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Practice English Speaking&Listening with: Short Selling Tesla and Japanese Businesses (w/ John Hempton)

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MATT MILSOM: Morning John, and welcome back to Real Vision.

JOHN HEMPTON: Thank you.

MATT MILSOM: I want to start off with everyone's favorite topic.

JOHN HEMPTON: And we know that is Tesla.

MATT MILSOM: Absolutely.

JOHN HEMPTON: It's like the most controversial stock in the world.

And it's my-- we have a tiny position short.

And there's a big picture and a small picture.

But the big picture is simply, this is the best example, at the moment, of turds mixed

with raisins on the stock market.

That's not my line.

It's an old Charlie Munger line.

But if you mix turds with raisins, they're still turds.

MATT MILSOM: [LAUGHS] All right.

JOHN HEMPTON: And Elon is-- the good things you can say about Elon are at least partly

true.

The car is wonderful.

MATT MILSOM: Incredible.

JOHN HEMPTON: Nobody who's driven it doesn't get it, it's like.

And moreover, electric cars are, in lots of ways, going to be superior to internal combustion

engines in ways you haven't thought through clearly.

In the end game, an electric car should have the maintenance profile of an egg beater,

an electric egg beater.

In other words, it just won't need much maintenance.

And I remember my old Toyota Corolla '73 model used to have had the oil changed every 5,000

kilometers.

In my current car, it's every 20,000 kilometers.

And the maintenance man used to be a serious mechanic.

And now he just plugs a computer in.

And it tells him what part he needs to bolt off and bolt on again.

And it doesn't need maintenance anyway.

It's just flawless.

But we're going to get that step of improvement again.

So that's the good bit.

The bad bit is that Tesla's manufacturing quality is kind of awful, right?

And you hear case after case after case of it.

And that reflects in both warranty costs.

It reflects in a few unhappy customers.

And it also reflects in just his manufacturing costs being way, way, way too high.

And there's a sort of big picture question here, which is, can he get his manufacturing

costs and manufacturing quality to match Toyota or Volkswagen before Toyota and Volkswagen

manage to match his technology in cars?

And so far, I hate to say it, both Toyota and Tesla have surprised me to the downside.

It's sort of annoying that Toyota or Volkswagen haven't achieved it yet.

The new Jaguar I-Pace is, in every sense, as good as a Tesla.

And the manufacturing quality is probably a bit better twice.

MATT MILSOM: The price at least, though.

JOHN HEMPTON: Yes, but Volkswagen and Toyota, when they do it, it will not be twice the

price.

That manufacturing quality will be astonishing when they get there.

And then there's the series of it doesn't add up.

And you could look at this 100 different ways.

And it's not going to add up, the idea that solar roof tiles were going to be as cheap

as asphalt.

MATT MILSOM: [LAUGHS] JOHN HEMPTON: Sort of bizarre.

The weird manufacturing ups and downs, the rush to deliver on the final day, and then

there's the wacky conspiracy theories like, where all the VIN numbers?

And the conspiracy theory about the VIN numbers-- and it's completely untestable-- is that the

VIN numbers don't match because Tesla is doing a Heilig-Meyers.

And I've heard this conspiracy theory from the Twitter-ati 50 times.

So I'm going to spell it out and tell you there ain't no evidence.

Right, no evidence that's convincing.

Heilig-Meyers was the first AAA securitization to default.

It defaulted in the early 90s.

And it's hard to work out what went wrong.

But I'm going to give you the bare thesis.

Heilig-Meyers was a junk furniture shop selling subprime furniture on installments.

And the AAA strip was 55% overcollateralized.

So in order to lose money on the AAA's 55% of the loans plus the spread, it needed to

default.

And as it turned out, about 65% or 70% of the loans defaulted.

And you end up with the AAA stripping impaired.

And after the event, it was discovered that only 25% of the loans corresponded to real

addresses.

Now, it's actually hard to work out what happened because the documents are terrible.

And it went through bankruptcy court and litigation.

And no one ever went to prison.

So but the absolute hyper bear case was that they were selling furniture to fictional people.

And then they would fill out a fictional loan.

And they put the furniture back on the store.

And they're sell it to another fictional person.

And they keep repeating.

And they put these fictional loans into a securitization, sell the securitization to

the market.

Some of the cash that they got was used to pay on the interest on the past fictional

loans.

And some went into their South American bank accounts.

And at the end of the day, they left.

And there's a giant shortfall.

And all the loans of fictional people.

So they're, by definition, uncollectable.

Now, the wackiest conspiracy theory I've heard-- MATT MILSOM: On the VINs.

JOHN HEMPTON: --is that the VIN numbers don't work because of that.

So at one end, you have these Elon being a complete innovator.

MATT MILSOM: But the cars have to end up somewhere physically.

JOHN HEMPTON: Who knows?

In the Heilig-Meyers case, no furniture ever moved.

You just had furniture that didn't match reality.

MATT MILSOM: Well, I saw these tweets where the guy had tracked the car once he gave it

back to them and they'd bought it back at the wrong price sort of thing.

He tracked the car on his app as to where it was in the battery level, what the level

of the battery was.

And it just parked.

They hadn't tried to do anything with it.

Battery died, it had been there for six months without being tried to be resolved.

JOHN HEMPTON: So the question is, well, has it been resolved to a securitization vehicle?

MATT MILSOM: Right.

JOHN HEMPTON: You can't see.

This is some bad asset backed paper out there.

Now, I only point this out because I actually think Elon's an amazing guy.

MATT MILSOM: Right.

JOHN HEMPTON: The car really is amazing.

And there are bits that don't make sense to me like solar roof tiles.

There are bits in the short seller conspiracy that are off-the-planet wacky, the idea that

Elon is pulling a giant Heilig-Meyers is a pretty large stretch.

And there are bits out there, this guy really has changed the world, right?

I mean, don't kid yourself.

Launching a rocket is hard.

And there are a lot of hedge fund managers who are nowhere near that competent.

I'm fascinated because it's really good stuff mixed with really bad stuff.

And really good stuff mixed with really bad stuff is fun to watch.

We are short.

We're short about that much.

If the stock goes to 400, I won't be very unhappy.

I still wish I'd never heard of the company.

I've been short for a few years.

And I've paid a few years of borrowed cost.

I've had a small number of options expire worthless.

If the stock goes to zero, I'll have a drink at Elon's expense.

And I'll actually be sad for the world.

MATT MILSOM: But this is a philosophical thing between your shorts and your longs.

Are you doing on a forward basis or a value basis?

In general, it's forward.

JOHN HEMPTON: Generally, we're short forwards.

And Elon has about 300 red flags.

This is a company full of red flags.

You've shown me 15 red flags of certain types, and I'm shorted.

And every now and again, I get stuffed by that.

MATT MILSOM: Not just accounting things, but-- JOHN HEMPTON: Not just accounting things.

I'll give you an example.

There was a company called Amarin last year, which was a biotech testing high purity fish

oil for cardiovascular disease.

It had associated with it a single person who I am not going to name who wasn't a director

but it had done business with the company.

And to my knowledge, that single person had never been associated with a company that

didn't go to zero.

And so we were shorted.

We weren't shorted because we had any view on the science.

We weren't shorted because we know a lot about cardiovascular disease.

We don't.

We were shorted because it had a red flag.

And the red flag is fairly good.

And over the history of Bronte, we've run 1,000 shorts.

And we've managed to run shorts through the bull market profitably.

And almost all of them are chosen just because there's a red flag.

And the red flag indicates that there might be fraud.

MATT MILSOM: One?

JOHN HEMPTON: Well, in this case, it was one red flag.

But it was a really good one.

And it was a really good one in the sense that there were 15 previous examples that

this person had been associated with that had gone to zero.

And if you're involved in fraud A, fraud B, fraud C, fraud D, fraud E, and you're now

involved in stock F. MATT MILSOM: And never been to prison.

JOHN HEMPTON: And you've never been to prison, I'm going to guess that stock F is a fraud.

MATT MILSOM: Reasonable.

JOHN HEMPTON: And in this case, I was wrong.

MATT MILSOM: Ah.

JOHN HEMPTON: And I wasn't wrong a little bit.

I was wrong spectacularly.

So it turns out that, in the double blind study, high purity fish oil looks better than

statins at reducing heart attack to the point that I think pretty well every adult over

50 is going to be on high purity fish oil at some stage in their lives.

And they have a registered version that's going to get FDA approval as a drug.

And the market is potentially huge because it's taken as a prophylactic effect.

The stock was trading at about $3 the day before the results came out.

And it's trading at $19 now.

We covered it at $14 on the way up.

I'm just reading the results and thinking, oh Jesus.

Now, there's a fund run by a friend of mine who didn't tell me he was long to the eyeballs.

But he was long to the eyeballs.

And he was long on the science.

Now, as I said, we've run 1,000 shorts over the history of Bronte.

We currently have 200 on the books.

We've managed to run 1,000 shorts and not lose money.

In fact, we've made a double digit percentage in aggregate over 10 years of the bull market.

Now, I don't get out of bed for 2% per year.

But it does allow us to be 120% or 130% percent long and have a beta at that 0.4.

It's a lot of effort in the short book.

But it's chosen on red flags.

And some red flags, they're so good that just one red flag will be enough.

We thought that with Amarin.

Sometimes you need five red flags.

Tesla has like 25.

There's no way that I'm not going to be short Tesla.

But I'm short this much, just like I was with Amarin.

And if I'm wrong, which I doubt in this case, but if I'm wrong, it's not going to worry

me.

Now, the other thing about Tesla is it doesn't look like the penalty for being wrong on the

common is very large.

Tesla has a market cap north of $50 billion most of the time.

The market cap looks roughly like a completely unimpaired GM.

That's a half a Toyota.

And even if they get there, they're going to be copied.

There's a large amount of capital needed to ramp up their production.

It doesn't just-- even if the current production were entirely salable, which may not be, it's

not big enough to justify the current market cap.

In order to get there, they need sort of $15 or $20 billion of capital for expansion plus,

of course, the shortfalls in the current book which are not-- But I don't know how large

they are.

They're probably 3 to 15.

If they're 3, Elon will raise it.

And if they're 15, we'll be pushing up daisies at some point or other.

MATT MILSOM: But they can't cover you think because of the margin or not with the market

alone-- JOHN HEMPTON: Well, we don't know-- look, the business was profitable in the fourth

quarter, probably and legitimately.

And I do say probably and legitimately because I don't trust the accounts.

There is absolutely no way it's profitable in the first quarter with the deliveries that

they've done.

Absolutely no way.

Elon's admitted that it's going to draw a lot of cash.

It's drawn down cash almost every quarter of its existence.

The first quarter is evidence that the turnaround is not today or tomorrow.

when Between now and the turnaround, if the turnaround ever happens, it's going to need

a lot of cash.

If that lot of cash is $5 billion, the bit in the stock is sufficient to pay for it.

If that cash is $15 billion, then he probably needs to raise so much stock that the stock

price will go down low enough to trigger his own margin loans.

And that's a sort of catastrophe version for the longs.

I don't want to express really strong opinions on this because I actually like the guy.

I think the world could do with a few more Elon Musk's.

Elon Musk could do with a bit of adult supervision.

MATT MILSOM: Thoughts on the SEC?

A bit toothless.

JOHN HEMPTON: It's hard.

Look at-- Elon Musk clearly and flagrantly breached his court orders.

MATT MILSOM: He's doing it now.

JOHN HEMPTON: Yes, clearly and flagrantly breached his court orders.

It wasn't even close.

The penalty for a normal person for doing that is actually to be locked up.

If you do that, Tesla collapses instantly.

There is no judge.

And there is no SEC that wants to be responsible with their paw prints over the collapse.

The SEC will investigate after the event.

They're archeologists, not investigators.

MATT MILSOM: I guess they're coming to the end of a two week period now, aren't they?

They have to try and sort it out between them.

Yeah JOHN HEMPTON: They're, going to sort it.

There'll be some kind of rap over the knuckles again.

If you think that a judge is going to do something that causes the imminent collapse of Tesla,

you haven't watched the way that judges behave.

Now, if Tesla were to collapse, he might wind up in prison as well for just breaching court

orders.

Contempt of court is imprisonable in most parts of the world.

But as long as Tesla's alive and dependent on him, no judge is going to call it.

And I don't know anything about this judge.

I suspect he's like every other judge-- competent and methodical and cautious.

And the end cautious is the reason nothing's ever going to happen there.

I can't understand why you would own it.

But can understand why you would own it is a common phenomenon in this market.

Things are expensive.

MATT MILSOM: Why?

T Rowe Price are beginning to agree with you.

It seems like it's been taken up by retail from-- JOHN HEMPTON: Did T Rowe Price own

a lot?

I really don't-- MATT MILSOM: They just announced they just slashed it.

They cut the whole thing massively earlier today.

JOHN HEMPTON: I'm sorry.

I don't follow other people's 13x.

MATT MILSOM: But I think Robinhood has taken it unfortunately.

JOHN HEMPTON: Yeah, that Robinhood data.

We're short Sellers and the classic thing we short is promoted fraud.

We short whatever the hot stuff that can be sold to retailers.

And the Robinhood data is somewhat useful.

When you see vast accumulations of crap in Robinhood accounts, it's probably somewhere

near the end of the line.

And Robinhood have an open API that releases vast amounts of the data about their holdings.

It's bizarre.

To give Interactive Brokers a plug, there's no question that paying a little bit of fees

at Interactive Brokers produces better trading results than Robinhood.

The Robinhood people sign a contract that allow them to buy several percentage points

higher than the current market.

The Robinhood thing is, let's give our data to hedge funds who know we're retail.

And hence, they can guarantee-- the usual problem with a market maker is you're trying

to cross the spread, ding, ding, ding, ding, ding, ding, ding.

And the problem is that somebody off wants to buy $1,000 worth of stock.

And you'll automatically sell them.

Then they want to buy 5,000 more.

And that's within your lumber.

You want to sell them.

And then you want to buy 20,000 more, and you might sell them.

But now you're 30,000 short the stock.

And then you discover that they want to buy 10 million.

And the market maker loses money on those transactions.

But they make money on the small ones.

That person buys 5,000.

And that's it there.

And somebody else sells 5,000.

As long as they're crossing spreads on small amounts, they will.

The Robinhood is all small amounts.

So the guys that are doing market making know that they're never going to get hit by that

$20 million order.

And they never going to be on the wrong side of it.

It's just an invitation.

Hey, you know, I'm a small investor, right?

It's like, I've never seen-- the idea that this is actually something that retail investors

do astonishes me.

MATT MILSOM: You use Interactive for execution?

Or no, your investor-- JOHN HEMPTON: I used to.

And I'm an investor.

And I miss them.

We had-- MATT MILSOM: Yeah.

JOHN HEMPTON: No, I missed them for our fund.

We actually had $100 million sitting in interactive as a prime at one stage.

And we were shorting stuff that was sold to retail.

And so they had a really, really good borrow book.

If you wanted to borrow $200,000 worth of some particularly crappy AMES stock, Interactive

Brokers usually had it.

MATT MILSOM: At GC?

JOHN HEMPTON: Sometimes at GC, sometimes not.

I'm going to give you a pluses and minuses.

It turns out that their execution is extremely cheap.

And we've measured it extremely good.

But their borrows outside the US are somewhat expensive.

And inside the US, we did some price comparisons on borrows with Fidelity of all people.

MATT MILSOM: As a broker?

JOHN HEMPTON: As broker.

Fidelity has a prime brokerage service, which has a really, really good borrow book in the

US.

And Fidelity's prime brokerage was cheaper on a lot of the borrowers than Interactive

by about half a percentage point, which, if you're shorting $200 or $300 million worth

of stock, it starts adding up.

MATT MILSOM: They didn't have Harvey Norman, Interactive.

JOHN HEMPTON: Yeah, they're not very good in Australia.

And the reason is they don't have a lot of retail clients in Australia.

And if they don't have retail clients in Australia, they don't have retail borrow in Australia.

MATT MILSOM: What I liked about them is when they alert you to, if you have a negative

yield in currency, they say, you know you're going to have to pay us, and all that.

JOHN HEMPTON: Yes.

[LAUGHTER] MATT MILSOM: Which is very generous of them.

Shall we move on to longs?

JOHN HEMPTON: No, but it's also fair.

IB has a simple rule about here is LIBOR.

If you have a deposit with us, we pay you 25 BIPS less than LIBOR.

If you have assets, it's 25 bits more.

It doesn't seem to matter which currency.

MATT MILSOM: But the warning was good of them.

JOHN HEMPTON: Yeah, but it's also fair.

I mean, the idea of negative yielding-- the people who want to short bonds and they have

these negative rate bonds they want to short it, but the problem is that they short the

bonds.

And then they get a whole lot of cash.

And they've got to deposit the cash.

And that yields even a higher negative rate than the bonds so that they pay to short a

negative yield bond.

MATT MILSOM: Ouch, so longs and the world of longs.

JOHN HEMPTON: This is hard.

This is hard.

We buy really high quality companies.

And we're not interested in buying second tier companies because they're cheap.

And the problem we have is that the really high quality companies are kind of expensive.

And they didn't go down last year.

And there's a simple explanation for our returns in the first quarter, which is everything

that went down hard last year bounced hard in the first quarter.

And everything that didn't go down hard last year didn't bounce.

And it's actually, the worst stock we had in the fourth quarter, was our best stock

in the first quarter.

But we have long after, long after, long after, long it just barely went down.

So if you look at our fourth quarter, we were up.

And we were running.

In December, we were 130 long and 70 short.

And we wound up up 3% in US dollars.

And our longs only produced minus 4 in December.

MATT MILSOM: There should some second convexity in your shorts, I guess, all right?

If that makes sense.

JOHN HEMPTON: There's all sorts of mathematical problems in our short.

[LAUGHS] Our shorts, if you're running 200 shorts at any time, your management is a set

of mathematical problems.

It's not a set of, do I understand this business?

I've just hired a mathematician.

I actually don't know what he's going to produce for me.

But then the idea, I guess, is to hire people who are smarter than you.

And John Graham clearly is smarter than me on this stuff.

So that should work.

But yes, there are convexity problems.

There are all sorts of other problems.

MATT MILSOM: So how concentrated is the long book?

JOHN HEMPTON: Our ideal long book is sort of 15 longs of 7% to 8% each, adding up to

sort of 120-ish.

MATT MILSOM: So 15 by 200.

JOHN HEMPTON: Right, but if you look at our top 10 longs, that adds up to about 75% exposure.

We have a lot of little longs.

And the classic little long is an extremely superior business that we mettled with that

was superior, thought was a little expensive, bought 50 pips as a rating position and come

back three years later and the 50 pips is up threefold, and we just wish we bought more.

There's a lot of those in the portfolio.

I'll give you an example.

This is a long that's not in the portfolio.

It's possibly the best company I know anywhere in the world.

And I expressed it earlier.

And you had never heard of it.

It's called Christian Hansen or just CHR Hansen.

And they make bacteria.

Now, it's a really good thing if your business does a small but critical part of some big

process because then you can charge money based on that big process.

And you want it to have a high switching costs.

So if they change to a different supplier, it's going to stuff them up in some way.

Then you've got this really good pricing pattern they can't get away from you.

Christian Hansen's core business is it makes bacteria for yogurt.

And in the old days, the way you used to make yogurt was you'd have a vat of milk the size

of this room.

And you'd have an old tub of yogurt.

And you just hit old tub of yogurt in.

And the bacteria in the old tub would spread through the new tub.

And hopefully, the yogurt tasted the same.

And you'd get drift.

You'd get the odd phage.

A phage is a virus that eats bacteria.

They're actually the most common pieces of animal on the planet.

You would get the stray bacteria so that the flavor would change.

And every now and again, you'd get a bad batch.

And a bad batch was expensive because you'd throw out a pile of milk the size of this

room, says, 50 or 100 tons of milk.

These days the way you do it is you get some freeze dried bacteria.

And the freeze dried bacteria comes from the factory.

And every topic freeze dried bacteria is exactly the same as the last tub.

And you just inject the freeze dried bacteria into this.

And then your yogurt tastes the same every time.

And you never get a bad batch.

Now, the branding and the flavor are interrelated.

If you change brand of bacteria, you're going to change flavor.

And then people who are used to your brand will think maybe this is off.

And then they won't buy it again.

So the switching cost is very high.

Then what they've done is they've selectively bred the bacteria for years and years and

years and years.

And they've selectively bred it so that the yogurt tastes creamier or the yogurt tastes

sweeter.

And you now see a plethora of low fat yogurts on your shelf in the supermarket, and they

don't taste like crap.

And the reason they don't taste like crap is that Christian Hansen has bred bacteria

to make the yolk that taste creamier than it really is.

Now, this is a product that can really charge for.

It's a small part of a very big process.

It's got a very high switching costs.

It just means money.

They also do bacteria for cheese.

And every cheese you've ever seen has basically the same ingredients-- milk parts and bacteria,

and all the flavor differences of bacteria.

Some French runny cheese and English Stilton have basically the same ingredients plus a

different bacteria.

And so there's a wide range of bacteria that they can use for flavors.

And not only do they do 70% of the world's yogurt, they're probably approaching half

the world's cheese and all the industrial cheese of the world.

It's an astonishing business.

And when I first found it, it was six times sales.

The revenue was six times sales.

And it was still growing.

But it was sort of over half the world's yogurt.

So I didn't think it was going to double.

It's now 10 times sales.

No, correction, it's 11 and 1/2 times sales.

And sales have gone up a fair bit.

Now, there's an old Scott McNealy quote after the last bull market or the tech bull market.

And he's quibbling with his audience who are happily buying Sun at $64, which was just

over 10 times revenue.

And his simple question is, what were you thinking?

In order to get a 10% return, I have to give you 100% of revenue as dividend.

And I pay any tax, which is rather difficult.

Holders you can't pay any tax on your dividends, which is kind of illegal.

And I've got to somehow or other pay my 38,000 employees.

And I've got to do enough R&D to keep my position.

What were you thinking?

You didn't need any footnotes.

It was just dumb.

And we're seeing these really high quality companies-- And Christian Hanson may be the

best company I've ever seen in my life.

But they're trading at multiples that looked like Sun at the height of the bubble.

And you'll come back in five years, And the question is, what were you thinking?

And yeah, some of them will work.

When Google IPO'd, it was 12 times sales.

And sales went up.

And then they went up.

And then they went up some more.

And I used to think that Google was getting ridiculous when the revenue was approximately--

and I still own it.

So I had to bite my tongue the whole way.

MATT MILSOM: What were you thinking?

JOHN HEMPTON: But I used to think it was getting ridiculous when it was approaching the revenue

of US Network TV.

And Us Network TV supports a lot of people.

It supports cameramen.

It supports all sorts of things of Hollywood types who have egos and fast cars like Teslas

and whatever it is.

But lots of egos and lots of people.

And all of that is supported out of the revenue line if US Network TV.

And Google didn't look like it had cost structures that looked like US Network TV.

They looked a lot better than the US Network TV.

And it was approaching the revenue of US Network TV, and I thought, it's probably nearly done.

The revenue's doubled and doubled again since then.

And I've underestimated how far revenues can go the whole way.

It's now trading at five and a bit tons revenue.

And given its cost structures look relatively light, that doesn't look awful.

MATT MILSOM: How do you compare this to the Lyfts and the Ubers because that's IP.

That's technologically advanced businesses, new things.

This is catching a cab and getting food delivered.

JOHN HEMPTON: Yeah, Uber puzzles me.

I can't work out-- I haven't read-- MATT MILSOM: The S1?

JOHN HEMPTON: --the S1 that came out this week.

MATT MILSOM: Total addressable market, is it?

JOHN HEMPTON: Yeah, no, no, you told me about this.

I was asked to guess what the total addressable market was.

And I said, well, land transports, like 6% of global GDP.

So I thought 5% of global trade GDP, so I thought about $6 trillion.

And the answer comes back-- but you've forgotten food.

MATT MILSOM: And you've forgotten all these other things.

JOHN HEMPTON: Freight, and they think the total addressable market is $14 trillion.

And global GDP is, what?

$83 or $84 trillion at the moment, something in that range.

MATT MILSOM: $88 now.

JOHN HEMPTON: $88, I'm sorry.

MATT MILSOM: And they're thinking $12 trillion.

JOHN HEMPTON: Yeah, right, yeah, the addressable market is from a different planet.

But what Uber does is it organizes a taxi for me.

And it takes 20% of the revenue.

And all it does is a software tracking it.

The only really service is I have a piece of software that connects this person to another

person.

This should be the most astonishingly profitable business in the history of Christendom.

MATT MILSOM: And yet.

JOHN HEMPTON: It hasn't made a penny.

If I understand-- MATT MILSOM: $10 billion in the last three years.

JOHN HEMPTON: I understand.

But it's one of those-- you ask me, would I short it because it loses money?

And the answer no because the underlying business structure just looks like it should be the

most profitable business in the history of Christendom.

MATT MILSOM: And not a fraud.

JOHN HEMPTON: And not a fraud.

And someday or other, it just doesn't have very many of my red flags attached to it.

And some day or other, if it really can be that profitable, well, maybe a management

team will want to make it that profitable.

At the right price, I'd go along the thing.

I don't think this is the right price.

MATT MILSOM: It hasn't been set yet, I suppose.

JOHN HEMPTON: Yes, but I don't think this is going to be the right price.

I don't actually have a problem with it.

I tend to prefer my businesses have management that demonstrates that they know how to make

a profit.

MATT MILSOM: With a bit of a track record.

JOHN HEMPTON: Yeah, if they risk it a little bit.

But when Google came public, it didn't have profit.

And the revenue went further than you could possibly imagine.

And the management team still look a bit fragile.

Part of the issue with Google is we don't know how much money they spend on their bits.

It just looks rather black box-ish.

But it's pretty hard to fault them.

If I'm saying they look a little bit fragile, I'm kidding myself.

They've done way better job than you would rationally have expected.

MATT MILSOM: At least they those-- hundreds of them don't leave every year, I suppose,

like at Tesla.

JOHN HEMPTON: No, they're not obviously running out of cash whereas, you know-- and I guess

Uber at one stage is probably going to have to become rational because you can run out

of-- it's like the problem with socialism.

You'll eventually run out of other people's money to spend.

MATT MILSOM: In this case, the Vision Fund or SaudiJOHN HEMPTON: Whatever it is.

It's a great welfare program.

MATT MILSOM: So you see this as a bear market rally in the first quarter.

JOHN HEMPTON: Yes, but I'm talking my book.

MATT MILSOM: I've got longs and shorts.

JOHN HEMPTON: Yeah, but we're sideways.

And I would be much, much happier with them.

We tend to go up very slightly when the market goes down.

But the real thing is that, when the market goes down, our shorts are deliver us a big

whack of cash.

And that big whack of cash is there to buy Christian Hansen at 3 times revenue rather

than 10 times revenue.

MATT MILSOM: Right, but it's not the beater of the shorts.

It's when they go under is when you really make the killing, right?

JOHN HEMPTON: Yeah, well, if I can find longs at will and shorts with some difficulty, then

I'm going-- which is not the case at the moment.

But if I could, I would run with it.

If we come to a world where the Christian Hansen's, the really fine companies, are trading

at three times revenue and the crappy companies are blowing up, then I will take the profits

that we made from the shorts in cash and go buy large whacks of longs.

And I probably won't replace the short because, if I can find lots of longs at willingness,

the market's going to go up.

MATT MILSOM: So you got stopped out a couple of times last year?

JOHN HEMPTON: If you have 200 shorts, you get stopped out on some.

We tend not to get stopped out very much.

And the reason we tend not to get stopped out is that our starting position is like

20 pips.

And we're actually tolerant of the short tripling.

And the ability to just be tolerant to the short tripling means that you don't get stopped

out very much.

MATT MILSOM: But you don't add.

JOHN HEMPTON: We don't add.

You can't add at that point.

Now, if a stock triples and our red flag looks like it was a mistake, we will cover it so

fast it's silly.

Amerin is my classic example.

But there's an Amerin most years in our fund.

Some of them really annoy me.

There was a tiny little one.

If any of your readers have ever heard of it, I will be stunned, could Aurore Med Pharmaceuticals.

And Aurore Med Pharmaceuticals were testing an oral version of insulin.

And the oral version of insulin was going to be wrapped in some kind of gelatin.

And the first tests were phase two A's, which were safety tests.

And of course, they passed because it was a protein wrapped in another protein.

It's going to be safe.

The basic problem is that oral insulin ain't going to work because your gut is going to

digest the stuff.

The reason why it's given intravenously is that it's got an atomic mass over 130,000.

And if your atomic mass is over 130,000 for a protein, your gut has to break it down to

get it inside.

You might be able to breathe it in.

And that's a very marginal thing.

There's a longstanding drug promote called MannKind, which was about inhaled insulin.

But this one was completely bozo.

It turns out that the chief scientist was undisclosed the mother-in-law of the CEO.

MATT MILSOM: Was that the red flag?

JOHN HEMPTON: There were 20 red flags.

MATT MILSOM: Oh, OK.

There you go.

JOHN HEMPTON: And we put it on, our usual 30 pip position.

And then they hiked the successful phase 2A test.

And the stock went up six-fold.

MATT MILSOM: D'oh.

JOHN HEMPTON: We didn't cover it all.

But we covered some.

We finally took it off down about 70% from where we originally put it on.

MATT MILSOM: Happy end?

JOHN HEMPTON: 34 years-- no, not a happy ending because there's no way that we can recover

the stuff that we sold.

We short sold at $6 and covered at $30.

And when it was up fivefold, we had to cover some.

We were stopped out.

But we were stopped, if you understand.

MATT MILSOM: Right, right.

JOHN HEMPTON: And we kept some position on.

But if a stock goes from $10 to $0 over your $65, I'm losing money on it.

And if you have 200 shorts and you're right about most of them, it turns out that most

the place you lose money is ones that go from $10 to $0 over your $60.

It happens all the time.

And if you short 3% positions-- and a lot of people do-- one of those is going to give

you a very bad year.

MATT MILSOM: So this, in terms of hiding in plain sight, are you publicizing-- well, you

can't really publicize your situation.

JOHN HEMPTON: No, we don't publicize our shorts at all.

MATT MILSOM: But in terms of the story.

You're involved in the Twitter sphere on Tesla for example.

JOHN HEMPTON: Yeah, look.

Yeah, I'm involved in the Twitter sphere on Tesla because Tesla's the most fun you can

have on Wall Street.

MATT MILSOM: It's amusing.

Yeah, OK, gotcha.

JOHN HEMPTON: Basically, it's the most fun you can have sitting in a chair.

[LAUGHTER] MATT MILSOM: Steady.

JOHN HEMPTON: Steady, steady, it's a really good fun.

MATT MILSOM: Yeah, right.

There's just so much volume in terms of people's views.

It's so emotive, clearly.

JOHN HEMPTON: Yeah, look.

The whole idea that Tesla is something between, it's going to save the world from greenhouse

gases and completely change the way we live-- MATT MILSOM: It might blow up the world with

those batteries.

JOHN HEMPTON: --to Heilig-Meyers-- MATT MILSOM: Yeah, really.

JOHN HEMPTON: --with nothing in between.

MATT MILSOM: That's right, it's pretty bright black and white.

JOHN HEMPTON: Both of those views are way too extreme to be real is my view of them.

MATT MILSOM: Somewhere in between.

JOHN HEMPTON: Somewhere in between.

MATT MILSOM: We'll find out more on April 24th.

JOHN HEMPTON: We find out more every day.

MATT MILSOM: That's true.

JOHN HEMPTON: It's like, if you wanted to follow Tesla-- MATT MILSOM: And do nothing

else.

JOHN HEMPTON: --you could do nothing else with your life but follow Tesla.

MATT MILSOM: It's crazy.

JOHN HEMPTON: One of my staff for first Tesla is a short seller distributed denial of service

attack.

[LAUGHTER] It's so spectacular and such a sort of car wreck that every short seller

is just focused on Tesla.

And there's all this stuff out there that they're ignoring.

And they're ignoring it because Tesla's so god damn interesting.

MATT MILSOM: Not as big.

JOHN HEMPTON: It's big.

But it's colorful.

When Valiant finally blew-- and they made the Netflix documentary-- it was so colorful

in the end.

It was hysterical.

The idea that a company registered a couple of hundred fake pharmacies so that they could

send prescriptions to insurers without the insurer knowing where the prescription came

from-- MATT MILSOM: Hiding in plain sight.

JOHN HEMPTON: --and all of those fake pharmacies were named after characters in Stephen King

novels.

MATT MILSOM: Right.

JOHN HEMPTON: Right, I mean, that's bizarre.

But Telsa's that bizarre every day.

MATT MILSOM: Absolutely.

JOHN HEMPTON: It's like-- MATT MILSOM: Well, we'll see.

JOHN HEMPTON: We'll see.

But I don't want to play the Tesla denial of service attack because there are other

things to do with your life other than watch Tesla.

MATT MILSOM: Absolutely.

Speaking of which, I saw you off shore recently, Japan?

JOHN HEMPTON: Yeah, I was in Japan.

And two weeks of that was visiting companies.

And one week was with my wife.

MATT MILSOM: Potential longs?

JOHN HEMPTON: All potential longs, although we found a few shorts on the way, too, because

we can't help ourselves.

MATT MILSOM: And micro caps, or?

JOHN HEMPTON: Everything from micro caps to large caps.

But we have a sort of mystery.

The Japanese mystery is you keep finding these companies that should make pot loads of money

and don't.

And you're wondering whether they don't make pot loads of money because the management

have their fingers in the till or because they are incompetent or because they've got

lifetime employment obligations or because they have obligations to their account parties

so the money goes out via suppliers.

In some Japanese conglomerates, that's clearly the case, where you have a company that is

part of the Toshiba group.

And all the profits disappear because they buy overpriced services from other Toshiba

companies.

MATT MILSOM: And cross-holding-based or just relationship?

JOHN HEMPTON: Relationship based, and most of it is so opaque that the chance of a Westerner

like me understanding it is something approaching zero.

I have an example we've been talking about, which is a company called Takasago.

And I doubt you've ever heard of it.

And not having heard of it means you've missed nothing in the world.

Flavors and fragrances are an astonishingly good business.

This is the business of providing a small part, but a high value part, to, say, a food

or a cosmetic that gives it its flavor, its texture, its odor, and its branding.

MATT MILSOM: Like the probiotic story.

JOHN HEMPTON: Yeah, the probiotic-- thing version.

That's how we found these things.

The biggest flavors and fragrances company in the world is a French Swiss company called

Givaudan, which is also one of the finest companies I've ever seen.

And I went to their investor day in Jakarta, of all places.

It was a bad thing that everybody at a food company's investor day got food poisoning.

[LAUGHTER] Which is classic.

I blame the hotel.

It was a five star hotel.

But I blame the hotel.

But it was really bad.

I promise you.

But Givaudan's offices were a bit like a sort of Willy Wonka Charlie and the Chocolate Factory

experience.

They have, for instance, rooms that they set up with coffee beans in them.

And you walk in.

And every one has a slightly different smell.

And then they'll show you these smelling chips you put to the nose.

And there's 500 different slight variance in the coffee smell.

And then they will sell a coffee smell to a chain of cafes.

And you walk into the cafe.

And it smells like this really authentic coffee shop.

But in reality, the smell is coming through the air conditioner provided by Givaudan.

And that smell becomes the branding of the shop.

And they will never sell the same flavor or fragrance twice.

So one of the rooms they showed us had a bunch of smelling chips.

And you put one to the nose.

And it was Dove soap.

And you know it was Dove soap.

You've smelt Dove soap all your life.

They made the fragrance 70 years ago.

They've never sold it to anybody else.

And it's a beautiful locked in business.

A small parts of a big thing, lots of pricing power, very high switching costs.

Now, there are four big flavors and fragrance houses in the world and lots of little ones.

The four big ones are Givaudan, which is French Swiss International Flavors and Fragrances,

which is a stock that you will know if you have read Phil Fisher's books-- it's one of

the stocks in Common Stocks and Uncommon Profits-- a German one called Symrise, which is the

number four, and the possible number-- the number two in fragrances and number three

in flavors, which is a privately held company in Germany called Firmenich.

And these are fantastic businesses.

High teens margins have grown forever.

Very high switching costs.

If you go back 30 years ago, there was a fifth one.

MATT MILSOM: The Japanese one.

JOHN HEMPTON: The Japanese one called Takasago.

MATT MILSOM: What happened?

JOHN HEMPTON: That's a good question.

Takasago say that their stated margin objective is 5%.

When I went to Jakarta, the Indonesian people at Givaudan used to talk about the big five.

But the only market outside Japan where Takasago has made an impact is Indonesia.

They have not spread in any meaningful way to the west.

They have some astonishing technology.

The most important piece of technology is that they develop-- that they have a catalyst

business inside the company.

And catalysts are also a fantastic business.

It's a small part of a big process.

But it's the bit that determines everything.

So you get lots of pricing power.

And they invented a catalyst that could catalyze molecules forming either right handed or left

handed.

So molecules can be symmetrically one way or the other.

But they have different characteristics if they're one way versus the other.

But it was always hard to make left hand ones versus right handed ones.

And they had a catalyst that did that.

And believe it or not, it's one of the few companies I know where their own research

stuff won a Nobel Prize for doing that.

This should be astonishingly profitable.

And it's not.

And they don't take meetings.

We've tried and tried and tried to get a meeting with them.

They have some English language material but primarily because they want to sell stuff.

They have a quarter of the margin they should.

And this is a bad thing because, if you don't make enough money, you don't do R&D.

If you look at Givaudan, which is the best company in this space, Givaudan has 10,000

staff.

And only 3,000 are in manufacturing and the backend.

The other 7000 are in pure R&D and development for customers.

So almost all of the staff are in the front end of developing new business.

And if you have a fat margin, you can spend more money developing new business.

Takasago has gone from being a genuine number five 30 years ago to an -- MATT MILSOM: You're

not long.

JOHN HEMPTON: No, I'm not long.

And yet it has astonishingly good technology.

And it has genuine leadership in some parts of f it's the synthesis thing that-- the main

product from that is menthol, which you can get from peppermint by refining or you can

get by synthetic root.

And they originally had a monopoly on the synthetic root.

And then Symrise, the German company I mentioned earlier, also developed the synthetic root.

And eventually, BASF, the big German industrial chemical conglomerate, the mega cap, developed

the synthetic root.

But when they had an absolute monopoly on synthetic peppermint or menthol, they should

have ruled the world for a while.

And they never did.

And it's like this is Japan writ large.

You find these companies with these utterly beautiful positions that, for some reason

or other, just don't-- waste it.

And you're sort of pinching yourself and thinking, god, I wish I could give the CEO a big pile

of options.

If you gave the top 10 brass a big pile of options and said, go out and get as rich as

you can, then wonders would happen.

MATT MILSOM: But it's not America.

JOHN HEMPTON: It's not America.

And it's like Japan-- America has too much incentives on management.

And they do stupid things because they're incented by options.

MATT MILSOM: And the buybacks, therefore-- JOHN HEMPTON: Well, we'll talk about buybacks.

And Japan has not enough.

Yeah, America the classic is, you give the person too many options, they'll buy back

stock.

And of course, they'll buy back stock when they're selling their own stock because, you

know, what's a buyback for?

MATT MILSOM: Yeah, with debt.

JOHN HEMPTON: Right, and they'll lever themselves up.

And there is a golden variety of the absolute case point, which is General Electric.

And General Electric is a pretty bloody good company.

Its jet engines are amazing.

The technology that they just sold to Danaher, which was technology for membrane separation

and for making various proteins and biologics was also amazing.

Their are equipment is still the best in the world.

And yet the company is near insolvency.

And the only reason its near insolvency is it bought back $100 billion worth of shares.

It also spent $10 billion buying Alstom, which might be worth minus $10 billion, and a couple

of other mistakes.

But if GE had only bought back $70 billion worth of shares, nobody would be stressed

about it at all.

GE is the poster child for bad incentives producing bad results.

MATT MILSOM: Or a tipping point of leverage.

JOHN HEMPTON: Yeah, but the bad incentives were all the way down.

For instance, you had staff who were awarded based on various stated profits.

And so anything that could advance profits advance all right?

And leave risks entails rewarded them.

There's a JP Morgan analyst who's really negative about GE.

But his simple observation is that, over the last 15 years, the top five staff have had

$1 billion in take home pay.

And you know, I thought I was well paid as a hedge fund manager.

But I just don't cut it.

MATT MILSOM: Not trying hard enough.

JOHN HEMPTON: I'm not trying hard enough.

But yeah, but this GE problem is written all over the place.

My favorite example of buying back too much stock is Mattel.

And Mattel make boys' toys and girls' toys.

And girls' toy equal Barbie.

And boys' toys equal Matchbox and Hot Wheels.

And actually, it's a pretty hard business.

And they haven't run it really well.

And the reason it's a hard business is goddamn obvious, which is computer games.

Once upon a time, you could sell a Matchbox car to a 9-year-old.

If you showed a Matchbox car to a 7-year-old, 7-year-olds just want Mario Kart.

The only people that buy Matchbox cars are 3-year-olds and creepy 40-yearold men.

[LAUGHTER] MATT MILSOM: Not I. JOHN HEMPTON: And the company bought back literally billions

of dollars worth of stock.

The debt is trading is sort of good single B. But the difference between good single

B and bad triple C is not very much.

MATT MILSOM: What's the ratio of the CEO to median employee?

Do you know what I mean?

JOHN HEMPTON: Yeah, I know what you mean.

And I don't know.

I never actually looked.

But Hasbro has done absolutely everything right for 15 years.

And by doing everything right, your sales are about the same as 15 years ago, a little

bit higher.

But Mattel has not done everything right.

And some of the things they did wrong I would never have understood.

Like my favorite example-- which I'm not a consumer person, so I don't get this at all.

But when it was pointed out to me, I go, oh.

So I'll tell you, American Girl dolls-- these American Girl dolls were ridiculously expensive.

But you took your five-year-old to the salon.

And she'd have her haircut.

And the doll would have a haircut that was identical.

MATT MILSOM: Bless.

JOHN HEMPTON: And you'd walk out in identical sets of clothes.

And the dearest dad would be down a few hundred dollars.

It was an incredibly profitable business.

It had $700 million of revenue.

And then they decided to sell it in Toys R Us.

MATT MILSOM: Not quite-- [INTERPOSING VOICES] JOHN HEMPTON: --completely destroyed the cache.

The revenue went from $700 million to $200 million.

Now, for the life of me, I don't understand how to sell to consumers.

I just don't get it.

But it's still pretty obvious ex post.

MATT MILSOM: Yeah.

JOHN HEMPTON: They've sort of stuffed it up.

MATT MILSOM: Hindsight, a powerful thing.

JOHN HEMPTON: Hindsight's a powerful thing.

But you could stuff up American girl.

Or you could buy a few billion worth of shares.

But doing both was sort of a scary mistake.

And it's like, can I take some of this Japanese conservatism and sprinkle it over-- MATT MILSOM:

But there is reform going on there?

It is changing, maybe not by activists, but-- JOHN HEMPTON: I haven't been there enough

to know that.

The people that know it tell me that it is.

And they keep saying, think about it being slow.

So for instance, in the corporate reform with cross shareholdings, you either have to sell

them or justify them.

MATT MILSOM: With a one liner?

JOHN HEMPTON: You just have to justify them.

And so-- MATT MILSOM: It was cheap.

JOHN HEMPTON: You see people selling them.

And then when they sell them, they buy back an equivalent amount of stock.

So their first buyback, so we're seeing buybacks across the board in Japan.

And when you go ask them, why did you buyback the stock?

They said, because of that-- because we had to.

Not because it was optimal for the shareholders, not because it would make the management rich,

which is the American reason for buying back stock, but just because there was some kind

of corporate law reform.

We were sort of aching for somebody that said, yeah, we bought back the stock because it

was cheap.

And here's the measure of cheap.

And here are our measure of what opportunities we have to grow the business internally.

And yeah, we'll grow the business internally if it's optimal to do.

I was just waiting for a Warren Buffett view of the world.

But I wasn't getting it.

And I thought the chance of my getting it became thinner and thinner.

Now, there were some exceptions.

I'm not going to name names.

But we went to see some micro caps.

And where the micro cap had a family shareholder and the family shareholder was rational, you

had at least fairly good governance because the governance was that the family shareholder

kind of liked their lifestyle.

And in one case, the father had taken up with his mistress in the south of France.

And the son was running it.

And in fact, it was quite clearly run for the benefit of shareholders, which included

the father in the south of France.

MATT MILSOM: Self-interest.

JOHN HEMPTON: And self-interest is a pretty good motivator.

I just sort of wanting to sprinkle a little more into Japan.

MATT MILSOM: You came away with some longs or?

JOHN HEMPTON: I came away with some longs.

But nothing that felt like it was unambiguous, just stuff that felt really cheap and with

some optionality around it.

MATT MILSOM: Value traps, potentially?

JOHN HEMPTON: If they're buying back stock, at all, probably not, but the risk is the

same risk that you've had in Japan for a long time, which is you buy a really good company.

You wake up in 10 years.

And it's a slightly less good company.

And it has accumulated a large amount of cash.

And the stock has gone sideways.

Then there were things in Japan that just scared the willies out of me like lifetime

employment is a real thing.

Established Japanese companies do not fire people.

And they do not buy them out except at the most extreme level of reluctance.

But they fire nobody ever.

And we asked about it.

And they said it would be a national scandal.

That was the end of the answer.

If you have high technology plus lifetime employment, it's a scary combination because

the nature of high tech companies is that they have beautiful global monopolies that

last for three years.

And you have to be able to deploy the profits of this to try and develop the next one.

And if you don't develop the next one, you basically sell yourself.

Or you fade away.

But lifetime employment means the employment ramps up the big pile of cash because they

did make some genuine profit.

But for the next 15 years, all that cash goes out the door to pay their lifetime employment

obligations, the most shocking misallocation of resources.

MATT MILSOM: But there are Western practices coming in.

There's a SoftBank.

These are mega caps where they're changing slowly.

JOHN HEMPTON: Very-- if the Western practice is, we make up our accounts, then we did find

some frauds.

MATT MILSOM: Through the database?

JOHN HEMPTON: No, a database doesn't work very well in Japanese because mostly it's

about chasing names.

And we're not very good at chasing Asian names.

We just haven't computerized it the same way.

I have an intern who's just sitting over there listening.

And he knows a fair bit about-- he can speak Mandarin.

So we are thinking about using him in part to work out the systematic ways of chasing

Chinese names.

MATT MILSOM: So your bottom up approach, you're not thinking of whether we should-- obviously,

not thinking about whether we should be in yen and therefore-- JOHN HEMPTON: No.

MATT MILSOM: You go on the trip with the specific alpha in mind, the next-- JOHN HEMPTON: Yeah,

look.

We went look-- there are lots and lots of cheap shares in Japan.

We're not sure we own any of them, even if we buy the stock.

A lot of time, it was very straightforward.

When you said, why did you buy back shares?

It's because we have a 7% ROI target.

And we buy buyback sufficient shares in order to meet the ROI target.

Yeah, they're not lying to you.

They really do have a 7%-- and guess what?

You're going to make 7% return if the business doesn't implode.

And if the business does implode, you're going to get screwed.

7% return's OK.

But given it comes with a lot of risk, I'm generally not that interested.

MATT MILSOM: So what's the geographical breakdown currently?

JOHN HEMPTON: Look, we find shorts more easily in the US.

And we find the longs more easily in Europe.

So if you looked at us, we are about 70% short, 50% of which is in the US.

We're about 60% or 70% long in the US, and about 50% long in Europe, with a few incidental

things in Australia and in Japan and things like that.

MATT MILSOM: But no currency hedging?

JOHN HEMPTON: Very little.

I'll go back to Christian Hanson, which we don't own.

If it's in, of all things, Denmark, which still has its own currency.

Quasi pegged to the euro, but it still has its own currency.

The crown goes up, Christian Hanson's profits go down because-- MATT MILSOM: Inherently

hedged.

JOHN HEMPTON: It's inherently hedged.

If we owned a Danish-- which we wouldn't-- a Danish retailer, then we actually got a

currency exposure.

We've never mathematically optimized that currency to work out what our true exposures

are.

What we might do is say do some regressions of our portfolio against various currency

movements and pick the currency hedge that minimizes the volatility of the portfolio

on the basis that we have no ability to pick currency.

But anything that reduces risk is probably a good idea.

But we've never done that.

Most of the stuff we have is inherently pretty hedged just by its own business.

There was a quarter a while back, which was where the euro went from $1.30 to about $1.10

in a quarter.

And in the same quarter, the European stock markets had their best quarter in like 20

years.

And if you looked at it measured in US dollars, our Euro positions were just a wash.

Stocks with great.

Currency was awful.

They matched.

MATT MILSOM: Like Sterling at the moment.

JOHN HEMPTON: Yeah.

MATT MILSOM: But let's not go there.

JOHN HEMPTON: Let-- let's not go there.

Brexit is just a dog's breakfast.

The joke about British politics is that it exists to make Australian politics look competent.

[LAUGHTER] MATT MILSOM: Savagery.

JOHN HEMPTON: They're both pathetic.

We are a little worried about it, though, because one of the hardest positions we are

in long is Rolls-Royce.

We've owned it for a while.

And it just looks like a Brexit dog's breakfast.

Now, GE and Rolls-Royce are a global duopoly in wide body engines.

And wide bodied engines, they're going to sell a lot of over the next 15 years.

The most fuel efficient plane in the world is an A350.

We've checked that with pilots.

It hasn't had any notable problems.

It's not a 737 Max.

A global duopoly and a growing business selling a high tech product with vast amounts of revenue

should be as profitable as hell.

And it's not.

And it's not through a variety of mismanagement problems, some of which they're probably getting

to grips with.

But if Takasago is a Japanese company that is under earning, Rolls-Royce is a Western

company that is underearning.

And it's not underearning by a little bit.

It's underearning by an astonishing amount.

For years and years and years, GE's jet engine business had a margin that was 25-ish, 25

to 30.

And it was real.

The cash was largely all taken, buybacks and then some.

But nonetheless it was real.

And Rolls-Royce is lowest single digit.

That company could, conceivably, earn 5x what it currently earning, certainly 3x is easy.

And it's never failed to disappoint.

MATT MILSOM: But you're still long.

JOHN HEMPTON: I'm still long.

It's just that it's one of these positions-- I went on a factory tour there.

And the factory tour was just good fun.

What boy does not want to go to a jet engine factory?

If there's privileges in this job, one of the privileges in this job is the ability

to go to a jet engine factory every now and again.

And we walked around and saw various bits.

And the most impressive bit was the testing room at the end.

And the testing room, you walk into a sort of linoleum covered thing that looks a little

like my kitchen with a few computers sitting around.

And it doesn't look very impressive.

It's the control room for the testing room.

Then you go through a pair of lead doors and walk down this set of stairs through, maybe,

10 feet of concrete and lead into an underground hangar the size of a football stadium with

jet engines strung up on cables and cable tied to the wall and big that black marks

where the engines had been firing into the walls.

And now you're in the set that looks like a James Bond movie.

It's astonishing.

And there's an X-ray machine so powerful that it could take your chest X-ray at eight miles.

MATT MILSOM: Wow.

JOHN HEMPTON: And they use it film the inside of a jet engine when the jet engine is running.

Now, it turns out that every testing room in-- the testing room is the single most capital

intensive part of the whole jet engine manufacturing process.

Every jet engine comes in and spends a week on the testing beds while they do everything

to make sure it really works.

They x-ray it from all sorts of angles.

And fire it.

And burn lots of fuel.

And make lots of noise.

And every engine that comes back after its five year maintenance haul also goes through

another week of testing.

So you can sort of work out how many planes there are in the world and how many planes

are on their order book and five year maintenance cycles and how many testing rooms they need.

And it turned out that they needed many more.

And these testing rooms were about 100 million quid each.

And we sort of did the back of the envelope and worked out that they had about half a

billion pounds to spend on testing rooms.

And they had done the back of the envelope by the time I was in the factory.

But quite literally, they hadn't even done that back of the envelope calculation three

months before we met them.

That is, they had pre-sold all these engines on the A350.

There's a forward order book as long as your arm.

And it's pretty obvious they're going to be profitable.

I think, touch wood.

But they haven't even worked out how much capital they needed for the ramp up.

It was the weirdest case of engineers not thinking through finance.

MATT MILSOM: So you're going to stick with it?

JOHN HEMPTON: We're sticking with it.

I said that three years ago.

And the stock is sideways.

MATT MILSOM: Decent yield?

JOHN HEMPTON: No, they actually halved the dividend along the way.

And they had to halve the dividend because suddenly they realized, oh my god, we've got

to spend half a billion dollars on testing rooms-- half a billion quid on testing rooms.

So this has just been a hard situation.

And I was sort of cheered when ValueAct, who are actually pretty good at this sort of stuff,

got involved and bought 10%.

And ValueAct just trimmed their position the other day.

MATT MILSOM: Uh oh.

JOHN HEMPTON: And I'm thinking, uh oh.

I'm getting a tiny little bit squeamish here.

And ValueAct and I are actually fairly good friends, primarily because I was on the other

side of Valeant rather.

And they held this huge mega position in Valeant.

And it's kind of mutual respect because I've looked at the things that they've done really

well.

And they've done them really well.

And they seem to respect me because, when they made a mistake, I spotted it.

So it's a nice situation.

But Rolls-Royce also has the most complicated supply chains you could imagine.

There are millions of parts that come from all sorts of places.

Each part has to be tracked, x-rayed, tested for integrity.

Expensive and complicated process, making jet engines.

And you look at it and think, Brexit?

This is diabolical.

MATT MILSOM: Outside of customs union?

JOHN HEMPTON: Outside of customs union.

MATT MILSOM: Oh!

JOHN HEMPTON: Now, we had some Brexit hedges on.

I'm not going to tell you what they are because I want to put them back on later.

MATT MILSOM: OK.

JOHN HEMPTON: But the only stock we have that scares me for Brexit is Rolls-Royce.

And it's sort of also a measure of the irrationality of the whole thing.

There was a town in Wales where the only big employer was the Airbus consortium.

And they had a factory with a few thousand people working for Airbus.

And the town still voted majority for Brexit.

What were they thinking?

It's the same-- MATT MILSOM: Not well explained.

JOHN HEMPTON: Not well explained, anyway.

So there's-- Brexit just looks bizarre to me.

But then so it's politics at the moment.

There was a consensus in politics from Margaret Thatcher to about five years ago.

And the consensus was that free markets and liberalism was the way to get rich, good rule

of law, free markets, free trade.

And there was a left wing of that consensus and a right wing of the consensus.

And then the right wing-- MATT MILSOM: Way more extreme now.

JOHN HEMPTON: And the right wing of that consensus said, yeah, and freedom and free markets and

getting rich is an end in itself.

And that's good.

And the left wing of that consensus said, and yeah, getting rich meant that we could

had a more robust tax system.

We could afford a welfare state.

We can afford environmental protections, et cetera.

But they both agreed on the free market data.

They don't even agree on that anymore.

MATT MILSOM: It's not free market.

JOHN HEMPTON: They don't agree on that.

No, no, there's a perfectly respectable view that says, you have a neutral tax system that

takes 35% of whatever.

But you have an otherwise completely even playing field.

75% of your profit is still a pretty good incentive for most people.

Or 85%, 70%, or 65% of your profits, you know, it doesn't kill incentive.

It just dampens it a little.

MATT MILSOM: But it's the access to capital.

Inequality is just driven higher by central bank action.

So if you can't get access to capital-- JOHN HEMPTON: Yeah, I am firmly on the left wing

of that view, which is that, by and large, markets are the way to get rich for the whole

of society.

But you need to have a tax system and welfare systems and an education system, so you don't

leave large classes of people behind.

And the cost of leaving large classes of people behind is becoming apparent at the moment.

And the cost is, ultimately, this is a democracy.

And they vote.

And you either treat them fairly, you treat everybody fairly in some sense-- MATT MILSOM:

Or face the unrest.

JOHN HEMPTON: Or face the unrest.

And Brexit is the classic example.

There was no rational reason to vote for Brexit other than it was opposed by the elites.

And I want to stick it to them.

MATT MILSOM: It was the marketing, I think, inherent in the NHS.

JOHN HEMPTON: Yeah, but you know-- The marketing was appalling.

MATT MILSOM: It was lies.

JOHN HEMPTON: Both sides, incidentally.

MATT MILSOM: One side didn't try very hard.

JOHN HEMPTON: No because they thought they'd win.

MATT MILSOM: Yeah, arrogance.

JOHN HEMPTON: Yes, but that seems to be-- MATT MILSOM: A common factor.

JOHN HEMPTON: A common factor these days.

It's sort of annoying because the free market delivered a lot of goods.

The post Margaret Thatcher globalization of the world worked in a very, very big way.

It just worked somewhat unevenly.

And then add in free money, a central bank, and asset price inflation.

And then it worked extremely evenly.

I don't want to pontificate about it.

I just need to work out how not to lose client's money.

MATT MILSOM: Excellent.

JOHN HEMPTON: Because that's really the job.

Well, my job is, of course, wealth inequality is fine.

Most of my clients are rich.

And I want to keep them that way.

MATT MILSOM: OK, it looks like we have run out of time again.

I never got criticized last time for bringing it to a very abrupt close.

But we've got more interviews to do today.

And great to see you again, John.

Thank you very much indeed.

JOHN HEMPTON: Thank you.

The Description of Short Selling Tesla and Japanese Businesses (w/ John Hempton)