Correspondent Comment on Russia

Russia gets 6 to 10 times more from a dollar of defense spending than the US does. It probably has far less graft in its defense industry because Russians feel so threatened by the US.

War like Kursk and Manchuria is totally outside US experience. Russia had 16,000 war deaths a day for the 46 months of its participation in World War II. It will be in deadly earnest if attacked.

Review of The Oligarchs: Wealth And Power In The New Russia by David E. Hoffman

Saving the Sun, about Japan, and The Oligarchs, about Russia are not useful because we care about the dysfunction of those countries, but because reading about corruption and decrepit economic systems helps us understand our own system more objectively, by seeing the parallels and differences.

The Foreign Affairs summary of The Oligarchs describes it well,

"Hoffman traces how Smolensky and four other restless young men on the margins of Soviet society -- Boris Berezovsky, Vladimir Gusinsky, Mikhail Khodorkovsky, and Vladimir Potanin -- assembled empires by methods that made the American robber barons look like choirboys."

Or, "behind every great fortune lies a great crime," even when the fortune belongs to the Russian owner of a Manhattan condo or an NBA team. The most probable explanation is that they were sociopaths who were in the right place at the right time:

• "In Soviet times, [these men who became oligarchs] found the keys to locked libraries and read the 'restricted' books on Western economics and finance. [...T]hey were tutored personally at the knees of global tycoons and financiers..."
• "'[It] became clear that this system was going to survive. So, the question became, what's going to happen when the system collapses? What are the scenarios?' [...] Some of the participants wanted to debate the shape of a theoretical alternative economy for the Soviet Union... he wanted to focus the debate on the actual transition to a new economy." 
• Khodorkovsky worked at the Mendeleev Institute of Chemical Technology, and the "technical sciences were a breeding ground for many new capitalists because their studies included only a minimum amount of ideology and focused on practical questions of what worked and what did not."

The soviet system had two kinds of money. There was cash (nalichnye) that was the banknotes and coins, used for wages. Then there was non-cash (beznalichnye) which was a quasi-money that the government would distribute as subsidies to factories. There were extensive regulations on the use of each, and for a factory manager to convert non-cash into cash was prohibited. The purpose of a system like this, although the book does not explain this, would have been to reduce the inflationary impact that the subsidies would have on prices of goods in cash rubles.

Using a combination of bribes and loopholes that are unclear to this day, Khodorkovsky apparently found a way to convert beznalichnye into nalichnye. They were nominally both rubles, but a beznalichnye could be had for something like a tenth of a nalichnye, and there were "arbitrages" because pricing of goods were not consistent in both.  Minus bribing and other expenses, you are talking about a corrupt Russian equivalent of the Buffett cocoa bean trade:

I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 5¢ per pound. In 1954 a temporary shortage of cocoa caused the price to soar to over 60¢. Consequently Rockwood wished to unload its valuable inventory - quickly, before the price dropped. But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

The 1954 Tax Code came to the rescue. It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business. Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity. Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.

For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were good and my only expense was subway tokens.

Khodorkovsky's trade was sort of like that, except his competition was afraid of the KGB - which he probably had to bribe or cut in on the scheme. He said,

"Many years later, I talked with people and asked them, why didn't you start doing the same thing? [...] They explained they had all gone through the period - the Kosygin thaw - when the same [experiments in capitalism] was allowed. And then, at best, people were unable to succeed in their career and, at worst, found themselves in jail. They were all sure that would be the case this time, and that is why they did not go into it. And I did not remember this! I was too young! And I went for it."

That reminds me of how Tom Ward of Sandridge and Aubrey of Chesapeake born were three days apart in Oklahoma. In his January 2014 letter, Howard Marks mentions that the Microsoft, Sun, and Apple founders were all born 1953-1956 and that all four founders of the law firm Wachtell, Lipton, Rosen and Katz were born in 1930-31.

It's kind of like being too young to remember the 2000 tech bubble, and also not realizing that you need a license to sell taxi service. (Or do you? I guess Kalanick is like Khodorkovsky and we are all the old, law-abiding chumps.)

I give this book a 3/5. If nothing else, it is a brilliant illustration of the size of the control premium in Russia! Some examples:

• "[Berezovsky] liked to say that in Russia, the first treasure to be privatized would be profit, then property, and finally debt. He meant that the first thing he wanted to take in a company was its cash flow, and only later would be be interested in owning it, and perhaps never."
• "Even for gamblers, there were risks in buying shares in oil field extraction companies like Yuganskneftegaz. First, there was the theft. Russian oil industry managers, local politicians, criminal groups, and assorted sharks and financiers discovered ingenious ways to leach the wealth out of the extraction companies. Buying the stock did not guarantee that you would get the oil wealth. The managers, for example, could easily siphon off the profits into an offshore private 'trading company' and leave you with the debts..."
• "Khodorkovsky did not own all of the oilfield extraction companies, They were still partially in the hands of Kenneth Dart, the foam cup magnate who had bought his shares in the early 1990s. Khodorkovsky's transfer pricing was pumping value away from Dart's holdings. [It] demonstrate what became a fundamental rule of Russian capitalism in the late 1990s - control over a company was winner take all."
• "When he first won Yukos, Khodorkovsky sent three hundred of his best security men to Siberia to physically take over the company's wells and refineries."

Russians think that shares are for chumps. They have never had a stock market of worthwhile minority stakes, and it does not look like they are going to any time soon.

25th Anniversary of USSR Collapse

Printing money isn't a solution to bankruptcy if no one wants what you print. Eventually, it comes down to being able to produce goods [pdf]:

"On August 22, 1991, the story of the Soviet Union came to an end. A state that does not control its borders or military forces and has no revenue simply cannot exist. The document which effectively concluded the history of the Soviet Union was a letter from the Vneshekonombank in November 1991 to the Soviet leadership, informing them that the Soviet state had not a cent in its coffers."

Maybe two evil empires can disappear in one lifetime...?

Gary North: "On Replacing the Keynesian Establishment"

Essay:

"Murray Rothbard observed remorsefully after 1991 that nobody in the libertarian movement had ever sat down and devised a transition program for the Soviet Union, on the assumption that the Soviet economy would collapse, and there ought to be a program to make the transition to free-market capitalism. That had never been attempted. It was not implemented. And so the Russian economic system is basically a version of Keynesianism. The central bank dominates. Bureaucracy dominates. The markets are not free. The system is rigged. It is simply Western crony capitalism superimposed onto the old Soviet bureaucracy, which was what Lenin imposed on the old Czarist bureaucracy. Russia is still essentially a top-down bureaucratic economy, with productivity coming from the bottom. What is different today is this: with capitalism, there is greater productivity in Russia than there ever was in the Soviet Union or Czarist Russia."

The "BRICs" Are Uninvestable

We were talking about China this week and about how "China and Russia have the same problems - pervasive corruption, an aging population, higher birthrates among separatist minority groups". I think we have thoroughly established that China is an immense fraud and misallocator of capital.

I have never talked about it on the blog before, but I have business experience in Brazil, and their economy is total chaos. As corrupt as China but more disorganized: siesta culture. As an outsider or public company, you automatically have a higher cost of capital and less profitable business model than local, private competitors because you have not paid the right bribes to avoid taxes and regulation.

I rarely hear anyone seriously propose to invest in India. But many people are also unaware that India is a country that has considered toilets and rejected them, even at great cost to their own health!

Russia is a sad case that I am ambivalent about. Russia has aspects of anti-fragility because it already collapsed to a low order of complexity, and because it is net long and benefits from higher energy and commodity prices. It is just dumb luck that Russia has so much natural gas. If the communists could have sold it all in one slug to the west at any point, they would have. But they couldn't and these resources have now conferred an anti-fragility on Russia.

Unfortunately from an investment perspective, Russia does not have a tradition of harmonious minority ownership of corporations. We will watch and see whether ownership in Russian public companies eventually translates into meaningful economic interest, but right now it doesn't.

I propose a long-term short of the BRICs. Only a very ebullient social mood - and overpriced U.S. securities to match - has caused investors to be interested in abstract (imaginary) claims on BRIC businesses.

The BRIC ETF BKF has a dividend yield of less than two percent. One of the funny things about buy and hold investors is that they choose to ignore some very unpleasant discontinuities in stock index time series. For example, once during the past century you would have lost all of your investment in Chinese companies in a confiscation. How do you account for that? Are you getting paid for that risk with a two percent yield?

New German-Russian Axis Forming?

A correspondent writes in regarding a Zero Hedge post, The Emerging German-Russian Axis,

The land area from the North Sea and the North Atlantic to Vladivostok will knit together during the next fifteen years because the US cannot meet the energy needs of its allies and because its most powerful weapon, the US Navy, is obsolete (except for boomers).

Air- and ground-to-ship missiles make it impossible for navies to live in narrow waters such as the Black Sea, Baltic, Persian Gulf, Red Sea, the northern part of the Indian Ocean, and anywhere else within four- or five-hundred miles of land.

Narrow waters such as the Persian Gulf and the Mediterranean are analogous to what is called in land warfare, "killing sacks." These are places that are everywhere subject to a massive volume of enemy fire. That means the struggle of maritime powers to control the Eurasian landmass is over, with the Eurasian landmass wining.

The English Channel used to be a protective moat that allowed the British navy to force unequal commercial transactions on on inhabitants of sea coasts of the world without Britain paying the expense of a first-class army to defend Britain against invasion.

Today, the Channel is a maritime killing sack. A rowboat could invade Britain without the British navy being able to interfere, provided that sufficient rockets emplaced anywhere on the continent within four-hundred miles protected the rowboat from British ships and aircraft. An additional weakness of navies is that attacks from them have no deniability.

Sergei Lavrov, the Russian Foreign Minister has just told the Ukraine regime that Russia will use nuclear weapons if Ukraine attacks Crimea. So the only spot on the southern border of Russia that once was reachable by maritime power is out of reach.

The ZH article argued that "a combination of German industrial might and Russian raw materials and military strength would instantly create a colossus."

Indeed, the only thing I can think of that would be bearish for the dollar would be if the Holy Roman Empire was reborn with nuclear weapons and issued bonds in a currency not subject to devaluation by a central bank.

But there is yet time for another another deflationary squeeze of the crowded dollar shorts before any of this happens.

Вертушки идут на Бельбек

A Plea for Caution From Russia

"No one doubts that poison gas was used in Syria. But there is every reason to believe it was used not by the Syrian Army, but by opposition forces, to provoke intervention by their powerful foreign patrons, who would be siding with the fundamentalists."

Russia's Energy Resources Give it What Nassim Taleb Calls "Anti-fragility"

Nassim Taleb, the author of Fooled by Randomness and The Black Swan has a concept called antifragility, meaning the opposite of fragility. (See his discussion and draft chapter for antifragility book.)

Taleb's concept is that the opposite of "fragile" is not "robust," because robustness denotes resistance to shocks but not the property of benefiting from shocks. He asks us to imagine a package marked "antifragile" instead of "fragile":

"The contents of such package are not just unbreakable, but benefit from shocks. Let us coin the appellation "antifragile" for such a package; a neologism is necessary for there is no simple, noncompound word in the Oxford English Dictionary that expresses the point of reverse fragility."

It occurred to me that the United States (and other countries like Japan) are very fragile to the extent that they rely on imported oil, and can be brought to their knees by supply shocks. In contrast, Russia is robust because it has already been through a collapse that resulted in resilient institutions with a lower level of complexity (but also lower productivity). Dmitry Orlov calls this the "collapse gap." As one Credit Bubble Stocks correspondent puts it,

Russians own their own houses, such as they are, free and clear because the state that owned them went out of business and left no one else with a stronger claim on the houses. Compare that with the % of Americans underwater on their houses, in debt to lenders who are simply unworthy of payment. Americans would have to repudiate their mortgage debt just to draw even with the Russians.

Americans would have to repudiate federal, state and local debt, too, just to draw even with the Russians, for the Russians do not have a debt-based currency.

Also, Russia has a public transportation network--trains, buses, trucks. Nothing like it exists here. So we have to spend thousands and thousands of dollars a year to maintain private transport

Russians, even when they live in the cities, get part of their food from their own plots of land. We have very little of that here.

A lot of our GDP is vapor. Beauty contests, TV shows, financial manipulations.

But Russia is also anti-fragile to the extent that it benefits from higher energy and commodity prices. They are making money off of the Libya events by selling more natural gas at higher prices to western Europe.

Maybe there is no word for anti-fragility because it rarely exists in nature. As I mentioned in my Conquer the Crash review, "The different parts of economic cycles occur so infrequently that the intervals between them exceed the working lifespans of investors."

It is hard to plan for, let alone benefit from, rare events, because your competitors can use the "What, me worry?" strategy to grow by taking stupid risks. They can be the fastest growing bank for a decade by making really bad loans, and you will look obtuse for refusing to participate. They will only get their comeuppance when the downturn finally rolls around, and that may not even happen during the careers of the executives involved!

It is just dumb luck that Russia has so much natural gas. If the communists could have sold it all in one slug to the west at any point, they would have. But they didn't and these resources have now conferred an anti-fragility on Russia.

"One man’s cyber-crusade against Russian corruption."

He quickly noticed that the companies, despite surging commodity prices and prime access to Russia’s vast natural resources, paid surprisingly small dividends. Then he learned, from a newspaper article, that Transneft had donated three hundred million dollars to charity in 2007 alone. The sum was more than ten per cent of its profits that year and more than it spent on maintaining its entire network of pipes, but Transneft did not disclose where the cash went.

A Couple of Links

NYT: "For Hedge Fund Investors, Brazil Is the Country of Now", yet they are not interested in Russia.

"Our lives are spent trying to pixellate a fractal planet."

Russia's Surprisingly High Output of Academic Research on the Hard Sciences

From a Credit Bubble Stocks correspondent:

Think about this in connection with the undervaluing of Russian equities.

For physics, Moscow publishes the most papers of any city in the world, but they are not in the orbit of the West and they publish in Russian, so they don't get cited as much. For chemistry, Moscow publishes the most papers of any city in the world, but they don't get cited so much for the same reasons that apply to physics.

I guess this has to do with empire building, grant hunting, favor trading, monoglotism and such.

For psychology, London publishes the largest number of papers of any city in the world and they are heavily cited. Moscow doesn't bother. Hardly anybody outside Western Europe and the United States does. This might be an aspect of the chattering done by people with soft hands and baby rabbit minds, in declining empires

As a Bengali friemd of mine said to me, once, "Psychology ... bogus!" He was an engineer.

Or it might be as the result of specialization for complicated swindles.

WSJ: "Kremlin Orders Ministers Off Corporate Boards"

This seems like a good sign and a move towards better corporate governance:

"Mr. Dvorkovich said the public companies, including Rosneft, should take appropriate measures to replace ministers and deputy ministers with independent directors ahead of their shareholder meetings."

Russia

I'm not about to run out and buy Russian equities - I am just trying to reconcile the valuation gap between Russia and other "emerging" / "developing" countries that mysteriously trade at higher multiples.

Here's a research report on Gazprom, for example, which trades at the lowest EV/EBITDA of any large oil and gas company. Even Petrobras trades at a multiple two times higher!

Two Opinions on Investing in Russia

We were thinking about Russia last week, and it looks like Bloomberg was too:

"Peter Elam Hakansson of East Capital Group says the country is no more risky than other emerging economies and its stocks will beat those in rival markets by 25 percent in the next three years to reflect this. Fredrik Colliander of Carnegie Fonder AB says corruption and corporate governance concerns justify a discount to nations such as Brazil. The two have each returned more than 700 percent in the past 10 years."

That is absurd. Brazil is a total basketcase - there is no way that Russian corruption and corporate governance is significantly worse. Also, Russia has an average IQ of 96 and Brazil only 87, which is 0.6 SD, a huge difference.