What We’re Reading (Week Ending 17 December 2023) - 17 Dec 2023
Reading helps us learn about the world and it is a really important aspect of investing. The late Charlie Munger even went so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 17 December 2023):
1. J&J Hired Thousands of Data Scientists. Will The Strategy Pay Off? – Peter Loftus
Johnson & Johnson is making one of the biggest bets in the healthcare industry on using data science and artificial intelligence to bolster its work.
The 137-year-old pharmaceutical and medical-device company has hired 6,000 data scientists and digital specialists in recent years, and spent hundreds of millions of dollars on their work, such as using machines to scour massive health-record datasets. Last year the company opened a state-of-the-art research site near San Francisco that houses advanced data science…
…The long game, though, is a goal that has seen a lot of hype but less concrete proof that it will become a reality: using AI for drug discovery.
Startup biotechs are in the early days of human testing of AI-discovered drugs. Google this year introduced cloud-based AI tools to assist drugmakers in finding new treatments. But it could still be years before an AI-discovered drug is approved for sale by regulators.
Some pharmaceutical leaders have expressed skepticism that AI could ever discover new drugs any better than humans can.
J&J says it has an edge: a massive database called med. AI that it can sift for patterns to help speed up drug development. The info includes “real-world data”—anonymized information collected from everyday patient visits to doctors and hospitals—and years of clinical-trial results…
…J&J says it has already used machine learning to help design an experimental cancer drug that is scheduled to start human testing next year.
A few things make J&J’s effort different, Khan says. Its data-science workers are tightly integrated into the company’s strategic decisions on drug research. The company’s massive datasets—med. AI has more than three petabytes of information—are made available to tens of thousands of employees. And it has hired people who aren’t just data scientists but also have skills in chemistry, biology or drug development…
…Analysts consider J&J to be one of the most active large drugmakers in its commitment to AI. Market intelligence firm CB Insights recently ranked it third of 50 companies in its Pharma AI Readiness Index, which tracks companies’ patent applications, investments, deal making and other efforts related to AI…
…Today, most of the company’s drug-development projects incorporate some aspects of data science, up from just a handful five years ago. Its San Francisco-area research site in Brisbane, Calif., places data-science projects alongside R&D focused on finding treatments for retinal and infectious diseases. Many of J&J’s data workers are spread across multiple company locations including in the U.S., China and Belgium…
…In one recent project, J&J scientists led a collaboration of 13 drug companies that analyzed blood samples collected from more than 50,000 people in the U.K. as part of a national database called UK Biobank. They identified thousands of genetic variants that influence levels of certain blood proteins, about 80% of which weren’t previously known.
J&J plans to analyze the dataset using AI and machine learning to help spot patterns. This in turn could lead to new drugs or diagnostics that target the gene-protein links to various diseases. In the past, industry scientists would look for such molecular drug targets by scouring academic papers. The AI-enabled approach could spot many more targets, more quickly.
The company also is using an AI algorithm to study digitized images of biopsies to detect subtle differences between tumors, which could lead to identifying genetic subtypes for certain tumors. Researchers could use this information to make a medicine that specifically targets the genetic subtype…
…J&J and its partners amassed six million patient records, stripped of individuals’ identities. including more than eight million electrocardiogram readouts. An electrocardiogram, or ECG, is a procedure to record the electrical signals in the heart. They fed the records into a software algorithm to teach it to spot patterns in the electrical readings that were present in patients later diagnosed with pulmonary hypertension. Using the algorithm in conjunction with ECG’s can shorten the time to a pulmonary hypertension diagnosis by 12 to 18 months, J&J says.
The Food and Drug Administration has granted “breakthrough device” designation to the algorithm, for products that could improve diagnoses or treatment of serious diseases. The FDA hasn’t approved the algorithm but a decision could come next year.
2. Lenders of Last Resort – Marc Rubinstein
So La Jolla, California-based Silvergate paid a visit to its local Federal Home Loan Bank in San Francisco. As a “member”, it was entitled to draw on special loans. By the end of the year, it had tapped the Home Loan Bank for $4.3 billion, up from $0.7 billion at the end of September. Although it paid them all back by the beginning of March, the loans provided Silvergate with a lifeline that kept it afloat longer than its fundamentals warranted.
Silvergate wasn’t the only struggling bank to make the trip to San Francisco. Three of the Federal Home Loan Bank’s six largest customers at year end 2022 would cease to exist a few months later; some 38% of its outstanding advances were to borrowers who wouldn’t make it. And it’s not the first time the Federal Home Loan Bank of San Francisco (FHLBSF) has found itself in that position. Two of its biggest four borrowers at the end of 2007, accounting for 32% of advances, failed over the course of the following year.
The optics haven’t been lost on FHLBSF’s regulator, the Federal Housing Finance Agency (FHFA). In a report released earlier this month, authorities made a number of proposals to reform FHLBSF and its peers. The regional bank failures, they said, “highlighted the need for a clearer distinction between the appropriate role of the FHLBanks, which provide funding to support their members’ liquidity needs across the economic cycle, and that of the Federal Reserve, which maintains the primary financing facility for troubled institutions with immediate, emergency liquidity needs.”
So who are these Federal Home Loan Banks? Few outside the US financial services industry are familiar with them. Yet, with $1.3 trillion of assets, they wield a power that dwarfs their low profile…
…In August 1931, with American homeowners facing an unprecedented wave of mortgage foreclosures, President Herbert Hoover summoned the country’s housing experts to a Conference of Home Building and Home Ownership. Around 3,700 delegates attended and the event generated 11 volumes of reports. The mortgage industry at the time was a patchwork of different interests: Country banks offered mortgages in the West, mutuals dominated in the Northeast and savings-and-loan institutions operated nationally, with a market share of 38%. While some of these lenders had access to emergency credit support, not all of them enjoyed such benefits. Banks could access the Federal Reserve system, farms could access the farm loan system, but savings-and-loans (S&Ls) had nothing. A key proposal of the Conference was to set up a system of credit support for the S&Ls.
On October 15, 1932, the Federal Home Loan Bank system officially opened. Modeled after the Federal Reserve system, it comprised a network of 12 banks, initially capitalized with $125 million from the federal government. Savings-and-loan institutions could become members by subscribing to shares of their local Home Loan Bank. With membership came access to a borrowing window, where S&Ls could pledge home loan assets as collateral in return for liquid funds. By putting up $100 worth of single-family mortgage loans, say, they could borrow $75 of cash.
In the space of a year, just over 2,000 of the country’s nearly 11,000 S&Ls joined, and over the next four years another 3,900 paid up. This group formed the core of the mortgage industry, going on to hold 92% of all S&L assets by 1950.
For much of the early history of the FHLBank System, eligible collateral was limited to home mortgage loans…
…To secure the funds to make available for borrowers, Federal Home Loan Banks issued bonds into the market. From the very beginning, FHLBanks were jointly and severally liable for each other’s debt, reducing risk and making their bonds an attractive proposition for investors. The system’s first debt issue in 1937 was “oversubscribed many times within a few hours.”
Their bonds also carry an implicit government guarantee. Although all obligations of the FHLBanks are required to “plainly state that such obligations are not obligations of the United States and are not guaranteed by the United States,” nobody really believes that. Government influence courses through these institutions…
…Because FHLBanks do not directly lend money, their role is obscured. But by providing a cheap source of funding for S&Ls, they played a part in the expansion of home ownership in the US and all subsequent mortgage cycles…
…The Federal Home Loan Banks might have had their day with the demise of savings-and-loan institutions in the 1980s and the rise of securitisation as an alternative means of obtaining liquidity from traditionally non-liquid mortgage assets. But rather than retire them, policymakers changed the rules to keep them in the game…
…As of September this year, they had pre-approved $3.6 trillion of collateral to lend against. Around half is single-family mortgages, but commercial real estate loans (20%), multifamily mortgage loans (10%), and mortgage securities (10%) appear as well…
…When it became clear S&Ls were not going to recover, policymakers repositioned FHLBanks, allowing them to accept commercial banks and credit unions as members so long as they had at least 10% of their assets in residential mortgage loans. Initially, a hierarchy of other criteria were also imposed to limit the extent to which these new members could obtain access to borrowings. But in 1999, these were eliminated leaving only the 10% threshold. By 2004, S&Ls made up only 16% of members, down from 100% in 1989. Today, they make up just 9%. Of the system’s 6,494 members, the majority are commercial banks…
…Silvergate Capital became a member of the Federal Home Loan Bank of San Francisco in 1997. It had been founded as a savings-and-loan institution but was reorganized into a bank by new owners a year earlier. At the time, its business strategy and profile were consistent with the FHLBank System’s mission. Over 10% of total assets comprised residential mortgages and it met all other statutory conditions of membership.
By 2022, though, Silvergate held only $38 million of one-to-four family real estate loans on a balance sheet of $15.5 billion. Once you’re in the FHLBank Club, you’re in. As long as you have sufficient collateral, and aren’t in breach of some basic financial requirements (like having positive tangible capital) you are eligible to borrow from the FHLBank System…
… At the end of 2021, the weighted average rate charged by home loan banks was close to 1%. Even after the Fed embarked on its hiking cycle, FHLBank money cost members 4.6% on average at the end of September.
Federal Home Loan Banks are able to offer such good rates because of their ability to raise funds so cheaply. In the nine months through to the end September, their average funding cost was 4.80%. The system keeps a spread of 0.34% but otherwise such beneficial funding rates get passed on to members…
…The FHLBank System is proud of its role connecting domestic financial institutions – many of them small, community-focused lenders – to the global capital markets. In this sense it acts no differently from other wholesale banks overseas (although unlike German Landesbanken which lost theirs in 2005, FHLBanks still retain state support).
But in the aftermath of Silvergate and the regional bank failures earlier this year, the FHFA is reviewing the emergent role the system has taken on as a lender of last resort. “Ensuring that the FHLBanks are not acting as lenders of last resort for institutions in weakened financial condition will allow the FHLBanks to use their available liquidity to provide financing to all members so they can continue to serve their communities,” it writes in its report.
The problem is that by being so readily available in the good times, banks may be more inclined to tap the same resource in the bad times, particularly as their FHLBank contact isn’t incentivized to ask questions. FHLBanks underwrite the collateral pledged rather than the institution, so as long as collateral is available and a sufficient haircut is applied (25% in the case of single-family mortgage loans, on average) the money will be there. (Unless they leave it too late in the day when debt markets have closed and FHLBanks are unable to raise funding – a feature in Signature Bank’s collapse.)
Perhaps because FHLBank funding was so easy to access, many banks did not have systems in place to access the legitimate lender of last resort – the Fed. According to the official post-mortem into Silicon Valley Bank, “SVB did not test its capacity to borrow at the discount window in 2022 and did not have appropriate collateral and operational arrangements in place to obtain liquidity.” The FHFA has committed to embark on an education drive but it may not alleviate the stigma the Federal Reserve’s discount window carries which emerges partially because it is used so infrequently.
3. Chinese borrowers default in record numbers as economic crisis deepens – Sun Yu
Defaults by Chinese borrowers have surged to a record high since the outbreak of the coronavirus pandemic, highlighting the depth of the country’s economic downturn and the obstacles to a full recovery.
A total of 8.54mn people, most of them between the ages of 18 and 59, are officially blacklisted by authorities after missing payments on everything from home mortgages to business loans, according to local courts.
That figure, equivalent to about 1 per cent of working-age Chinese adults, is up from 5.7mn defaulters in early 2020, as pandemic lockdowns and other restrictions hobbled economic growth and gutted household incomes…
…Under Chinese law, blacklisted defaulters are blocked from a range of economic activities, including purchasing aeroplane tickets and making payments through mobile apps such as Alipay and WeChat Pay, representing a further drag on an economy plagued by a property sector slowdown and lagging consumer confidence. The blacklisting process is triggered after a borrower is sued by creditors, such as banks, and then misses a subsequent payment deadline…
…The personal debt crisis follows a borrowing spree by Chinese consumers. Household debt as a percentage of gross domestic product almost doubled over the past decade to 64 per cent in September, according to the National Institution for Finance and Development, a Beijing-based think-tank.
But mounting financial obligations have become increasingly unmanageable as wage growth has stalled or turned negative in the midst of the economic malaise.
As a growing number of cash-strapped Chinese consumers have struggled to make ends meet, many have stopped paying their bills. More Chinese residents are also struggling for work: youth unemployment hit a record 21.3 per cent in June, prompting authorities to stop reporting the data…
…China Merchants Bank said this month that bad loans from credit card payments that were 90 days overdue had increased 26 per cent in 2022 from the year before. China Index Academy, a Shanghai-based consultancy, reported 584,000 foreclosures in China in the first nine months of 2023, up almost a third from a year earlier.
Life for blacklisted borrowers can be difficult as they navigate dozens of state-imposed restrictions. Defaulters and their families are barred from government jobs, and they can even be prohibited from using toll roads.
4. The Fed Matters Less Than You Think – Ben Carlson
The Federal Reserve plays an important role in our economy and the functioning of the credit markets. But investors give the Fed far too much credit and blame for how things shake out in the financial markets.
The Fed does control ultra short interest rates by setting the Fed Funds Rate but they don’t control the long end of the curve…
…The 10 year went from a low of 3.3% in the spring then shot up to 5% this fall for no apparent reason whatsoever. Since then yields have fallen back to 4.2% in a hurry. That’s not the Fed; that’s the market.
A lot of people want to blame the Fed for allowing inflation to get out of control following the pandemic. I do agree the Fed should have acted sooner.
But would it have mattered as much as people think?
Just look at the path of inflation readings across other developed economies:
All of these countries had different fiscal and monetary policy responses to the Covid outbreak. And yet inflation rates all went up at the same time and fell at the same time…
…Obviously, the increased consumer demand that came about because of the fiscal policy response played a huge role in these supply chain problems. Inflation came about from supply problems that coincided with pent-up consumer demand.
But that wasn’t the Fed’s doing. The government was trying to keep the economy afloat while corporations were preparing for armageddon.
The Fed’s low interest rate policies don’t control the stock market either. Rates matter but they’re not the be-all-end-all.
Yes, rising interest rates were one of the reasons for the bear market in 2022. Going from 0% to 5% in such a short period of time certainly changed the dynamic in the markets. But that doesn’t mean the stock market only goes up when interest rates are low.
That’s silly talk.
The Fed raised rates 375 basis points last year and the stock market sold off. But the Fed raised rates another 150 basis points and has shrunk the size of its balance sheet in 2023. The Nasdaq 100 is up almost 50% on the year. The S&P 500 has risen 20%…
…I know everyone wants to say the only reason we had a bull market in the 2010s is because of the Fed but isn’t it possible stocks went up a lot because they crashed 60% during the Great Financial Crisis?
And if low interest rates are the sole reason stocks go up, why didn’t we see massive bull markets in European and Japanese stocks in the 2010s as well? Their rates were even lower than ours…
…The Fed doesn’t matter as much as you might think when it comes to something as big and complex as the $27 trillion U.S. economy or the $50 trillion U.S. stock market.
5. Not all growth is created equal – Thomas Chua
Business growth is often celebrated. Yet, not all growth is good for shareholders.
Tom Murphy, the former chief executive of Capital Cities, once summed up this approach with a metaphor: “The goal is not to have the longest train, but to arrive at the train station first using the least fuel.” here, the train symbolises a company’s size, while the fuel represents the capital required to grow…
…Buffett’s test is based on a simple idea: A company should only retain earnings if they can create at least a dollar of market value for every dollar retained. This criterion ensures that the money kept by the company works as hard as, or harder than, it would in shareholders’ hands.
Suppose you own a 10 per cent risk-free bond with an unusual feature: Each year, you are given the option to either take the 10 per cent coupon in cash or reinvest it in more 10 per cent bonds.
Assuming that you do not need the money, your decision to take the coupon in cash or reinvest it should be based on one factor – what is the latest interest rates offered by these risk-free bonds today?
If the prevailing rate falls to 5 per cent, then reinvesting into your existing 10 per cent bonds is the better move because this 10 per cent interest rate is more than what the market currently offers.
However, if the prevailing rate rises to 15 per cent, then you would not want to reinvest in the 10 per cent bond. Instead, you should take your coupons and invest them in new bonds with a 15 percent interest rate.
This bond analogy applies to a company’s earnings too. If the profits can be reinvested at higher returns than the shareholders could earn themselves, then the earnings should be retained…
…Increasing shareholder value is not just about growth, but also about judicious capital allocation. The Starbucks and Teledyne case studies are a reminder that growth is not an end in itself, but rather a means to an end – with the desired result of the creation of shareholder value.
We should always scrutinise management’s capital allocation decisions, applying Buffett’s one-dollar test: Are they creating at least a dollar of market value for every dollar retained?…
…In the absence of good reinvestment opportunities, shareholders are better off if management simply returns excess capital via dividends or share buybacks.
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. We currently have a vested interest in Starbucks. Holdings are subject to change at any time.
