Thursday, February 19, 2015

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.


Viennacapitalist said...

I think it is a bit more complex...
how do you square the high dividend yields some Russian companies pay (high even before the recent crash) with the fact that they do not care about their shareholders?
Why care, if just control is important...

Anonymous said...

Why anyone would invest in Russia or China is beyond me.

CP said...

The dividend yield is not important, it's the amount of earnings that are skimmed off.

Viennacapitalist said...

I'd say everything is a matter of price. If the dividend is sustainable and compensates for risk.skimmed earnings can be dealt with...
Also the 90ies are probably not entirely comparable to today...

CP said...