the cycle their customers are and therefore offer appropriate upgrades and replacements
The central logic of all this seems hard to argue with within the Australian context. It helps to know that Mr. Pretty spent a significant period at Telstra Australia during the transformative 1997 - 2005, so has the advantage of being involved in a business that had to change from hardware to software if it was going to grow. At the moment I got the sense that Hills is still struggling to lift what I'll call "add-on" revenues, though I haven't dug into the numbers and the full scope of the businesses they've been buying. If I understood correctly (and I'm happy to get feedback on this) "services" revenue is at about 10%. While Mr. Pretty didn't give us a target number on where he wants this portion of revenue to go I got the sense his ultimate goal with Hills is to turn the business into a consultancy of sorts. Looking at my notes, I wrote down: Does Ted Pretty want to be Louis Gerstner? Of course, Gerstner is famously credited with saving IBM by turning it into a consultancy based business during his period as CEO. Given that Pretty was at Telstra when Gerstner took an axe to IBM the chances are he's well-versed with the play book. The trouble is its an easy strategy to understand, but a hard one to pull off as it relies on buying the right businesses at the right time and cutting old product lines to finance the transformation. IBM got rid of the PC business to Lenovo because of margin compression, Hills probably still has a few businesses that could go out the door in a similar fashion. Ted Pretty and the team have some challenges and look determined to execute. I have no view on the stock price, but I like the idea as an investor that Hills is of a size that makes it easier to monitor the various acquisitions, divestments and the effect on the balance sheet. Think about it this way, if Google buys a $5bn business it's a bit like throwing a stone in the ocean, the effect is minimal and hard to see. If Hills buys a $10m business, it's likely to have an effect that is far more observable.

Zhenya Tsvetnenko is the Executive Chairman of Digital CC Ltd (ASX: DCC) which styles itself as a Bitcoin-centric business offering various services to companies and individuals who want to participate in the Bitcoin currency. I think this was one of those rare occasions at events such as this where I gave up taking notes as I struggled to get my head around the Bitcoin world. Essentially I'm still running to catch-up with the likes of Mr. Tsvetnenko, but here's where I am.

Bitcoin is a digital currency invented (if that's the right word) to dis-intermediate various financial institutions from transactions involving two parties. Consider this; you contract to buy a product from a producer, but in order to complete the contract you pay a fee to at least one other third party to facilitate the movement of the agreed consideration between the two of you. That fee may be in the form of the banking charges on your accounts, a credit card fee or some other charge added by a wire transfer service. The value-add by these groups is minimal to the contract itself and therefore in the world of Bitcoin is a cost that could be reduced at a minimum, or better still eliminated. To accomplish this the inventor(s) created a cryptographic protocol that essentially awards Bitcoins to those working to administer the system. This is called mining. The protocol throws off about 25 Bitcoins per hour and is bounded by an upper limit of 21m Bitcoins. Now this is where it gets fuzzy for me because I think as Bitcoins are produced is gets harder to solve the encryption and it costs more and more to be a successful miner because the amount of computing power you need to participate expands continuously. It's kind of like an arms race. In the meantime part of the mining process is the administration of the public ledger. Every Bitcoin transaction is available on the ledger. That means you can trace the exact owner of each bit coin (or fraction thereof). Having said that, the transactions themselves are anonymous, so prima facie you can see where central banks and governments might have a problem with this. The upside, of course, is complete control of the money supply making it inflation proof (given the upper boundary), because unlike fiat currencies issued by Fed, ECB, BoE, etc. Bitcoins can't be produced ad infinitum. For mine, it's like being back on the gold standard when it was at its strictest.

Readers of this blog will know my concerns regarding the current fashion for QE amongst central bankers, and this is in essence what Bitcoin is trying to solve. Bitcoin in a way is the ultimate answer  to an ageing world where the biggest risk the individual has is that he or she wakes up one morning to find the cash they have in their bank accounts is worth progressively less. It's not as though we haven't seen this phenomenon before. It's only a few years back that Zimbabwe's central bank decided to keep the printing presses rolling until the currency was worthless. For me, Bitcoin is the synthesis of all my own and many other investors most neurotic concerns about the global monetary system. That doesn't make it a bad thing, rather it shows once again that man is extremely adaptable to his environment when challenged by even the most disruptive events. The key is hopping on at the right time.

When Zhenya Tsvetnenko finished his presentation, I looked over at Ted Pretty to see his reaction. I think like me he was still trying to take it in. I know at least one of his team was there and is very pro Bitcoin, so I'll guess he had the basics already, but answers, well that might be a bit more difficult. It's hard when you've got a business and business plan that you see as transformative to consider that there's even bigger forces at play that might even scupper your best ideas before the ink is dry on the contract to complete a transaction. It's happened to me, and I'm betting it's happened to most of my readers. Buying a copy of "Bitcoins for Dummies" probably isn't going to be enough given the various vectors that could influence the course your investments might take. You can't get a bigger brain overnight, but as always you can choose to confront the change rather than ignore it.

Generally CEO's have a pretty high opinion of themselves. Why shouldn't they, especially where the profits and growth match the hype? I saw this on my twitter feed over the weekend, and I responded as follows:

It seems somewhat nonsensical to worry about future growth when your most successful tactic has been to cut deepest fastest since the crisis. I've always been a fanboy of Caterpillar, a company who responded swiftly and effectively to the downturn, but even they reached the limit of what's possible under this plan. Consider this, if your company is being driven by a top-down strategy of "shrink to grow" should you be surprised when those executing the shrink part have lost the ability to respond when and if the J-curve comes?

The surprising thing to me is how often I've heard that whole departments at banks no longer exist, mainly because they're deemed as unprofitable because of the volume or regulatory capital required to operate them. It reminds me of armies post-WW1. The defence establishments caught most on the back foot by 1939 were those that essentially eliminated their cadre of further leaders. I'm already seeing the first signs that the investment banking world is fighting back against its own establishment. Take last week I had several meetings and teleconferences with individuals displaced from financial institutions looking at a way of reconstructing business lines at a lower cost. I wasn't surprised to hear that in my favourite financial sector of Peer-to-Peer lending that investment bank Jefferies had successfully securitised part of a company's loan book. It seems funny, but also logical to me that even though P2P was supposed to dis-intermediate banks that what it may have, in fact, created was an opening for the potential losers to become winners again. I don't know the securitisation team at Jefferies, who did this deal, but I'm sure that they understand the lifeline that they've been thrown. Recently I looked at a similar type of use for the loan book cash flows of a P2P lender and came to the conclusion, that someone would have to step-in to scale the returns to facilitate the growth of the business.

Finally, I've spent a lot of time in the last week considering the CalPers decision to axe hedge funds from its portfolio. On the face of it, I bet whoever it was at CalPers who finally pulled the plug would say it was the easiest decision they ever made. That to me seems very short term thinking and is designed to hide their own underperformance. Consider the current environment. We have ultra-low volatility in nearly any market you care to contemplate. Add to that a huge limitless put option sold by central banks via QE. How then does a hedge fund manager differentiate him or herself and produce alpha?

It's interesting to consider the correlation between HF performance and volatility. On one hand volatility is often seen as a "dilutor" of performance while on the other hand it opens up the ability for funds to express themselves through situational developments. If an index such as the S&P 500 experienced mild volatility (+/- 1% per day) for an extended period I would bet on Alpha returning. Therefore if like me you're watching as the Fed and the BoE turn from doves to hawks you'll no doubt be considering the return of volatility, and the likelihood for renewed differentiation amongst investment alternatives.

As to the question of HF fees, it seems that funds will need to adapt to the new environment by openly auctioning their capacity to investors. They should drive fees  and salaries down, but produce more efficient and sustainable winners.

CalPers may have surrendered to the "shrink to grow" strategy at the very moment the cycle was turning and in doing so may have released the cadre of professionals they'll most likely need in the coming years. Those let go will be free to create their businesses that will ultimately disrupt the behemoths that once were their employers. I think Mao may have put it best in considering his own problems running a nation as vast and complex as China:

Letting a hundred flowers blossom and a hundred schools of thought contend is the policy for promoting the progress of the arts and the sciences and a flourishing socialist culture in our land. Different forms and styles in art should develop freely and different schools in science should contend freely. We think that it is harmful to the growth of art and science if administrative measures are used to impose one particular style of art or school of thought and to ban another. Questions of right and wrong in the arts and sciences should be settled through free discussion in artistic and scientific circles and through practical work in these fields. They should not be settled in summary fashion. 
(On the Correct Handling of Contradictions Among the People, February 27, 1957)


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