01 May 2010
2010 Q1 Investor Letter
I am writing this quarterly letter as the UK General Election results come in. For the last year, I have been predicting a small Conservative majority of approximately 20 seats with a strong possibility of a second election in October. In fact, the UK now has its first hung parliament in 30 years and, despite the Conservatives winning the most number of seats, there is no clarity about who will form a Government.
The new Prime Minister, whoever he is, has the unenviable job of governing a UK that is in its worst financial position since the end of the Second World War. Once he has struck any political deals that he needs to make so that he can actually form a government, he will have to start thinking about how on earth he is actually going to solve the UK’s major problems. The nation is increasingly divided politically along regional lines (as are many Western countries) and has over the last 13 years papered over the resulting social issues by funding large targeted government programmes. The resulting budget deficit can no longer be sustained. Government must, therefore, address the deficit while simultaneously promoting economic growth, encouraging entrepreneurism, defending the UK’s competitive position in financial services, providing good social services, maintaining a stable society, and offering to all a future filled with optimism. As the Prime Minister takes up the burdens of his office and faces this challenge, I might suggest that he does not read what follows.
Western governments, having come to the rescue of their financial institutions and provided stimulus to their respective economies, are now beginning to suffer from a hangover of too much public debt. The unfolding crisis in Greece is clear evidence of the difficult path ahead. The odd thing about the Greece situation is not the market’s reaction to the country’s fiscal problems, but the market’s lack of focus on the rest of the West. The market at some point will realise that this is a problem for all Western governments and not just a problem for Greece in the same way that the markets finally realised in autumn 2008 that the financial demise of Lehman Brothers was a global banking problem and not just a Lehman problem.
It is not clear to me how Western governments intend to come to terms with their excessive debts, budget imbalances and loose monetary policies. But it is clear that the next phase of this crisis will mean a significant reduction in Western living standards over the next 10 years of about 20%. The maths is simply irrefutable.
Again, let us look at the UK, and some simple facts about personal debt, public debt and providing for a comfortable retirement in old age. During the last ten years, the average Briton ran up personal debt, spent everything and saved very little. In fact, he or she should have been saving 20% of their pay packet to have any chance of maintaining a reasonable living standard in retirement. The UK government has been equally profligate, and public debt is now equivalent to something like £90,000 per household, and that is before you include the unfunded public pension deficit which is more than 100% of GDP. In short, the new Prime Minister will confront a greying consumer saddled with too much debt, who is ill equipped for retirement, and a government that is in no position to help. I believe that the only way the UK government will be able to deal with these debt levels is to inflate its way out of both the government and consumer deficits by devaluing Sterling and printing money. The UK has a history of following this path for most of the last 100 years. This is effectively defaulting in all but name. The UK will simply pay back its debt in currency that is worth substantially less, while Greece will in time simply pay back less than all of its obligations while the currency stays the same. In either case, creditors will take a large loss.
This is not just an economic problem. It is likely to have social consequences as well. The rest of Europe should not assume that Greece is the only country where riots and social unrest will be a by-product of the deep financial problems facing their governments.
If the West only had to deal with excess leverage in its government and consumer sectors, it would have monumental challenges before it. However, the West faces at least three other big challenges in attempting to maintain a competitive economy and stable social structure.
Research & Development: The West’s investment in R&D is lower than it has been for forty years. While we want to believe that the West is more innovative and creative than the East we could be in for a shock very soon. Take the aircraft industry which the West has dominated since the dawn of aviation, and in which Boeing and Airbus completely dominate commercial aircraft production. China, however, has already developed a commercial regional jet, which has had successful test flights and could enter service later this year, and is also in the process of developing a narrow body plane that should be in service by the middle of this decade. Green energy is another area where the East may soon surpass the West in developing and manufacturing a wide variety of technologies.
Education: The West used to have a large lead in producing engineers and scientists. However, in 2009, India produced five times more engineering graduates than the US and China produced almost nine times as many. As the East becomes proficient in many highly skilled vocations at a fraction of the cost in the West, there is a real chance that a generation of students in the West will find themselves ill equipped to compete. Once the West loses its edge in education, it will take decades to regain and our economies will suffer in the intervening years.
Employment: The West went through a painful adjustment in the 1970s and 1980s when our heavy industry was challenged and eclipsed by the emerging economies. The reality is that many of those made unemployed from the steel works of Britain never found jobs again and today in too many cases their children and indeed even grandchildren still have not found meaningful employment. My earlier point on education outlines the poor prospects for today’s youth in Britain, but the sad truth is that the number of long-term unemployed who are over 50 is actually greater than those in the 18 to 24 year old category.
Rather than rebuild our employment base over the last 30 years, the West has focused on placating consumers with cheap goods and services financed with abundant credit. Our best and brightest minds were lured into banking and finance in order to help engineer Western prosperity, rather than careers where they could build wealth through production, manufacturing and innovation. Today the West has discovered that an era of relative stability and prosperity has been replaced by an era of extreme anxiety.
This undoubtedly will be a very challenging environment for investors, especially in the public markets. While there will be periodic opportunities to make money in the stock and bond markets, it will become increasingly more difficult to manage businesses in the public arena. Capital markets are likely to open and close with little warning making it difficult to plan and fund long-term projects. Many of the largest banks have survived the financial crisis and rebuilt their capital both through government bailouts and by raising capital from institutional investors. However, they still have much to do in shrinking their balance sheets and resolving problem loans if they are to achieve the capital ratios that many regulators and politicians are now demanding. For business, credit and access to capital will be by no means assured in the next several years.
Thus, I believe many businesses will find that private equity whether provided by sovereign wealth funds, high net worth individuals or private equity funds will be a more stable and attractive model than the public markets in the next decade for building and expanding businesses.
Where does this leave Terra Firma? We continue to pursue our contrarian strategy of investing in businesses requiring fundamental change. However, as we invest the remaining capital in TFCP III, we are mindful of the major themes shaping the world. We are focused on a two-pronged strategy. If a business or sector faces West, Terra Firma is focused on companies that provide essential or competitively priced services and products to an ageing and substantially poorer population. If the business or sector faces East, we are interested in companies that will serve a growing and substantially wealthier population.
This strategy is illustrated by two classic examples in our current portfolio: Odeon/UCI Cinemas in TFCP II, and Consolidated Pastoral Company in TFCP III. Our cinemas business is unequivocally a competitively priced service that is well suited to thrive in a weak European consumer economy. By contrast, CPC is an Australian beef producer with its principal markets in Asia, where rising wealth is enabling many people to increase the amount of protein in their diets.
In considering how to invest our LPs’ money, I wish the economic outlook were more favourable. I would much prefer to have a positive view of the West, but the evidence does not support that case. Nonetheless, this is an environment in which Terra Firma will find compelling investment opportunities, and our portfolio companies can generate value for our investors.
We very much appreciate your continuing support.
With best wishes