Weekly Thoughts


Weekly Thoughts: Quitting Finance, Italian Socks and High Grading


Here are three things that caught our eye this week:

Quitting Finance

Although financial markets have largely recovered from the Great Recession, the debate over the financial industry’s utility to the economy at large continues. While clearly financial institutions and markets play an important role in every economy, the question is how big that role should be. From a recent article in the Economist:

“A recent paper from the Bank of International Settlements, the central bankers’ central bank, concluded that ‘the level of financial development is good only up to a point, after which it becomes a drag on growth.’ Note that [this objection is] not the same as the argument, familiar from the crisis, that individual banks are too big to fail (or TBTF). This approach is more akin to the idea of the ‘resource curse’ that economies with an excessive exposure to a commodity, such as oil, may become imbalanced. Just as the easy money from drilling for oil may make an economy slow to develop alternative business sectors, the easy money from trading in assets, and lending against property, may distort a developed economy.

With this debate in mind, we have been following General Electric’s recent restructuring initiatives with interest. Earlier this year, G.E. sold most of its financial arm, the aptly named G.E. Capital, in order to refocus on its core industrial businesses. The sale is notable given the considerable role G.E. Capital has played in the success of the company over the last three decades. Spurred by the arrival of Jack Welch in 1981, G.E. Capital grew almost twice as fast as the overall company and expanded into every corner of the financial marketplace. An article in the New Yorker highlighted this growth:

“G.E. Capital had a couple of advantages. Because it was not officially a bank, it faced less regulatory supervision. And, because G.E.’s industrial businesses still generated steady profits, the financial arm operated with a pristine triple-A credit rating. (Most big banks are a notch or two lower.) That meant that it could borrow money more cheaply than its competitors, which made its lending highly profitable…By 2000, financial services accounted for more than half of G.E.’s revenue. Even after Welch retired, in 2001, finance remained crucial. By the middle of the decade, it was responsible for about half of G.E.’s profits.

Of course, the focus on finance came at a cost. Overtime, corporate resources were increasingly diverted towards the support of the finance arm, which caused R&D spending as a percent of sales to plummet. Indeed, in many ways, G.E.’s experience was symbolic of a shift in the economy as whole. As Vijay Govindarajan, a management professor at Dartmouth notes, “financial engineering became the big thing, and industrial engineering became secondary.”

Moving to the present, as regulation and capital requirements for financial institutions have become more severe, G.E. Capital’s growth trajectory has flattened. This contrasts strongly with a more promising backdrop for American industrial manufacturing. Again from the New Yorker article:

“American manufacturing was decimated during the first decade of this century, with six million jobs gone, and it was easy to believe that manufacturing was a lost cause. Yet it still accounts for more than two trillion dollars in output, and American factories are still among the most productive in the world. What’s more, energy costs here are falling, and labor costs abroad are rising. Suddenly, the U.S. seems like a reasonably affordable place to make high-end products, like G.E.’s jet engines and gas and wind turbines.”

We think the restructuring of G.E. could represent an important shift in the evolution of the domestic economy. A refocus on capital spending and R&D could have profound trickle-down effects to other businesses and industries. We’ll be interested to see if this shift away from finance is a sign of more such change to come.

New YorkerEconomist

Italian Socks

This week we learned about 55 year old Sandro Veronesi, a billionaire Italian businessman, from an FT exposé. Given the nature of the publication and the country in which Veronesi lives, we admit to initially assuming he amassed his wealth in finance or high fashion. As it turns out, Veronesi became a billionaire in a much less flashy way. From the FT:

“Veronesi understands socks. Socks and stockings have made him a very rich man, his net worth estimated at nearly $2bn in this year’s Forbes World’s Billionaires list. [His company], Calzedonia, which started with a small store here in the middle of Verona, can be seen in virtually every high street in Europe and the brand is beginning to make inroads in Asia.”

We are always eager to study the paths of successful professionals, particularly those with unconventional paths. Veronesi’s career, from a small store in Verona to world-wide hosiery domination, certainly qualifies:

“[H]is first job in 1984, following a degree in economics and commerce at the University of Verona, was for Golden Lady, then the world’s leading manufacturer of tights, or pantyhose. ‘It was a different time,’ he says un-nostalgically. ‘We would supply wholesalers and they would supply specialist shops…It was very traditional…We would go to visit a wholesaler, say in Napoli. We would go out, have a very long lunch, mozzarellas, wine. We would reach an agreement. And then the client would pay with a cheque that was postdated by six months, nine months. They were financing themselves by delaying their payments.’

Liberation came following a visit to London. ‘I saw these new kinds of stores: the Body Shop, the Sock Shop, and I thought to myself, I can do that.’ He opened his first branch of Calzedonia in 1986. It was, he says, a moderate success…’I didn’t know anything about retail. But I began to understand that a good location was very important, even though it cost more.’

For the next few years, Veronesi devoted himself exclusively to his new project. The old business model was defunct, he concluded. He verticalised his operation, putting the company in charge of manufacture, distribution, retail. Everywhere he turned, it seemed, there were gaps in the market. Swimwear: ‘There were the great brands, which were very expensive, and the very cheap ones, which were not very nice.’ Underwear: ‘There were beautiful luxury products around. But underwear is not like a watch, or a jacket, or a jumper. It is hidden. No one sees it. And you have to wash it every day. Why would you spend €500 on it?’

Using his new model, Veronesi has gradually built a business empire that now consists of multiple brands, and reported consolidated sales in excess of €1.8bn in 2014. Reflecting back on his decades building Calzedonia, Veronesi highlights something rather surprising, the frequency of his errors. “‘[I fail] continuously’, he says, ‘the important thing to remember, if you are trying something that is an innovation, is not to think too much about it. Because if you take too long, by the time you get there, the world will have changed. You take a risk, and if it doesn’t work, you make a change. We are not betting our lives on it.'”

Given Veronesi’s successes, an entire book could be written on his business savvy. For us, Veronesi’s story provides two valuable lessons. First, we should never assume that any given industry structure or dynamic is static. Second, those who see potential where most see status quo, and have the courage to take a risk, can reap sustainable outsized rewards. We search for overlooked potential daily, and strive to make challenging the status quo a central tenant of our business.


High Grading

Some of the most interesting and potentially profitable opportunities arise from an investigation of second-order effects. In the case of crude oil, one simply has to look at a chart of collapsing rig counts to understand that oil companies are re-thinking their production profile with prices near decade lows. However, as a recent Bloomberg article highlights, the knock-on implications of this adjustment can produce profoundly different results for different communities depending on the wells that happen to be nearby. Karnes City and Smiley are great examples. Both are towns in Texas that until recently were humming with drilling activity. From the article:

“For the townspeople of Karnes City, it’s like nothing ever changed: Roughnecks pack into Stripes gasoline station by the dozens to load up on Doritos and Slim Jims at the end of their shift; giant drilling rigs dominate the horizon in all directions; and the roar of tanker trucks and industrial machinery is never-ending. Up the road in Smiley, there’s nothing now. No workers in the fields, no rigs, no noise.”

The two towns have dramatically different outlooks because of the manner in which many oil drillers have chosen to adjust production. Rather than cut across the board, they have chosen to mothball less productive wells while at the same time driving production higher at their best sites. The strategy, called high grading, results in lower costs and production that in some cases has actually increased year over year. Again from the article:

“In North Dakota’s Bakken region, Hess managed to boost its output by 6 percent to 108,000 barrels a day in the first quarter by ramping up drilling in the best spots at the same time it idled five rigs in costlier sections. Greg Hill, Hess Corp.’s chief operating officer said, ‘We’ve collapsed to our core and said things outside the core, we’ll save for a later day…’ In all, drillers have taken down 941 oil rigs across America since the peak in October. That’s 58 percent of the total. And yet U.S. output is forecast by the government to rise for a seventh straight year in 2015, underscoring the powerful effect of high-grading.

We believe this is an important development for three reasons. First, studying how management teams respond to adverse business environments can provide valuable information if we are ever in a similar position. Second, the influence of high grading on different players in the market reminds us to always try to think a level deeper when analyzing the impact of a particular event or trend. And finally, when considering the oil market itself, high grading and other strategies being used by drillers to save production for the future suggests that a move back to summer 2014 price levels should be looked at with a healthy degree of skepticism. Despite the recent rally, we suspect it is not yet time to sound the all clear.

BloombergBloomberg 2

Have a great week,

Your Chenmark Capital Team

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