Introducing Net Interest

I’m toying with entering the newsletter market.

I’ve been looking at banks and financials for 25 years. First from the perspective of a sell-side equity research analyst. Then as an investor in a specialist global hedge fund. More recently out of sheer interest.

So the idea of crafting a newsletter as an outlet for my thoughts on the sector is quite appealing. I’ve registered Net Interest over at Substack and we’ll see how it goes.

But why financials?

Well, they’re central to the functioning of the global economy. So there’s that. But that’s not my primary reason. I have four better ones:

For a start, there’s something exclusive about them.

There are some industries on which everyone has a view. Supermarkets for example, or consumer tech. Financials isn’t one of those industries. In fact, many investors steer well clear of them. And that even extends to professionals. I have come across plenty of portfolio managers in my career who lump financial companies together in the ‘too hard’ pile. Although, given the long-term share performance of most financials, they’ve been paid well not to understand them.

The industry has been very good at creating a veil of complexity around itself. Financial companies work hard to preserve that veil, often creating complexity for its own sake. If properly devised it can offer competitive advantage. But it’s a veil that few outsiders are prepared to lift.

Second, financials are everywhere.

Even companies that on the face of it aren’t can be financial companies in disguise. The following exchange took place in May 2001 on Enron’s first quarter earnings call between Richard Grubman, co-founder of Highfields Capital, and Jeff Skilling, Enron’s CEO:

Grubman: You’re the only financial institution that cannot produce a balance sheet or cash-flow statement with their earnings.

Skilling: Well, you’re – you – well, uh, thank you very much. We appreciate it.

Grubman: Appreciate it?

Skilling: Asshole.

The asshole comment made the exchange famous. Bethany McLean and Peter Elkind wrote in their book, The Smartest Guys in the Room, “[Ken] Rice, who was half asleep, bolted awake. Jaws dropped around the table.”

What’s not clear is whether jaws dropped over the asshole comment or the exposé that Enron was a financial institution. Aside from Richard Grubman, few outsiders understood it as one. Most analysts on the call were energy specialists. A few months later one of them, working for Goldman Sachs, would write “We view Enron as one of the best companies in the economy, let alone among the companies in our energy convergence space.”

Unzip companies across a range of industries and you will find financial companies lurking inside. In 2018 US car dealerships made over twice as much on finance and insurance as on actual vehicle sales. It doesn’t even matter whether the core product is high priced or low. The Foschini Group, which sells clothes in South Africa, does a quarter of its sales on credit; Wyndham Destinations, which sells timeshares, does over two thirds.

These are less car/retail/hospitality companies, and more credit companies with a sideline in subsidised pick-up trucks or T-shirts or holiday lets. Not that different from the bank that gives away toasters.

This trend is only growing as tech companies increasingly get into financial services. Angela Strange, general partner at Andreessen Horowitz reckons, “In the not-too-distant future, I believe nearly every company will derive a significant portion of its revenue from financial services.”

The third aspect of financials that makes them especially compelling is they’re a great metaphor for the world around us.

OK, maybe I’m stretching things a bit, but hear me out.

The financial system operates as a complex adaptive system. It consists of a network of banks and other financial institutions each of which operate according to their own incentives. But unlike in other industries where competitors don’t have to talk to each other, financial companies do. They pool resources in the interbank market, they trade with each other and they co-own many of the same assets. These interactions have important implications. In the supermarket industry (I told you everyone has a view) if one player goes bust, there’s more market share to go round for the others. In the banking industry it can lead to disaster.

More generally, the interactions can lead the overall system to behave in a way that is inconsistent with any one participant’s intentions. We saw that play out during the financial crisis. Contrary to some narratives, the particular financial crisis we experienced wasn’t the inevitable result of a linear chain of cause-and-effect. It emerged from the interaction of players pursuing their own paths in a complex system. And contrary to the view of most politicians, the world’s like that, too. Perhaps a simpler way of saying this is that the financial system is a representation of the overall system, but that’s less profound.

A few weeks ago, I brought these strands together in an essay on what the financial crisis of 10+ years ago teaches us about the Covid crisis of today.

My final point is that looking at financials closely over a long period of time can be productively humbling.

Years ago, it was a burgeoning sector making up nearly a quarter of the entire European stock market. Bank analysts were rock stars whom investment banks would pay huge sums of money to attract. Today the sector barely contributes 7% to the index and many of those analysts have been fired. As Piers Morgan – and I hate to quote him – says “One day you’re cock of the walk, the next a feather duster.”

The humility of experiencing a full cycle provides a useful perspective. The internet, and in particular the newsletter market, is overweight tech commentary and underweight this kind of stuff. A quick search of Substack throws up scores of newsletters dedicated to tech and few to financials (most of which are about tech in financials). But their exclusivity, ubiquity and usefulness as a metaphor makes them good fodder for a newsletter.

So there it is. Let’s see how it goes. I’m hoping that newsletter-writing offers economics opposite to those of managing assets. With assets returns diminish with scale; with newsletters they grow.

All feedback welcome.