Barbarian Capital

They Don't Always Ring a Bell at the Top But They Sure Eat a Lot of Steak

2012-01-29T02:44:00.000Z

Here's the thing about IPOs. They are about supply and demand. Yeah, sure, access to "permanent" capital, "liquidity events" for the founders and the Mitt Romneys, recapitalizations, and so on, but, fundamentally, they are about supply and demand. Offer too much stock, and it might be a flop (see GRPN's "float" in their I"P"O). Generate robust demand, and it might pop. But by the time a company gets to that stage, it has been scrubbed, polished, shopped and priced to perfection (which is why Uncle Warren does not play the game). Demand comes in cycles, and high beta companies usually go public later as they need to show a good upswing in results.

The Facebook IPO filing hogged all the attention this week, but what caught my eye was Del Frisco's, a steakhouse chain, filing an S-1 for a $100 million IPO. Uncle Lehman (now trying to pay off his creditors) has bought me meals in the Del Frisco's across the street. Great place.

But what does it indicate about "the cycle"? Steakhouses are "expense account" locations: business lunches, deal closing dinners, awards banquets, top sales teams doing the single-malt tasting menu, you name it. It is all "high beta" spending, and it all (or nearly all) goes away when the purses tighten.

What does history show? Let's look at the comps.

Morton's (MRT), a larger steakhouse chain, went public in early 2006 in the $16-$17 range, just as the national housing prices peaked. Do you remember 2006? The housing bubble was in full swing, everyone made "product", from the mortgage broker to the securitization machine, and the times were good, and the purses were loose. MRT then went on to drop to the $1.60-$1.70 range in early 2009. This is a 90% loss for the IPO buyers who held. The company was just taken private at $6.90/share but at least you can enjoy their internet-only NYC surf-and-turf three-course special at $109.99 for 2 through March.

Ruth's Chris (RUTH), also larger than Del Frisco's, went public in the summer of 2005 above the initial range, at $18/share. The IPO was in the $200 million range. RUTH tanked to $0.75 or something in early 2009, so call it a 95% loss for an IPO-price buyer. The stock is currently in the $6 range. Their Midtown location is running a $44.95 filet-and-lobster tail special for Valentine's Day, so get with the program (and do not take her to White Castle's Valentine Day specials, seriously).

But the icing on the cake is... Del Frisco's themselves. They filed their first ever S-1 on October 23, 2007, barely 12 days after the S&P500 index reached its all-time high of 1,530. The registration was withdrawn in December 2008. No, I am not making it up, and, yes, the irony is juicier than anything you can pick out from their menu.

They don't ring a bell at the top but they do eat a lot of steak.

Thoughts for 2012 and Selective Review of 2011

2012-01-04T04:08:00.000Z

I am crossposting here and on Davian, the technology and marketing partner for my inflation-focused product.

Thoughts for 2012 (some more serious than others):
- Flash mob acceleration makes standard retail an even less desirable place to be; retailers blame evil short-sellers for organizing the mobs
- The "better burger" and the soft-serve ice cream waves top out, there might be an IPO or two (Smashburger, Red Mango)
- Carl Icahn buys a ton of treasurys, demands seats in Congress, asset sales
- Apple somehow takes over your TV, car and fridge
- Hillary for VP; gets elected and takes "the suitcase" away from the O-Fail
- Brazil starts to look uglier than most think possible
- 100 m sprint record broken in London 2012
- Social media and tech start-up rapid valuation deflation
- Germany wins Euro 2012
- Chris Christie weight loss surgery during his summer vacation fuels 2016 speculations (promptly denied)
- Since every hedge fund strategy is negative for 2011, many expect mean reversion in 2012: the reversion does not happen
- US ISPs tighten data limits + USPS down to three delivery days = NFLX in the teens
- The Fed is sued by a pension funds group led by CalPERS for causing severe underfunding by rate manipulation
- Some widely despised sector does really well (financials, sovereigns, old telcos, big pharma?)
- Department of Education requires that colleges take "first loss" position in any student loan; this leads to differential pricing by major and a big decline loan availability for worthless/hobby/lifestyle degrees
- Surge in specialty spirits: ouzo, calvados, grappa, cachaca, etc.
- TSA-free/fly-at-your-risk airline fails to take off due to red tape
- Obama caught smoking with Carla Bruni, Michelle disapproves and flies coach back home
- Twitter still can't figure out how to make money, introduces a paid 240 character account; paid individual "pimped tweets" displayed in color and flash
- Unsynchronized transmissions and carburated engines make a comeback with enthusiasts
- ACLU sues school districts on behalf of American Muslims juveniles who feel excluded from football because of the "pigskin"
- Major newspaper takes a position against veteran privileges based on non-draft, paid military
- Perry, Palin and Santorum co-author a book on evolution, promote it with a trip to the Galapagos Islands
- Payroll deductions renamed from abbreviations to "old people pay", "old people healthcare", "Middle East occupation", etc.
- Cocktail food trucks (these really are coming)

Looking at my meager blog postings over 2011, here are a few things that make me look good. Not that I can eat that: inflation-positioning, even with good sized TIPS and cash/opportunistic holdings, was a disaster in the 2nd half of the year.

January 2011: Stay away from the Crumbs Bakery reverse-merger IPO. The stock gyrated in the low teens after the transaction closed later in the spring, prior to tanking to $3-$4 range. Who knew?
April 2011: Are we at the peak? This was a well-timed listing of current events pointing to a peak in economic activity. The US has not gone into a double-dip but we are not seeing mega deals, big resource mergers, and so on. Follow-up post in June, M&A Activity Indicative Of Peak Cycle
May 2011: The Ira Sohn Conference Lemming Trade: from the charts there, HOGS $15 to $8 now, CIT $44 to $34, MBI $9 to $12 (this one is up on the legal developments), BPI $26 to $24 (not bad, and a great story about the guy presenting it), MMC $30 to $32, AON $52 to $46. As discussed, one should not be following blindly (unless it was for a quick trade)
June 2011: Howard Marks is Selling, Should You Be Buying? Oaktree's filing was not a good harbinger. I discuss why.
July 2011: Coffee Stocks: Do Not Burn Your Fingers. This post discussed some of the hot coffee stocks. JVA, JCOF, JAMN, CRVP have all tumbled since then (some were on their way down already); the real businesses (SBUX, THI, PEET) soldier on, while the grandfather of all hot coffee stocks, GMCR is... well...GMCR.

With that, good luck in the new year.

Tom Russo Lecture At Columbia Business School/Greenwald (2009)

2011-12-03T01:49:00.001Z

I am crossposting here and on Davian, the platform for my inflation-focused product.

This is a 1.5-hour Columbia Business School lecture by Tom Russo from Spring 2009 (unconfirmed, my estimate).

Staying the course is important and hard to do in bear markets: Buffett visited his Stanford bschool class in 1980 and gave the following principles.
(1) The IRS does not tax unrealized gains so try to find things you can hold forever, the long term matters
(2) In a lifetime, you might have 20 great ideas so buy and hold
(3) Define your circle of competence (for Russo, consumer product and media companies)
(4) Choose management well. There is no deal to be made with corrupt people. It is an agency cost.

Long-term holding/stay the course has worked for his partnership. In 1999, they were down while the markets were up 27%. The story at time was that the internet will change everything, including grocery shopping and media. Traditional businesses were sold off, and the investors were bidding up the glamorous internet. Then in 2000, the market was down, while they were up 17%.

Also thinking long-term, stocks do reflect underlying cashflows. Since they hold a lot of basic consumer companies, these cashflows have been generally stable and growing over time. Also brand owners are able to match inflation well.

In addition, consumer companies are very shareholder-friendly: less agency costs. They do keep shareholders in mind when making capital allocations. He likes family-controlled businesses (unlike many who are wary of it) provided that, upon inspection, there is no self-dealing. Gives Adelphia vs. Comcast example. The families do not need to get bigger, and are less likely to do accounting manipulations.

Since they invest in global companies they also get some currency tailwinds. While admittedly not statistically significant, their experience has been that during years in which the US markets are weak, the US dollar has been weak. So an investor holding 40-65% international portfolio gets some boost from currency gains. For example, in 2002 they ere barely down (with 6% gain in currency) vs. S%P down ~25%.

Now the downside, they hold PM: they expect 80c decline EPS decline on $3.40 solely due to currency. Also holds other brand companies, Nestle, SAB, Heineken, Pernod Ricard, and likes the products, as it makes the research more fun.

There are few new ideas. A professor had an investment: an undervalued champagne company with no earnings, lots of inventory and acreage. Then at Sequoia Fund, he researched Brown Forman. BF then expanded into the flavored alcohol/coolers business. The stock shot up on the acquisition, but then the business fell off the cliff and the stock tanked. The shares plunged, and Sequoia researched them. So he's been investing in alcohol for a while. In 1987 the partnership was up 35% vs. market down 7% largely because of an alcohol company they had (Beefeater-brand owner) that was acquired. Great single brand companies do not survive for too long on their own: usually no distribution clout. Overtime they owned Corby, BF, Diageo, Allied Domeq. The point is you can figure out things, you will have multiple times to participate in the industry you know.

He also invested in newspapers, straight from Berkshire, so he started following them ("no new ideas"). Now that industry has hit a wall.

Now owns global liquor businesses: huge reinvestment opportunities. The brands have very small shares in the most interesting markets (China, India). So the cash flows from the mature business go to build in the new markets. So the real return to value investors is not only from the discount but also growth because of good reinvestment prospects. The market sometimes gets it wrong when the emerging market investments create short-term financial reporting disappointments. But these are often fixed cost investments, then they scale very well. So "reported" profits may be understated. This is true across many businesses they have with EM operations. They first bought BF in 1989, doing at 5 mm cases of Jack Daniels, mostly in the US. The multiple was low. The entire return since that time has come from growth abroad. They do 10 mm cases now. The shares have compounded at 15% per year. It has never been very exciting, largely a forgotten company. And now the future prospects are even higher as they hit the breakevens on the various international markets. Same with Pernod.

Pernod case: management has a good record. They started with a small cashflowing business in France, then started acquiring abroad. Irish Distillers, then Seagrams. With Seagrams, they got a good China business, Chivas and Martell. Then the 1997/98 crisis happened in Asia, and many Western businesses shut down. Back then, the crisis led currency collapses adn lack of buying power. Importers found it very hard to import, so foreign companies left. Pernod did not leave, and ended up "owning" the market once the recovery came. Many portfolio companies have the ability to endure losses like these. Then Pernod bought Allied Domecq and became a global. The business is decentralized. They own their distribution channels whenever possible. Now Pernod bought Absolut, the shares tanked due to the leverage, so Russo is buying Pernod. Pernod understands branding: in China, they just increased Absolut prices 50%, it was not aspirational enough. They will quickly make up the volume with dollars margin. Also very good at localizing products to taste or complimentary products. Price is suppressed: fear of emerging markets, fear of downtrading in OECD, the Absolut acquisition put 5 bn euros of debt/future credit access, share repurchases have stopped and the price paid for the acquisition. Position sized at about 5%, have 25% in alcohol. Across the board at single P/Es but all have good prospects for growth.

Q&A:
Q: Formula for financials' assessment?
A: the core business of Pernod is strong, Absolut is transformative in our view. We cannot put a precise number on that.

Q: Do you have an intrisic value for Pernod?
A: No

Q: On currencies/EMs in the turmoil?
A: Currencies and foreign markets are unknowable. Met with PM CEO, and he thinks the crisis is a US crisis. So (EM example) Russia, will be better vs. 1998: stronger country, local expenses, local production, several pricepoints. Russo has exposure in E Europe: the currencies look wobbly but no view on the future.

Q: How do you assess total addressable market in EM?
A: You will know it when you see it, no real approach. You know an elephant when you see it. He's investing in the conversion of rising GDP to branded consumer products. Often this displaces an indigenous product, like baiju in China, with a global brand. In India, beer is at 0.7L per person vs. 17 in china and 100+ in US. PG and disposable diapers: started at 3 mm cases few years ago, 2008 70 mm cases. But this is 2 cents per capita vs. few dollars/capita in the US. PG has tiered the product. New diaper plants come pre-assembled and can put it up in a week.

Q:How do you measure management alignment of interest with shareholders?
A: Have to pick the family right. No litmus tests, spend time with the family.

Q: Direct EM investments?
A: Often have the multinationals that deal in EMs, so they get more control over local management, more audit certainty, etc. Had a direct investment in a Slovakian chocolate company. The information flow burdens and the risk were too high to bear. Also the valuations have been much higher in EM for locally listed subsidiaries (ie Unilever Hindustan).

Q: Sell discipline
A: Now more prepared to take a critical look after 2008. But now harder to want business at lower prices.

Q: ??
A: Good discussion of how Richemont expanded in Russia (carefully, no partners, spent more for real estate they control).

Q: Tech?
A: Can't see Dell's future so no investment there. Ultimate commodity, and threatened by technology. Can't model it after consumer company process.

Q: ??
A: Sarbox is helping them with more controlled entities. Comfort varies from family to family, it is qualitative. With Berkshire's new independent board, succession is centerstage, and this is helping them as outside holders.

Q: Brand impairments?
A: Try not to get involved with impaired brands. Absolut might have been underutilized, and Pernod has the capacity to revitalize. Cadbury Schweppes: their great growth came when Mars went to sleep. Mars is now back, bought Wrigley, and this might hurt C-S company.

Q: Sell at what multiples?
A: At very high multiples, he'd sell no matter what; at high multiples, they reduce if it is a higher percent of the portfolio (i.e. grown from 5% to 8%). Often uses the cash to add to undervalued/underrepresented positions.

Notes from Bloomberg's "One Hour with Bill Ackman"

2011-10-06T18:31:00.001+01:00

I am crossposting here and on Davian, the technology and marketing platform for my inflation-focused autotraded product for retail.

This is a very recent interview with Bill Ackman (BA) in which he discusses several of his past and present investments, and shares thoughts on Hewlett-Packard, Fannie/Freddie, and the overall US economic policies. About half the questions are from the Bloomberg interviewer, and about half are from the admittedly friendly and well-heeled audience. I use Bill Ackman ("BA") when he uses "we" to refer to his fund, Pershing Square. The headlines focused on the HPQ "brain damage" line but the interview has a lot more interesting bits.

Q: What is activism to Bill Ackman?

Lots of capital is managed passively: we are more concentrated. Look for undervalued companies and understandable reasons, and then work with management ("come up with irrefutable answers to problems").

Recent examples:
JCP: "iconic" retailer, moved from NYC to Plano, TX, in 1992. Stock was at $38, BA bought it at $21. JCP also sold its Manhattan building (today worth probably $2.5 bn) and built HQ in Plano. JCP spends $1.3 bn/year on marketing. Old CEO made two changes, but they needed to do more. CEO was near retirement, and BA was invited on the board.

New CEO: HBS, went to Mervyn's, then AAPL eleven years ago to build AAPL retail from scratch. BA worked hard to recruit him.
New CMO: just hired out of TGT

They will work with great assets: the brand, owns most RE or leases it for free, and it will be transformational over time.

JCP is an example of their longer-term, operationally focused approach. A different example is Fortune Brands (BC: formerly FO). FO owned three disparate businesses: Titleist golf, Moet faucets and the parent company for Jim Beam, Sauza and other alcoholic beverages. FO was trading at a substantial discount, BA built a 12% stake at $41, met with management, laid out a case, and the businesses were separated. Today they trade at $57 on an equivalent basis.

GGP: took a 25% stake in Nov 2008. Market cap was $23 bn in 2007, to $10 bn before the Lehman weekend, to $100 mm market cap in November. Founding Bucksbaum (sp?) family stake went from $4 bn to $25 mm. BA bought 80 mm shares for less than $1/share, joined the board (adviser Goldman Sachs did not want him; family member cast the deciding vote), BA led the restructuring. Now BA chairs HHC (Howard Hughes assets from the GGP Rouse acquisition).

Q: Why is JCP going to be successful where you [failed] at TGT?

TGT: it was already successful. We had two ideas for them, sell the credit card business (uses up capital, subscale, no advantage) and separate the owned real estate they own into a very safe REIT with NNN leases (ground rents). The land was worth $40/share with TGT at $50/share.

Went to management, management was very receptive and asked them to be quiet. Management was slow and really missed the market to sell, our loss was 50%, BA was upset, led a proxy contest, management agreed to some changes, little profits after four years. Now JCP hired their top marketing guy that led the designer strategy and now JCP will make it easy to buy Missoni and others.

Beauty of the retail business: JCP has 1,100 boxes, selling an unimpressive $150/sq ft of product. With retailers, next year you can be selling something very different so with the right marketing, merchandising and customer service, the number can improve a lot.

Q: People think that a proxy contest is needed at HPQ. They have hired GS preemptively to defend even though there is no activists around. Why do you think people think that an activist is needed?

Over the last few months, BA has gotten calls from the 5-6 top shareholders of HPQ begging him to take a stake and be proactive. BA focuses on predictability, and HPQ is a number of businesses that are difficult to predict even on a five-year basis. the PC business might be irreparably damaged after the spin announcement. So it looks cheap but it is a "big complicated mess".

BA learned early in his career to do "return on brain damage" for investment decisions: there would be too much brain damage at HPQ without the potential profit to justify it. GGP justified it, HPQ is a big mess. HPQ is also very large, BA likes 10% stakes.

Q: You recently bet on the reevaluation of the HKD: you gravitate towards retail, real estate, etc. Is it out of your comfort zone?

BA are known for our large stakes but also do small "mispriced probabilistic investments" like CDS on MBIA, bought for $30 mm, ended up at $1.1 bn. Small position; investors "would not notice if we lost it"/asymmetric payouts. Also likes to hedge the big stakes against market declines. Used to do it with CDS but now corporate America has recapitalized and is in good shape. So this is how he came across the HKD.

HKD was pegged to silver, then to GBP, then floating but in the early 1980s, the UK/China handover negotiations were not going well (Thatcher broke her leg, bad sign), the HKD started to depreciate rapidly, people panicked and started stocking up supplies. The government was forced to peg to the USD. However, since then, the GDP has grown by leaps and bounds, HK gained AAA rating while the US lost it, housing market is overheating, inflation is high, but their monetary policy is identical to the US. So ZIRP with 6% GDP growth, heavy imports, heavy asset inflation. The currency is artificially held. Eventually it will break.

Because it has been pegged for so long, the volatility of the options is zero. The bet is $100 mm in calls so a small move will yield enormous profit. It is also a hedge against a USD collapse- we might be headed in that direction. You're earning zero on your money market, buy some HKD, better yield, and may be you'll make out well if the peg is removed and the HKD appreciates.

Q: How do you keep your LPs from getting "squirrly"? Your strategies take time, people redeem.

Benefit of good record over eight years, low 20% compounded net of fees. We've made people money. But more importantly, BA is the opposite of a black box strategy: most investments end up being public and people just know what BA tries to do. They also understand that it is a concentrated strategy. BA does not offer smooth returns and investors understand this. BA communicates quarterly and annual dinner.

Q: Loeb and Einhorn have created reinsurance funds for permanent capital. Will you do this?

Buffett has the best permanent capital because he does not have to worry about redemptions. In BAs case, even though they had good 2008, in 2009, they lost 27% to redemptions from investors who had outside liquidity needs. This means being defensive when it is the best time to be offensive.

BA does not like mixing reinsurance risk (with no expertise, small scale) with investment risk. The world is too uncertain; can't really feel confident in the maintenance of the 30-year old reactors like Fukushima. BA plans to issue a closed-end vehicle to investors some time in 2012 for permanent capital.

Audience questions:

Q: Auto industry?

Might be cheap now, post-restructuring GM is competitive cost-wise, but does not/never did love it. It is too volatile (likes "annuities"-type businesses), too capital-intensive, labor unions always ask for more when times are good. Better opportunities elsewhere.

Q: Newspapers?

Learned a valuable lesson 5-6 years ago with Borders investment. NYT is relatively better now (become more national) as the smaller competitors have blown up. The iPad gives some hope, people are paying for it. The NYT might be a vanity investment, like the WSJ/Murdoch. NYT is now more like artwork, not for me. Also controlled.

Q: Human capital/marketing/etc/ investment in JCP that is required?

JCP is a $18 bn "Start-up", $1bn+ EBITDA to do whatever he wants to. Big advantage. Replacement cost of the real estate is $12-15 bn. You get all that for about $6 bn market cap. The business is cheap, good place to start. Now has to attract talent, new CMO is a coup: now people want to come work for them. With the asset base, attract people and go from there.

Q: Financials?

Likes the big banking franchises, likes C the most, at these prices: there is a lot baked in the prices. The government bailed out the banks, converted to common, sold it, and now sues the banks. FRE/FNM lawsuit is absurd that they did not know. Now best thing, the government should take a face-saving litigation, and let them focus. Regulation also a problem, reporting to too many agencies: hurts small/medium business access to capital. Current stock prices factor a lot, C is still at 6x current bad earnings, and may be 4x core earnings after the noise which will take time. Interesting risk/reward but don't put half your assets.

Q: Why did you not wait to buy financials until now?

By the time the dust settles, the stock is up 50%; you have to do it when it is cloudy. BA bought GGP 11/16/2008, on the brink of bankruptcy, no securitization market, BA has to predict the future but the odds have to be good.

Q: Occupy Wall Street consequences?

Not sure what they are protesting but it should not be ignored. Governments can be overthrown without leaders now. Unemployment and disparity is a problem, especially for non-college educated. Cost of healthcare, housing, commodities increasing. It is critical to have leadership in DC.

The president is the CEO of the US as a business, we can have real problems. Obama began as anti-business, and it cost us. Legislation has made it more difficult, tax policy does not incentivize investment.

Whoever is the next president will have to make the country succeed as a business.

Q: Russia and China/rule of law?

(Goes on to talk about US legal system instead of the international investing question). Our legal system is still pretty good. Some expections to that. Recent proposals are hurting the markets. For example, Wachtell Lipton is in the busienss of protecting entrenched management to get M&A deals. WL invented the poison pill. WL is now trying to speed up activist disclosures and impose cooling off purchasing periods post-5% acquisitions which would effectively mean that BA will not be able to accumulate the target 10% stake. The passive and small retail investors rely on activists for helping but we have to buy a big enough stake.

No outstanding CEO worries who the shareholders are, only the weak ones do.

Q: Yahoo is putting up a fight with Loeb; is corporate America getting better at "defending"?

Usually the entrenched CEO is defending himself. HPQ is very unfortunate story: Hurd had an incident, got fired (is the Board held by the same standards), then hired CEO with no core business expetise. He said he's not acquiring anything then overpays. Then the stock tanks, the Board fires him, does no search, hires Whitman with no core expertise. Morale is low.

Boards are to blame, and the election process is Stalin-esque: there are no alternatives on the ballot, plurality voting, etc. BA ran the TGT slate: it cost BA $10 mm to put up alternatives for shareholders. Last year SEC put up a new rule to help this but it was defeated. The directors are typically selected by other directors or the CEO. TGT board had no retailers, no real estate, no credit card execs.

Q (from Ackman's father): Congress is a disgrace; we cannot get qualified people to run; what can we do to get qualified people to run for office?

Likes the Bloomberg model: business oriented, rich, and can do what is right. Country is ready for a candidate who says what he thinks, this is why people were excited about Chris Christie because he does not care what people think. If BA were Obama right now, he'd come up with a few pro-business policies:

(1) To change both the spirit and the confidence of business, get rid of all tax loopholes. Do a flat rate with no exemptions. Do something similar with personal tax code (incl. HF manager taxation). But now 49% of people pay ZERO taxes: so if you don't pay for the country, you don't care about it. Everyone should have some ownership in the country. Two-page form, couple of rates. BA's personal tax form is an absurdity, has not read it, has no idea if it is right.

Repatriation should be easy/low tax: no sense to have HPQ overpay because it will be taxed at home and subsidize UK employment. Obama has to respect the business community, the corporate aircraft industry is great, don't pick on Las Vegas, people there need jobs, too.

(2) Merge Fannie and Freddie, stop dumping foreclosed houses, turn them into REITs for single homes. In most markets you can make high single digits unlevered. This will dry up the supply in the market. Now FNM FRE are subsidizing apartment construction, their competition. Better off having local renters/maintenance, may be tweak the tax on home capital gains, too.

/end/

Is High-Frequency Trading (HFT) Harming Progress?

2011-09-25T23:06:00.000+01:00

I am crossposting here and on Davian, the technology and marketing partner for the inflation product I have.

In part, yes. My thoughts below.

There are many definitions of progress, but I am going to skip over the more politically convenient ones. I view progress as truly novel ways to do old things (i.e. cell phones, internet, alternative energy), getting rid of widespread diseases (i.e. polio), order of magnitude cost reductions (i.e. chips for calculations), and the like. One can include things we can't imagine yet (past examples include plastics, telephony, flight). Twist-off beer caps, heated car seats or seaweed yoga pants do not count as progress.

For thousands of years, individuals have been able to make various important discoveries and inventions by and large on their own, or with relatively modest capital investments. These days are gone, for the most part: no one truly expects to mix up a cure for AIDS in a basement or to sequence the human genome on the kitchen table over yesterday's NY Post. The next large steps in progress will- in all likelihood- require that the person is a part of a large organization such as a university or a corporation. The next large steps would also likely require deep specialization in a certain field: after all, most- if not all- of the low-hanging fruit is gone, and the new generation has to step on the shoulders of the giants of yesterday.

Progress is in some aspects also a product of luck: you need lots of people doing lots of things, and some will be successful. These people nowadays are usually hard science PhD-level individuals- and, while I am mindful of individual choice and preferences, it seems that society (and progress) would be advancing faster if the high level of specialization was put to work in the proper conditions.

The problem is that less and less of this is happening. Big Pharma has been shrinking for years. The old tech giants seem more interested in behaving like patent trolls rather than funding R&D (for example, what used to be a highly innovative company, Hewlett-Packard, has cut its R&D from 6% of sales to almost 2% of sales in about a decade). R&D is viewed as a cost and is high on the list for outsourcing, creating even less incentives for people to take risks by working on what might be career and scientific dead-ends for a disloyal employer. Who is picking up the talent?

One industry is high-frequency trading. The low-to-negative societal value of co-location, quote/cancellation tricks in nano-seconds, order sniffers and the like is established beyond doubt, in my view. But these companies are dangling $300k++ packages to physics and engineering PhD's straight out of school to come up with even more innovative ways to milk fractions of pennies from your orders. This effectively removes talent from what might be the "unimaginable" developments and puts them to addictively lucrative work that one might argue contributes to regress, not progress, by undermining the faith in and the integrity of the capital markets (the flash crash last May being a recent popular example). So, it does seem to me that HFT is impeding human progress.

Labor Day: Barbarian Capital author is looking

2011-09-05T23:47:00.001+01:00

In line with the Labor Day spirit, I am exploring career options-- analyst (generalist/consumer-retail/real return/inflation), product development within these areas, or something along these lines. You can contact me via twitter or by leaving a comment (comment will not be published so you can leave your email in it).

Andrew Redleaf Lecture at Yale Fall 2008

2011-09-04T00:39:00.000+01:00

This is a lecture by Andrew Redleaf, co-founder of Deephaven and Whitebox Advisors. It was given in Fall 2008 to Prof. Robert Shiller's class at Yale (Shiller of the Case-Shiller index and Irrational Exuberance fame). Redleaf is not a natural public speaker ("graduated from Yale University in three years with a BA and MA in Mathematics and was recognized as the top mathematics student of his graduating year in 1978"), and there are no slides, so here are my notes. I have bolded what I found interesting.
Efficient market theory: two camps, yes/no.
A theory has to be predictive, and EMH is not: dual class stock, CEFs discount/premium to NAV, stubs, less volatile outperformance, certain outperformers, bubbles all refute EMH
Once the hardcore academic believers die, it will not even be an open question whether markets are efficient

But doing better than the markets is non-trivial (not impossible but hard)

Challenges
For individuals, should stay within area of information advantage but they will not be diversified; also individuals have more limited access to products and information; less assets

For institutions, there is the constraints: liquidity requirements by outside investors (i.e. 30-day notice); institutional biases stemming from individual biases; problems with decision making in the areas that have a mix of randomness and skill; understandable areas are fully random are easy; poker is similar to markets because of the randomness/skills mix; often someone who plays will admit to not being that much into it, why would they do tell you? Pet theory: setting up in advance to lose and easier to deal with internally . Other individual biases are causality just because one thing happened after another, recency, anchoring

What they try to do:
3 principles
(1) The investment world divides b/n coupon-clippers (cash flow-oriented investors) vs. re-sellers (owning to re-sell to someone at a higher price). There are successful people in both areas, and they make their money off the less successful people in the group. They are about the coupons: focus on cash flow. VCs are re-sellers: find an idea, sex it up, and get a good valuation from the public.
(2) Risk is primarily about what is the worst thing that can happen. Typical Wall Str risk management is about VAR: how wide is the range of probable outcomes. The VAR approach is fundamentally wrong but it done because statisticians are good at it, and it is hard to imagine the worst that can happen.
(3) Most at odds with the academics/general perception: you don't get paid for taking risk, you get paid for eliminating it. In the history of the planet, very few people have been paid for taking risk. A tightrope walker in the circus is an example: it is paid very well but you have to look at lifetime income, it is not that great if they fall. They are paid well because they have been working on training not to fall (=eliminating risk). Pharma drug development is uncertain risky business. Are they paid for the risk? No, they are paid for applying intelligence and eliminating certain compounds and combinations in advance. Insurance companies: if they are doing their job right, they should be avoiding risk. A casino does not have the risk that they will lose money because the law of large numbers takes care of it (the risk is in traffic/visits).

So we look at what is the coupon, what is the worst outcome, and how can we eliminate it? Sometimes it is diversification (independent positions; or sometimes offsetting positions, such as long a high yield bond and short the common in proportion is a simplistic example of clipping a coupon and reducing risk.

The next part is a discussion of events happening around the time of the lecture (November 2008) and Q&A.

Q: Are markets less efficient if prices are going up vs down?
A: No systematic view, but in recent years, more examples of overpricing but not clear if this is due to money creation.

Q: ??
A: An individual's default position should be cash; should invest only in compelling cases. Equities get cheap periodically by most standards. Recommends buying stocks now (Nov 2008). With the housing bubble taking off a few years ago, apartment REITs were interesting (below replacement cost) with compelling comparative yields (5-9%). Municipal bonds now yield more than equivalent treasurys, that's compelling. Has not happened since the fears of them losing their tax exempt status.

Q:??
A: The long term argument for stocks in the US has strong survivor bias and has benefited from the US switching from agrarian to industrial. It is not clear at all whether the next 100 years will be like this.

Q:??
A: Swensen of Yale Endowment has strong preference for equity; Redleaf likes fixed income securities a bit more because they are more analyzable inherently. Stocks have to be really cheap because they don't pay out earnings and in the future, they might do something stupid. Buying stocks at mid-single digit multiple for a good reason, you will get paid twice: multiple expansion and earnings growth. The market is telling you though that the earning are going down if the P/E is mid-single digit. RIMM is risky: very high multiple, it might not matter if they double earnings, and they'll never pay any dividends.

Q:??
A: Involved investors are good (activists or direct owners). Executive comp is not the result of arms-length negotiations unlike hedge fund comp which is market-negotiated.

Final Q:??
A: Lengthy discussion of special situations where there is an event of default for delayed financials filing, and how they are active in it. They co-owned Sun Country Airlines with Petters Group (now a known massive ponzi scheme)

Why ZIRP is Bad for the Middle Class

2011-09-01T21:36:00.000+01:00

I am crossposting here and on Davian, the technology and marketing partner for BCIF, an inflation focused product for retail investors.

The Fed announced recently that they will continue with their zero interest rate policy (ZIRP) at least until 2013. May be they want to see a wholesale flight out of paper dollars like we saw last fall. Regardless of the market implications, I think that ZIRP is bad for the middle class in many ways, including some that are less quantifiable. As Charlie Munger says, not everything that counts can be counted.

A fundamental tenet of "middle class-hood" is future orientation (vs. present orientation). People with present orientation like to do things without regard to future consequences (driving drunk, having unprotected sex, skipping class, buy now/pay later, etc.) A core middle class value is future orientation: decision-making that takes into account future consequences. This has meant staying in school, not fathering children left and right, and, the focus here, saving: saving for a downpayment on a house, saving for a car, saving for college, saving for retirement. ZIRP discourages saving by stealing the interest earned on savings and encouraging present consumption. This leads to both overconsumption (relative to incomes) and to lower retirement savings (and, in part, to defined benefit plan underfunding).

ZIRP is also bad for middle class jobs. In many businesses there is an optimal choice between capital and labor (sometimes not direct, make something manually internally vs. buy machine-made from outside). A factory owner would love to fire all workers if robots were cheap enough: I know I would prefer to deal with machines than people who stay home when their kid is sick or walk in the office with an offer letter, asking for a raise. ZIRP (and Obama's accelerated depreciation stimulus) heavily favor machines vs. labor. I am all for progress/mechanization but I think that the relationship has gotten a bit distorted.

ZIRP leads to malinvestments: we had a housing bubble a few years ago. We not only ended up with too much (and highly energy-inefficient) housing but also we ended up with a large % of the workforce in the bubble-fueled real estate economy, from the slick jumbo mortgage broker to the gruff plaster guy. Some of these were formerly middle class jobs, especially in smaller communities, and now the sheer decline in business volume has hurt them. The decline in housing prices post-bubble has also cost the middle class dearly in equity.

ZIRP speeds up job exports. Large international companies, like MCD or WMT, can borrow at very low rates here in the US and invest these money at much higher returns in emerging markets. These create not only MCD or WMT front-line jobs: with every expansion come the accountants, the marketing personnel, the buyers, the logistics, the IT, the management, and, perhaps most importantly, the R&D. GE just moved their X-ray R&D work in China. This probably would not have happened so quickly (if at all) if they could not borrow so cheaply to build or acquire abroad.

ZIRP is an implicit policy of dollar devaluation. People argue about the mechanics but the message is that the dollar will be weaker. This means inflation as the US is an oil importer. The middle class is already already struggling the points above (unemployment, reduced wealth, no interest on savings), this hurts even more, be it at the pump, the heating oil delivery, the airline fuel surcharge or the consumer-level price increases due to higher energy costs. The winners here (exporters such farmers and miners) are a small percentage of the workforce. The middle class is not a winner from $120 oil.

ZIRP discourages real capital formation. This is a off-shoot of the savings and employment point: capital formation for small businesses comes from savings- we are talking about rentals, restaurants, car washes, chips delivery routes, hair salons, food trucks, small shops, etc. Most everyday people are not into social media start-ups. A potential entrepreneur (and his/her family) actually loses money after taxes and inflation while trying to save up for the business. This hurts both entrepreneurship and, consequentially, hiring (oft cited stat is that most jobs come from small businesses). There is an argument that loans are cheaper, too, but the contra here is that higher equity businesses are more robust.

ZIRP needs to end. To give you an idea of where the rates "should" be, for a 1-year CD to earn a meager 1% in real after-tax return, the 1-year CD rate should be at about 5.75% (simplified calculation: 1% real return + 3.6% LTM inflation =4.6% after-tax, at 20% total tax rate-Fed/State/Local- this implies 5.75% pre-tax). The average one-year CD is at 0.84% today per Yahoo Finance. Who benefits from this? Three administrations have worked to double the size of the government in 10 years via cheap deficit spending, while the banks are getting nicely recapitalized.

A Better Way to Hire?

2011-09-01T21:34:00.000+01:00

I am crossposting here and on Davian, the technology and marketing partner for BCIF, an inflation focused product for retail investors.

The labor market has been a challenge for years. A part of the problem is that the market one of the least efficient markets out there. Many transaction opportunities are not advertised, limiting the flow to a small network. And even the more widely advertised positions often have a gatekeeper: HR or recruiter whose short attention span (and, often, lack of ability to discern quality) means that only the "best-branded" resumes get a priority. Like in the supermarket, going for the brand makes the buyer feel more secure and reduces time spent on making decisions. This is a part of the larger credentialism problem that we have as a society.

So is there a better, more meritocratic way to hire? There is a good recent example of that. A NYC-based hedge fund manager, Aram Fuchs, was looking for a junior and a senior analysts to work for him. Instead of playing the "resume game," as he calls it, he managed an open forum, the Capitalist Collective, where anyone, regardless of background, could submit stock ideas, discuss others' ideas or engage in general discussions. Mr. Fuchs recently announced four "finalists", and the process will culminate in a day-long investing conference on September 9th, 2011, featuring speakers, stock speed-dating, and, of course, the grand finale. Along the way, Mr. Fuchs hosted a couple of socials and had calls with some of the participants.

While obviously longer and more involved than the traditional route, the process draws from a much larger audience and the hiring person can observe and interact with the applicants over weeks, thereby developing substantially more valid views on suitability and other important factors. The forum format also allows a lot more contact points with people who are currently working elsewhere. There are unlimited opportunities to show and defend ideas rather than the regular 1-2 stock pitch approach. Finally, the participants know that the opportunities advertised are "real", unlike the phony "openings" that collect stock ideas without any intention to interview or hire.

Let's hope that this approach becomes more widespread with time.

Teacher Cheating, Banking Self-regulation, LIBOR, and Ethiopia's Population: How Incentives Matter

2011-08-06T16:50:00.001+01:00

I am crossposting here and on Davian, the technology and marking partner for my autotraded inflation product.

There is widespread mandated standardized student testing in the US that is supposed to measure the learning outcomes of cohorts of children. These are high stakes tests: teachers and school administrators have a lot to lose (depending on the locality) if the tests show no progress, or even regress. However, there is one flaw with the system: the teachers administer the tests to their own pupils (!). So, much to the surprise of people with low real world IQ, turns out that there is widespread cheating by teachers across states, cities and districts (some teachers tell students what some of the answers are, others manually correct wrong answers prior to submitting the tests for official grading).

The teacher situation is similar to banking (or any other industry) self-"regulation". I won't belabor the point as there is plenty that has been written on dejure and defacto (regulatory capture) self-reg. Though one of the more memorable moments from the credit crisis was the probe into LIBOR manipulation (LIBOR is probably the widest-use reference rate globally): it is still on-going. LIBOR is a self-reported rate by the banking industry, and, needless to say, there is a strong suspicion that individual banks might have "mis-reported" their numbers during the peak of the crisis to make it lower than it actually was.

There is a horrible famine (pics link) going on right now in East Africa (which most Americans associate with the movie Blackhawk Down). Hundreds of thousands might die. Back in the 1980's there was a similar situation there- in Ethiopia: the world came together and brought food in. But there was a message about incentives that got lost: Ethiopia's population in 1983 was 33 million, now it is...~~75 million~~ (Update: 91 mm per 2011 CIA esitmate). If the US had grown at that rate since 1983, we'd be north of ~~500~~ 600 million people now.

People do what you incentivize them to do: if you pay them to report improved scores, they will report improved scores. If you pay them to report low borrowing costs, they will report low borrowing costs. If you pay them to lack foresight, they'll surely not have any.

Case-Shiller in Gold

2011-08-04T00:58:00.003+01:00

So what happens when you put together one of the most beloved assets and one of the most maligned? I pulled the Case-Shiller Q1 US Composite (since 1987, first year available), and compared it to the average gold price in USD/oz from the World Gold Council (and eyeballed $1,500 for YTD). The chart shows Case-Shiller divided by 1 oz of gold in USD.

On a relative basis, housing in gold was most expensive in 2000. By 2005-06, the peak of the housing boom, gold prices have already appreciate substantially. The mean, median and harmonic mean for the period are 24.6%, 20.8%, and 20.9% respectively.

Based on the most recent Q1 C-S read, and $1,500 average gold for 2011, we are at 8%, the lowest value for the last 25 or so years.

More importantly, what are the implications? I wish I knew for sure but it appears to me that housing, in certain areas, might have gotten "de-risked" enough (read, cheap) where it is a better relative value vs. gold, which has been both unstoppable and a very one-sided trade for a long time.

Book Review: 40 Actionable Trade Setups From Real Market Pros- The StockTwits Edge

2011-07-27T20:38:00.002+01:00

I am crossposting here and on Davian, the tech and marketing partner for my autotraded, inflation-focused fund.

This is an unusual book: in a true Twitter spirit, it is crowdsourced from various Twitter/StockTwits members. This "portfolio" approach is both a strength and a weakness: while there is a good variety of approaches described, some of the authors are not natural writers. On the positive side, the chapters are relatively short and any one that is a drag can be skipped over.

After reading the intro, I thought that the book would be a bit more balanced between various investing methods: it is not. Various momentum trading strategies (broadly speaking) are over-represented (probably more than half of the book) while others (options trading, value) get some space but it is pretty far from even. The final part of the book, The Art of Trading, is a catch-all for a few non-specific essays, some of which I found very interesting. Also of note, some chapters are parsimonious with their insights but very generous with pushing certain subscription products; other authors spent a bit too much time discussing their personal backgrounds. Finally, I was very surprised to see that Joe Fahmy was not in the book.

The sections within the book are: trend following, value, day trading, swing trading (longest), options, forex (shortest) and "the art of". I think an "average" investors would benefit from how various market participants think and act, while an "average" trader would find a good number (less than the promised 40) of set-ups for different markets and timeframes.

My favorite chapters- without giving away the store- were:
Value: Michael Bigger looking at CROX/fallen angels; Eddy Elfenbein looking at Aflac/quality
Swing: "ChessNWine" on trading break-outs from bases; Ivanhoff/Stocktwits50 has a thoughtful chapter on momentum
Options: Joe Kunkle has a good multi-factor approach (market sentiment, technicals, fundamentals) combined with spotting unusual options activity
The Art Of: well-known bloggers Greg McDonald and Josh Brown have good pieces, while Charles Kirk has three pages on insights from years of mentoring traders (might well be extended to "long term" investors, many similar issues pop up).

Net-net, there is something for everyone in this book but the slant is towards momentum traders. This is a natural offshoot of Twitter (and the smaller group, StockTwits, which sourced the book) being very trading oriented. May be the next book can be targeted towards "long form" investors.

Full disclosure: I received a free copy of the book from Ivanhoff, one of the editors and authors

Coffee Stocks: Don't Burn Your Fingers

2011-07-09T03:56:00.000+01:00

I am crossposting here and on Davian, the technology and marketing partner for my inflation-focused product.

Anything related to coffee has been hot recently. There are some fundamental reasons for this: bean prices have been dropping, people are drinking more specialty coffee, the k-cup business is becoming big. However, it seems to me that there is a lot of speculative moves: be careful.
GMCR has been one of the best performers of the decade. Their meteoric rise has fueled the search for the next great coffee stock.

Several coffee-centric restaurant stocks have done well over the last year: SBUX, THI and CBOU. Even "fallen angel" KKD is rising nicely.

Things start to get a bit strange when we hit the bean roaster side of the business. Here's PEET, the company that locked horns with GMCR over the legendary DDRX acquisition (DDRX was a fortunate k-cup license holder and was acquired at $35/share after trading in the sub $1-level less than a year prior to that).

And now we are deep in bizarro world. JVA sells coffee to GMCR (as they have been for a while). Somehow this became explosive news recently.

But they are not alone: heavily promoted JAMN and under-the-radar JCOF have also had spectacular runs recently:

Which leads to today, when a small water distributor with a coffee operation just blew up:

Don't burn your fingers.

Too Long for Twitter, Too Short for Separate Posts, 2nd Edition

2011-07-03T13:29:00.000+01:00

Crossposted here and on Davian, the technology and marketing partner for my retail inflation-focused product.

"The Recovery", regardless of various statistics, has been a disappointment. One part of the issue is the anemic economic and employment growth (GDP at 2%ish). The big problem that I see is that we no longer have a normal market economy across many sectors, therefore we should not be expecting recovery patterns that are consistent with market economies. As we move closer to North Korea and Cuba via central planners/bailout managers in DC, we are going to be seeing slower and slower growth across the cycle. Until the powergrab reverses (both sides are guilty, as are their fossilized corporate and union patrons), we will have to learn that we are in a recovery because the Treasury Secretary said so in an op-ed called "Welcome to the Recovery". Turbotax Tim misses the subtlety of the principle "if you have to say it..."

Soon we'll reach the 4th anniversary of the first shot in the credit crisis: on August 9th, 2007, BNP Paribas halted withdrawals from three subprime funds. This begs question: was the crisis wasted? Absolutely: the too-big-to-fail banks have gotten bigger and none of the top-level perpetrators are in jail. I am not a lawyer but sure seems plausible to me that the DOJ can and should use RICO to go after the control fraud leaders. There is ample evidence, in my view, of organizations engaged in various types of frauds going back a fair number of years. If this means the closure of the TBTFs then so be it: ring-fence the essential operations and manage the rest. Instead we get a few showtrials of insider traders: not that these are not needed but the failure of Obama's DOJ and its leader, AG Eric Holder, has been stunning.

"The way to crush the bourgeoisie is on the grindstone of taxation and inflation"- Lenin. The Comrade had been targeting the capital owner class but these might also be two possible reasons for the decline in the middle class in the US. There are many others, of course, and the debate is still very much ongoing. However, the middle class has proportionately borne the brunt of taxation (holistic view of taxation here: % of income going to income, SS, medical, sales, property, tolls, excise taxes) and inflation (think of inflation in non-discretionary spending: energy, food, medical care and education). What do we have in DC now? Continuation of taxation (via deficit spending=future taxation) and inflation (explicit inflationary policies). So our reps should really look in the mirror while searching for the culprits.

"Taxing the rich" is a grossly misleading marketing soundbite. Obama makes no difference between stock and flow. Steve Jobs is "rich": billions (stock) in Apple equity (that pays no dividend) and $1 in salary (flow). XYZ MD just finished her residency, started working at $150k (flow) and has a negative net worth of $250k (stock) due to med school loans. Who's rich here? Who's paying higher taxes? Does it confirm that taxing income = taxing the "rich"?

The majority of babies in the US are now non-white. While this is bad news for some people, I think that it will add another angle to the debate regarding the inter-generational wealth confiscation going on from the non-voting minors to the voting seniors. This, of course, presumes that the system has not blown up by then.

Eggs. Yes, eggs. Eggs have been unfairly maligned for a long time. Here are a couple of things. One, the USDA recently reduced the cholesterol estimates by 14% (215 mg to 185 mg per egg), and increased the Vitamin D estimates by 64%. Second, and more interesting, there is a phospholipid in the yolks that prevents cholesterol absorption: some scientists were actually granted a patent on that, so I'd think the evidence is strong.

Understanding Sovereign Credit Risk

2011-07-02T19:23:00.001+01:00

One of the phenomena in sovereign credit is that the spread that certain countries and regions have to pay over the benchmark (such as US Treasurys or German Bunds) persists for many, many years. Surely some of it is factors such as intertia and liquidity. Some of it is simply credit risk: who is a more credit-worhty borrower? Since I like looking for new perspectives, here's a couple of brass music videos, one is from the Balkans (Greece, fmr Yugoslavia, Albania, Bulgaria, etc.), one is from Germany. Whom would you rather lend to? (based on some feedback, I should point out that these are extreme, caricature examples not to be taken literally)

Howard Marks Is Selling: Should You Be Buying?

2011-06-19T04:37:00.001+01:00

I am crossposting here and on Davian, the technology and marketing partner for BCIF, an autotraded inflation-focused product.

Surely it was all coincidental: Howard Marks, probably a top three favorite manager of mine, recently released a book ("The Most Important Thing: Uncommon Sense for the Thoughtful Investor"). A chapter from the book was the front page story in last month's Institutional Investor magazine. In March there was a lengthy Fortune/CNNMoney feature on him. Then on Friday 6/17/11, Bloomberg Markets ran a long profile with details all the way to his diet and parental occupation, casually mentioning that Oaktree is... going public. The Bberg article was time-stamped at 17:43, while the S-1 filing was stamped at 16:25. A marketing professional might call this "generating buzz around the brand": turns out, the sudden burst of publicity had a reason.

Mr. Marks is a true legend: according to the S-1, his distressed debt funds have averaged a gross IRR of almost 24% since 1986 with Sharpes above the benchmarks. This is nothing short of phenomenal: remember that we are talking about credit here! Very few equity equity managers can claim a record like his, let alone managers in the fixed income space. Interestingly, Oaktree was an early investor in Jeffery Gundlach's DoubleLine, a new but already stellar fixed income fund family, despite Mr. Gundlach's "difficult" separation from TCW.

Unlike many other investors, Mr. Marks has been very generous with his insights. His "Memos From Our Chairman" are available on Oaktree's site, and I strongly recommend that people read them all. There was also a 700-page pdf collection floating around with many of the letters combined: between Mr.Marks and his colleagues, we are talking about hundreds of years of investing experience all distilled for you. He really drives a few points: the primary job is to control risk. An investment cannot be viewed as more risky or less risky without discussing the price: at the right low price, nothing is too risky. Mr. Marks is known for returning capital to investors when the opportunities are not there, and for putting money to work when the window is open ($6 bn late 2008, just like Warren Buffett, except that you never read about Howard Marks riding on a white horse in the GS boardroom and asking for usurious preferred stock). There are a few other insights in the letters that you should discover on your own, including a few from an "earlier" version of Michael Milken.

So here is a guy who was buying during the biggest liquidation in a generation, and now he is selling a piece of his management business (not in the funds themselves): should you be buying? In a word, no. Here's why:

(1) Just common sense: don't be seduced by explanations such as "liquidity needs", "permanent capital", "estate planning" and the like. Another professional seller partnership, called Goldman Sachs, went public in 1999: you all know what happened to the market soon after.

(2) Are we at the end of the bull market for credit? The economics of the fund management business are driven by the fund results and the AUM. The two are inter-connected: good results beget higher AUMs. We have had a 30-year bull market in credit, and the phenomenal results we have seen might not be repeated by anyone at any time when the credit cycle reverses upwards. If you look at the 10-year yield chart since 1980, you are seeing a series of lower highs and lower lows. This means that a high yield loan might be at 10% initially, 25% in distress (when Oaktree buys it), and then at 8% when things stabilize ("lower low"). The IRRs would not be there if the credit cycle were going the other way, i.e. 10% new/25% distress/15% stabilized.

(3) Unfavorable structuring for the investors: the units do not have voting control, lose some of the tax benefits, generate peculiar income tax liabilites, and a few other things that make them differ substanitally from a "normal" stock

(4) Generally poor performance by investment manager LP units in the market. Oaktree is not the first partnership to go public. AllianceBernstein has been public for a number of years. In more recent history, Blackstone, Ochs-Ziff and Fortress all marked the top with IPOs in 2007, and proceeded to tank 85-95% off the IPO price (!) in 2008, and they are still at 50-85% off. AB, too, was $92+ in 2007, and is at $19 now. In recent months, we've had the IPOs of PE titans KKR and Apollo, and a recent bake-off by The Carlyle Group: again, remember that these are professional sellers. This, and the record of unit performance post IPOs, make me unenthusiastic about the offering. That said, to channel my inner Howard Marks, if the price is low enough...

M&A Activity This Week Indicative of Peak Cycle

2011-06-17T23:19:00.000+01:00

I am crossposting here and on Davian, the partner for the BC Inflation Fund, an autotraded product for retail investors.

Back at the end of April of this year I wrote an article asking where are we in the current economic cycle. I looked at several "real time" indicators such as profitability of cyclical companies and the IPO pipeline, and I thought that there is evidence suggesting that we are at the "peak". The stock market has certainly been unhealthy since then with several recent IPOs burning their investors, and the collapse in commodity and China stocks.

We also had a lull in merger announcements recently (one of the other factors I had looked at), until this week. While by no means a predictive factor, I like keeping an eye on what is happening in the space as it captures several factors at once: management's views of the future, management's view of the value of cash vs. own stock, equity and debt financing conditions, industry consolidation drives, even mood.

So here are a few noteworthy deals, events related to deals or rumors that happened just this past week. While the S&P500 might have been down 6-7 weeks in a row, it does not seem that the M&A cycle has slowed.

-CapitalOne possibly acquiring ING Direct for $9 bn: this is one of the largest deals this year and will make CapitalOne big enough to be TBTF (7th largest by assets) and enjoy the unfair funding advantage that comes with it
-Energy Transfer buying Southern Union for $4bn+/~$8 bn EV: this is a gas pipeline consolidation, everyone knows the US natural gas story
-Allied World/Transatlatic $3bn+ reinsurance deal: I don't have the details/views on this one
-Avis car rental buys back into Europe for $1 bn: high-beta company expansions are peak cycle material
-Graham Packaging going with Reynolds/Rank instead of Silgan: this is after another unsolicited deal on the paper side, with International Paper going after Temple Inland
-BJ's Wholesale Club being acquired by Leonard Green Partners and CVC. BJs had been on the block for a while, and LGP is a PE firm well known for its expertise in retail.
-Wendy's selling Arby's for a paltry sum upfront: while it does not look good on WEN, the fact that there was a buyer (Roark, big investor in restaurants) is a positive sign
-Unusually high profile hostile deal with the Toronto Stock Exchange means that people are braver
-Boyd Gaming making a small Gulf resort purchase: this is a regional destination resort, would be interesting to see the traffic numbers trends there vs. slow/no-recovery markets like LV or AC
-HCA is buying out JV partner in 7 Denver hospitals for $1.45bn: while most financial media attention has been focused on the big pharma decline, it is interesting to see what hospital operators are doing in light of the greatest industry uncertainty in many years
-Dish Network offers $1.4 bn for TerreStar out of Chapter 11
-Air Products buys a semiconductor industry suppliers: this is peak cycle material

Rumors:
-The two Russian fertilizer behemoths Uralkali and Belaruskali are denying talks: when there is smoke and industry consolidation, there's fire
-Blackstone in exclusive talks with Jack Wolfskin: interest in discretionary brands is usually a topping signal (also of note, the Samsonite and Prada IPOs in Hong Kong were not blockbusters)
-GM might be selling Opel again, this time from a position of relative strength
-Glencore denies interest in a large Kazakhstan commodity company

What is the conclusion? We are seeing more of the typical signs of peak-cycle merger activity. There are deals across many sectors. Some of the deals are very substantially sized. Some of the deals are hostile. What we are not seeing is high equity vs. cash usage: part of this might be that there is a lot of cash sitting around earning nothing. While not indicative of where the market will be next week or month, we are seeing that the corporate titans are still optimistic and willing to take on high-risk moves.

An Accidental Victory Against Credentialism: When A Nobel Prize Isn't Enough

2011-06-06T16:00:00.002+01:00

I am crossposting here and on Davian, the technology and marketing partner for my inflation-oriented product for retail investors.

President Obama's Federal Reserve Board nominee, Mr. Peter Diamond, just joined tens of thousands of recent college graduates who discovered that having their degrees and awards is insufficient in getting hired. Unlike Mr. Diamond, however, the generation saddled by student loans and tasked by Obama himself with "Winning The Future" do not have the option of going back to their "congenial professional existence as a professor at MIT."

Mr. Diamond penned a widely-read op-ed in the New York Times on June 5th, 2011 ("When a Nobel Prize Isn't Enough"), in which he laments his inability to get hired despite his expertise in the labor market. It is fairly ironic that a labor market "expert" cannot get himself hired but this speaks to the wider disconnect between high-rent academics (as well portrayed in the Oscar documentary "Inside Job") and the real world.

Here's the news, Mr. Diamond: what you offered to the people who have to approve your nomination does not meet the market needs. You may view this as unfair, as an affront to your lifetime achievements, as idiotic, as politically-motivated, and so on, and, no doubt, these are all true statements, but may be you should just accept that the trebuchet of reality has demolished your self-congratulatory ivory tower. The process has been political circus of the lowest order but don't hate the player (Senator Shelby), hate the game. And stop with the sense of entitlement: clearly your Nobel is not enough for the market. Markets are forward-looking and the market has clearly communicated that it would like to see people who do not rubberstamp every decision, as has been the case all along.

I have been on both sides of the "credentialism" wars and I am an active proponent in demolishing academic and professional "branding" through initiatives such as Khan Academy and the Thiel Fellowships. An Eight Schools Association boarding school, followed by a legacy admission to an Ivy League and a fencing championship, followed Goldman prop desk easily leads to hundreds of millions for a "start-up" fund: but what percentage of this success is linked to parental zipcode and the access/socialization associated with it, rather than merit?

Too Long for Twitter, Too Short for Separate Posts

2011-06-02T15:09:00.001+01:00

I am crossposting here and on Davian, the technology and marketing partner for my inflation-oriented autotraded product.

Spain, just like China, has its own set of empty towns. Whenever you see these satellite pictures, you can be sure that there is a bank somewhere holding the bag (or keys, if you'd prefer). Long periods of mispriced credit look great on the income statements but, as they say, the balance sheet is the future.
*****
Currency devaluation chart from the Roman Empire: tracking the decrease in silver content in the coins over the years. Persistent currency devaluations seem to cause a lot more problems than they solve. Since it is difficult to imagine life without money, I wonder if there are two future scenarios possible: a "stable" global currency (many countries do not have own currencies now as it is) and/or a group of competing or complementary private currencies without governmental control. Private currencies would need major network effects to be successful, so, dare I say it, hello facebook dollar!
*****
Speaking of countries that need a new currency, look at Belarus. After its currency devaluation, the government decided to freeze food prices until July 1st of this year. These attempts never really work and lead to shortages. Other Eastern European countries learned the hard way and have been operating with currency boards for many years quite successfully as a stable currency is major factor in predictability, and, hence, economic development. In general, countries that are not that great at self-governance are not that great in managing their currencies, either, and the populace knows this so most contracts are denominated in the "USD equivalent of..."
*****
Energy is a precious resource that should be used judiciously. I wonder if some emerging markets are making a major mistake by encouraging the rapid automobilization of their countries. The single-driver daily commute is very energy intensive, often stressful, and a noticeable waste of time for highly specialized labor. No easy solutions exist for the US but some markets might be making the mistake of copying the US model.
*****
The ore barons in Australia and Canadian homeowners might not have a full idea what is coming to them if/when there is a slow-down (or worse) in China.
*****
Three quotes I posted on Twitter recently that got "mileage":
Coco Chanel: "Some people think luxury is the opposite of poverty. It is not. It is the opposite of vulgarity."
Leon Trotsky: "You may not be interested in war, but war is interested in you"
George Orwell: "If liberty means anything at all, it means the right to tell people what they do not want to hear."
*****
On the topic of liberties, the gradual erosion of liberty is in full bloom. Recent court decisions have rolled back rights going back to the Magna Carta (that's 1215 AD), including the right to due process. We're not at the EU stage of targeting free speech as thoughtcrime but we are getting there (“one sees the sun slowly set, yet one is surprised when it suddenly becomes dark.”)

Is There A Lemming Trade? The Ira Sohn Conference Effect

2011-05-26T00:53:00.002+01:00

I am crossposting here and on Davian, the technology and marketing partner for my inflation-focused product for retail investors.

The Ira Sohn charitable conference took place in NYC today, and a large number of well-known and successful fund managers presented their best idea/s in rapid succession (each has ~15 minutes). The effect on the stocks in questions only confirms that stocks can be "branded" by being associated with the right manager on the right platform. It was fascinating to see the jumps in prices in real time during the afternoon. Did people do it just for a trade? Is this a buy first, think next situation? I don't know and I stayed out: no one is infallible, including these very smart guys who were actively talking their book.

Here are a few charts:

Real Median Incomes vs. Supermarket Stocks?

2011-05-10T23:06:00.000+01:00

I am crossposting here and on Davian, the technology and marketing partner for my inflation-focused product for retail investors.

I had a very interesting conversation yesterday with a top-ranked analyst at a financial institution. Among the topics we discussed was the state of the average/middle-class consumer. My views, expressed here and on twitter, have been that healthcare costs are a significant and growing tax on the middle class (both directly and indirectly, by making US labor more expensive), and that US median incomes in real terms will trend towards global median incomes due to globalization. Structurally weak labor market keeps the growth nominal down, while inflation reduces the real growth.

The analyst's insight was regarding supermarkets. Supermarkets have been a challenging area to invest in over the last decade (some high-profile bankruptcies there are Winn-Dixie and the A&P parent). He overlaid a real median income chart over the stock charts of some of the big names, and the charts look very similar. I am including WMT here as the argument has been that the supercenters are responsible in part.
I find this very interesting because I have the sense that the migration to new formats (i.e. COST) cannot be wholly responsible for the stagnation in the stocks: with flat real incomes, price has become a bigger factor, and the traditional supermarket channel might not be the most competitive.

Charts via Safeheaven and Big Charts.

Are We At The Peak?

2011-04-27T14:48:00.000+01:00

I am crossposting here and on Davian, the technology and marketing partners for my inflation-focused product for retail investors.

Forecasting is difficult, especially when it is about the future, someone quipped. So instead of pretending that I can look through the windshield, I am looking through the side windows at the scenery passing by. From what I am seeing, there are signs that we are either at peak or post-peak economic expansion.

Here are a few signs:
- Big earnings by a lot of the cyclical names: Ford, Whirlpool, Cummins, Electrolux, VW, Volvo, etc.
- Inflation acceleration (surely there are many reasons here but at least some of it is bonafide demand growth)
- Big resource mergers: there was a bidding war over an iron ore producer, lots of consolidation in fertilizers, large gold miner buying into copper
- Other marquee volume deals happening: JNJ doing a $20bn buy, T + T-Mobile, etc.
- PE is back in the game buying riskier companies: retail, chip makers, software.
- We have not seen the balance sheet impact of Japan and euro-peripherals restructuring
- Actual and planned IPOs of weak companies (as in "never profitable/does not expect to be in the near future")
- Very speculative mood in certain equity sectors (i.e. China and India internet companies)
- Very speculative mood in private markets for "social media" companies
- Emerging markets trying to confiscate (vs. attract) foreign capital (Bolivia, Venezuela's new windfall tax)
- Pronounced recent strength in defensive sectors (XLP, XLV)
- US residential rents have been strong for a year
- Modern Chinese art hitting record prices, Ferrari introducing its first 4-seat model, law school applications down
- No discoveries of massive NEW frauds (the prior set of whales beached a while back, some are in jail already, others- Mozilo, Fuld, Raines, etc.- are roaming around free)
- Pretty much everyone who could have written a book about the crisis has already done so

What we are not seeing/non-confirmation of my opinion:
- Actual improvements in total employment (not rate but number of people working)
- Rates marching higher in developed markets (not yet at least)
- Single-family housing not recovering (though there is a case here that mean reversion + weak labor are the primary forces)
- Retail stocks (XRT) closed at all-time highs yesterday: not indicative of a peak

What are you guys seeing real-time? Missing anything major pro/con from the list?

Can Corporates Trade Through Sovereigns?

2011-04-14T18:31:00.000+01:00

I am cross-posting here and on Davian, the technology and marketing partner for my autotraded inflation product for retail investors.

There has been some discussion regarding the spread of corporate bonds over treasurys, and, more widely, can corporates trade “through” sovereigns, that is, can corporate bonds yield less than the government bonds of their domicile?

For starters, it is already happening in the periphery of the eurozone.

Greece’s 5-year is at over 15% as I write this, while Coca-Cola Hellenic, a Greece-based bottler, is paying 4.xx% for their 5-years. This is a full 1,100 bps under the Greek sovereign. (Of course, CCH is international and backed by KO's credit implicitly)

Can it happen here? At this stage, no. The US is not Greece as the US can both borrow and print in its own currency. Greece has not had the drachma for years and its borrowing is in euros. There is no reason for the US to default on obligations in its own currency: most holders are domestic, and defaulting would mean the near-certain end of pensions plans, numerous financial institutions and insurance companies who are legally required to hold a lot of US credit instruments. The other option is to pay back in nominal, but not in real terms: this is the path we are on.

However, what would happen if the US cannot issue dollar-based debt? This is a possibility, few countries in the world have the luxury of borrowing in their own currency, and we have certainly abused this privilege (along with the privilege of having the main reserve currency).

If the US has to borrow in SDRs or in currency X, I do think that high quality corporates in the same currency will be trading substantially lower than the US debt. Why?

Let’s review the 5 C’s of credit: character, capacity, capital, conditions, collateral. I will focus on three: character, capital and collateral. Compare the US government to a large corporation on these three counts: the corporation has its books done properly with adequate disclosures of future obligations. The US is not even putting GSE debt on its balance sheet, let alone unfunded promises. A large corporation is run, generally, by rational decision makers. Can we say the same about Congress? A large corporation has global, relatively predictable earnings stream from which to pay back debt. The US government is wholly reliant on its taxation power, something that is not nearly as predictable. Of course, the government can pledge or sell federally-owned land and other assets but I hope we won’t get there. A large corporation has well-established audit/security procedures. The US government is rife with waste.

It is clear that a well-run global corporation should be a lower credit risk than any one sovereign risk provided that the borrowing is done in a currency that neither party controls. There is no reason why JNJ or WMT or MCD have to pay a spread over Geithner & Co. It will be a major paradigm shift when it happens in the US.

2-for-1 Book Reviews: "Lay the Favorite" and "Gaming the Game"

2011-03-25T16:52:00.000Z

I am cross-posting here and on Davian, the technology and marketing partner for my inflation-focused autotraded product.

Of the two, "Lay the Favorite" is by far superior in the literary sense, while "Gaming the Game" is poorly written but has a lot of details on actual booking and betting operations.

"Lay the Favorite" by Beth Raymer is an autobiographical book, chronicling her entry and work in the world of high-stakes sports betting.

Raymer stumbles into working for "Dinky," a professional bettor in Vegas while working as a waitress. Dink is a Jewish guy from Queens who ended up moving to Vegas to work professionally. He teaches Raymer the ins and out of the job: lines, runners, various contacts around the country. Dink bets his own money exclusively and does not do bookmaking. He comes across as a very smart and genuinely nice guy. They do go down to the Caribbean during the offshore gambling boom: Raymer describes a non-stop Spring Break scene with money flowing in at incredible rates, though few of the bookies who set up shop there were able to build a serious, professional enterprise.

Raymer moves to NYC for boxing, and ends up working for another major gambling figure, and a friend of Dink's, on Long Island. "Bernard Rose"'s character is also intricately chiseled: a sharp, gregarious glutton who, like Dink and Battista (from below) works long hours across many markets. She does a stint in Curacao with Bernard, too, while the boom still lasts. Raymer eventually leaves this world for a new life and a new boyfriend.

Overall, the book is very enjoyable and can even be classified as "chick lit" while a guy might read it for the underworld detail. The writing is crisp, the stories flow and connect well, while the characters are unforgettable.

"Gaming the Game" by Sean Griffin is the story of the alleged mastermind behind the NBA referee betting scandal, James "Sheep" Battista.

The books seems to have been edited only for spelling, and not for style. The result, outside of the direct interview quotes that take up about half the volume, is a tedious, tortured narrative, often clearly taking Battista's street-talk and putting it in the storyline. There is also quite a bit of minutiae on local bookmaker "legends" and a drawn-out appendix that make the book sound like a rushed term paper stretching for the required length. This is ironic considering that the author is a professor (criminal justice) at Penn State- Abington. There are other fillers, such as pictures of the airport Marriott where the characters met or the front doors (really) of the high school the characters attended. The final style quibble is the gratuitous use of "consequential" (28 times), "legendary" (10 times) and "seminal" (5 times).

That said, the book is a must-read for fans of true crime and sport bettors. Through a series of interviews, Griffin chronicles Battista's rise to the top echelon of professional bettors and his subsequent downfall, driven by opioid addiction and his involvement with the NBA ref scandal. The book also works to correct the wrongful impressions that the media had created about Sheep: he does not seem to have been involved with organized crime, and he had not been a threatening figure in the "industry" that forced the ref to participate in the scheme.

Battista comes from a hard-working lower middle class family from a Philadelphia suburb. He gets by in school and eventually enrolls in a university, but drops out shortly thereafter. He had been around drug dealers, and starts using his shoe salesman job for this purpose. He then moves on to an electronics store, where he organizes an embezzlement scheme but gets caught. Eventually he winds up working in the bar/restaurant scene, and starts picking up bookmaking skills. He learns the trade with a couple of local bosses before forming up his own group, The Animals (based on the guys' nicknames). They work very hard and do well, hide from the local mafia, move to Vegas, spend some time in the Caribbean running a sportsbook, and then break-up. Battista eventually moves up and becomes a helper to four or five of the really large professional bettors, helping them place bets (one of these is "The Computer," who was, my guess, profiled on 60 Minutes recently).

To use the finance terminology, the sharps are portfolio managers: they have analysts (handicappers) working for them to find value: a discrepancy between the actual line and what the line should be. Then the PMs make the capital allocation, and traders, people like Battista, would have to place the order in the market without moving it (or moving it in the other direction prior to placing the real money).

Tangentially, Battista gets involved with Donaghy, an NBA ref, through a small-time drug dealer with a Napoleonic complex who is a mutual acquaintance/friend from high school. It appears that Donaghy had been betting, quite successfully, on games he reffed for years. He ends up being paid for his "picks" by Battista, who himself places sizable bets on the inside information. Donaghy is portrayed in the book as a greedy, aggressive, misanthropic and socially maladjusted man.

Of course, the word gets out, and the FBI is eventually on the case. Battista is the only one who does not cooperate, and all three end up with similar sentences. Battista is now free and trying to rebuild his life outside of the underworld, reconnecting with his five children and repaying the restitution he was ordered to pay.

The book is interesting in several other ways. It offers an inside glimpse into the world of high-stakes betting and the hoops these guys go through in order to place bets (hopefully the system will change, and the US will get Betfair, a true peer-to-peer exchange, where anyone can bet or lay). The other significant new piece for me is the entire shadow banking system that exists to support the bookmakers who currently operate on the ground in the US: this is a network of guarantors, deposit-keepers and cash runners, spread around the country, settling accounts once per week, collecting or forgiving debts, transferring cash, etc. Unlike lotteries or casinos, it appears that most illicit sports bets are done on credit, with periodic settlements. Finally, there are the market dynamics of how lines move based on money flows, rumors and news.

Linkfest of Linkfests

2011-03-17T18:49:00.001Z

I am cross-posting here and on Davian, the technology and marketing partner for my inflation product.

Linkfests are great. They are a very efficient way of gathering information and analysis. People who share links consistently deserve admiration as they greatly improve the ecosystem.

Here are the linkfests I follow in my RSS feeds. I link to recent editions so you can go and check them out for yourself. There is no particular order of importance as many are not directly comparable.

Barry Ritholtz/The Big Picture: One of the most influential bloggers shares Afternoon Reads quite often. Generally finance-focused.

Yves Smith/Naked Capitalism: Published author and voice of integrity does an extensive list daily, always with a picture of cute animals at the end as an "antidote".

Bess Levin/Dealbreaker: Dealbreaker is well known for its proprietary flow of information and rowdy commentariat, but wonder-editor Bess also has opening and closing links with nice summaries.

David Merkel/Aleph Blog: Merkel shares interesting reads with commentary on twitter, no linkfest per se on the blog itself.

Josh Brown/Reformed Broker: one of my favorite bloggers and emerging media mega-personality does not one but two linkfests, one on the blog and one for RIAs on the WSJ

Clusterstock: There are a few daily things there that can loosely qualify as a linkfest but I always go for the main morning one and Wall Street Gossip in 60 Seconds in the afternoon.

Felix Salmon/Reuters: Famous corporate blogger shares a few links nightly.

John Carney/CNBC: Former Dealbreaker and Clusterstock guy, now at CNBC, does a headline roundup. Unfortunately, he does not have a full RSS feed which means that I visit about 5% of the time.

Miguel Barbosa/Simolean Sense: This is the Renaissance Man linkfest. Miguel painstakingly puts together a long collection of cerebral articles on a wide variety of topics every Sunday. You can feel smarter just by reading the summaries. He shares links continuously throughout the week but the Sunday effort is true feast.

Crosshairs Trader Blog: trading-focused links

Calculated Risk: another titan blogger shares his finds periodically. CR also has very high quality weekly summaries and graphs.

Tadas Viskanta/Abnormal Returns: the only full-time links "curator" in finance that I know of. He does an early edition and a full edition of carefully categorized links, along with interesting periodic interviews. Daily read even just to pick up what people talk about.

MaoXian: MaoXian's shared links are easily the most eclectic bunch that "the Chairman" collects as he surfs: homemade nutella recipes to Beijing air quality to stocks making new lows, it is all there.

Pakiya Funds: weekly links on various topics of interest to value investors

Jay/Market Folly: Many people know MF as the pre-eminent hedge fund tracking service, but he also has a periodic, high quality reading list.

George/Fat Pitch Financials "Festival of Stocks": weekly links primarily on value topics

Some Assembly Required: this is a bit of a left-leaning, alarmist daily links list that I keep an eye on for topics I rarely encounter otherwise

Ed Harrison/Credit Writedowns on delicious: CW links primarily to news articles

Tim Iacono/TimIacono: Daily news links, well sorted

James Altucher/Daily Finance: yes, that Altucher does links periodically

iShares blog: the mothership of ETFs has a blog, and a relatively new weekly links effort, I hope it stays

Marginal Revolution: slightly more econ-focus here, more or less daily

Insider Monkey: a relatively new blog focused on insider moves and hedge funds that shares good finds periodically

Tom Brakke/Research Puzzle/RP Pix: underfollowed but very thoughtful blog and separate "pix" with links

Surly Trader: sorted news links weekly

Review of Client 9: The Rise and Fall of Eliot Spitzer

2011-03-06T00:01:00.001Z

I am crossposting here and on Davian, the technology platform partner for the inflation-focused product that I have.

Short version: I recommend viewing the documentary Client 9.
Longer version: Client 9 is an excellent two-hour documentary movie on former NY governor Spitzer, covering his time as a NY Attorney General to his resignation as a governor after the revelation that he had been using a deluxe escort service. The director of the movie is Alex Gibney who also made Enron: The Smartest Guys in the Room. I was not impressed by Enron, as the movie skimped on a lot of the relevant technical details, had little input from the main actors and presented Enron in an uniformly negative light.

Client 9 is very different. The filmmaker interviews Spitzer at great length on many topics, as well as his main aides, adversaries and other actors. The story is complex, there are a lot of legacies at stake, and I walked off thinking that the only people who were really fully honest in the interviews were the "regular" prostitute he was using and the Madame. Everyone else, Spitzer included, comes across as calculating and being sincere only on select items. Spitzer's collaboration can be viewed as an attempt to start his public image rehabilitation, so on a couple of occasions he compares himself to great tragic figures, like Icarus, while at the same time continuing to insist he was the good guy excluding the prosties (and even there, he sells it as something better than an affair with emotions and as something easier to compartmentalize and rationalize).

The movie does not highlight what is widely viewed as a perversion of justice by Spitzer's AG office: the use of press releases and selective leaks to muscle companies and people into settlements before even going to court, often with negative effects on the stock price. Some companies rolled the dice and fought, some settled, but the overall perception was that while Spitzer actively marketed himself as a sheriff, he was really collecting feathers for his hat on his way to Albany, and, later, on his way to be the first Jewish president of the US. At the same time, "the Sheriff" had missed a number of abuses that came to light post-crisis, including mortgage fraud, control fraud, "naked" CDS contracts and many others. With the benefit of hindsight, Spitzer's efforts were off-the-mark in the bigger scheme of things while the extra-judicial methods were not commendable.

The story line follows Spitzer as an AG going after Wall Street's so called "research" in which high-powered analysts were publicly recommending internet and telecom stocks while bashing them privately. The movie highlights Jack Grubman, formerly of Citi, and a "failed writer" who "stumbled into research", Henry Blodget, who referred to some of his "buy"-rated stocks as POSs. Blodget now runs Business Insider, an online news and slideshow service. Spitzer did have an impact on the research business, for the better in my opinion, at least because the research is now more independent (on the surface). Of course, there is the argument that broker research is conflicted by default as the banks seek other business from the covered companies.

Spitzer's next target is AIG, at the time one of the most powerful companies in the world. AIG had engaged in a transaction with Buffet's Gen Re that had the effect of concealing AIG's true level of reserves. A number of people from Gen Re were indicted and sent to jail, and the then-CEO of AIG Maurice "Hank" Greenberg is called an "un-indicted co-conspirator." Greenberg is very evasive in the movie interview claiming practically no knowledge of the matter while the handwritten (!) memo of understanding between the two has his initials all over. Greenberg is fired by his board which is something unprecedented for a company of this size and stature.

The movie then makes the tenuous connection between the AIG Financial Products division that caused the bailout and the Greenberg years. This is a big overstatement: the AIG FP scandal (and the MBIA and Ambac situations) is illustrative of massive regulatory failure specifically from the regulators who need to control insurance and insurance-like products. Further, the AIG bailout was a political decision to save the well-connected companies who had voluntary (!) credit exposure to AIG. But this is a different topic.

Spitzer's going after Greenberg is stopped by the US Justice Department, more specifically Michael J. Garcia, who advises the NY AG to step off the case as the federal government will be taking over. Nothing happens after this. Garcia appears later as the prosecutor of the prostitution ring that brought down Spitzer.

Next up is NYSE's chief executive Dick Grasso, who fought Spitzer in court and won (on a technicality, per the movie). The headline marketable issue here is CEO pay (viewed as outrageous) so Spitzer goes after the (then) non-profit NYSE and the outsized CEO pay package which, in Spitzer's view, is illegal by NYS regulations of non-profits. Spitzer gets a powerful nemesis in the process, Ken Langone, the head of the NYSE board compensation committee and co-founder of the Home Depot. It is alleged in the movie that Langone had someone following Spitzer who saw him buying money orders in a US post office. Langone speaks at length about Spitzer's alleged shortcomings, including anger management problems, sexual addiction and subversion of proper legal process. Langone is very sincere about his intense dislike of Spitzer though he avoids any detail in the "behind the scenes" action to bring Spitzer down.

The movie takes a brief look at the gubernatorial elections and Albany politics (for the uninitiated, Albany has been an absolute cesspool for years). Spitzer, as a governor, very quickly ticks everybody off (even in his own party). Again with the benefit of retrospect, as a governor, Spitzer, like all other governors, has zero foresight on the actual problems that face the states. Further, again in retrospect, his lieutenant governor choice, David Paterson, is well-below what can be considered executive level material. Clearly Spitzer needed the voting block that comes with Paterson and did not expect that he'd be stepping down.

Spitzer locks horns with Joe Bruno, the Senate majority leader, on a number of issues, including "troopergate" and the budget. Bruno is later convicted on corruption charges (something not that unusual in NYS, unfortunately). Bruno is interviewed at length for the movie and gives a lot of spicy details of the fights. Along the same lines, the filmmaker talks to a fair number of Spitzer aides both from his time as an AG and as a governor, a NY Post journalist and a "sleazy" political consultant, who is alleged to have been brought in to harass Spitzer (as well as Spitzer's father). My take is that the Spitzer period as a governor can be viewed as a failure, his lieutenants are guardedly loyal and somewhat objective, while Spitzer's enemies do not hide their true feelings, from hate to jubilation at the downfall. This makes the movie very special: it is rare to get a glimpse of true emotions in a high-profile case like this.

On to the downfall itself. Spitzer is pretty honest about it, he says he brought himself down.

There is a fair bit of speculation as to how the investigation of the Emperor's Club had started. The official version is that there was a suspicious activity report filed by a bank on a wire transaction in which Spitzer did not want his name used. Since there are thousands of these filed daily, the movie implies that it was a private investigator following Spitzer who reported a suspicious money order transaction at the post office. Either way, the FBI tapped the agency's phones and computers, and collected enough data to indict the couple running the ring. However, the charges describe briefly Clients 1 through 8, and spend a lot of time on Client 9. The NYT takes on the story, and the rest is history, like they say.

Obviously, it is highly unusual to detail so much on the clients, and the movie implies that the whole thing was a set-up to bring Spitzer down as the FBI does not normally go after prostitution rings, the head of the investigation is Michael J. Garcia and few other tidbits that point to a heavy political motivation. My view is that if you live by the sword, you die by the sword, and the alleged subversion of justice was not different, in character, to what Spitzer had been doing as an AG.

There were three people interviewed regarding the escort operation. One is a painter/pimp who explains how the system works in general (including online ratings, charges, etc.) and how the famous "Kristen" came into the picture. The guy's monologue at the start of the movie is out of place but it makes sense as the movie develops. I actually met and spoke with him this morning in SoHo. He sells his paintings there on the street and had the trademark hat on, so I recognized him.

The co-owner of the agency is a girl that did six months in prison for running the business, and she's pretty forthcoming about the operation, the markets they served and so on.

The director had also interviewed at great length Spitzer's "regular" and hired an actress to read/act out the interview as the woman had moved on with her life and works, interestingly, as a commodities trader. Ashley Dupree, who became famous based only on one encounter, is not interviewed and is portrayed as someone who grabbed the spotlight aggressively on her way to becoming a D-level celebrity.

Overall, the movie is very interesting as it presents a number of important players in their own words while generally reserving judgments, half-truths and innuendos that normally go with American documentaries (Michael Moore's Sicko is so egregiously defective that it was banned in Cuba!). The story, as told by the moviemaker, is that Spitzer went after powerful interests and was brought down partly by them, partly by himself. While I do not think that this is a complete version (hence the mind-numbingly long review), it does a very good job at having people on the record discussing what happened, and contains a lot of unreported details.

Handy Guide to Investor Presentations

2011-03-01T00:45:00.001Z

I am crossposting here and on Davian, the technology and marketing partner for my inflation-focused product.

This is a public service announcement to all IR departments (with a sense of humor). Follow the template to avoid awkward moments during investor conferences. We list the essential elements of effective PowerPoint communications with your investors. Here’s what you need to say and show:

(1) You are “on trend”: whatever it is that you do, be it fried chicken, mining equipment or vaccines, make sure you specify the undeniable, secular trends you are on.

(2) You are a “growth” company: if there is any doubt, be explicit, “XYZ is a growth company.” Any information that you present should be sliced and diced to show growth. Make sure you accentuate the CAGR with a splash. If you do not have EPS, do “adjusted” EBITDA, if that doesn’t show, do only revenues. If you can’t even do that, do page views, employee count, ocean temperatures or obesity rates.

(3) Show Asians: Asian farmers, Asian children, Asians in business suits talking on a cell phone, Asians with shopping bags, Asians families eating.

(4) If your business destroys something, show it whole. If you cut trees and chew them into paper, show vibrant green saplings. If you pollute the air, show blue skies and flowers. If you are polluting the water, show alpine lakes or mountain streams. If you are outsourcing or claiming incredible “efficiencies,” show smiling workers.

(5) Don’t forget a map of the world, full-slide size. If you have a web site, you are global.

(6) Extrapolate into the future. If the stock market has been so-so, use straight-line. If the stock market has been strong, use exponential growth.

(7) Compare against the competition but make sure it is in the most favorable light possible. Your company is both the most efficient AND the most undervalued. If you are a conglomerate, present a sum-of-the-parts and lament that the market is discounting you instead of valuing you fairly.

(8) Mention something about shareholder value. This can be a discussion of buybacks and dividends. Do not, under any circumstances, discuss option grants that neutralize any buybacks announced. If you are actively destroying value through acquisitions, go full 1984, and say you are creating it through acquisitions.

(9) If your company really hit the floor in ‘08/’09, mention something about “lessons learned” and “being stronger and smarter as a result.” Do not credit stimulus spending, bailouts or ZIRP and its short-term effects.

(10) If you’re a commodity company, always place yourself on the upswing of the curve, with plenty more runway to go. Also on the graph showing future cyclical low earnings, make sure the low is higher than the current normal because this time, it is different (really).

(11) In the unlikely even that the company is in legal hot water, be explicit that you are cooperating fully, committed to doing the right thing, and that you have the strongest ethics policy in the industry. If there have been actual indictments, these are a few rogue actors acting on their own, without management’s knowledge, let alone tacit or explicit approval.

This post was inspired by The Reformed Broker's Recipe for a Trading Blog.

Muni Meltdown: Should You Play?

2011-01-14T20:24:00.001Z

I am crossposting here and on Davian, the technology and marketing partner for the BC Inflation Fund.

Yes, but only if you know for sure what federal policymakers will do AND when. I do not so I am staying out. Also, quite simply, I do not know enough about the market (outside of a few ETFs) to feel comfortable: there is a very wide variety of issuers, underlying collateral, income tax considerations, and so on. But the policy response, basically whether we have QE3 for certain muni obligations or not, will be decisive. Despite the posturing of the newly elected majority, I simply do not see them letting a major electoral state go without money or borrow at prohibitive rates, as they should, for too long. Mass support will be easy to get: just inconveniencing people by not having their kids in school will stir the pot quickly; let alone having a major hospital shutdown. So there will probably be a bipartisan agreement of some sort, kicking the can down the road as this seems to be the only approach our elected officials use.

Of course, the tough choices will be made for them sooner or later.

Here's Obama's primetime TV statement, coming in a few months:
"Fellow Americans, I am very pleased to announce that today I signed into law a bill passed almost unanimously by Congress to solve the difficult situation that our states and cities are finding themselves in.

Like many hardworking American families, states and cities have been mislead by unscrupulous Wall Street bankers into borrowing more than they need on terms they did not understand. Through no fault of their own, our firefighters, policemen, teachers and civil servants were likely to suffer deep, devastating cuts in salaries, benefits and pensions, thus putting a dent in the fragile economic recovery and reversing the improving employment situation.

This 999-billion dollar bill is an investment in our communities that will help tide them over through the rough economic patch. The Treasury Department's investments in municipal bonds will be financed by the newly extended and very successful quantitative easing program of the Federal Reserve. It is time that we take a stand against the big bank bailouts and bonuses, and for the prosperous future of hard-working American families across this great nation of ours. Thank you."

Crumbs Cupcake Bakery Reverse-Merger IPO: I Take a Bite So You Don't Have To

2011-01-12T17:54:00.002Z

I am crossposting here and on Davian, the technology and marketing partner for the BC Inflation Fund (retail investor product).

The news on Monday was that Crumbs Bake Shop was going public via a reverse merger with a SPAC. Several other consumer businesses have gone public via SPACs, and the track record is not exactly great. JMBA, Jamba Juice, was at $12 in '06 after the merger, currently at $2.30. SMBL, Smart Balance, reached $13 in '07, and is now at $4.50. APP, American Apparel, a company I have written extensively about (be it defaults, illegal alien employment, or the CEO's "idiosyncrasies" ), was a $15 stock in early '08, and $1.50 now. May be fourth time is a charm.

I glanced through the materials, and my view is that the growth that will undoubtedly come is priced too aggressively. I have some other considerations as well.

The strong sides of the business are: good growth, excellent sales per sq ft/good store-level economics, broad appeal, NO onsite baking.

Valuation: as proposed, Crumbs is valued at 16x 2011 EBITDA vs. 11x for their sel-selected peer group (SBUX CMG PNRA JMBA RMCF CBOU BAGL etc). Setting aside the "sausage" (aka adjusted EBITDA) forecast for next year, this multiple is very aggressive. More on the EBITDA later.

Dilution/overhang: it is not just the SPAC warrants. There is a large contingent share issuance to management that will kick in 2013. Large grants like that might depress the per share value even if the underlying business is doing well.

Sales composition: this is a big one for me. 78% of the sales come from cupcakes, 12% from other baked goods, and only 9% from beverages. This is a BIG problem in three ways. One, cupcakes are trendy (some may say, past their prime). This is a risk. Two, the cost of the ingredients has been marching up (flour, sugar, oil). What is the pricing power of a cup cake? Zero. Third, only 9% of the sales are from beverages. Beverages is where the money is made in the vast majority of food service establishments, and these guys really should have a good, solid coffee program by now. They don't. I would have liked to see a more balanced sales mix. We have seen a number of consumer companies overly dependent on one product or trend crash and burn: Jamba, Crox, Heelys, Atkins, Krispy Kreme.

Average check: the company says that its $20 average check is a good thing. It might be, but it might also be too much of a good thing. It means that customers do not visit the store on a regular basis so the purchase is completely discretionary (also 2-6 pm is the biggest sales period). This is a less robust model. High average check places are more susceptible. For example, high-average check restaurants like RUTH went from $20 to $1, MRT from $20 to $2 and MSSR from $30 to $2 when things really went downhill in 08-09. Low-average check place did much better during the period, MCD gyrated around $60 and YUM went from $40 to $25 at the very bottom. There are easier, less painful ways to add beta if you need it.

Aggressive growth: this is a part of the story. The company currently has 34 stores, and targets 200 stores by 2014. Here's a little secret. Stores are not as easily scalable as iPhone apps. There are operational problems, and then there is the capital required. The company says that it costs them $300k to open a store. This is $50 mm for the 166 stores they need to open for '11,'12,'13 and '14, assuming, bravely, no inflation. The company's "adjusted pro-forma EBITDA target" for '11-'14 is $5mm+$12.3mm+$17.5mm+$25 mm, or $60 mm total. Sounds like all the money will be going for expansion capex. Call your inner Warren Buffett on this one.

With that, good luck to the new shareholders, and enjoy your cupcakes. I am watching both my waistline and my wallet.

Twitter vs. Facebook

2011-01-06T15:58:00.000Z

Note: I am crossposting here and on Davian, the technology and marketing platform partner for the BC Inflation Fund.

The two are not mutually exclusive, of course, but here is why Twitter is far superior for me personally.

Twitter lets you plug in conversations and thought streams that otherwise you would have no access to. I am pretty careful in picking whom to follow and read most of what these people share. There is a lot of insightful information available, absolutely free, coming from great (I am sure) individuals, and, often, not available anywhere else. Twitter is less of a burden than "powerblogging" so the diversity of ideas is greater. Someone joked that FB is for people that you went to school with, Twitter is for people you WISH you went to school with.

Twitter users are anonymous, if they choose to be. Anonymity is conducive of freedom of speech. Freedom of expression matters a lot, and people really are hesitant to voice non-mainstream views if they perceive there might be something at stake (professional image, career, relationships). Many people probably would opt not to discuss politics if the shield were not there. In part because of political correctness, there is a growing gap between what is expressed and the actual actions. You can see the gap in dating site behavior studies (stated preferences vs. actual preferences), it sure applies elsewhere.

Twitter is an extension of your information gathering routine. It is not just following MSM twitter accounts. Great people find great things, and share the link. So if you follow great people, every day you will find great articles, underreported news, opinions and interpretations. In many ways, Twitter, when carefully managed, can be a live linkfest that can be read in addition to the "regular" linkfests one follows.

Twitter is unbeatable for instant information finds: news, sport scores in action, stock news, vote counts in progress, Gmail outages, and so on.

Twitter can be interactive and can be used for crowdsourcing ideas. Obviously, people with many followers can't reply (and some people simply view it as a one-directional promotional pipe) be but many do interact. This enables discussions like "has anyone looked at stock XYZ?" Twitter in this case makes you better at what you do (invest or trade) with great ease. Twitter is even good for grounding highfliers: a famous book author (who is not fooled by randomness) was twitting in Arabic one day, so I commented that he does not know that his twits are available to the "unwashed masses" via Google Translate. He put a few untranslatables up and wrote that Google Translate can't do this particular dialect. You win, buddy.

Facebook, obviously, is neither of these things, on top of being a huge waste of time. Surely there are people who value looking at their high school girlfriends' wedding (or beach) albums or their old neighbor's garage remodel in progress. Surely there are people looking for "the cure for boredom" as Mark Cuban said in his great Stocktwits interview. Surely there are "worthy causes" that millions can "support" effortlessly by licking "like" and forgetting about them that very instant. Surely FB enables inter- and intra-country rivalries who can "collect" more people to support soccer team A or the "annexation" of island B by country Y. Surely FB has exceptional information on who you are, where you are, what you click on (even outside of FB) and other valuable targeted ad information. But, by and large, for me personally FB is worth close to nothing. I can see some value for advertisers and social gaming, etc. companies that need network effects.

So, speaking of FB's worth and the breathless coverage it is getting, here's something very basic that I read and re-adapted from marketticker: FB has 500 mm users, and at $50 bn valuation, this means that a user is worth $100 in net income. If the average life of a user is 5 years, this is $20 per year, call it $30 pre-tax. If the pretax margins are 25%, this implies revenue per user per year of $120. That's an awful lot of ad clicks, in my humble opinion. FB really must have a stack of aces up their sleeve. Good luck to the new buyers.

Few 2010 Stories as Told by Mr. Market

2011-01-03T19:54:00.001Z

I crosspost here and on Davian, the technology and marketing partner for the BC Inflation Fund.

People often mention that the market is "forward looking": that is, market action often forebodes the future. The S&P bottomed out in March 2009, well before the broader economy started recovering. Here are a few 20/20 hindsight observations from 2010. Keep in mind that the S&P had its yearly low in July and returned about 15% for the year:

The surprisingly strong holiday shopping season: XRT, the broad retail ETF, did not have its yearly low in July. It bottomed out in February and got close to that in July. There is probably a certain technical analysis significance to this but, for me, it is evident only in retrospect. XRT started rallying in September (both with the broader market and with the decent back-to-school data).

Did your rent increase this year? The rent concessions by the large apartment REITs (EQR, AVB, UDR, ESS, etc.) started reversing last year and all are now posting solid rate increases on new and renewal leases. When did their stocks bottom? Early February.

The unemployment rate is routinely described as "stubbornly high" be it U3 or the "real" U6. Can we expect some change there? Well, my four employment horsemen, Manpower, Robert Half, Kelly and Monster all outdid the S&P for the year, ditto with the more niche DHX. May be good news are on the horizon even there. Even uniform providers GKSR and UNF beat the S&P (though the largest, CTAS, did not).

We often read that the "rich" are doing very well. What is the story there? Sotheby's, (ticker BID), perhaps one of the purest "rich people" investment plays, bottomed in February, like XRT discussed above. It is up 100% for the year, in case you were wondering how the "moneyed elites" were doing. BMW (owner of the eponymous aspirational car brand but Rolls-Royce as well) also bottomed early and near-doubled for the year. To complete your package, tuck a Hermès in your pocket: up 70%, again, no July dip here either.

Related to employment and retail spending is travel spending: a number of names there are running really hot. PCLN and TZOO were up almost 250% and 90% respectively, the cruise duopoly, RCL and CCL are up 90% and 50% respectively. Hotels are back: the big names, MAR, HOT, WYN, GET, H are up multiples of the broader market, ranging from 50% to 85%. Heck, even "horse and buggy" LodgeNet (LNET) somehow managed to lose only 20% on the year.

And, don't forget the ladies: shockingly, they do want to look and feel beautiful, regardless of billions of pending mortgage putbacks. A semi-random sampling from my "beauty" tracking list shows a pretty picture: LULU up 130%+, Estee Lauder (EL) and Arden (RDEN) up 65%, FACE and Interparfum IPAR 50%+; salon stuff distributor HELE up 25%.

See, isn't hindsight easy?

My Two Cents on Income "Inequality"

2010-12-06T22:48:00.000Z

I am crossposting here and on Davian, the technology and marketing platform for the BC Inflation Fund.

The quality of the debate on income inequality in the US is scraping the bottom, so I might as well contribute to the decline. Quite often, some innumerate journalist would quote some scary statistic about the top X percent taking home Y percent of income, while the bottom Z percent take home substantially less. But there is something missing from the discussion: a serious look at the link between productivity, growth and inequality.

If you roll back time, you will find that one of the oldest forms of wealth was livestock. If you have a cow, how long would it take before you become twice as rich on a "per household member" basis? There are some limitations to the enrichment scheme, both in the numerator and the denominator. People back then had many children, hoping some would survive to help on the farm. So you have your own progeny's growth working against the "per capita" wealth. The limitations in the numerator are well-known: the cow can only have one calf per year, some might be male or stillborn, the cow itself may die, and, even if you grow your herd, there are external factors, such as feed availability or raids by the Visgoths, the Vikings or the Vandals. Clearly, accumulating livestock wealth on a per capita basis had been a long and arduous challenge.

Jump ahead a few centuries. Now imagine you're an intrepid merchant loading up sacks of spices on your caravel docked at what might still be considered an exotic location. You sail off for the homeland, hoping to sell the spices at a nice mark-up. The treacherous trip around Cape Good Hope might take a couple of years. You might also run into Berber pirates: again, accumulating wealth, even with good tail winds, took a lot of time.

If you fast forward again a few hundred years, you might see that a series of inventions (such as steel and the steam engine) had given birth to a new boom industry: rail roads. Laying track is substantially more capital- and labor intensive than breeding cows but, once completed, the lines started generating untold, for the day, riches for the tycoons of their time. So technology enabled faster accumulation.

And, if you fast forward to last week, the founder of a three-year old web site called Groupon walked on a $6 billion offer from Google. Just to put it in perspective with our livestock example, live steers/heifers trade at about $1 per pound, or about $1,250 per animal based on some USDA release I just read. The gentleman founder of Groupon could have had quite a herd. It is also important to recognize that the founder is literally standing on the shoulder of giants: countless manhours of thought and labor are making his success possible: electricity, power plants, metallurgy, conductors, semi-conductors, plastics, glass, paper, and, yes, even Albert Gore Jr., father of the internet.

So what is the progression in these examples? It's the ability of technology to accelerate value creation exponentially. This means that we might see bigger winners more often. Look at the social media space, something virtually unknown five years ago. Today, Facebook, Twitter and Zynga combined are worth in the tens of billions. Are the mythical Top X% more likely to benefit from this acceleration? You bet.

My view is this: I do not mind that people make a lot more than I do so long as it is done fairly. Someone's making more than you should be a source of motivation not envy. And we should be happy that we are in an environment where people can achieve so much, so quickly. Talk to your Eastern European friends about the gifts of institutionalized equality. More importantly, the income growth is NOT a zero-sum game: someone creating billions via twitter did not hurt the income of the greeters at Wal-mart (but making it sound so makes a better story to sell.)

Time For A Taxi Cab Medallion ETF

2010-11-13T13:32:00.004Z

I am cross posting here and on Davian, the technology and marketing platform partner for the BC Inflation Fund. This article was featured at The Reformed Broker, a noted financial blog. The article was subsequently quoted and linked to by the Wall Street Journal.

Half-joking, of course. Let's talk about the ETFization of just about anything. But before we talk about ETFization, we should talk about securitization.

Most people by now have heard of securitization in the mortgage context. It has a bad rep but it does not have to have one, if it is done correctly. Mortgage securitization has been around for many years. But as any business gets standardized and more competitive, the profit margins in these deals decline for the people who put them together. At the same time, these people's steak dinners, condo dues and private school fees do not decline, quite the opposite. So the friendly folks start looking for other things to securitize, and get very creative with it. Toll road revenues. Parking fee revenues. Communication tower rents. Restaurant franchise fees. You might not know but the Dunkin Donuts buyout happened at an untold leverage number precisely due to the "award-winning" finance package put together by people who, in another day and age, would have been designing fuel pumps for diesel locomotives. The theory is simple enough: find predictable enough source of cash flows, tranche them, slap an insurance from the esteemed AAA-rated mortgage insurers, have them rated, and sell them to income-seeking investors. Voila! Oh, the things you can get away with when everyone is chasing yield...

But exotic securitization and mortgage insurers are so 2006. We have ETFization now. The scheme is even simpler. Find an asset class. ETF it. Collect 69-99 bps on AUM. Wash. Rinse. Repeat. Rare earth metals came in the spotlight after an unfortunate fishing trawler incident in Asia and the resultant spat between the Middle Kingdom and the Land of the Rising Sun, that led to claims that the former had stopped exports. The shares of the rare earth miners skyrocketed, and Joe Sixpack could get into the action very quickly with a convenient new ETF, REMX, that debuted just in time for the news that exports have resumed. Then last Wednesday, the CEO of Alcoa, the third largest aluminum producer, said that he'd be very supportive of a physical aluminum ETF and that they'd be more than happy to supply the product. I would like to warn you not to be too surprised when next Wednesday, the CEO of Kraft Foods comes out in full support of the new physical cheese ETF.

What is happening here? ETFs are great. They enable efficient sector exposure and are more liquid that mutual funds. Some invest in geographies or securities (esp. low-priced stocks) that an individual investor might not be able to acquire efficiently. BUT the creation of ETFs brings in new money into the pond without improving the cash flows of the underlying assets. Your risk increases simply because the asset prices are now higher. But the higher prices might result in more interest, new share issuance or whole new ETFs. This might be creating a positive feedback loop.

Let's look at an example of how things evolve. GLD, the major gold ETF, has been around for a few years. A year or two later, we got GDX, gold miners, and SLV, silver ETF. Well, that's not enough for a hot sector. We got palladium and platinum to play with via PALL and PPLT.

You'd think that this is enough for sector exposure? Think again. We got GDXJ, junior gold miners, for people who think that GDX is too staid. Why have five mines in Canada when you can have one in Burkina Faso?

By now we should be done, right? Wrong. There is a better mouse trap. GLD and SLV are favorites for PM market alarmists, so we later got the "physical" gold and silver, PHYS and PSLV. That should wrap it up, this looks like an ETF buffet table. Again, wrong. Why should you limit yourself to gold miners, when you should really be playing the silver miners, SIL. And if having operating mines just does not sound rewarding enough, you can always try to strike gold with GLDX, the "gold explorers" ETF released last week. And, where would we be without the levered gold and silver ETFs, UGL and AGQ.

I am no Soros/reflexivity expert but I can tell you that this looks like market participants really wanting to believe in their investments, and acting it out.

On to my proposal for a NYC cab medallion ETF. For the uninitiated, the cab medallion is the NYC license that allows the operation of the iconic yellow cab with all duties and privileges. The number of licenses has been roughly fixed since the 1930s (yes) which has meant that the price of having one has been increasing steadily as a testament to NYC's foresight, Byzantine politics and anti-entrepreneurial attitude. There are roughly two types of licenses, owner-operator and "corporate". The more expensive corporate (fleet) licenses are rented out. The current price of a corporate license is $825k. The price in October 2004 was $343k. So you have the asset price up 140% in 6 years. It is also cash flowing, and the cash flow is inflation-linked, as rates go up periodically. So, unlike gold, there is the combination of scarcity, desirability AND cash flow. Of course, if a buyer of size enters the market, you know what will happen to prices and yields: the cabs will not be producing more cash just because the medallion prices went up.

And don't get me started on my idea for a pre-paid college tuition ETF with redeemable shares...

ZIRP Thoughts: Labor vs. Capital

2010-11-09T01:38:00.001Z

I am cross-posting here and on the Davian Letter site. Davian is the technology and marketing platform partner for my autotraded fund.

In many businesses, there is a trade-off between labor and capital. A very simple example is a ditch-digging business (look under “excavation” in the yellow pages). A ditch-digging entrepreneur can hire a few people, hand them out shovels and send them to the job. Alternatively, the same entrepreneur can purchase an excavator and hire an operator and send him to the job. The trade-off capital vs. labor is pretty clear. The racing track can hire people to check the redeemed tickets or it can have machine-readable tickets with the requisite system. The vending machines in the office can be monitored remotely or a guy can come through and check. The landscaper can push a mower or ride one. You get the idea. Now imagine our ditch-digging entrepreneur could have financed the excavator at 25% last year because the banks thought that ditch-digging is not coming back. This year, however, with the recovery and the bank’s own low-cost financing (0% on demand deposits, 1-2% on 3-year CDs for the typical corner bank), our entrepreneur can finance the said piece of equipment at 6%. Clearly, he’s not buying shovels and not hiring. Capital has won.

Looking at the labor part of the equation, is labor getting more competitive or less competitive vs. capital? My bigger picture view is no, even though high unemployment should be lowering labor cost. Why? The big factor is lack of predictability for labor costs: no one really knows what the effect of the healthcare “reform” will be. The other sad factor is that payroll taxes are the most easily collectible taxes for the Treasury. If there are tax increases, one can expect to see them (eventually) there. Then you have a heavily pro-union administration. The capital maintenance costs are generally predictable: depreciation, consumables, insurance, etc. Oh, and there have been accelerated depreciation tax hand-outs. No wonder capital is winning.

Who benefits from this? You see companies like Wal-Mart and McDonald’s issuing fixed-rate debt at record low yields and investing. It would be criminal for them not to. Where is the money going? Wal-Mart just announced a major acquisition in Africa. McDonald’s is continuing their expansion in emerging markets. These companies are building the future first world. Who’s paying for this? It might very well be you: zero-interest is the destruction of prudent behavior and a confiscation of wealth.

There are other beneficiaries that engage in little-to-no value added financial transactions: PE firms. Ridiculously low high yield rates are encouraging PE takeovers and aggressive dividend recaps. Buyouts also often involve “synergies” (read: labor redundancies) to make the projected IRRs, now advertised as “good” if they are in the teens. But the credit wave surfers will surely make it up on volume.

Where are the landmines in the process I describe above? One is that the commodity inflation is getting out of control. I won’t recite the YTD figures here but when there are such one-directional imbalances (everything is up by a lot), there will be winners and there will be losers. There will be margin compression if you’re short cotton (and not charging 10,000% mark-up for your logo). There will be margin compression if you’re short coffee (and not selling the 20 cent cup for $3.49).

Then there are the legacy pension liabilities for a number of companies (not discussing state/local but they should matter to you if you hold munis). Low bond rates make it very hard for pension plans to meet their projected obligations: this means that companies will eventually have to make large contributions to the plans, essentially transferring money from shareholders/bondholders to former employees.

Two For One Book Reviews: “The Greatest Trade Ever” and “The Big Short”

2010-11-09T00:18:00.002Z

I am cross-posting here and on the Davian Letter site. Davian is the technology and marketing platform partner for my autotraded fund.

In short, I recommend reading both books to people interested in finding out more about the few investors who were able to make money during the housing meltdown in 2006-2008. The two books track several people, the bets they made, the challenges they faced from their investors, competitors, ill-wishers, families, partners and brokers. There is a certain overlap in two of the characters covered between the books (Michael Burry, Greg Lippmann) but otherwise “the tracks” are separate and yet complementary. Both books are generally “mass market,” that is, neither requires heavy finance background to comprehend and appreciate.

“If you’re not inside, you’re outside”- Gordon Gekko

The overriding (and highly inspiring) theme of both books is that several relative outsiders in the world of high finance (neither character had had a high profile bank/sell-side or fund/buy-side career) were able to see the magnitude of the bubble, and, with the substantial help of the “housing” CDS apostle, Greg Lippmann of Deutsche, were able to short it. Here is a run-down of the characters. If you like stories like Susan Boyle or Paul Potts, these books will inspire you. If you have ever been annoyed by the non-stop optimism types, these books are for you: most main characters are painted as rather somber, dark types.

Lippmann: the odd man out of the group as the only member of the “establishment.” A fixed income trader at Deutsche, Lippmann is instrumental to the creation and proliferation of the CDS contracts linked to the performance of mortgage bonds. He ends up accumulating a large position, making his superiors uncomfortable. Lippmann’s endless proselytizing raises the profile of the new instrument. His is the insight that housing prices just need to level off to see the defaults spike. He’s described as a brash, arrogant, flippant character: how much of that is stereotyping of bond traders, how much of that is a literary embellishment, and how much is the truth, we will never know.

Favorite quote: Deutsche is trying to collect $1.2 bn from Morgan Stanley. MS argues that it should be putting up less because the models indicate that the value of the bonds in question is higher. Lippmann: “Dude, f*ck your model. I’ll make you a market. They are seventy-seventy seven. You have three choices. You can sell them back to me at seventy. You can buy some more at seventy-seven. Or you can give me my f*cking one point two billion dollars.”

Paulson: Paulson is probably the most connected, plugged and conventionally successful fund manager in the group. After enjoying a bon-vivant lifestyle for years, Paulson had moved up to become an M&A MD at Bear Stearns, eventually opening up a merger arb fund. The fund had been “another ham and cheese shop” until the big hit. There is quite a bit of interesting personal details on him in The Greatest Trade, especially his younger years. Otherwise, there is no deviation from the many media stories that have followed his hit.

Pellegrini: Pellegrini had known Paulson since business school and ended up working as a junior analyst at the fund basically as a last chance job substantially below his age. He had suffered setbacks both in his family life (twice divorced) and career (spent seven years as a VP at Lazard). Pellegrini had been the guy behind the housing analysis and the trades that netted Paulson the record wins. The relationship between the two is described as strenuous, mistrusting, and, ultimately, failing. It does not sound like Paulson ever fully trusted Pellegrini with decision-making. Ultimately, Pellegrini leaves the fund.

Burry: a bit of a fairy-tale story. Burry, as a medical resident, starts writing online about value investing at the height of the internet bubble. He ends up being seeded by Joel Greenblatt who had read his writings. Burry, an anti-social guy with one glass eye, ends up figuring out both the bubble and how to short it all by himself. However, he ends up having really hard time keeping his investors on board once they feel that he had shifted from value stock picking to macro. The stress and indignations he goes through are vividly described. Ultimately, he shuts down the fund. Burry’s problems with the banks are also detailed: from “massaging” the marks to outright lies about the contract values once the ball starts rolling to salespeople not even answering their phones, later blaming system problems at their respective banks on the same day.

Eisman: one of the “original” subprime specialists. Eisman had covered many now-bankrupt aggressive consumer finance companies since the early nineties as an analyst at Oppenheimer. He had been known for his too-honest analysis. Eisman had known the sleaze from before so he had been able to recognize it early on in the government-sanctioned expansion of subprime. Post Oppenheimer, he ends up trying to open his own fund only to find that the doors are all closed. Finally, he assembles a good crew of pessimists and some funding from a couple of places. Eisman was recently in the news with his aggressive questioning of Genworth’s management at the last conference call. It really sounds like the character from the book.

Favorite quotes: from his days as an analyst, “The Lomas Financial Corporation is a perfectly hedged financial institution: it loses money in every conceivable interest rate environment.”

Greene: a rich playboy real estate magnate and an acquaintance of Paulson’s ends up stealing the trade idea, and is the only individual able to pull off the CDS trade in size.

Lahde: Andrew Lahde made a splash with his long “good bye” letter. Younger than most, he had started out as a broker, getting his MBA at UCLA after a year of rejections, then working at a third-tier bank and a fund. He starts running his fund out of his apartment, almost runs out of savings before he gets a lucky break with funding. Lahde’s letter is reproduced in full in the book, as he touches on a wide variety of social problems, such as blind credentialism (a class struggle of a different sort) and inane government actions as well as his future plans.

Ledley, Hockett and Mai/Cornwall Capital. Three laid back guys that stumble into the trade somehow after having made outsized wins on a few options trades. Their story is probably the most underreported in the media pieces covering the housing debacle.

There are several other characters in the books that really help flesh out important pieces of the stories. Joe Cassano of AIG is there. CDO managers are there. Subprime industry leaders are there. Family members with various degrees of supportiveness for the main characters are there.

Full disclosure: no connection of any sort to the publishers or the authors of the books. Not that any of them clamor for my views.

Forensic "Accounting": Is This High-profile Betting Exchange Minding the Store?

2010-10-23T16:13:00.000+01:00

I am crossposting here and on the Davian Letter.

Betfair Group PLC had a high profile IPO on Friday (yesterday, October 22nd 2010) in London with shares doing well in aftermarket trading. Betfair (and its closest competitor, Betdaq) are a different breed of online bookmakers: they are the so-called "betting exchanges" where anyone can be the bettor or the bookie, and the odds are determined by supply and demand. Further, one can place a bet at the prevailing market, or can place a limit order of sorts at higher (or lower) odds in the hope of getting it filled if the market moves. One can trade in and out of positions as many times as he wants to, and can act as a market-maker, quoting bid/ask at any time. Unfortunately, Betfair does not accept US participants for regulatory reasons, but one can still poke around the site.

For any game, Betfair gives not only the odds but also the liquidity offered at each level, as well as the total matched (traded) and unmatched (bid/offer) volume so one can find the more liquid games where the spreads between the back and lay are tight. To back is to bet on a certain outcome; to lay is to bet against that outcome=what the bookie does. Betfair collects a % from the winnings for the service of matching counterparties, and, unlike a traditional bookmaker, does not act as a counterparty in any transactions.
It should be noted that most of the volume is in Western Europe soccer, and since soccer is a low scoring game, the typical bet is a straight-outcome bet (moneyline) and not a spread bet. There are three outcomes, home win, draw or visitor win (denoted as 1x2; and the home team is listed first, unlike the US standard). The odds are quotes as coefficients, that is the multiple of your bet you can expect to have back. For example, a 1.25 means you get $1.25 total back for a $1 bet (25% ROI). This is the equivalent of a -400 moneyline (you get 500 total back for your 400, 25% ROI).

I decided to check where the liquidity is on Friday night. One can search either by unmatched bets (bid/offer volume) or matched bets (traded volume). A decent % of the bets listed are longer-term bets (i.e. England Premiership winner this season), with some of the upcoming games mixed in (i.e. England Premiership weekend games). So imagine my surprise when I looked at the following ranking for matched bets liquidity:

Most liquid games as of Fri 11 pm EST:
Chelsea v Wolves $1,032k matched /$4,053k unmatched
Spartak Niltchak-Tom $527k matched/$101k unmatched

Tottenham-Everton $501k matched/$1,360k unmatched
Real Madrid- Santander $428k matched/$3,430k unmatched
Stoke- Manchester United $286 matched/514k unmatched
Birmingham-Blackpool $265k matched/$190k unmatched

There are a few REALLY odd things about #2. It is from the Russian Championship. Neither team is one of the premier teams in the league by far. There is a 5-to-1 ratio of matched-to-unmatched volume, versus 1-to-8 for the Real M game or 1-to-4 for the Chelsea game. A bit odd, right? Even the Birmingham game ratio is 1.4-to-1. So the data is showing lots of volume traded, but shallow depth, unlike most other games that show depth much greater than traded volume.

So this peaked my curiosity: since when has the Russian championship become so popular? I went to see the volumes traded in all the other games and I was in for a surprise. There was one game (Spartak Moscow, a high profile team) with $217k matched, but the other were $1.6k, $1.1k, $0.85k, $11k, $12k, $2.2k for the Alania, Saturn, Amkar, CSKA, Anzhi and Rostov home games respectively. The odd game has 50 times the average volume traded for all other games but one! Now this is getting really interesting.

Betfair also shows how the coefficients (the odds, basically) have changed over time. Based on my observations, the odds are fairly stable over the few days leading to the game, barring any major unexpected changes with one of the teams. So imagine my surprise when I saw that the coefficient for the home win (where most of the volume is traded, 521k of 526k total) has been DROPPING like a rock, from 1.60 to 1.25! So, in other words, you're seeing the strange "price" dropping on unusual volume over a few days, while bids/offers are uncharacteristically sparse at any level.

By now I was suspicious. I decided to check on WSN to see what is going on with the regular bookmakers and the Betdaq. Here are the odds quoted for a home town win: 1.57, 1.50, 1.53, 1.55, 1.57, 1.50, 1.53, 1.30, 1.23, 1.22, 1.53, 1.55, 1.53, 1.55, 1.53, 1.24, 1.24 from bet365, Wm Hill, bodog, unibet, expekt, sportingbet, Ladbrokes, PaddyPower, 188Bet, VCBet, BlueSquare, interwetten, totesport, bet-at-home, betsson, betfair, betdaq respectively. This is a HIGHLY unusual dispersion in quoted coefficients. It looks like some of the bookies had caught on the falling price, while other had not. The coefficient falls if there is large volume coming for the particular outcome (the equivalent of moving the line on a football game).

So what is happening here? To me it looks like there may have been some trading back and forth to move up the liquidity rankings, and once "dumb" money started coming in, there was heavy buying of "home win", moving the coefficient down. Again, usually the coefficient does not move much while here it looks like there was a big disbalance: someone was hogging all "home win" bids. The small number of unmatched bids is showing that there wasn't really a functioning market but rather an absorption of whatever "dumb" money came in to take the other side of the "home win" bet.

Was there an informed insider making the bets? Quite possibly, E European championships are (allegedly) rife with rigged games, reflecting the high levels of corruption in general. Traditional bookmakers will not take high volume bets on odd games, BUT the exchange gets paid on volume. So things like these can happen much to the detriment of the small bettor. If you think HFT and stock exchanges, you are not far off. You are not far off either if you think manipulation, "tape painting", etc.

Oh, yeah, and the final result: 2-1 for the home team. Color me surprised. Be careful because you don't know what the other side knows about the trade, and the deal facilitators will not look out for you.

Heretical Thoughts on Gold Miners

2010-10-06T13:10:00.005+01:00

I am crossposting here and on the Davian Letter. This story was linked to by WSJ columnist and investment book writer James Altucher.

Over the last few days, I went through over 90 precious metal miner presentations from a recent forum. The companies presenting ranged from the major majors to minor juniors (pre-production, spending your cash on drilling holes across the globe).
Here is what I found out:
-Every miner is undervalued compared to its peers
-Every miner is a steal at its 2012-2015 projected production level
-Every miner has multiple high-potential opportunities in the world's most prolific mining region
-Every miner has an experienced management team that has a history of delivering results
-Every miner operates in politically stable, mining-friendly jurisdictions
-Every miner has wonderful community relations
-Every miner is a low-cost operator and is also sure that their costs will continue to go down
-Every miner is drastically increasing both reserves and production, but overall reserves and production are expected to decline
-Every miner expects gold and silver prices to go up due to multiple, undeniable fundamental factors
-Every miner is unhedged (well, almost, there were 2-3 that were removing hedges)
-Many miners have brand-name investors that they are proud of

So, satire aside, can all be right? The answer is an obvious 'no' for some of the points, and a subtler 'no' for some of the others. Here is what I was able to surmise about the industry and its underlying dynamics.
-Demand for both gold and silver comes from two general sources: actual use (industrial apps, jewelry) or "investment." As investment demand has increased, so has the commodity price. It appears to me that investment demand for gold is about 3x the level it was at in 2006-2007. You don't have to be a market maven to know what happens to price when supply is relatively inelastic.
-Miners are generally levered to the underlying commodity price level, so the miners' shares have been going up as well. This also attracts attention, and additional investment demand for the sector. Again, you do not have to be a market maven to figure out the price dynamic in a relatively fixed supply environment.
-There has been phenomenal growth in the AUMs of ETFs such as GLD, SLV, IAU, PHYS, CEF as well as miner ETFs like GDX, GDXJ, SIL, and broader "material" ETFs
-ETFs are just like many other asset management businesses, they do very well for their sponsors if AUMs grow; AUMs grow very well if the sector is doing well, so sponsors issue more shares and buy more of the underlying assets
-This is a positive feedback loop, and I am not sure that I like this dynamic longer-term, particularly for non-productive assets
-Imagine having a fund that accumulates residential lots in California, starting in 2002. The fund issues shares, and starts buying lots, moving the price up. Other market participants see that and start buying lots, too. The fund is doing very well because the underlying assets are appreciating. So they issue more shares and go back to the market for lots. The fund also thinks that every investor should have residential lots in their portfolios because they don't make land any more, while demand for housing is projected to increase for the next 50 years, real estate is a privileged asset class, expanding home ownership is a national priority, most millionaires come from real estate, etc.etc.etc. You get the picture and you know how the story ends. It is not a perfect parallel but there are some striking similarities.
-So increased investment demand moves up the underlying PM prices, charging the miners higher. With miners being higher, now there is a 2nd level of investment demand, that of the miners' ETFs + everyone else who wants in. Does it mean that the feedback loop is accelerating? Possibly.

More importantly, does it mean "sell now"? Absolutely not. I do not have a price target for gold (and, hence, miners) because I cannot estimate for how long central banks and governments around the world will continue with their inflationary policies. I would think that most of the appreciation in PMs/PMMs between now and "the peak" will be due to psychological factors, and, by this stage, there are no milestones for them.

Full disclosure: both BCIF and I personally are long miners of various sizes and precious metals, and short the Bernanke- Greenspan- Obama- Pelosi- Geithner- G.W.- Rumsfeld complex and everything it stands for.

How Not to Woo Customers: Craig-Hallum Edition

2010-10-04T19:15:00.000+01:00

So, imagine this: several of your micro-cap holdings and research targets are presenting together in a conference in your city. You register for said micro-cap stock conference put together by a small bank called Craig-Hallum. There are no restrictions of any kind on the registration process: a straight-forward registration form with standard questions.

The day before the conference you get a call, asking you who you are. You explain your story, your plans, and specifically why you registered to attend. Then you get the question "so how can we benefit from your presence there?" You are a straight-forward guy and you explain that at this stage, there is no benefit to the organizer. Of course, there is a direct benefit to the corporate (so-called) clients as they get to present to a wider audience, and there might be benefits down the road to said bank.

But, as is the case with non-apex creatures, such foresight is deficient. The caller just tells you point-blank that you're not welcome.

So, dear Craig-Hallum, thank you for allowing me to register just to call me the day before your event to tell me that I am not welcome: you win my eternal adoration (and some fame on the internet).

Labor Day Thoughts

2010-09-04T20:13:00.000+01:00

I am crossposting here and on the Davian Letter site.

Former Labor Secretary Robert Reich has an interesting piece out today on his blog regarding the state of the labor force and the overall economy ahead of Labor Day. While I disagree with a number of his interpretations and prescriptions, he does share a few thought-provoking things. Many have been repeated over and over, while some are under-discussed:

-Laments both poor private job creation and low % of union representation in the private sector
-The "standard" prescription has not worked: stimulus, ZIRP, tax credits to small businesses, low yileds
-So the problem must be structural, and we have to boost demand (by this paragraph, I was laughing)
-The current crisis has its origin in the growth of technology that increased productivity and enabled outsourcing
-This has kept a lid on real earnings for men for 30 years, while women entering the workforce enabled household consumption to grow
-The average workweek also went up, and, finally, debt/home equity extraction came into play
-This all came to an end, and now we have overcapacity
-The gains have been concentrated at the top, with the top 1% taking in 9% of the total income in the late 1970's, up to 23.5% in 2007; very similar to what had happened between 1913 and 1928 (as a reminder, income was not considered a bad thing and, hence, it was not taxed prior to 1913)
-This is bad because the "rich" spend less than the rest of us and this is not helping the economy (no comment)
-On top, the "rich" do not invest in America only but wherever the returns are the highest (capital mobility is a good thing, Mr. Reich)
-The Great Depression leveled the playing field with social security, union bargaining, minimum wage (laughable views, but more on that later)
-The GI bill along with a vast expansion of public education reduced economic inequality and was funded by 70-90% marginal income tax rates on top
-The result was rapid growth and more jobs (a very myopic view of the post-war economy, as Mr. Reich ignores demographics, relative peace, technology advancements, low-cost energy, no international competition, etc.)
-The only reform to "widen the circle of prosperity" since 2008 was the healthcare "reform" (another laughable statement)
What should be done per Mr. Reich?
-Extend the EITC to the middle class and pay for it with a carbon tax
-No income tax on the first $20k paid for with additional payroll taxes on $250k and over
-"0.5% transaction tax on all financial transactions" for early childhood education
-Free public universities with graduates paying back 10% of income for 10 years after graduation
-"Earnings insurance program" vs. unemployment benefits to pay 50% of the earnings difference to workers who take lower-paid jobs Here is my take.
That the problems are structural is one thing that I agree on with Mr. Reich. There have been many years of government-guided malinvestment in housing and education. Both have really distorted market dynamics and we are paying the price: too many houses, but also too many lawyers, art historians, gender study-ists, and so on. While I am all about the importance of education, the system proposed by Mr. Reich would create incentives for lower-productivity performance past graduation as it would effectively make "easy" majors free, and would not discourage loafing post graduation.

We are also facing the bill for the lack of actuarial foresight in all these great "equalizing" programs that Mr. Reich praises. At this stage, the message coming from all forms of government should be that your old age will not be what your grandparents' old age is now, and, chances are, your old age will be worse off both in terms of income from SS and healthcare price and availability.

Work (productivity), income, saving and investing are good things, not bad things, and this point is strangely missing the Labor Day piece by the former Labor Secretary. Taxation of work, savings and investment is very easy to do, but is but is simply wrong: tax the things you want to discourage: smoking, drinking, obesity, energy inefficiency, bad haircuts, etc.

Along the same lines, that mythic, evil "top 1%" is a very fluid group: many are people who have worked hard for years, built up their businesses, and are selling them before retirement. Do they deserve this spit in the face? No. The 1% subset that do deserve a kick are the likes of that tip-scrounge jumping entertainer that went to Miami, or that philandering endorser that hits plastic balls with a club, or that mummified former nude model that adopts African children as if they are some novel fashion accessories. Related, we really shouldn't be justifying policies by saying that they affect only X% and 20xX%: should we ban group Z from enrolling in college because there's only 3% of them but their disproportionate enrollment will open up space for all the rest of the population?

Former Secretary Reich also rails against the fact that the "rich" don't spend as much, and seek good returns for their savings. Capital formation, Sec. Reich, is a good thing, and capital floating to the best ideas is also a good thing. Your comrades' "usual" prescription of ZIRP discourages capital formation, and it really misprices capital, leading to a host of undesirable consequences.

Further, Mr. Reich is not considering the scalability of the rewards in the digital sector of the economy: the accumulation of wealth is now possible on a much faster and much grander scale than before because of the very high scalability of technology: that extra 1 million downloads does not require nearly the same capital as an extra 1,000 restaurant locations, thus, skewing the natural 80-20 distribution even further to the top.

If jobs are the primary concern at this stage, and I think they are for most policy makers, the discussion should center around job genesis. Is there a reason why an existing business should hire an employee today? Frankly, there isn't. From the macro-themes, like "regime uncertainty", twin deficits and kleptocracy, to day-to-day unknowns, like healthcare costs, the new burdensome IRS filing requirements, the increasing cost of simple banking, increased unionization threats, etc. there is simply no reasons for businesses to expand. Without business expansion, there won't be "good" new jobs, frustrating a full generation of people. Unfortunately, Mr. Reich (and the former media star currently occupying 1600 Penn Ave) are people who have spent their entire lives signing checks on the back, never on the front, so they can't really relate to the job-creators and are boxed in by their superficial, academe understanding of the process.

2015: Where Are They Now?

2010-08-20T20:11:00.000+01:00

Some summer Friday humor, guaranteed to offend everyone.
2015: Where are they now?
Business:
Carly Fiorina: Runs a high-tech recycling company called Compaqtor after her political career ended due to an unsuccessful merger attempt between the US and New Zealand
Warren Buffett: Fixes soft-serve machines at local DQ Grill and Chill's, mumbles something about a missing part called "collateral"
Jimmy Cayne: Early investor in the California legalization business; has own brand of tie-dye t-shirts, lava lamps and glass pipes
Mark Hurd: QVC spokesman for scissors, shears, mowers, whackers, chainsaws, razors and other cutting tools
Steve Jobs: Unveiled the iAircraftCarrier, a cooperative effort with the Department of Defense; built by FoxConn in China (but designed in the US)
Donald Trump: Licensed a new line of fine aged beef, called Donald Rump
Bill Gates: Finally lets himself go, buys a pound of organic Granny Smiths at Whole Foods
Steve Ballmer: Wears only sleeveless shirts and runs an electronics store by Times Square; he carries Zune, Kin, hotmail mousepads and other hard-to-find items
Richard S. Fuld Jr.: Trying to collect on an insurance payment for his Sun Valley mansion that he burned down while trying to find the hidden Krugerrands
Stan O'Neal: Opened 3 mini-golf courses in Fairfield County, CT, branded as The Hundering Turd
Steven Rattner: Appointed as Sr. Brand Manager for Matchbox cars after his stint with Obama's auto taskforce
Politics:
Timothy Geithner: Runs an amusement park called "The Recovery" in NJ; plays target in Shoot The Elf, the park's answer to Coney Island's Shoot the Freak.
Mike Huckabee: As Education Secretary, cuts federal funding for schools and universities teaching sciences of any kind
Rahm Emmanuel: Joined his Hollywood agent brother; specializes in vampire and ghost movies
George W. Bush: Still working on cattle-generated methane capture system at his ranch it Texas
Barack Obama: Dissolved by oil dispersants while demonstrating that Gulf waters are "absolutely safe for the summer of 2014"
Elena Kagan: Argued in a minority opinion to have the Constitution discussed and voted on annually by Congress
Sarah Palin: Insists that her brown-shirt brigade is not what you think it is, and that she's not a modern "Jenny Dark" as she's not French-Quebecadian
Rod Blagojevic: Last seen trying to exchange a seat on the bus for a 6-pc Chicken Nugget value meal
Mitt Romney: Regretting his big screen debut as James Bond because Americans cannot yet accept a Mormon as 007
Barney Frank: Busy personally approving every mortgage in the US between poker games "to make sure we don't get in trouble again"
Last but not least:
Ben Bernanke: Retired, leads the influential group "Pensioners for Higher Interest Rates"

Thoughts on Historical Multiples and Value Investing

2010-07-20T19:51:00.003+01:00

I am crossposting here and on the Davian Letter.

These two are somewhat connected, and let me explain how. Every once in a while, especially around sharper market moves up or down, the TV channels would parade numerous experts who argue if the stock market is overvalued or undervalued. One of the experts' favorite tools is looking at the 30-40-50-60-70 year average/median P/E ratios. Then the expert would inevitably make a pronouncement about the current state.

Here's something that goes a bit underappreciated in my view. Before the computers and the internet, collecting corporate data was a really labor-intensive exercise: I doubt many people active in the market now have gone "down to the library" of their institution to get the filings of Company X, and then proceeded to manually fill ledgers with numbers. I doubt anyone thought it would be possible to get all of this data (some vendors even adjust for non-recurring items), plug away a few numbers, press F9, and, voila, we "know" to the cent how much Company X is worth because "this is what the model says." The end result is that in the computer/internet era, financial information is much more democratic. So is corporate transparency: one can check if company X has that many stores, even ogle the storefronts with Streetview, or snoop on company Y's Peruvian open pit mine in 3D. If the management team seems fishy, one can check them out on LinkedIn or the federal prison bureau, lexis/nexis, facebook, basic searches, real estate records and so on. If you don't know much about the product, check the pricepoints online, see the vendors, read the reviews, order it for yourself to test. The drastically increased transparency reduces risks. Reduced risks increase multiples, and I think we have seen some of that: so that a 1920's P/E incorporates a lot more unknowns than does a 2010 P/E.

So, how is this linked to value investing? In its classic sense, value investing is about buying $1 for 50 cents. One of the most popular approaches is Ben Graham's "net-net". But here is the problem: back when Graham came up with the formula (or when Buffett did his famous cocoa liquidation trade), just trying to do a net-net calculation had been very laborious, as I describe above. And the people who did the work got rewarded. What is the situation now? One can screen thousands of companies just with the click of a button. What is the end result? Much, much fewer bargains (in my view, I have not validated at it statistically). Most of Graham's net-nets are usually small cap, illiquid stocks of companies in the middle of some reorganization: these might be fine for a smart individual investor, but difficult for anyone running more serious money. The greater transparency has resulted in making the screaming bargains nearly extinct. Even Buffett himself rarely makes substantial open market purchases any more (substantial vs. the size of BRK). Outside of the railroad acquisition, his other recent investments (GS, GE, etc.) were effectively private transactions.

"This time, it's different" is a dangerous statement, but maybe, this time it really is different: higher transparency and easy information flows might be warranting higher average multiples.

Launch of the Barbarian Capital Inflation Fund

2010-07-07T04:00:00.002+01:00

Today, in partnership with the Davian Letter, we launched the Barbarian Capital Inflation Fund, a reference portfolio-type product that contains several securities that are specifically selected to outperform during increasing and high inflation but with lower volatility than the widely popular commodity investments. During the selection process (a version of the top-down approach), I read a number of historical sources regarding high inflation bouts, from Rome to Weimar to Lat Am and E Europe to the US (70's and '05-'07). Believing that history rhymes, I noticed several recurring themes across these episodes not only regarding assets that should do well, but also regarding the more insidious effects that inflation has on the economy and on society as a whole. I will leave the details for the clients.

But wait, there is no inflation! Think of it this way: Noah built the ark before the rain started. This is my personal approach. By the time inflation makes it to the front pages, a lot of what is to come will be priced in, especially in the more popular "hedges." Taking it one step further, inflation, as defined by CPI, does not capture asset price changes. Without considering those, one risks making the famous mistakes of '00 rate policies. And, then, looking further at things like unfunded promises, energy scarcity, structural deficits, deficit rollovers, QE initiatives, positive productivity shocks (or lack thereof), and so on, one can conclude that high future inflation is nearly inevitable. I will leave you with a quote from the intro letter: "Quite frankly, we have no idea if annual inflation will average 5%, 15% or 50% over the next ten years. We do think that it is likely to be substantially higher than the one experienced since the mid-1990’s, and we will do our best to be responsible stewards of your capital."

Unstructured Thoughts on Structural Problems

2010-07-04T19:18:00.000+01:00

I am cross-posting here and on the Davian Letter.

Here are some unstructured thoughts on structural problems and malinvestments that I see. As long-time reader know, I belong to the Garage Logic University school of economics.

The whole housing "boom" was a malinvestment. Detached single-family homes are a malinvestment (vs. denser solutions) and lead to built-in dependency on oil, malinvested commuting times, too many furnaces, ACs, washers, dryers, roofs, siding, lawns, garage doors, automobiles, etc. Pushing homeownership is another malinvestment (even without the credit risks) as it reduces labor mobility, a US characteristic that has served us well. A big part of the euro-zone problems is the lack of intercountry mobility, while here people move for jobs from state to state quite often.

There is a structural problem (connected to the real estate industry kidnapping the American Dream and making it a single-family house). We are structurally short oil. This has translated to (1) permanent trade deficits with a number of hostile countries and (2) enormous military expenses to secure the flow of oil (please have no illusions about Iraq and the ~stan countries). I do not know what the solution would be here: Manhattan project, market forces, managed market approach (ie communicating that the excise taxes on gasoline will go up by 20% every year for the next X years).

College education is a malinvestment for many of the students (and the taxpayers who subsidize them). The generous (6-year) graduation rate is 56% as of 2008. This means that 44% of the enrollees possibly waste years and thousands of dollars (I say possibly to account for people who enrolled just for a class or non-traditionals). Of the 56% that graduate, there are plenty that majored in practically useless subjects, from Art History to Medieval Lit to Photography to "Interdisciplinary Studies", whatever that is. Sadly, the government policies will only increase malinvestment there: subsidies for college education are only going up and the government policies are based on the assumption that more people need to "go to college". This is pure malinvestment, as the likelihood of actual benefits accruing to the new marginal student is very low. The system is failing both the students and society as a whole. We really should face up to the fact that a "degree" does not ensure real world success, and, in some case, might actually impede it. Success in highly structured predictable environments, such as colleges or doctoral programs, can lead to both false confidence and inability to think independently.

We have other massive malinvestments, too: large federal bureaucracies that run large federal programs (for example, why do we have HUD or Dept of Education? Solve any issues in these areas at the local level.) There are too many others to list. On the other hand, we have the SEC and the DOJ completely asleep at the wheel with the frauds, including C-level, that became apparent with the crisis.

There are other structural problems besides malinvestments. There is a demographic tidal wave that is starting to hit now. As noted management guru Peter Drucker had once said, demographics is the future that has already happened. Ours is not pretty. The current crisis has only sped up the day of reckoning for the endless promises made by our election-cycle driven politicians. Now is the time to make decisive, drastic steps (raising the retirement age to 75-80 and truly reforming healthcare, for example): of course, the failure of leadership is astounding, but not surprising.

The demographic tidal wave can be offset some by immigration. The structural problem with the current system is that it does NOT favor skilled immigration. Many other "first world" countries have independent professional immigration programs, while our system creates disincentives for educated, law-abiding people to stay around, while, through lack of enforcement and promises of amnesty, keeps the low skilled people here as they have nothing to lose (even Obama's aunt ignored deportation orders). Between the crisis and the work visa quotas and kinks, many highly educated friends that were employed in brand-name places had to move (for some, 10 years after coming to the US for undergrad): this is not the sort of out-migration we want.

We also have a structural problem with healthcare at all levels (privately purchased coverage, employer-provided, government-provided). The upcoming reform does nothing to lower the cost of care: it neither reduces demand, nor does it increase supply. Healthcare is the millstone around the neck of small businesses (both for starting one up, and for attracting talent), and instead of moving away from the employer-based system (that originated by "great" government policies in the 40s), the current disastrous bill is expanding it. Also, when looking at real incomes, one sees that the increases in productivity have not resulted in increases in incomes: but employers have been absorbing higher and higher HC costs. So one can infer, non-scientifically, that the increases in productivity over the last 20 years have been expropriated by the HC complex. Then there is the problem of % dollars spent on actual care vs. % dollars spent on paperwork, administrators, and trial lawyers. There is also the unresolved basic fairness problem of paying for the care of the irresponsible (including the "clusters" of acute and chronic diseases associated with smoking and obesity, both largely "lifestyle choices").

And, happy Fourth, it's a holiday after all.

Tesla Motors: The Risky Fendi Bag of the Highways

2010-06-30T03:06:00.007+01:00

I am crosssposting here and on the Davian Letter. The article was also linked to by WSJ and Daily Finance Columnist James Altucher. The Kirk Report members-only section linked to it, too.

Tesla Motors (TSLA) IPO'ed today and rose 40%, underscoring investor enthusiasm for popular perceived "green" investments, underwriting ineptitude, or both. Congratulations to the lottery winners here, and best of luck because you will need it. Here is why:

(1) Tesla's product/s are/will be status symbols because they are transportation solutions that are inferior to existing, low-risk, well-known solutions. Here's my back-of-the-envelope calculation over an expected 200k mi life (and, no, if it does not work on the envelope, it won't work in Excel either). Tesla hopes that its "mass market" (20k units/year; 250-300 mile range) will sell for $50k. However, according to public information, the current battery pack needs to be replaced at 100k miles at a cost of $36k as it loses 30% of the range at 50k (and, presumably, 51% at 100k). Tesla reports subsidized (PG&E night charge) electricity cost of $0.01 per mile (per wikipedia). A 200k mile life of a Tesla would then cost $50k car + $36k battery pack + $2k power = $88k. A new VW Jetta Diesel is $23k, and gets 40 mpg. Over a 200k mi lifetime, that would be 5,000 gallons, at $3/gal, is $15k. So the Jetta cost would be $38k. Diesel would have to be $13/gal for the Tesla to break even. (As a side note, diesel at $13/gal would mean that a bunker with food and a shotgun would be the best use of money). I am making a number of simplifying assumptions here, including similar maintenance and insurance costs, and residual values. If I had to guess, Congress will make regular car owners subsidize the insurance of electrical car owners.

So the conclusion here is that because of its costs and limited range, the "mass market" Tesla will likely be a 2nd or a 3rd vehicle in for a well-to-do suburban household.

(2) The ecological benefit of electric cars is substantially overstated. First, most of the US electricity comes from fossil fuels (coal and natural gas), and, second, battery metals present problems both at the sourcing and at the recycling ends. So just relocating the tailpipe from the car to the power plant and the cyanide leaching ponds of the mines does not make electrical cars zero-emissions, despite them being advertised as such.

(3) The company has manufactured a little over 1,000 cars thus far, and the bodies are actually made by Lotus. This means that the production know-how is very low. On top Tesla plans to make the cars in a high-cost location (the old NUMMI plant in Fremont, CA). The location was unionized prior to the shutdown by Toyota and MTLQQ (aka "Old GM"). It is also highly visible politically, with Nancy Pelosi and Barbara Boxer hovering over the area. So you can imagine the pressure to have "good paying, union, green jobs"= tax payer and shareholder money spent for political favors. Also, Tesla does not even have the production machinery yet.

(4) Tesla is heavily subsidized by the taxpayer. The expected effective price of their "mass market" model is $50k after a $7.5k tax credit. Tesla also has a loan facility from the taxpayer via the Department of Energy. Just remember: good business ideas do not need subsidies. Apple's app store does not need them to thrive, nor do Biore strips, nor do tube socks, nor does the halal skewer vendor down at the corner.

(5) Tesla's CEO's personal financial problems are well-known. But here is what worries me: "We are a Silicon Valley company. Closer to an Apple or Google than to a GM or Ford in the way we operate the company"-- Mr. Musk said in a very recent public statement. I have some news for you. You are in the car business. This is a cyclical business that depends heavily on financing availability (for mass-market products). The scalability of your business is much lower. The likelihood that you will have to deal with a unionized, politically powerful, inflexible expensive workforce is high. 2 of the 3 US car companies are bankrupt, and the 3rd barely made it.

(6) Tesla is losing money hand-over-fist, but you probably knew that already. It will also have a period of no production as it gets ready for the "mass market" car.

(7) Last, but not least, Tesla means "adze" (a woodworking tool) in Serbian, Nikola Tesla's native language. Nice attempt to honor one of the most important inventors in history but it is also bringing a decidedly low-tech connotation to this aspirational company.

A Quick Look at Booz Allen Hamilton's S-1 Filing

2010-06-23T02:19:00.001+01:00

I am cross-posting here and on The Davian Letter. It was also featured on The Reformed Broker's Hot Links.

The market's rebound over the last year+ has brought some "interesting" potential IPOs. Back in February, we had FriendFinder Networks, a company in default, trying to raise cash. These folks own a number of adult-themed social networking sites, including adultfriendfinder, which they claim was among the top traffic-ed sites worldwide. The market events in February shelved this masterpiece. Then in April, a small movie production company called The Film Department filed for an IPO. This company focuses on movie productions (as if the Hollywood Exchange was not enough to skim money off the naive), and outright warned that they face substantial liquidity constraints and that even with the IPO, they would still have to raise additional funds for each production. Also one of the underwriters was getting warrants for the deal: generally, not a good sign. So that IPO also got delayed as the market got rocky in May. One can even track how the offering price was dropped over the months through the S-1s.

On to a substantially better business that filed yesterday: Booz Allen Hamilton, a brand-name consulting company that derives 98% of its revenues from the taxpayers (the US government). The company is owned by Carlyle, a top PE shop, and has hired Credit Suisse (left underwriter) to do the deal. I browsed through their financials and I really do not see myself as an owner of this business. Here is why:

A feature of attractive businesses is earnings growth outpacing sales growth. This is called scale, and is an essential factor with any enterprise. Some kinds of growth are more capital-intensive (i.e. build more stores/get more inventory), some less so (app downloads). But the scale exists in both cases as the fixed costs are spread over more profit-generating units. Building additional stores does not mean hiring more accountants in corporate or upping the national advertising budget.

Since BAH was LBO'ed, I will look at EBIT margin instead of NI to eliminate the effect of the increased interest expense.
2007: Revs: $3,209,211 EBIT: $130,695 (Margin: 4.07%)
2008: Revs: $3,625,055 EBIT: $153,481 (Margin: 4.23%)
2009: Revs: $4,351,218 EBIT: $66,401 (skip, LBO year)
2010: Revs: $5,122,633 EBIT: $199,554 (Margin: 3.90%)

What is going on here? Revenues are up 60% and yet, the margins are going the other way. This is not desirable. Where is the money going? Here's a clue:
2007: Revs: $3,209,211 G&A: $421,921 (13.15% of revenues)
2008: Revs: $3,625,055 G&A: $474,188 (13.08% of revenues)
2009: Revs: $4,351,218 G&A: $723,827 (16.64% of revenues)
2010: Revs: $5,122,633 G&A: $811,944 (15.85% of revenues)

If the G&A in 2010 were at the 2007-2008 levels (13%), then EBIT would have been $146k higher, and the EBIT margin would have been 6.75%, or exactly in the way an owner would like to see it go.

On the positive side, comp expense seems to be coming down, with last year's being "only" 51% of revenues. This is not unusual for "professional" firms, such as investment banks (see JEF or GHL), but as the crisis showed, labor expenses tend to be fixed when things are going downhill and variable on the upside. There is no shareholder control over these which is something that even Buffett was unhappy about when he owned Salomon Brothers.

Then there is the whole "use of proceeds" aspect. A potential shareholder would like to see that he is funding future growth or paying down debt. At the other end of the spectrum would be a shareholder selling out directly. BAH is paying down debt, but how did this debt come about? There is the LBO debt, and then there is a subsequent recapitalization which resulted in the sponsor's receiving a special dividend last December (on top of receiving a special dividend last June). So, in effect, the IPO investors are funding the dividend that Carlyle pulled out. This clearly is not growth capital.

Finally, BAH's services are expensive. The company has 23,300 employees and generated over $5 bn in revenues from the US government. This means that the taxpayers are paying $220,000 per employee per year to Booz (all employees, not just front office). This is approaching investment bank levels but the money is coming from the pockets of the tax payers. With 98% of the revenues coming from the government, I would be worried that BAH's gold-plated services might be an easy target.

One has to keep in mind that there are two components to a purchase: price and value. If the price is low enough, then the purchase is de-risked and may present a good value. But somehow I doubt that the IPO will happen if the price is low enough for me to buy.

A New Partnership Between Barbarian Capital and the Davian Letter

2010-06-10T23:16:00.000+01:00

I am very pleased to announce that Barbarian Capital and the Davian Letter are partnering up to offer a new product: the Barbarian Capital Inflation Fund. The Fund will launch around July 1st with the goal of out-performing US inflation with lower volatility than commodity-only investments. Without getting into details regarding the exact portfolio composition and weights, we will focus on liquid traditional and not-so-obvious securities that we believe can accomplish the goal of the Fund. BCIF will be initially available to clients as a reference portfolio only, with the possibility of expanding the offerings in the future based on demand. The portfolio will be managed by me, Nick, the author of the Barbarian Capital blog, former "bulge bracket" banker and a Columbia MBA. More detailed bio information on me will be available to potential clients on the DL site. The operational aspects of BCIF will be handled by the Davian Letter, a well-known and established robust platform that already features several products, including fundamental tech/gaming, commodity, options, forex, rates, natgas and algorithmic products.

As long-time readers know, I am a student and an admirer of inflation. I started doing my own inflation tracking in early 2009 as the headlines were blaring "deflation". Whether you experienced inflation or deflation over the last two years certainly depends on your personal situation: if you were healthy, had no children in college, bought a car and moved into a new home (bought or rented), chances are your expenses were lower than they would have been 2-3-4 years ago. The same, of course, cannot be said about someone who had to find a new job at a lower salary with worse benefits and a longer commute, had a kid that started college and had a mortgage on a house bought in 2005: chances are his/her life got a lot more expensive when measured against the value of a unit of work. Beyond that, I do think that higher inflation will play a much bigger role in the future for a multitude of reasons. Timing and sizing the pick-up is impossible for me but Noah built the ark before the flood, and this is how I feel about preparation. The communications from BCIF will not focus on "why inflation" but rather on "what now," a consummate focus on the practical implications.

As always, thank you for reading, and do check-up on us periodically over the next few weeks.
Nick

Long Book Review: Confidence Game (the "Ackman/MBIA book")

2010-06-03T16:51:00.003+01:00

I am crossposting here and on the Davian Letter site. Update (July 5th, 2010): I strongly recommend reading John Hempton/Bronte Capital's review of the bond insurers (it is not exactly a book review but Mr. Hempton provides an incredible personal perspective on several of the underlying themes in the book).

In short, I recommend to anyone with an interest in finance to read Christine S. Richards’s Confidence Game, probably better known as “the Ackman/MBIA book.”

Since I enjoyed Mr. Einhorn’s book on his short position in Allied Capital (“Fooling Some of the People All of the Time”), I think that that drawing some comparisons is appropriate as it would help me flesh out the intrinsic worth of the new book. I have not read “The Big Short” and “The Greatest Trade” yet, so no parallels there. Also, the latter two are not about specific companies that turned on their critics, unlike MBIA and Allied. Please do read Dasan’s book review that was posted here a short while ago.

To better understand the significance of both Mr. Ackman’s and Mr. Einhorn’s roles in the crisis, one needs to understand the role that iconoclasts play in society. The term “iconoclast” derives from the old Greek/Byzantine movement against the use of icons in church services. They questioned the use of artificial, human-created objects of worship much like Moses many years earlier had objected to the Golden Calf as a man-made idol, an action that, at its time, was, well, iconoclastic. Later in history, other men would risk their lives to challenge the man-made status quo, men like Galileo and Copernicus. In other words, the iconoclasts, the people who challenged authority, with the appropriate intellectual backing, did more to advance the world than did millions of compliant, complacent men. Much along the same lines, this book is a story about having the intellectual wherewithal to question an edifice raised by man, the triple-A credit rating, AND to take the iconoclastic position financially AND to have the courage to see it through. Mr. Einhorn, for those who have not read his book, took on the privileged status of Allied Capital as a BDC, which, much like a top credit rating, enabled its holder to do things that would not be done if there were sufficient market discipline. Mr. Einhorn was also probably the loudest voice regarding Lehman Brothers’ troubles, and was viciously attacked by the Repo 105 crowd that in a normal country would be digging ditches in orange jumpsuits for life.

In addition to appreciating the important societal role of iconoclasts, I also had the benefit of having read Mr. Ackman’s original white paper on MBIA, along with having followed all of his public presentations on investment ideas, such as GGP, TGT, CXW, O, KFT, and FNM. These materials, along with a basic understanding of the principles of general finance, financial reporting, credit ratings, municipal bonds, structured finance and insurance operations, will make the book much more enjoyable.

On to the book itself. It starts out in 2002, when Mr. Ackman, then a manager at Gotham, established a very inexpensive position in MBIA CDS. MBIA had enjoyed a cozy position for many years, using its own triple-A rating to guarantee municipal obligations against default, for a certain fee. There were three problems with this. First and foremost was the dependence on MBIA’s own triple-A credit rating. Its single largest producing asset was not under its control. Second, the ratings agencies admittedly used a two-tiered bond rating system, which was much harsher on municipalities (from a default standpoint), meaning that the agencies were costing taxpayers billions of dollars in either extra interest because of the lower rating or in fees to MBIA/cronies. The third problem with MBIA was that it had practically no insurance reserves because it operated recklessly on the assumption that even if a municipal issuer were to get in trouble, they would get bailed out one way or another by the state as a “moral obligation.” When that was not likely, MBIA would muscle the states into shifting funds all over the place to cover the shortfalls so that MBIA would not have to incur losses. In other words, if the game were not rigged, there would be no underlying need for municipal bond insurance.

Since the muni business is so sweet (even Buffett got into it when the established players got in trouble), this attracts competition. Eventually, MBIA decided that they are smart enough to do insurance on other products, namely structured finance. This is where Mr. Ackman’s 2002 white paper comes in, well before subprime became word dujour. The white paper itself is not a Cassandra-style vision of the financial system or of the credit bubble, but rather a very interesting and thorough analysis specifically focusing on MBIA’s risk exposure, and its inconsistency with the company’s triple-A rating.

From that point, all the way until MBIA’s collapse in 2008, Mr. Ackman and his team would uncover more and more problems with the company, while Mr. Ackman takes on the role of being the lone voice warning about the danger to anyone and everyone that would listen. Quoting Natalie Merchant, “a wild-eyed misfit prophet,” Mr. Ackman’s unstoppable zeal is described in full detail, including calls, letters and meetings with then-NY AG Mr. Spitzer, insurance commissioner Mr. Dinallo, the SEC, a number of analysts following the stock, the CEOs and chief credit officers of the ratings agencies, the board of directors of Moody’s, later on, the Warburg Pincus and Citigroup “rescue” financing teams, the auditors, and so on. Clearly Mr. Ackman had no shortage of courage, persistence and resourcefulness to bring the world to his viewpoint.

What makes this persistence even more admirable is that Mr. Ackman defacto took on “The Establishment” even as his original fund, Gotham, was falling apart because of an unrelated court decision on portfolio entities’ merger. It must not have been easy, particularly in the somewhat small and insular world of Wall Street. The bond insurers have been great fee generators to Wall Street, both via their own financing needs as well as their role in making sure that the municipal and structured finance machines keep churning. Obviously, the banks’ self-interest was not aligned with Mr. Ackman’s regardless of who was “right.” Additionally, companies and their management teams do not like having their stock shorted: it seems that many managers take this as a personal affront, and are classless enough to show it like MBIA’s CEO who demonstratively refused to shake hands with Mr. Ackman after threatening his career. MBIA goes on the offensive in many ways, some are direct, some are alleged, like having NYAG Spitzer (at the peak of his power) and the SEC investigate Mr. Ackman, or having undue influence on the court case regarding an unrelated Gotham investment. While it does not seem like MBIA went to the lengths that Allied Capital admittedly did (phone record theft, having his wife fired), MBIA and its management did engage in a number of unsightly and completely inappropriate tactics in their attack on Mr. Ackman.

Again, remember that this is a book about iconoclasm. Being a dissident in the financial world is not easy, because it is costly, the timing is very difficult, and simply, it is much harder to win against a large, entrenched member of the system. But, just like Goliath was taken down through leverage, so was MBIA taken down through its inadequate capital reserving, aggressive underwriting and greedy, myopic management. More contemporaneously, be alert when someone from the “establishment” blames market participants or critics for unfavorable development in the market, be it MBIA, Lehman Brothers or

Greece

. Ask yourself, why aren’t these “evil speculators” or “wolf packs” or “sharks” attacking the creditworthiness of Norway, Nestle or Exxon?

Unlike Mr. Einhorn’s book, which is written (predominantly, I assume) by the fund manager himself, the Ackman book is written by a journalist. While obviously edited/redacted by Mr. Ackman, the book is sorely lacking the true insight of what went on in the manager’s mind as well as the intricacies of the actual security analysis that went on inside the fund. Mr. Einhorn’s provides much of that, including the careful research of specific (fraudulent) properties backing the BDC financing, such as shrimp boats in Louisiana or gas stations in Detroit (yes, Allied, with its privileged tax status and SBA relationships, did lend against such “gems.”) The author here does describe only one specific situation uncovered by the fund, a hospital bankruptcy, along with several cases of municipal finance or collateral abuse that were investigated by herself in her own role as an MBIA reporter. While the journalistic gumshoe work is interesting, I found the lack of insight in the workings of Mr. Ackman’s funds’ approach to analysis quite disappointing.

Additionally, while very-well footnoted, the book is written with the grandeur vision of a classic novel, and, as a result, it does not have a single graph of MBIA’s stock price or its CDS! Not even as an appendix. I can probably blame the number-phobic liberal arts establishment for that, but I do hope that the soft cover would include at least a two y-axis time graph that plots the stock price and the CDS over the six or so years, along with notations of the major events in the book. That should not be that hard to do.

Finally, one should also remember Howard Marks’s maxim that being early is often indistinguishable from being wrong. Mr. Ackman’s vision of reality did lose money for the original investors in Gotham Credit, as they had a negative carry position in the MBIA CDS. People who stood by did eventually make a lot. So, much like the Dutch buying Manhattan for $600, timing is (nearly) everything, and Mr. Ackman’s campaign was, in my opinion, his way to accelerate the perceptions of the market participants towards his view, which, with the benefit of 20/20 hindsight, was absolutely correct.

(No Amazon commissions here, I purchased my own full-priced copy, I earn no compensation for writing this and I am not affiliated with the author, publisher or any of the characters in the book, save for the first Pershing analyst on MBIA, Mr. J. Bernstein, whom I knew only socially from a b-school committee we sat on; I was left with highly positive impressions of him.)

Shorting Treasurys In Anticipation of Inflation: Harder Than It Seems

2010-06-03T16:48:00.000+01:00

I am crossposting here and on the Davian Letter site.

One of the “slam dunk” trades for the inflationist camp has been to short treasury bonds, especially the long ones. On the surface, it makes perfect sense: a fixed income instrument should decline in value when rates rise. Notwithstanding the recent gains in T-prices, along with the commensurate pain for the shorts, this trade is much less of a slam dunk than it appears. Here are my views on why it will be a while before the short LT treasurys trade works the way it is supposed to.

First, interest rates in general. A bond short can be based on two views. One is credit quality, the other one is a view on rates. Credit quality (i.e. getting paid back as contracted) would be a problem for the US if we were not borrowing in a currency we do not control. For now, we can get away with both taking the loans out and keeping the printing press, and this privilege has been recklessly abused. In other words, the US government will almost certainly take the easy road of printing rather than the harder road of actually paying down the debt. So if there are no nominal credit problems, this leaves rates. Normally, the central bank/s raise rates when inflation picks up in order to cool off demand/growth, generally believed to be the driving factors behind inflation (a misguided, incomplete view, but this is another topic). When rates rise, bond prices fall. Longer duration bonds drop more for the same increase in rates. But my problem with this is that the interest rates are one of the most managed (manipulated, if you prefer the conspiracy lingo) aspects of the economy. There are very strong incentives besides steroid-based economic growth for low rates, namely the cost of government borrowing and bank profitability. The Fed is not really independent, and Zimbabwe Ben has this moniker for a reason, so you can be almost sure that headline rates will be managed to stay low by all means necessary.

Second, in-built structural demand and potential new (!) demand. Do not forget that there is substantial built-in demand for treasurys from a number of market participants. Since bonds mature, there is a ready roll-over market. If bond fund flows increase (which could be just a function of increased retirement savings contributions in target-date plans), this creates additional demand. Pension plans, endowments and so on have pre-set government bond allocations, and the simple act of portfolio rebalancing can increase the demand for treasurys. Then you have insurance companies that are subject to rigid portfolio holding regulations, as well as to liability matching (which is done via longer-term treasurys). I am sure that there are more examples. Finally, you have “your” politicians “working” hard to “protect” your retirement savings from the evils of the stock market, so do not be surprised if there is an Argentinean-style theft of the 401k/IRA balances to be put in treasurys (or removal of their tax status, unless they invest in Ts). This can be in addition to new, mandatory employer retirement contributions to all employees (de facto, an employment tax) that automatically goes into Ts unless otherwise specified by the employee.

Third, a possible slow-down in new supply. Despite Washington’s best attempts to saddle the economy with a whole new round of structural problems (healthcare “reform”, “climate” bill, financial “reform”, idiotic stimuli programs, etc.), the economy and the tax base may begin creeping back up, surprising everyone. Some of it might be natural, some of it might be due to some productivity breakthroughs, some might be due to baby boomers working much longer than anticipated, or withdrawals from the cesspools that Bush got us in and so on. This will reduce the supply of new paper (the rollover requirements will stay, have no illusions, the national debt cannot be paid off, let alone the unfunded liabilities). But shorter term, lower funding requirements for admitted tax cheat Turbo Tim might end up putting a lid on the yields.

Finally, the coupon. Don’t forget that the bond is a contractually yielding instrument. So in effect, you are already swimming against the tide to begin with, hoping that the rates move down enough to beat the coupon pass-on, and then cover the opportunity cost of the position.

Frankly, I am as bearish as anyone, may be even more, regarding long-term government finances/demographics/entitlements/etc. I am just afraid that there are too many tricks in the bag left to keep the government borrowing costs low. A few weeks ago I closed out of TBT (2x inverse LT Ts) at a small profit, and I do not foresee re-entering the trade any time soon (and if I do, it would not be with TBT for sure).

Gone for 2-3 weeks

2010-05-15T13:09:00.002+01:00

No posts until early June, in all likelihood. Thank you for reading.

GMCR: Why I Worry Little About the Patent Expiration

2010-04-26T04:36:00.002+01:00

I am cross-posting here and on the Davian Letter.
Update 9/28/2010: I have been getting a lot of hits today from a number of prominent asset managers after the SEC announced inquiry into GMCR's dealings with a "fulfillment vendor", most likely M Block and Sons. There have been allegation about channel stuffing for a while, as I note in the last paragraph, because a number of the short theses that I had seen question the relationship. This article has very little to do with the allegations: I refer to them only in the last paragraph+comments.

Original article.

There is a lot of noise about the expiration of the k-cup patent protection in 2012, and its impact on Green Mountain Coffee Roasters (GMCR). Of all the possible problems with GMCR, this one is not a priority, in my view. (I have no position in GMCR but this can change at any time.)

Let's talk about patents first. Patents provide protection for inventions and are good for a certain number of years. Patent protection is crucial to human progress as it provides incentives for people and companies to go out and develop new things, as the inventors can reap the benefits of their efforts. There are certain industries in which patent protection is of paramount importance: pharmaceuticals for example. A patent-protected drug is a gold mine, de facto a monopoly. This is why one of the crucial metrics in valuing the large pharma companies is how many drugs they have that are coming off protection in the next few years. Patents are also important with tech companies and some industrials for the same reasons.

Enter GMCR. GMCR's spectacular performance is due to the success of its Keurig brewer system. The company sells the machines at cost, and then sells really expensive "k-cups" (vacuum-packed roasted ground coffee) that work with the machines. The company describes the model as "razor-razor blade". I prefer calling it a Trojan horse (but this is good from a shareholder perspective). A bit of history, the company did not invent Keurig. They had a relationship with them that culminated in GMCR acquiring Keurig a few years ago. Keurig had licensed out the production of the k-cups to several roasters, including GMCR. GMCR has been working at bringing the k-cup production under its roof by acquiring the licensees, most notably the pending DDRX deal. It has been dragging but once done, GMCR will have only one licensee outstanding, a private company up in Montreal.

So the fear is that once the k-cup production patent expires in 2012, everyone will start making k-cups, suppressing GMCR's margins. I think that the importance of this expiration is overstated, and drawing parallels between a patent expiration event in pharma to this is misplaced. Here's why.

Look at the consumable products that you use in your daily life (including coffee) and think whether patent protection plays a major role. Are there cheaper cognacs than Hennessey? Sure. Do you drink them? No. Are there cheaper cigarettes than Marlboros? Sure. Are there cheaper chocolates than Lindt? Are there cheaper sodas than Coke? You get the picture. Very simply, you do not make consumption choices guided by price alone. What is the common thread in these examples?

Bingo. It's brands. None of the brands mentioned above are patent-protected and, yet, somehow, they are doing more than OK. This- in my view- means that it will be difficult for a non-major coffee brand to compete with GMCR for shelf space in the stores and for mindshare with the consumers. People who would buy a Keurig machine are already (1) higher income (paid $100+ for a machine vs. $10 Mr Coffee drip brewer), and (2) bought the machine precisely because they like good coffee. So I think that this eliminates the non-brand competition.

Now let's look at the potential major brand competition. What are the major coffee brands? Store: Folgers (SJM), Maxwell House (KFT), Taster's Choice (Nestle); Retail: Dunkin, Starbucks, Seattle's Best (also SBUX), Caribou (CBOU); Office: Flavia (Mars). There are a lot more brands at the regional and local level, however, to be a threat by 2012, the brand should have national visibility and distribution at this stage.

You may not know it, but Kraft, Sara Lee, Mars and Nestle have their own machine systems in existence for years: Tassimo, Senseo, Flavia and Nespresso, respectively. So the competition has been around for a long time. Of the major brands that I list above, Folgers (and related, like Millstone) and Caribou are aligned with Keurig, Starbucks is aligned with Sara Lee, and, obviously, the Kraft (Maxwell, Gevalia) and Nestle brands are with their own. This leaves only Dunkin out to the best of my knowledge. So, even with an expired patent, I do not see a major threat to the k-cup system from the branded competition either. Sara Lee is trying to do something like that with the Nespresso capsules in France but there they have major brand presence compared to the US.

Finally, you have the game theory bit. Even if you have a well-capitalized, popular brand enter the space, this does not mean that they will compete on price. If you look at instant coffee, for example, the only major new entrant (SBUX) is more expensive than Nestle, even though the margins are good. Players understand that competing on price simply shrinks the profit pool for the manufacturers. Further, an entry into the space by a well-known brand might even be beneficial to the wider adoption of the machines, which does help GMCR (a network effect of sorts).

So the patent expiration is not high on my worry list. If I were a GMCR shareholder, I would be a lot more worried about (1) compression of the earnings multiple, (2) dilution, (3) input costs, (4) integration issues, (5) the DDRX tender offer, (6) alleged channel stuffing, (7) the ongoing drop in average kcup usage per machine, (8) office market penetration, (9) growth/maturity issues, and so on. ***PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US

Corporate Governance Malpractice Case Study: Kraft Foods

2010-04-17T18:53:00.003+01:00

I am cross-posting here and on the Davian Letter.

In the earlier article about Kraft, I discussed at length the potential benefits and dangers of the combination with Cadbury. To summarize, I was mildly positive on the transaction as it provides a diversification away from KFT's commodity business. Additionally, I provided some color on Kraft's subpar performance vs. its comps. Pershing Square/Ackman came out with a presentation saying a lot of the same things a few days later but with the view that one should be long KFT into the transaction. Today's missive is about Kraft's problematic corporate governance and its link to shareholder value destruction. I have no position in Kraft Foods but this can change at any time.

One of the "textbook" problems in governance is the so called "agency" problem. Many years ago, when most owners ran their businesses, they made sure that things were running for their benefit. As businesses got bigger and more complex, the owners saw fit to bring in professional managers to run things for them. This is today's equivalent of the shareholders and the managers. And the relationship gives a rise to the "agency" problem. The interests of the managers are not always aligned with the interests of the shareholders. If you are a manager, you want to do as little as possible for as much money as possible. The shareholder wants the exact opposite. Since it is impractical for the shareholders to supervise managers, shareholders elect a board to keep an eye on the managers, set goals, set comp, hire, fire, vote on major decisions and so on. The most powerful position on the board is the board chairman (but you already knew that). Obviously, a hallmark of good governance is the separation of the chairman and the CEO role. After all, the board is supposed the defend the shareholders' interests, and the chairman should be spearheading the effort.

Enter Kraft Foods. The company brought in Irene Rosenfeld, a professional manager, from Frito-Lay in June 2006. She also became chairman of the board in March of 2007, and if you do not think that the chairman role was a part of the initial deal, you should keep your money in an index fund. The chairman has strong influence in the selection process of other board members. Since Mrs. Rosenfeld's appointment as a CEO (remember the high likelihood of her chairmanship being a part of the deal), the following individuals have joined the board: Mr. Banga (1/07), Mrs. Hart (12/07), Mrs. Juliber (11/07), Mr. Ketchum (4/07), Mr. McDonald (1/10), Mr. Reynolds (12/07), Mr. von Boxmeer (1/10), Mr. Zarb (11/07).

You might be asking yourself, was there a "friends and family" discount for Kraft board memberships? It sure seems this way: only 3 board members pre-date Mrs. Rosenfeld (vs. 8 post-2006). One also wonders about issues like continuity. More interestingly, management's compensation is set by the compensation committee of the board. Who are the members of the comp committee? Well, those are Mr. Banga (Chair), Mrs. Juliber, Mr. Ketchum and Mrs. Wright. Three out of four are "Rosenfeld appointees," so to speak. Last year, Mrs. Juliber's seat was held by Mrs. Hart, another "Rosenfeld appointee."

The only non-Rosenfeld member is Mrs. Wright, who, according to the proxy materials, is qualified to serve on KFT's board, in part, because she is the CEO of Carver Bancorp ("CEO of a federal bank"). You might be forgiven if you have never heard of Carver: their market cap is $21 mm. Yes, that is twenty-one million dollars, 2,000 times smaller than KFT's. They have 9 branches. She is also on a few non-profit boards, including The Sesame Workshop. Oreo cookies, Cookie Monster. You get the picture.

A cynic might call this board composition "stacking the deck." There is no way they would get tough on management. But cynicism alone is not a good investment approach, so let's look at some numbers from Kraft's latest proxy. I am looking just at actual comp, not at the golden parachutes and other uncertain/potential provisions, nor am I looking at the pay % based on "adjusted" measures.

How has the board done in the past with defending the shareholders' interests by rewarding performance and aligning incentives?

Rosenfeld total comp for 2007: $13.5 mm; 2008: $18.7 mm; 2009: $26.3 mm

So, Mrs. Rosenfeld doubled her income between 2007 and 2009. Not bad at all, I wish I could do the same thing. Surely the shares must have done very well if what should be largely a fixed cost is so variable on the upside.

How did Kraft shareholders do during the same period?

Kraft Foods share price: Jan 1, 2007: $31.45 Dec 31, 2009: $26.92 (both adjusted for dividends received, looks much worse without, $35.61 in '07 to $27.18 in '09).

You can judge for yourself. Like they say, where are the shareholders' yachts? And the shareholders pay the board members $250- $270k per year for this.

The increase in the 2009 compensation was justified with "Ms. Rosenfeld’s leadership in executing on the formal bid for Cadbury in November 2009 and closing this complex deal in early 2010 as exceptional" (this quote is the #1 reason given).

My guess is that the board did not bother with the question "what if the deal is ultimately value-destructive and how are we going to measure it, and how are we going to adjust comp if the deal turns out to hurt shareholder value?"

But wait, there is more, just like in a Billy Mays infomercial. Note that the board describes the leadership as "exceptional". Is it? Here are some recent developments to keep in mind. Also remember that the deal was uncontested: there were no other bidders.

During the due diligence process, Kraft had missed a substantial pension liability with some of Cadbury's UK workers and ended up forcing 3,600 workers to opt out of the plan or to have a 3-year pay freeze. During the bidding process, Kraft also lied about not planning to close the Somerdale factory: KFT changed its mind post-takeover, based on unknown new production capacity in Poland (if I remember correctly). While this has not been reported widely in the US, the scandalous takeover the iconic British candy marker led to Parliament hearings (!) during which Kraft promised NO more job losses in the UK for the next two years. Further, the EU mandated that Kraft divest some product lines in some geographies.

Poooof! This is the sound of your mythical "synergies" disappearing. You could add paying 100% more than the 52-week low for Cadbury's stock. "Exceptional leadership" in deed.

Here's something else, from My Investing Notebook, Jamie Dimon of JPMorgan possibly takes a stab at Kraft in his latest shareholder letter: "We do not pay bonuses for completing a merger, which we regard as part of the job. When the merger has proved to be successful, compensation might go up." Cold.

So, is it any wonder that Buffett, KFT's largest shareholder, is upset? There might be more to his displeasure than just the use of KFT stock in the acquisition.

The Value of Counter-intuitive Thinking

2010-04-12T13:04:00.000+01:00

I am cross-posting here and on the Davian Letter blog. This article was a featured link on The Reformed Broker's Hot Links.

There is this anecdote about the Battle of Britain (if you slept through history class, this was largely an air operation). After every mission, the planes that came back would be inspected for bullet holes and subsequently repaired and strengthened in the areas that were hit. Makes sense, right? It did, until someone pointed out that the ground crews should be more concerned with the areas of the planes that did NOT have holes in them: the planes that were hit there simply never made it back... This is a fine example of counter-intuitive thinking.

Here are my not-so-fine thoughts on a number of policy and other initiatives that might benefit from some counter-intuitive thinking (that is, counter to what seems to be the mainstream view). As long-time readers know, I belong to the Garage Logic University school of thought, so pardon any inconsistencies with what your advanced econometrics professor told you.

As a country "we need":

(1) A "jobs" bill: no, we do not. It is scary, arrogant and delusional to think that "jobs" can be created by decree. Central planning has failed over and over again but apparently this is beyond the comprehension of many of our elected representatives. The government should ensure that there is a fertile soil, and let the collective efforts of the market participants decide what the next growth industries would be. What would have happened if Congress, years ago, had decided to protect jobs in the horse and buggy, abacus, whale oil, vinyl record and candle industries?

(2) A healthcare reform bill that expands "access": no, we do not. There is no problem with access: there are no waiting lists, that I know of. The problem is cost. Cost=price. This means that there are issues with supply and demand. The thing that passed does nothing to increase supply, and does nothing to decrease demand (not even the simplest things, such as a minimum mandatory out-of-pocket copays for any office visit, a cap on malpractice liability and transparent pricing). Oh, and don't forget, it uses 10 years of taxation for 6 years of spending to be "neutral". It would be laughable if it these clowns (one thinks that Guam will capsize if there is more US troops there) were not in a position of real power.

(3) To encourage consumer spending to "help" the economy: no, we do not. Higher consumption (along with higher taxation) hinder capital accumulation. Having more capital is a good thing, not a bad thing. An added bonus, the joy coming from an acquired object drops very quickly post-acquisition, we just get used to having the object, and we lose the option of spending the money on something else.

(4) To keep zero interest rates to "help" the economy: no, we don't. Everyone loves free money, but this discourages savings. The rebound in banking profits is simply the expropriation of value by the banks from the savers. Greenspan waited for way too long to raise rates in the '00s, and it surely seems to me that Zimbabwe Ben is repeating the same mistake. ZIRP, the last time around, also had other undesirable effects, such as high housing inflation in select markets and the now-infamous "reach for yield."

(5) To increase government spending to "help" the economy: no, we don't. To begin with, the government must take the money from its rightful owner, the earner, via taxation. I am not sure that bureaucrats spending other people's money can make better spending decisions vs. people who spend their own hard-earned money. Second, since we have a huge budget deficit, the increase in spending has to be borrowed. When you add the shocking lack of political will to do a real entitlement reform, we are creating "path dependent outcomes". Simply put, the financial mismanagement of the last and the present administrations has cut the number of options that will be available in the future.

(6) To subsidize "green energy": no, we don't. If a certain technology is not ready for the market, then may be it should not be in the market. Last time I checked, there were no rebates for people buying iPhone apps because it is such a cool new efficient technology, and, yet, there were billions downloaded. Why? Because it makes sense to download apps that make you more productive (for example). The sad truth is that neither solar nor wind can have utility-level reliability. Further, with 50% of the current energy coming from coal, that electric plug-in is not the zero-emission vehicle it is sold as. Finally, with solar panel and car battery efficiency dropping with age, exactly what are the recycling implication? Or there will be a "hybrid car battery recycling tax" levied on all drivers that dare not to buy a Prius (on top of the tax subsidy for purchase)?

(7) To pass "cap and trade" legislation: no, we don't. The man-made global warming has been exposed as the single largest science fraud of our times. Further, carbon dioxide is an essential part of the carbon cycle, this is the cycle of life. The creation of a "carbon credit" to trade is simply a transfer of value from the productive segments of society to the financier class. Personally, I am all for fuel efficiency and mass transit: a driving commute is largely unproductive time from an economic perspective, but personal views are not necessarily a good starting point for a larger policy.

(8) To help stem the foreclosure tide: no, we don't. If anything, foreclosures should be accelerated. Instead of throwing good money after bad, the government should cut its support of the housing market. This way the speculators will get flushed out, and the prudent participants will be rewarded. Further, as the market finds its ground, this will, shockingly, spur more investment. Finally, more foreclosures will actually enable the home-borrowers (not "owners" btw) to move to where the jobs are: the mobility of the US labor force has been severely constrained over the last two years because of the real estate problems.

(9) To pass comprehensive financial reforms legislation: no, we don't. I can see something dealing with the Too Big to Fail problem, but outside of that, we need actual enforcement of existing regulations (instead we have SEC staffers surfing porn all day, and getting reassigned, not fired!). To wit, the costliest problems have come from institutions that were already heavily regulated and, on top, were dealing with heavily regulated products, such as mortgages. The biggest blow-ups (Lehman, Bear, Merrill, Fannie, Freddie, AIG, Ambac+friends, Countrywide+friends) have led to virtually no persecutions or convictions: normally "professionals" are held to certain standards, and doctors/lawyers/dentists/architects are sued if they fail to meet them. I do not see the equivalent level of responsibility with financial "professionals" at all levels, from Frauddy N. Komish, a mortgage broker, to Trancheè M. Bonusky, the guy who knowingly stuffed the MBS with garbage, to Mr. Bonusky's bosses, who were in on the 'bezzle and then some (i.e. the repo 105 crowd).

So, there it is, 9 areas that can benefit, in my humble view, from a counter-intuitive look that goes beyond the knee-jerk, soundbite non-logic that seems to dominate. Criticism and your own examples are always welcome.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Thoughts on "Fad" Stocks

2010-03-29T13:40:00.001+01:00

I am cross-posting on The Davian Letter and here.

I've collected a few random thoughts on some of the characteristics of "fad" stocks in my view. Of course, most thoughtful investors know one when they see one, but I have not seen a thorough write-up on the topic. Let's take a look at some common threads that I have seen over the last few years.

Business: many fad stocks are consumer-related stocks. Why? There are two logical fallacies at work here. One is that "seeing is believing": many people can see, touch, taste, or wear a product; this creates a familiarity, may be even a strong relationship with the brand, which then translates into the assumption that the business is a good investment ("because I buy it all the time for the kids"). It also creates popularity and recognition in a wider investor base, which helps drive the stock price up. People do not get psyched up about steam valves or workers comp insurance underwriters, but they do love to eat at X or to wear Y or to shop at Z. The second logical fallacy at work is the "worship" of simplicity, and the associations "simple=true" and "simple=good". Less sophisticated investors sometimes think that the presumed simplicity of the business (especially ones with visible, tangible products) makes it a wonderful, honest investment when, in fact, some have turned out to be quite fraudulent.

"A Great Growth Story": most fad stocks have a great story, usually one of growth. Like with all big "bezzles", the story is compelling, tangible, visible, delicious (in some cases), comfortable (in others). The sad truth is that rapid growth is very difficult to manage, and can be value-destructive. Rapidly growing companies often end up with marginal employees, marginal suppliers, marginal locations, marginal franchisees, and so on. Rapid growth also attracts competition from larger, better capitalized and better managed firms. All of this eventually contributes to the demise of the high-fliers.

Cheerleaders and mega-trends: great stories have great cheerleaders who like to drum up the "mega trend" that the company is capitalizing on. Apart from management, there might be a few vocal analysts who actively spew out propaganda on the topic. Dasan calls them "master extrapolators": people who do not get that trees do not grow to the skies, that profitable businesses attract competition and that "on trend" does not mean a good investment. Think of some of the unquestionable mega-trends now. Anything China is "on trend": no wonder so many companies have China-this or China-that in their names, much like the .coms a few years ago. Other often unquestioned mega trends include green energy, hybrid vehicles, recycling and Baby Boomer healthcare demand. These are the ones that induce instant head-nodding and agreement in the investment community, without much consideration regarding whether it is the most optimistic scenario that is priced in, and then some.

Single-product risk: many fad stocks are dependent on a single product, service or concept. This is usually their undoing. Once the novelty wears out, the popularity fizzles or some bad news come out regarding the product, the stock heads south, sometime rather quickly, never to return to its former glory.

Stock characteristics: there are a few of them that I consider typical for fad stocks. One is rapid, sometimes parabolic, growth on volume as the popularity of the stock grows and more people buy into the story being sold. The rapid growth sometimes prompts management to do splits, which in turn, produces even more growth. Another one is behavior on earnings: one can observe double-digit % jump on the day quite often, as analysts hail the king of the day. A third sign is that the stock is just popular: people talk about it, someone has made a lot of money on it, the yahoo boards have the armchair quarterbacks going at full speed and so on. The final characteristic is that the stock is difficult to short: it just seems to defy gravity and common sense.

Non-traditional valuation measures and aggressive accounting: GAAP, with all their flaws, exist for a reason. If the management team is spending a lot of time on explaining how much they are growing based on some self-designed, growth-oriented measure ("adjusted cash operating profit per new store, exclusive of stores less than 3-mos old and Florida stores"), one might be looking at a fad stock. An additional warning sign is a company using aggressive accounting to exceed the quarterly expectations, such as bumping sales by relaxing credit and under-reserving for doubtful accounts. Accounting changes are also possible signs of the steam running out. Sometimes losses are described as a positive because the company is "investing" for the future.

Other potential red flags. Backdoor IPOs via SPACs: these do not have the same process as a traditional bank-done IPO and are sometimes used by questionable operators. Traditional IPO done by a less-reputable underwriter: beware of banks whose business model is "we say yes when others say no". High underwriting fees and/or a "best effort" offering might signal discomfort by the bankers (who often do know what is under the kimono). Management is going at great lengths to promote the stock: they are at every conference, they issue many press releases, they market the stock ostentatiously on their product packaging, they attack their critics with unusual vitriol and so on.

So, let's look at some good examples from the recent past. HLYS, still kicking around at $2-$3, but nowhere near the $40 it once commanded. The kids got tired of sliding around on their heels, and the investors took one on the chin.

Another footwear high-flier, CROX, was at around $70 at one time, but crashed down to $1, currently at around $8. These unsightly colorful galoshes were a hot selling item a few years ago. By the time management got around to doing a brand expansion into apparel, the word was out that the shoes were getting caught in escalators. True or not, it seemed that this is what the market wanted to hear, and the stock started rolling downhill.

KKD, once a sleepy Southern donut chain, embarked on a very aggressive expansion campaign a few years ago. It was a $45 stock, currently at $4, and was under $2 recently. KKD was a mix of poor capital management, dishonest relationships with franchisees, and serious alleged fraud. The former management was not charged formally, if I recall correctly, and the company has shrunk. People loved the donut conveyor belts in the stores but single-store volumes never justified having a machine on-site. LT investors got more hole and less donut.

JSDA, Jones Soda, made a big splash years ago with their cool labels, exotic flavors and the use of sugar (instead of HFCS, something "hot" right now). It was once trading at near $30, but the fizz is long gone, and the stock is under $1 now and is subject to a bizarre take-under (!) offer.

APP, American Apparel, is a company known for its quasi-pornographic advertisements, "made in LA" garments and for running a "Best Bottoms" contest, went public via a SPAC, traded as high as $15, but is now at $3, after the growth slowed, the founder/CEO's idiosyncrasies (to be polite) became public via numerous sexual harassment suits, and the INS arrested about a third of their employees for immigration violations last August.

Other examples include Atkins Nutritionals (remember the Atkins diet?), Boston Chicken, TASR (from under $1 to $30 to $6 now), BBW, Build A Bear, down to $6 from $30 (but possibly a "value" play now), NLS, Nautilus, a fitness equipment maker, an on-trend stock that has done the soft landing over time from $40 to $2 until the recent rumors. One developing situation is DECK. 90% of their sales are the UGG brand boots, and recent news indicate that they are really bad for your feel. Is this the bell tolling? I do not know. Also, I wish I could buy Ed Hardy puts but the brand is 50% private, 50% owned by Iconix, a company with a wide brand portfolio. So, what are your favorite fad stocks?

Thoughts on the New Movies "Futures Exchange"

2010-03-12T15:33:00.000Z

Barbarian Capital is cross-posting here and on the Davian Letter.

There is this new "futures exchange" coming which will enable seemingly anyone to bet on the box office receipts of new movie releases. The article was in today's NYT's Media section. The exchange will be based on the existing successful "Hollywood Stock Exchange" (HSX) but with real money. Both are managed by Cantor Fitzgerald and the new project seems to be generating a lot of publicity in today's world of "crowd sourcing" and "crowd wisdom." Is it really such a great idea?

Let's follow the money and look at the participants:
(1) Studios/insiders have a substantially better view of how a movie would do by the time it is released than does the general public. How? They prescreen heavily, make adjustments, sign distribution deals, determine the marketing budget, follow the buzz, and so on. Personally, would you trade against them? Per the article, the studios are allowed to trade "within limits" whatever this means. The fact that they have not been able to "lay off box office risk" with insurance companies (risk pros) ought to tell you something about how great of a deal this is: the informational asymmetry is staggering. Not only that, but also, unlike a wheat producer selling weather risk, the studios CAN affect the outcomes. If this is not moral hazard, I do not know what is. If the studio buys enough "protection" on movie X, guess what, they will cut the marketing budget and # of screens!

(2) Cantor operates the exchange, and is probably interested only in ramping up the hype to attract the largest number of "investors". Cantor certainly does not care if anyone makes money, they just want volume. The President speaks of a "wide audience": quantity of participants is inversely proportional to their quality. I do wonder if there is a level of responsibility here that is ignored: stock brokers have to ascertain that the clients' risk profile matches the investments. How would Cantor do that? Would they accept credit cards? PayPal? Bets from people under 18? Is the whole thing structured as a "futures" exchange in order to avoid gambling regulations? This kind of bets are likely to be seen on European bookie lists, and I personally see no difference between "investing" in a certain outcome for a movie vs. "betting" on next year's SuperBowl champion. Is a win there taxed as a short-term capital gain? Are the losses deductible? And so on.

(3) The public: this is the tuna. The public has no informational advantage over the studios. Look at regular stock investing/trading. Even with huge amounts of publicly available information, audited financials, historical track records, and so on regarding potential stock investments, study after study show that the average active market participant underperforms the market. Compare that to investing in a completely unknown endeavor (a new movie): what are the chances that the average participant will be successful? I am sure that there will be widely publicized "success stories": these will be exceptions. The only market participants that will consistently make money are (1) the studios and (2) the exchange owner.

Think of it this way: the exchange owner charges rent. The studios have a deck of cards that they can look at in advance and place bets accordingly. The public can place bets without seeing the cards. Who do you think will win here?

I am all for markets for ideas, like InTrade, where one can instantly observe the crowd wisdom, even when it is very wrong (like the Great Hillary/Rudy Race of 2008). But it seems to me that on this exchange, the odds are stacked very much against the individual participant.
I will leave you with a quote from Howard Marks, found in his October 2006 memo: "Since I moved to Los Angeles in 1980, my friends in “The Industry” have been unanimous in one piece of advice: never invest in movies. Yet The Wall Street Journal of April 29 carried a story headlined, “Defying the Odds, Hedge Funds Bet Billions on Movies.”
For decades, movie studios have gladly accepted millions of dollars from a group
of investors collectively dismissed as “dumb money”: deep-pocketed dentists, oil
tycoons and other wealthy individuals eager for a piece of the glamorous but
high-risk game of film production. But the biggest influx of money in Hollywood
these days is coming from sharks, not suckers: hedge funds, private equity funds
and investment banks.

Take the example of “Poseidon,” which was co-financed by hedge fund-backed Virtual
Studios. It has brought in gross revenues of $180 million worldwide since May against its
production budget of $160 million, meaning that after the deduction of at least half the
revenues for distribution charges, advertising costs and exhibitors’ fees, it’s still a big loser."
(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

More On Inflation

2010-03-04T22:31:00.001Z

This month I am crossposting here and on the Davian Letter .

As I mentioned in an article not a long time ago, inflation has been a favorite topic for barbarians ever since Rome started debasing its precious metal coins. I just wrapped up my annual inflation tracking survey and I would like to share the results with you, along with some commentary.

I track a number of pricepoints in several general categories: consumables, housing, transportation, education, financial assets, clothing and healthcare. To get an accurate picture of the price changes, it is important to track the same item unit price across for the year: be it a gallon milk, gas or a credit hour at a university. I do not weigh the baskets or the items to get an "alternative" CPI number but will highlight a few points in the data set.

Consumables Section:
Food: of 52 items, 26 were up (range 1.90-50%), and 11 were down. Excluding produce items (those should be looked at over longer cycles due to crop variance), leaders were Domino sugar (up 33%), Bud Light (up 23%), M&M's (21%), pork chops (17%) and Lenders frozen bagels (15%). At the bottom, again ex-produce, ribeye steak (-14%), Crisco vegetable oil (-13%), Cheerios and Corn Flakes (-10%ish). The average increase was 3.30%, and the median 0.95%. I fail to see widespread "food deflation". Both General Mills and Kellogg increased cereal pricing last year so there might be some givebacks there.
Household and personal care, over-the-counter medicine: of 14 items, 4 were up and 1 (Tide detergent) was down. On the other hand, Charmin tissue was up 21% (yes, calculated on a per sheet basis) and Huggies Newborn diapers were up 6.7%. All OTC was flat year-over-year. Tracking prescription drug prices is much harder due to scarcity of information and the changes in various plans year-over-year, so I did not even try: I just looked at various Tylenols, Benadryls and the like.

Transportation Section:
The MSRP on the cheapest 4-door Chevy compact stayed the same. So did a one way Chinatown bus ticket from NYC to Washington DC. On the other hand, nationwide gasoline for the year is up 42%, diesel is up 29% and NYC subway single ride is up 12.5%. There was deflation in new cars for most of the year, between the incentives and the stupid stimulus- which increased the prices for the people looking to buy used-, so you might have benefited from that if you were in the market. However, for most drivers, the people that did not score on a new car, there is inflation.

Education Section:
You always hear that education is getting more expensive, so let's look at it. 2009 was a year of deflation according to the official government CPI. Someone forgot to tell that to the members of the self-congratulatory ivory tower establishment. Harvard increased its tuition by 3.5% and Stanford did by 3.75%. But wait, those are the elite schools, who cares about them? Well, SUNY increased resident tuition by 5.47%, SUNY room and board is up by 5.62%, and the University of Minnesota-Twin Cities, increased its resident tuition by 7.24%. No deflation for these folks, by far. If Obama wants to stimulate education, the affordability does not start with more loans and guarantees, but with taking a serious look at how these pig troughs operate and the financial damage they do to our youths.

Healthcare Section:
Gathering pricepoints on healthcare is very difficult, in part because there is absolutely no transparency in pricing. I used several state-level databases to track state median billed prices for hospital procedures. Of the ones that got updated over the last year, normal newborn costs are up 11%, psychoses hospitalization is up 13% and minor bowel procedure without complications is up 27%. Heart failure and shock billing was down 15% in the one state that I tracked that. You can look at your insurance premium, copays, benefit cuts and figure out what your healthcare inflation was. Nevermind the time spent filing forms and being on hold with some clueless insurance adjuster. Here, like with education, I fail to see deflation.

Housing Section:
Housing is the only segment where there was deflation along all pricepoints that I tracked. The most recent NAR single-family median price is down about 1% versus a year ago: this includes the $8k stimulus effect so the real deflation is deeper. Of course, this only helps if you are in the market. Rents (tracked 2-bed apartments in 3 major cities via rentbits) are down in the teens for all three cities. Again, helps only if you move. Interestingly, the national average kWh electricity and cf of natural gas are both down, 2 and 11% respectively. However, this does not mean that your bills are down: the increase in delivery charges and other fees probably gobbled up the cut on the actual energy units.

Clothing Section:
Clothing is not easy to track, either, because fashions do change. So I had to stick to the basics from one vendor here, WalMart, to have a consistent year-over-year read. 6-pack boxers were up 0.3%, cheapest jeans were up 37.5%, single t-shirt, up 22%. Basic work shoes were down 7%. Again, I do not see deflation here. I am sure there are "good sales" with deep markdowns here and there, but what I am trying to do is have something that can be compared consistently year over year.

Assets Section:
On to everybody's favorite part, assets. Well, assets also got very expensive over the last year. A big chunk of that is timing, of course, as we had a major market low last year at around this time. So what has been happening? The S&P is up 30-40%+, gold 20%, oil about 100%, copper 130%, DBC (a wider commodity measure) 21%. 30-year mortgage rates are down marginally. CD yields are down 17% for the 3-year. What does this mean? This means a very strong asset inflation over the last year. If you view your savings as an "expense"- which it is in a way- then your dollar this year will not go nearly as far as it did last year. Not when measured against gold, oil, or stocks. A big part of Greenspan's failure was ignoring asset prices in his view of inflation. Do not do that: there is rampant YoY inflation in financial and some hard assets. Whether this is due to them being mispriced a year ago or due to money supply growth or something else is obviously a matter of discussion. Also, if you were all-in last March, asset inflation is actually good for you.

So, there you have it. There is no deflation if, over the last year, you: ate, used toilet paper, drove a car, saved/invested, used healthcare or education, or bought clothing. There was deflation if you moved to a new apartment, bought a new car or a house. I already wrote about "personal rate of inflation" a few weeks ago: this basket might not be anywhere near your basket, but I think it is a wide enough data set for one to get at least a binary answer as to whether there is inflation, despite the official statistics.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Analyzing Non-Core Risks

2010-02-27T19:42:00.000Z

This month I am cross-posting here and on The Davian Letter. This article was also a featured link on The Reformed Broker.

My view on risks when analyzing a business is that there are two types of broad risks that investors take: core and non-core. "Core" risks are ones that are inherent to being in a business: input costs, competitive actions, regulations, pricing dynamics, lawsuits, even employee embezzlement, and so on. Then, in many businesses, there are "non-core" risks: these are risks that are above and beyond the regular business operations. The problems with non-core risks is that they are not always obvious and that they are harder to quantify, so it is difficult to know whether you, as the owner, get paid to bear them.

Let's look at some examples of non-core risks that an investor should be cognizant of.

Post-retirement liability risk

The two kinds I am looking at are pensions and healthcare. Like stock options, pension promises are a compensation expense that defers present cash payments for a future promise. The shortsightedness and the incentives of a number of management teams has been a factor in overpromising benefits to lower shorter-term cash costs. Many firms currently realize that taking on these kinds of liabilities is dangerous, and have discontinued their "defined benefit" plans. But the existing liabilities are on the books already, and the zero equity returns and extraordinarily low bond rates over the last 10 years have made meeting the target returns difficult.

-Pensions: The assets of the plan are well known, the liabilities are not. This is the essence of the "non core" risk: large cash outlays may be required in the future, lowering the equity value. Anyone with an iota of knowledge of pension accounting knows that it involves a number of actuarial assumptions including projected asset returns, projected worker tenure, worker compensation rates and worker lifespan. On top, these assumptions can be "massaged" by management for short-term gains.

- Post-retirement health benefits: some plans offer post-retirement health benefits. Normally these are unfunded: the costs are recorded as incurred without prior funding. Knowing what has been going on with health costs, would you buy a business that is paying for the healthcare of someone who finished working there 20 years ago? Ask Motors Liquidation Company, aka "Old GM." And I am not even discussing if employers should be involved in providing healthcare to being with.

Financing arm risk

There are financing businesses (banks, credit card companies, specialty finance co.'s) that are in the business of providing financing. And then there are goods- or service-producing businesses that end up providing financing to their customers. This is a non-core risk in my view. It is not a problem until it is, leading to unexpected losses. Some recent high-profile incidents are GMAC that got into a number of non-core areas, Harley-Davidson's financing arm, Target and J.W. Nordstrom with their own credit cards.
Think of it this way: providing both the product and the financing means you are "double-long" your customers. If you max out your Target card at the store, and then default on it, Target effectively "gave away the store". If you do not make the payments on your new Harley, and it gets repossessed, HD takes the hit both on the resale value and on the receivables. Further, as we saw during the credit crunch, trying to fund the in-house financing operations is impossible once the securitization markets freeze.

Hidden short-term funding risk

Again, one of those "not a problem until it is." Many businesses mix shorter and longer-term debt funding. Overreliance on short-term funding, with its constant roll-over can trip event the bluest of the blue chips. GE had problems with its commercial paper program, usually a low-cost, liquid form of financing even before Lehman (the largest CP player, I think) blew up. This risk can be mitigated if the company has access to ample revolving credit lines. It does involve reading the footnotes in the financial statements, of course.

"Cash-equivalent" risk

Another credit crunch issue, remember when the auction-rate securities markets froze completely? A number of completely unrelated businesses had parked cash there and had to reclassify those assets when they had no access to them. I am not aware of it being fatal for any particular business, but it is a good example of a hardly-disclosed non-core risk. You can be sure that Wall Street will come up with the next "better" product to push on their clients in the treasury departments, but we won't find out about it until it becomes a problem.

Unrelated equity investments risk

Surely there are legitimate, "core business" equity investments. These might include joint ventures with other industry players to develop a new product, or equity investments in foreign subsidiaries in partnership with a local entity, or equity ownership prior to a complete separation of a faster-growing business unit (i.e. McDonalds/Chipotle). But then, some companies, for historical or other reasons, have substantial chunks of completely unrelated businesses. Ralcorp, a mid-tier food company, is an example of such company: RAH has a sizable share in Vail Resorts, a resort operator. Deltic Timber has a golf course investment (seems legit, right?). Vector Group, a small cigarette maker, is also an owner of CBRE, a NY-area real estate brokerage. Medallion Financial, a specialty finance business that funds taxi "medallion" purchases in cities that have those, also has stakes in two SPACs (and BTW NYC yellow cab medallions cost 750k+ for a corporate, 500k+ for individual). One needs to think "do I get paid to bear all this additional, non-core risk here?" This risk also has potential upsides, if one can accurately identify a mispricing like we had with the Palm/3Com situation a while back.

Governance risks

Governance risks are anything related to management actions (outside of running the business) that presents a potential harm to shareholders. There are a number of these, but I will look at two.

-Related party transaction risk: these are generally disclosed in the filings. But disclosure does not mean that the transaction is not harmful to the shareholders, even when it is "approved" by the boards. For example, if a company rents office or warehouse space from a senior manager somewhere in town XYZ, I have no idea if the price is fair. There have been some really egregious examples, including using a manager's wife's architectural firm for all new bank branches (Commerce Bancorp had paid $50 mm to the CEO's wife's firm; he was asked to leave by federal regulators, which also shows how useless the board really was).

-Retroactive option expense increases: this one hit me last year when the stock market tanked. All of a sudden, companies started re-pricing their employees' stock options at lower prices! The whole purpose of having stock options is that employees are incentivized to bring the share price up. When the market moved lower last winter through March, shareholders took losses all along. But some employees did not: they had their options repriced at the new, lower levels which defeats the purpose of having incentive compensation. This way the shareholders took a hit in the market, and are much more likely to get diluted down the road. I think the biggest offender there was Google. The "do no evil" folks over in Mountain View last March (note the timing) repriced over 6 million options from $500 strike down to $308. This is creating Silicon Valley millionaires not by sweat but by expropriation. So, the employees had no downside when the stock moved down, while the owners are hit twice, once with the stock loss and, second, with additional dilution.

The point of this missive is: as a shareholder (=business owner), you are likely to bear risks above and beyond the ones that come with the business. It is important to recognize that those come in a wide variety of flavors and it is often impossible to tell if one gets compensated adequately for them. With that, we are going to wrap it up for today.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Analyzing Industry Pricing Dynamics

2010-02-20T04:26:00.001Z

This month I am crossposting here and on The Davian Letter. This post was also featured on The Reformed Broker reading list.

One of the most important aspects in fundamental analysis for me is understanding the underlying industry dynamics. Questions one should be asking include where is the value captured in the chain, what really drives demand, what really drives the costs, and so on. One thing that is very helpful to know is industry pricing dynamics. Of course, there are many parts to this puzzle, but by and large, you want to invest in companies that have their finger on pricing (just think, with relatively inflexible demand, every $1 extra in pricing is an extra $1 in pre-tax profit: all the costs are already incurred).

One of the ways pricing "get done" is via signaling to the competition what the plans are. Since it is illegal to fix pricing, companies resort to specific language when they want to communicate what they would like to do. So let's look at some of the recent examples of such communication that I came across. I am not endorsing any of the companies discussed: they just serve as examples. (All transcripts are a courtesy of Seeking Alpha, I have truncated the questions and answers, the emphasis is mine.)

First up, Sara Lee (SLE). SLE produces a wide range of products, including Jimmy Dean sausages (listen to this customer call, hilarious), BallPark franks, Kiwi shoe polish, and, of course, the eponymous bakery items, both fresh and frozen. The fresh bread business in the US is dominated by a handful of companies: SLE, Interstate Bakeries, Flowers Foods (FLO) and Bimbo/George Weston. They make both branded and private label products and have extensive DSD (direct store delivery) systems. There has been some promotional activity in the space now that wheat costs have eased up.
Eric Katzman - Deutsche Bank Securities
On the bakery, I guess there’s been a lot of commentary as to like who shot first and I just wondered if do you think that you’re, like some people say that you’ve been the most promotional in the category. Some say that it was initially Interstate Hostess. You know Flower says that they’re kind of reacting to everybody. [etc]
Brenda C. Barnes
...you probably will find most people are guilty... And to the extent that any of us drive the price to low, the retailer hurts, too. So I just expect there’ll be a little bit more rationality on everybody’s part.

Got that? Sara Lee's CEO is saying that pricing should be more rational (=higher) going forward. She also does not like that everyone jumped in and started competing on price. Will rational pricing happen? Something to keep an eye on as you're reaching for your turkey- provolone- chipotle mayo on whole wheat.

Next up, Spectrum Brands (old: SPC, new: SPEB). Spectrum is a Chapter 11 case that emerged last August but is still OTC. They had too much debt but now they think they've got it under control. SPEB makes a broad range of products within three general lines: batteries/personal care, pet supplies and home/garden products. Brands include Rayovac, Remington shaving, and Repel insect repellents. The battery business is a tough business: private label share is high, retailers left and right have been cutting the branded offerings, and, perhaps most importantly, consumers have been spending less on toys and, on top, have no idea if one brand is better than the other as battery lives are not easy to compare. The big branded players there, besides SPEB, are P&G (Duracell) and Energizer Holdings (ENR).
Karru Martinson - Deutsche Bank
And we've been hearing a lot from other consumer product companies about how there's increased trade spend, a very competitive environment. What are you guys running up against as you go to market?
Kent J. Hussey
Our business model has always been to win the consumer at the shelf...So we will take whatever steps are appropriate to maintain the value positioning of our products. That's most notable right now in the battery category...[answering another question]... Some of the step up in promotional activity that we're seeing right now in the marketplace will probably have a little bit of a dampening effect on the, call it the value growth in the category. But I personally think that's just a temporary phenomena, and as the overall economy begins to recover I think we'll go back to a more normal retail environment...[answering another question]...Of late we've seen competitors add two free batteries to their eight packs. Whether it's promotional or permanent I can't answer that. I think it's promotional. And one of our ways of competing is to typically give the consumer more batteries for the same price as a way of providing significant value. And so, during this particular cycle of promotional activity we'll increase the number of our batteries to main the value positioning, the value spread between us and the premium brands.

So what is happening here? This is signaling of a slightly different kind. One, Spectrum is saying that the ongoing trend of putting more batteries per pack is "promotional". This should be read as "we would like it to end some time", may be when the market stops shrinking. The second part, which we did not see with the SLE segment, is the threat that SPEB will continue to respond with lower prices if the competition continues to lower their prices (whether directly or by adding batteries to the packs). Some consumer products are priced based off the "premium" being a 100, and the value being somewhere lower, and this is the "spread" he refers to. For example, Tide detergent is the 100 in the category and, say, Cheer brand is an 86. I do not know what the battery indexing is.

On to the last signaling example, Sanderson Farms (SAFM). SAFM is a large chicken producers. Proteins in general are another tough business to be in. There are substantial swings in commodity input costs (i.e. corn) as well as in the output prices. In other words, these already low-margin businesses can have both the input and the output prices move against them at the same time. The results are not pretty. PPC (Pilgrim's Pride) just emerged from Chapter 11 last fall and serves as a direct proof of the dangerous mix low margins- commodity input/output volatility- leverage. Besides SAFM and PPC, the other big poultry player is Tyson (TSN).
Joe Sanderson
What those volumes are is a restoration of our normal slaughter schedule. Last year during January, February, March, April and part of May we had that cut back in place and we’re not going to do that this year. We’re going to be at our normal, a little bit less than normal at our Big Bird operations, but we are going to run at close to normal capacity. We feel like that with cutbacks that the industry has that we won’t be in as near the challenging environment that we were a year ago.
Christine McCracken – Cleveland Research
So you’re not expecting any improvement in demand, but you expect the competition to kind of stay rational?
Joe Sanderson
I do.

Again, let's read between the lines. If feed prices are high, operators sometimes produce too much, lowering output prices and shooting themselves in the foot. SAFM is not increasing production (trying to avoid the word "slaughter" here) and, more importantly, suggests that the competition does not do anything silly. Compare this to the battery business: there are no price wars or anything. Since the businesses are price-takers and cannot use other differentiators ("two gizzards for the price of one"?), SAFM is communicating regarding output quantities as a proxy for optimizing the industry-wide price/volume mix.

With that, we are wrapping it up for the day. This sort of pricing analysis is obviously not applicable to every industry. Points to remember: coordinated higher pricing = good, price wars = bad, and listen to what management says about pricing. Are they cutting prices, and why? Do they worship "share" disregarding profitability? Or do they say "we did pricing actions across the board earlier this year, most of it stuck, and we'll continue to be rational in today's tough environment"?

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Should We Get the Taxpayer Out of the Real Estate Business?

2010-02-13T18:49:00.001Z

This month I am crossposting here and on The Davian Letter. This post was also featured on The Reformed Broker. The TRB now has a weekly stocktwits TV show.

The taxpayer is more deeply involved in the real estate business than most people realize. I think it is time we pull the plug on the on-going blatant give-aways that go from our tax money to various constituents in the real estate business. So let's look at some of the known and lesser-known ways the real estate complex has been leeching for years. You can answer for yourself whether this is fair or not.

Multiple instances of preferential taxation
(1) At the corporate level, REITs are "special" in the eye of the taxman. REITs, unlike other perfectly good businesses, do not pay corporate-level income taxes so long as the income is derived from real estate operations and mostly paid out in dividends. Additionally, a substantial percentage of these dividends might not taxed at all as they are considered "return of capital." Just like this, the tax code has created a chosen sector, while "regular" companies pay income taxes and their owners pay taxes again on the dividends. (please no comments about BDCs, LPs, "c"'s, etc.: I am talking about regular mainstream businesses)

(2) RE developers also get local tax breaks for new construction in certain areas. Is this fair to the businesses providing jobs constantly in the area that do not get any breaks? I do not think so.

(3) There are breaks at the personal level as well. The big one is the mortgage interest deduction. Of course, you are fooling yourself if you think you are getting deal. If I were the seller and you were the buyer, and we both thought that a market price of X made sense, we'd transact at X. However, if I know that because of the tax break, you can actually afford X+20, guess the new market price? It is X+20. I will keep the surplus to myself while you think you're getting a deal on your taxes. For tax breaks to really work, they have to be private. Otherwise, in a large marketplace, the price will migrate up to where the sellers (the real estate industry) will capture the entire surplus.

(4) Another personal tax break are the very generous exemptions from what are in essence capital gains taxes. No other assets are exempt: short-term stock wins are even taxed at the high personal income tax rates. In other words, the tax payer encourages investment in largely non-productive assets with high carrying costs, while discouraging potentially appreciating, income-producing investments, such as stocks. Think about whether this makes sense.

(5) A loosely similar situation exists with 1031 exchanges of properties. In short, they allow sale and purchase of separate properties without taxes on any appreciation if the transactions happen within a certain time frame. Again, do you get a tax break if you sell a stock and buy a new one? No. The taxpayer is supporting a certain asset class over another for no good reason, in my view.

In addition to the taxation situations listed above (I am sure there are more but I am neither a tax nor a RE guy), the taxpayer is deeply involved in the real estate financing business whether the taxpayers want it or not. Let's look at some of the ways. Just remember that secured real estate lending is a mainstay of banking so banks have a vested interest in having collateral that receives preferential treatment.

(1) The taxpayer is the ultimate backstop for the FDIC. The FDIC insures deposits even in the most questionable banks. This (a) removes a source of discipline for the bankers and (b) perpetuates the lowest-cost funding for these questionable operators. Now, what do these questionable operators do? Well, they go out and lend to.... the real estate industry! If you look at most of the bank blow-ups since the "crisis" started, you will notice that they have been giving far too many mortgages and C&D loans to buccaneers who rolled the dice with little equity, or to johnny-come-lately's who knew little about the business.

(2) The taxpayer is on the hook for unlimited support for the "mortgage giants" FNM, FRE (+ the FHA). Remember that the news was released on the day before Christmas in the afternoon because the Nation's #1 TurboTax User (TM) was hoping that people would not notice? Anyway, what has been happening with these folks? For many years, under the guise of "making homes affordable", they have been interfering with the mortgage market and transferring value from the taxpayers to the real estate industry, in addition to being beacons of political cronyism. Now that the chickens have come home to roost, who gets stuck with the losses? You guessed it, the taxpayer.

(3) The taxpayer is also paying for VA program mortgages. Since we have a 100% volunteer army, why is the taxpayer subsidizing the career choices of other people by giving them money to give to the real estate complex?

(4) Let's not forget the current programs such as the housing purchase tax credit (another blatant giveaway to the industry), the various financing facilities from the Fed (only $1 tril in support of MBS), etc. Much is written on those (and not enough on the basics, so I am focusing on the often-overlooked latter).

So, the taxpayer is subsidizing both the industry via various tax breaks and its financing structure. Nice job if you can get it. But there are some other ways in which the taxpayer gets hit.

(1) Public housing and housing vouchers. The taxpayer, in addition to providing for his/her own shelter, is also providing for the shelter of many other people. Setting aside the discussion whether housing is a "right", lets look at some of the effects. (a) Voucher programs, such as Section 8, cover the difference between "market" rent and income, so the rent levels are artificially propped up. Also, there is a direct benefit to working as little as possible as any increase in income would go for rent. Not bad of a deal. (b) Public housing. "Projects" are now being widely demolished as a failed experiment. Is someone going to reimburse the taxpayer for the construction and demolition costs, along with the maintenance, policing, etc. costs that were associated with the projects? I doubt it. In places like Manhattan, vast swaths of the island are occupied by public housing thereby reducing supply and driving the market price up for the "regular" taxpayers (there are other factors in that price, of course, such as rent controls, being on an island, etc.). So the taxpayer has paid for the construction, maintenance, current housing AND has to pay higher rent because of the restricted supply. Makes no sense. Who benefits, besides the direct beneficiaries? The holders of the remaining housing stock, who can now sell high-priced condos and/or charge the highest rents in the country.

(2) Eminent domain abuse. Some cases in recent memory: the Kelo case up in New London, where a developer forced people out of their homes for a private project. Second, the Atlantic Yards project in Brooklyn (involving the participation of a Russian nouveau riche oligarch and Acorn- to hand out the "affordable units" allocation), the developer there is trying to squeeze some holdouts again for a private development (condos, office, retail and a new center for the New Jersey Nets). Also, Columbia University, a private entity, trying to expand its campus by steamrolling over the local property owners through incessant court battles, as well as through letting its own buildings in the area rot in order to create an appearance of "blight" and anoint itself as the savior. In all three cases, the developers are getting tax breaks to violate eminent domain principles. Big Pharma cannot confiscate your organs to do experiments, Big Oil cannot drill in your back yard, the local transit authority cannot confiscate your van to add to their fleet, and yet Big RE can defacto take your property against your will (the whole "has to pay a market price" argument is weak, there is no market price if the other side simply does not want to sell).

To summarize, the taxpayer has been too involved in subsidizing the operations and financing of the RE industry. This has lead to untold amounts of malinvestment and to widespread personal financial ruin for underwater home "owners." The taxpayer involvement should stop. Will it happen? Realistically, I doubt it: hoping it would happen is about as futile as trying to convince yourself that all children are above average. But, like Dexter's blog on suspicious trading, I am doing the SWPL thing here: "raising awareness."

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Is Whitney Tilson Running an Alpha-clone Fund?

2010-02-11T20:34:00.005Z

This month I am cross-posting here and on The Davian Letter. This post was subsequently featured on World Beta/Mebane Faber and MarketFolly. It was also linked to by WSJ columnist James Altucher on his dailyfinance blogwatch.

Let me preface this by saying that I like Mr. Tilson's work. He has done a lot in the worlds of value investing and value investing education. Further, he has been very forthcoming with a number of high quality materials on the housing crisis. I also follow all of his slides from events like the Value Investing Congress, as well as situation-specific presentations, like the General Growth dispute with Hovde. In addition, I doubt I will ever reach his level of prominence or AUM, or write a book, or have 5-star mutual funds like his.

Mr. Tilson is also one of the better thinkers on school reform (bet you did not know that). I have been blogging for over a year now, and Mr. Tilson is on my original "People Smarter Than Me" list on the blogspot site. I have no axe to grind.

So, back to the topic, is Mr. Tilson running a "clone" portfolio? I think the answer is yes.

In his 2009 annual letter, Mr. Tilson comments on a number of topics, but what got me thinking is the list of his top 12 positions. It seemed to me, after a cursory look, that most of his top positions are in equities that are in one way or another pre-approved or "blessed" by prominent value or activist investors (or both- i.e. Ackman).

(1) GGP Brand-name investor: Ackman
GGP/GGWPQ is one of the most fascinating stories of the crisis (yes, geeky). Mr. Ackman hit it out of the ballpark by realizing that (1) the assets are of superb quality, (2) the problem was a roll-over rather than a solvency issue, and (3) the structure of the liabilities was favorable. He coined what I am sure will be a classic: "good liabilities are an asset." GGP has returned multiples for his fund. More recently, Pershing and T2 have been involved in a public discussion vs. Hovde regarding GGP: if you like reading arguments about the proper ways to calculate NOI (even arguments about cash!), this series of presentations are for you.
(2) BRK Brand-name investor: Buffett
No further comments are necessary. Let The Oracle do your thinking for you.
(3) IRDM
This is a formerly bankrupt satellite phone service provider. T2 has some great slides on the whole idea, a nice "deep value" situation.
(4) MSFT
No comments here, either, though one has to wonder how much alpha generation is possible with everybody's favorite monopolist.
(5) AXP Brand-name investor: Buffett
In addition to being a long time BRK holding, AXP has been attracting attention of other value investors, such as Katsenelson. No longer in the deep value category.
(6) HUN Brand-name investor: Black/Apollo
This one is a bit of a stretch (both the idea and calling Black a "brand-name" investor). Huntsman will be a case study in corporate finance. Apollo and its banks were penalized for trying to walk away from a buyout/merger deal with Hexion, a portfolio company.
(7) PFE Brand-name investor: Berkowitz
Pharma is also attracting a lot of value investors, now that valuations have been depressed for numerous reasons. Berkowitz is a value investing celebrity, and his Fairholme Fund was the largest single fund holder in PFE the last time I checked. I do wonder what PFE's holiday gift baskets contain.
(8) DLIA
This is a unique T2 situation. Delia's is an online clothing retailer for girls. Market cap is ~50 mm. Tilson has quite a bit on it in both the '08 and '09 letters.
(9) Sears Canada Brand-name investors: Lampert, Ackman
Lampert, if you remember, had a huge hit with the Kmart bankruptcy and subsequent acquisition of Sears (US). It seems that he was the first fund manager in the recent past to both recognize and monetize the value of the underlying RE in a retail context. Both Lampert and Ackman own Sears Canada shares. There was some noise last year about Lampert trying to acquire the whole company after his failed attempt in 2006.
(10) YHOO Brand-name investor: Icahn
Yahoo, as probably everyone knows, was targeted by one of the old school raiders, Icahn, around its potential sale to MSFT. Icahn is still a holder.
(11) FFH Brand-name investor: Watsa
Watsa is often compared to Buffett; FFH is the insurance company he runs. Large holdings in KFT, WFC, just like The Oracle.
(12) WEN Brand-name investors: Ackman, Peltz
This is another two-fer. Ackman was an activist there a while back with his usual approach (also seen with MCD and TGT). WEN was then acquired by Arby's, which is a holding of Nelson Peltz. For the uninitiated, Peltz is a well-known activist in the consumer space, he has been involved at one time or another with Snapple, Arby's, Kraft and Heinz (probably the most public battle).

The more substantive question is, does "cloning" matter?

Probably not, but at 2 and 20 (presumably) one would expect more of the IRDMs and DLIAs and less of MSFTs or BRKs or AXPs. It is not unusual for big-time investors and their teams to reach the same conclusions about certain companies, especially ones of larger capitalization. This is particularly true when these investors adhere to a well-defined style, such as "value" which describes most of the names above. Further, PMs obviously share and discuss ideas, and selling your ideas to other investors then becomes a bit of a self-fulfilling prophecy as demand for the stock picks up.

But if you want a true "alpha clone" portfolio, there is a service for that (ain't America great?). It is run by Mr. Mebane Faber. (I have not used it/not affiliated with it/do not know Mr Faber. I just read his blog regularly.)

Do you know of other "alpha clones"? Or, even, "alpha clowns"? Let us know in the comments.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

A Look at Kraft-Cadbury (KFT-CBY)

2010-01-26T18:21:00.002Z

This month I am cross-posting here and on The Davian Letter. This article was featured on the Reformed Broker and on the Rational Walk twitter stream.

Barbarian Capital was asked to express an opinion on the Kraft/Cadbury deal. This is a long post (definitely not for ADD readers) and there is nothing “actionable” in it. In short, Barbarian Capital is neutral to mildly negative on the transaction. There are better-run, less risky staple stocks with better track records than Kraft’s out there. This also grew to be a mini-lecture on staples stocks so beware.

I am breaking up the analysis in two parts: the business part and the financial part. For the business part, I will look at the actual business units (something that does not happen very often in the financial press).

One of the most basic questions a fundamental analyst can ask is whether the business is a commodity business, or not. A commodity business is largely a price-taker business, offering undifferentiated, fungible product or service. On the other hand, non-commodity businesses have products or services that are distinct, have high switching costs, etc. The non-commodity businesses tend to have steadier margins, less volatile earnings, and other generally “desirable” characteristics. Not to say that commodity businesses are bad investments: they can be great so long as you are riding the wave up and recognize that you are doing so. Stay away from commodity businesses whose management claims unique abilities when, in fact, they are simply in the right elevator at the right time.

Most consumer packaged good (CPG) companies try to stay away from the commodity side of the business. They try to have distinct, innovative branded products with unique value propositions. They develop a lot of new things every year that you see in the marketplace. A lot of these products are “high value added products.” If you think about it, it is not easy to replicate the taste of Coca-Cola, Oreos, Cheerios, Snickers, etc. These are generally “good” businesses: with steady earnings growth, predictable margins, low betas and small changes in the earnings multiples, among other characteristics. They will not double overnight, nor will they disappear overnight. Think of them as the bonds in the equity world.

Kraft has some genuinely good businesses here and abroad: Nabisco (i.e. Oreos, Triscuits), Jell-o (“owns” the market for jello), Lu (Europe and here, higher-end biscuits, like Le Petit Ecolier), Milka/Toblerone (dominant Europe chocolates), Jacobs (dominant Euro coffee), etc.

However, despite its marketing to the contrary (especially in the materials facing the investment community), Kraft has a substantial commodity-like business, or rather businesses. These ugly step-children are not featured in management’s presentations but they do appear on a regular basis around the quarterly calls.

Who are they? There is the dairy business (the eponymous cheese, along with Philadelphia cream cheese, Breakstone sour cream, Polly-O mozzarella, Velveeta cheddar). Then there is the nuts business (Planters). Then there is the supermarket coffee business (Maxwell House). There is also the dry mix drinks (Crystal Light). There is the dressings and mayo business. You get the picture: these are largely low value-added products with dubious brand equities. They compete largely on price, and are likely to be economically unprofitable in the long run. Further, they expose the company to single commodity price risks.

Further, for various reasons, Kraft over the last 2-3 years has shed 3 high value-added businesses: Post cereals, snack bars and, most recently, frozen pizza. It has acquired one high value-added business (Lu biscuits from Danone). However, KFT has not shed any of the low-value units.

Then there are the non-stop Kraft restructuring efforts. They have been at it for a while now, doing all sorts of realignments and such. I personally have no idea whether they will be successful. On top, Kraft just did a large acquisition in Europe (Lu), which also prompted reorganizations there. My view is that constant reorganizations/fire drills are distracting, harmful and are no way to run a business. There will be more on the way, of course, with the Cadbury acquisition.

On the other hand, Cadbury is a high value-add “pure play” confectionary business (chocolates, gum, breath mints, etc.). The confectionary business is a good business. The products are difficult to make at home or by small players (especially of equal quality). There is also a very, very low private label penetration in the space. Further, globally, the confectionary business is quite consolidated: Kraft, Cadbury, Nestle, Hershey and Mars/Wrigley are the major players. Oligopolies are good businesses to invest in.

Adding to Cadbury’s attractiveness is their presence in emerging markets. Emerging markets are attractive for CPG companies because packaged good consumption there is just beginning to take off. If you look at the charts, the spending on CPG goes up dramatically with GDP. Since earnings growth at home has a limit due to slower population growth and high product penetration, EMs can provide a good “kicker.”

EMs have been tricky for most CPG players. Here is why:

If you look at any business, there is what I would call a “natural optimal scale.” On one extreme, there are the true global businesses because it makes “optimal” sense to be global. Look at a mining company: they have to be where the deposits are. Once there, the drill is largely the same: same equipment, same materials, same process, same shipping, same customers. You can extend that to almost any extractive industry.

On the other extreme, you have businesses that are optimally what I would call “niche national”: think of law firms. Even the “global” ones are simply brand-connected independent groups with very high local specialization which may not be worth anything outside of its immediate context. Sure, having offices in Country X can land the big deal but this brings little to no direct business outside of Country X.

CPGs are somewhere in between. Some products are highly local (think prepared meals) while others are near-global (think cigarettes or “thirst” products). Obviously, emerging markets expansion is easier if your products are near-global. Philip Morris International does a superb job with Marlboro across the world, as do Coke and Pepsi with their mainstay beverage offerings. So products being closer to global are better, and I think Cadbury’s are “closer” to global: chocolate, gum, candy. There are other trickier parts in EMs, such as appropriate marketing, lack of scale, lack of proper infrastructure, on top of the “regular” emerging markets risks.But this would be another topic.

So, if Kraft can issue its own less-than-inspiring equity for what could be great business, why not go for it? This is why, in my view, the Cadbury holders wanted more cash. I say that Cadbury “could” be a great business because we do not know yet. CBY spun off its beverage unit recently (Dr Pepper Snapple, traded as DPS) and is undergoing its own realignment.

This concludes the operating business review. Now on to the financials overview.

Owning Kraft stock has been a punishing experience for its holders since its float in 2001. The stock reached a high of $43 or so in 2002, and a low $21 last year, and has essentially gone nowhere since going public. The stock itself has a negative 9% return, which becomes mildly positive if you include dividends. KFT’s dividend yield is aligned with the industry but the share performance has really hurt the “total shareholder return.”

Taking a step back, as I mentioned above, staple stocks are the “bonds” of the equity world. The typical staple company is expected to have steady to growing margins, steadily growing EPS, steadily increasing dividends, regular buy-backs, steady earnings multiples and low volatility. If you look at how some management teams judge themselves, they focus on “cash returned to shareholders” via dividends and buybacks: as a shareholder, this is what you want to hear. What you do not want to hear is “our organizational realignment is progressing very well… we’re taking another $500 mm charge this quarter… oh, and yeah, price wars in our business killed the margins…” Kraft has been a lot more of the latter, and their share price shows it.

Comparing Kraft to some of its packaged foods peers, as I mentioned above, Kraft is at negative 9% since going public in 2001. For the same period, we've got KO +8.4%, PEP +35%, GIS +65%, K +105%, SJM +138%, all ex-dividends. If you expand beyond food/bev into other consumer staples, PG +89%, EL +25%, CL +37%, CHD +252%, CLX +73%. CBY (Cadbury’s ADR) is up 105% in USD at the deal price, plus the DPS spin-off, plus dividends.

You get the picture: Kraft has been a disappointment and continues to be a disappointment both from an absolute perspective (not behaving like a staple stock) and from a peer comp perspective.

Does this mean that Kraft stock is undervalued, like Warren Buffet believes? Not necessarily. KFT simply behaves more like a commodity stock like TSN (Tyson) or DF (Dean Foods) due to its large commodity business that I discussed above, even though Kraft goes out of its way to tell investors how many “billion dollar” brands they have. I would rather see the shareholders’ yachts, thank you very much.

So, to repeat from above, Kraft's using some of its not-so-great stock as an acquisition currency is not that bad of a move.

On to Kraft’s debt. Kraft has not been great for its shareholders, but has it been great with its bond holders? To reiterate some corporate finance basics, there is a natural tension between shareholders and bondholders. All the bondholders can hope for is to get their interest and money back as contracted. On the other hand, shareholders have a residual claim on the earnings, and are more likely to want to “go for broke”: exactly the opposite of what bondholders want. Bondholders do not like to fund share buybacks, special dividends or other “shareholder friendly” moves. Again, we know that Kraft has not been great for its shareholders, how has it been for its bondholders?

Not that great either. Kraft was just downgraded to the lowest investment grade level (a downgrade means that the value of the existing bonds drops to reflect the higher required yields). The problem with Kraft is that it already funded the $7 bn acquisition of LU with debt, and has not reduced leverage significantly since then. Now it is going for a major, major acquisition (=risk) by adding extra debt. Bondholders do not like this. A hiccup in the assimilation of the Cadbury assets can trigger a downgrade to non-IG, which itself can trigger a massive dump of KFT bonds as many funds are restricted from owning non-IG bonds. This in turn can trip up other funding venues, like revolving credit agreements and commercial paper (I do not know if they have any). So you get the picture.

Compare Kraft’s behavior to that of InBev before and after its acquisition of Anheuser-Busch. InBev communicated very clearly that they are taking on too much leverage, and that they will work hard to reduce it. They have been selling assets according to their promised plan, reduced or stopped the dividends, and redirected all cash to debt repayment. This is the kind of able, credible management team that both bondholders and shareholders want to see. InBev’s stock is 2x in a little over a year despite poor industry-wide conditions.

Now that we see that both shareholders and bondholders are suffering, what about the multiple Kraft is paying?

I am not worried about it at all. It is very much in line with the transaction comparables I have seen, may be a bit on the lower end due to the size and slower growth of the target. It is not a screaming deal, but it is not a rip-off either. I do not like that they are paying 2x the 52-week lows but this is life: if they had pulled an offer in early March, they would have deserved it.

The bigger issue (which is what my “non-thesis”) is based on, is how well Kraft will do the job of integrating and achieving the mythical synergies with Cadbury. Looking at Kraft’s record, I have my strong doubts that it will be a smooth sailing, and I fully expect “surprise” charges to come soon. Their task is further complicated by the high political visibility of Cadbury in the UK. Moreover, I think that considering Kraft’s difficult results in the US over the last 1-2 years create incentives for “kitchen sink” integration charges: this way the earnings improvement post integration will not be reflective of the true business trends but I would not be surprised if the market does not see through it.

The Barbarian Capital thesis is: keep an eye on Kraft. If the integration is not going well, the stock will be punished. This is the entry point. Why? Because the integration is not rocket science and things will straighten out sooner or later. If things go better than expected, then sit tight until they have a quarter or two of poor performance because of the commodity part of the business. Until then, stick with the guys who take pride in returning money to shareholders or make good on their deleveraging promises. There are plenty of other companies with steadier performance, better margins, and better yields that can fit in your “slow and steady” equity allocation.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

So What Was Your Stealth Inflation Last Year?

2010-01-26T18:14:00.002Z

This month I am cross-posting here and on The Davian Letter. This article was also a link on The Reformed Broker.
Special greetings to Sempra Energy Trading (Darien, CT), where someone really seems to like Barbarian Capital today.

So what was your stealth inflation last year? No, this is not a pick-up line from Argentina circa 2001. One has to be much more eloquent with the beauty queens from the land of Bife de Lomo and deep-hued malbec, as SC Governor Sanford can attest.

But since inflation has been a favorite topic for barbarians ever since Rome discovered it could pay more bills by reducing the silver content of the denarius, I thought I'd share some observations on what I call “stealth inflation”: price increases that are not likely to be captured by the official stats because they are household-specific and, yet, take money out of your pocket.

Most people simply accept the official CPI data, may be some even read into the first paragraph under the headline. For 2009, the headline number was negative 0.9%. But what does this mean to you personally? Is it meaningful? Probably not, unless your income is linked to some COLA index. As you probably know, the CPI tracks a basket of goods over the year, and does some adjustments if the price of one item becomes too high (i.e. they assume that if prices are high Jews and Muslims switch to pork from beef, or that Coke drinkers switch to RC Cola). The CPI does not track your basket of goods and services, nor does it track some other pertinent factors. In a couple of months, I will (probably) publish sample basket data that I collect but until then, here are a few locations where I have noticed “stealth” inflation.

Healthcare. Of course, “everyone” knows that healthcare costs outpace CPI. But here is something I have noticed that is not easily quantified. While your premiums certainly went up, did your co-pays and deductible also go up? Mine did. There are also reductions in lifetime maximums for certain conditions, as well as complete elimination of coverage for other conditions. These changes most certainly mean that you buy less healthcare coverage for your dollar, but they cannot be quantified within a basket of goods.

An additional non-quantifiable factor is if your doctor quit accepting your insurance, or started demanding full upfront payment, sticking you with the reimbursement waiting time. After all, MDs do get tired of waiting for three months to get paid 20% of the “list” price. Is there a price tag to this? Yes. Is it captured by CPI? No.

Transportation. Most places in the US one needs a personal motor vehicle to get around. While the costs of owning and operating one are known to most drivers (gas, maintenance, car loan, insurance) what happened to your registration fee this year? I am willing to bet it went up by multiples of CPI as most states are really scraping the bottom financially. Another stealth inflation factors are tolls: the Triborough Bridge here in NYC is now $5.50 each way, up from $5. It was also renamed the RF Kennedy bridge: quite appropriately for a taxing authority. I wish they’d sell the naming rights to Pepsi or something, instead of feed into this personality cult towards the descendants of Boston’s biggest bootlegger.

Speaking of NYC, the highly visible and politically important single ride is up 12.5% this year, while two train lines and several bus routes are likely to be eliminated (so you pay more with your time). Of course, the MTA really soaked the “rich” who buy the monthly passes.

Housing. Even if you own your home outright, what happened to your association fees? Property taxes? Especially if you consider property taxes vs. services provided: chances are you are getting less services locally per dollar. The only deflation in the housing market applies to people either actively shopping in the areas with the biggest decline, or to mobile renters who do not mind changing apartments every year. The alleged housing “deflation” is not helping out most households, in my view.

Stealth tax increases. Again, not likely to be captured by the regular CPI measures, but one or more of these may have happened to you in the last year. Remember that if the same item takes more money out of your pocket, this is inflation, whether the CPI thinks so or not. If you are a roll your own cigarette smoker, your federal excise tax went up 2,000% last April. If you were a saltwater fisherman in the state of NY, you now need a license, which is not free of course. Same with professional licensing fees and some permits. Are some items in your basket now a taxable sale in your state, when last year, they were not? Take a look at your utility bills: are there a bunch of little surcharges that keep increasing every year? I am sure you can come up with a load of examples on your own.

So, my message is this: Do your own thinking. CPI is a data point that may or may not have great relevance to you personally. At best, CPI presents an incomplete (and allegedly over-manipulated) picture of the real price levels across the economy. More importantly, if you are a businessman, do not price your products or services based on CPI: your finger should be on the pulse of your own costs, customers and competitors.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Why Are Academics Dangerous?

2010-01-23T02:06:00.004Z

This article originally appeared on the Davian Letter, a site where I am posting these entries a few days before they appear here. This article was also excerpted and recommended by The Reformed Broker. It was also linked to by Henry Blodget's BusinessInsider/Clusterstock.

Now that Dexter, Dasan and the Davian Letter have exposed smidiots, asset-gatherers, master extrapolators and link aggregators, let's talk about another dangerous element of the human ecosystem: the academics, and in particular, economists.

You see them everywhere: Bernanke, Krugman, Shiller, Stiglitz are well-known, but there are plenty of others in positions of real power like Christina Romer PhD, Chairman of the Council of Economic Advisers.

They all let you know how smart and useful they are, and they do sound pretty convincing. The intellectual lilliputians in the mass media can hardly hold their excitement once the academics show up on the screen. So why are the academics dangerous?

(1) An aura of absolute authority: what is the first thing your mother told you when she sent you to school? Listen to the teachers. Years of schooling reinforces "listening to the teachers" to the impressionable young minds, and this near-instinctive compliance and respect carries over in the adult world. In addition, our media is highly deferential to "experts" of all sorts, and someone with a PhD in subject X is often the ultimate, unquestioned "expert". Further, there is acceptance of scientific findings in "hard" sciences, such as physics, as the "truth", but this has carried over unjustifiably to social sciences, such as economics or finance. Shake off what your mothers told you, and do your own thinking.

(2) A pretense of objectivity: when a fund manager discusses an issue, more often than not, the listeners are aware that the manager is "talking his book", and is, hence, biased. If you are that guy running the $1 Tril "West Coast Fed", you'd probably never come out and say, "listen, I really do not think that most people should have bond funds" even if you earnestly believed that rates and spreads can only go up from here.
Academics, on the other hand, flaunt their objectivity when, in fact, they are just as conflicted as a fund manager. How is that? One, academics are slaves of their own work and would never, ever, do anything to undermine their pedestals. Second, many are pushing their ideas in books, thus their "assessments" of "the situation" (not to be mistaken with "The Situation") are nothing more than PR stunts and should be treated as such. Third, if you know anything about high-level academia, you know that many of these guys are heavily reliant on grants, and, thus, have a strong incentive to influence the federal policies in their own space, and often become nothing but mouthpieces for the official line. This goes well beyond finance/economics: academics are interested in creating "crises" that benefit them: "ClimateGate" and "swine flu" are recent examples of modern-day charlatanism. You can also see the excellent marketing effort surrounding AIDS, a 99.99% preventable disease with very low annual mortality rates. So whenever you hear about a "crisis", hold on to your wallet, or, better yet, figure out how to invest in the sham early.

(3) Lack of real-world experience: most academics are what The Governator once called "people who only sign checks on the back" They've never had to make payroll or rent. They've never made a sales call. They've never fired someone with a newborn. Most, I think, do not realize that their "success" comes from the structured, cuddly world of academia where the rules and relationships are not only clear, but also predictable. Those of us operating in the real world do not have that luxury, and yet, somehow the "distinguished John Q. Public professor of Economics" gets more airtime, more respect and more job security than the guy down the street trying to run a business. Makes no sense whatsoever.
Actually, often our "acclaimed" economists are business disasters: look at the imploded housing market ETFs from Shiller, or the Nobel winners at LTCM. Only academics can come up with theories based on a world with no taxes, or on efficient markets everywhere, or run a super-leveraged fund based on everything going right at all times. The reason why such absurdities exist is because there is no real clash of ideas in the Ivory Tower: they are all in the same boat, and pad each other on the back. For us, having the wrong idea hurts only the way a short squeeze or a big drop on volume can hurt.

(4) Expertise creep: most academics are highly specialized in a certain area. This is simply a necessity in a world with an ever-expanding body of knowledge: as one progresses in research, theoretically, one needs to discover "new things." These highly specialized academics are the academic world equivalents of specialization in many other fields: surgery, fixed income, engineering, etc. Most people would not voluntarily accept to have a knee replacement done by a neurosurgeon who has spent the last 20 years trying to reconnect neuron synapses inside patients' crania. And, yet, somehow most "popular economists" feel like they are experts on everything financial. Krugman won a Nobel prize for... international trade theory. And, here he is, The Authority on government spending, stimuli, and so on. Same with the other, more rotund bearded Nobel-winning fellow Stieglitz, an expert on globalization with an affinity for unsolicited advice to anyone who'd listen. Unfortunately, lots of lawmakers do listen.

What is the damage done?

There is a quite a bit, but the big one for me is the misallocation of resources. For example, the push for alternative energy has already resulted in the ethanol fiasco, and is also blowing up entire nascent industries, like solar: witness the wealth destruction last week when the word came out that Germany can cut the subsidies. Academics, in our case spearheaded by Steven Chu PhD, Energy Secretary, do not get that if something is a great idea, THE MARKET WILL SHOW IT.
Apple does not need special tax incentives to sell iPhones, right? Henry Ford did not need special handouts for Model T, right? P&G does not need tax incentives for the innovative Infinity pads they've got, right? The best, most competitive, most dynamic areas in business are the ones with the least amount of government interference: the federal government does not mandate quotas of certain classes of songs on iTunes, or certain features in enterprise management software products. The market does! If solar technology is not ready to compete, then, guess what, let it go on for one or two more iterations. But hardly a day goes by without some expert crying for a handout in his field.

Then you have the push for more spending at all levels of government based on "models" that someone like Krugman, in his $1.6 mm Riverside Drive coop, came up with. Stop it already: we were deep in debt before the current crisis. (This can be a very long paragraph but this is not the main topic, so I am stopping.)

The last example of misallocation of resources comes up in the indiscriminate push for higher education. Some researchers, obviously trying to protect their cushy academic jobs, found that going to college is a great idea because (on average) the college grads earn $X more. This has lead to an absolute overcapacity in the education space as people who really should not be going to college do (and fail to graduate even within six years but do create artificial demand for education). Imagine the contraction in the higher ed space once the flow of bodies reverts to what actually makes sense.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

If Bernanke Were a Biologist...

2010-01-18T01:02:00.002Z

This post appeared originally on The Davian Letter blog. I will be posting there first at least until the end of January. The DL is a site with a lot of interesting free and premium information for traders and investors. I am not affiliated with the DL beyond posting on their blog. This article was also featured on The Reformed Broker's reading list.

If Bernanke were a biologist, he would understand that the financial eco-system needs a process to excrete waste. That waste then becomes feeding stock for the real green shoots (some are affectionately known as "turd blossoms"). By keeping rates low and buying securities at mark-to-fantasy prices, the Fed is trying to recapitalize the entities that should be dead and thus stifling the true green shoots (in this case, able banking operators that can take over).

If Bernanke were a biologist, he would embrace natural selection. Generally defined, natural selection ensures the survival of the fittest and the smartest. By rewarding failure, the Fed does just the opposite as the fittest cannot take on the assets from the less fit. In addition, by punishing savers (the animals that stock up for the winter) via low rates, the Fed discourages what is prudent behavior for the participants in the system.

If Bernanke were a biologist, he would understand experimental learning. The frog that gets stung when it tries to eat a wasp, does not try to eat insects that look like wasps every again, not even ones that do not sting. We got in the current mess in a large part because of easy money over the last 10 years. How are we trying to fix the problem? More easy money.

If Bernanke were a biologist, he would understand that animals respond to incentives. Much like you should not feed birds and other wildlife as it creates incentives for them not to migrate in the winter, and to multiply beyond the area's "carrying capacity," ZIRP encourages malinvesment and the proliferation of various products that should not exist, and, more dangerously, it incetivizes people to gamble with reckless abandon as the chips are on the house (and "The Put" will be there.)

If Bernanke were a biologist, he would understand that systems are cyclical. Some years there are more wolves, some years there are more rabbits. By focusing on "full employment" and "price stability", both cyclical in nature, the Fed is interfering with the signals both markets would send to participants much to the long-term detriment of all parties involved.

If Bernanke were a biologist, he would understand that animals need food, warmth and shelter. By basing rate decisions in part on "core CPI", which excludes food and energy, and did not capture housing inflation in the 00's via owners' equivalent rent, the Fed's rate decisions are the old GIGO ("garbage in, garbage out"). Barry Ritholtz, quite accurately, calls core CPI "inflation ex-inflation."

If Bernanke were a biologist, he would understand that plants and animals need to adapt to survive and prosper. Contrary to that view, we have seen the Chairman do one thing, and one thing only, and that one thing is based heavily on his views of the Great Depression. These views have given him the academic acclaim and the resulting image to get the job, but what if the job requires some qualitatively different thinking?

For the record, I have never been a biologist and I do not aspire to be one.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Saturday Fireside Chat

2010-01-13T01:37:00.008Z

This article appeared originally on The Davian Letter, a premium content site for traders and investors. At least for the month of January, I will be posting the articles there first. I am not affiliated with the DL in any other way than just posting on their blog. This particular post was also a featured link on the Financial Times/Alphaville section, as well as on The Reformed Broker.

Let me tell you about this wonderful rock band from Liverpool, England. They were formed in 1959 and went on to have a three #1 singles in a quick succession. They were managed by Brian Epstein and signed with one of the EMI labels. You know who they were, right? They are Gerry and The Pacemakers.

Here's another story. In the early 1980's, a software company from Seattle develops and licenses a highly successful operating system for IBM 8086 PC's defacto becoming the (highly profitable) standard O/S for years to come. You know who they were, right? They were Seattle Computer Products who licensed the O/S exclusively to MSFT for redistribution for a fixed sum.

Here's something else. Have you tried France's oldest distilled spirit? It has been made in a specially designated geographic region for 700 years. There are also strict grape varietal requirements. The beverage is distilled and then aged in oak barrels. VSOP is an example of a grade for this spirit. You know what it is, right? It is armagnac.

And one final story. There are many sculptures and other artifacts left from a once-great civilization that lived on the territory of modern day Italy. They adopted Greek-style architecture, fought wars alongside with Carthage, mined copper and iron. You know who they are, right? They are the Etruscans.

This isn't some silly game show blog, why am I feeding you all the trivia?

I was listening to some Symphonic Pink Floyd on YouTube, and one of the suggestions that came up was a symphonic ABBA "Winner Takes All," a song where the Scandinavian beauties of the days past sing "the winner takes it a-a-a-ll..." Rome eventually absorbed the Etruscans and conquered a lot of other lands. Armagnac's largest export market is 22 thousand cases by my estimate (vs. cognac's 12 million case global volume). Microsoft went on to replicate its lack of original thinking by copying or acquiring Windows, Office, search, web-based email, game consoles, music devices, etc. And Gerry Marsden lives in anonymity while "Sir" Paul McCartney is worth over $1 bn, and enjoys a number of carnal privileges that come with fame and fortune.

The stories above are "winner take all" stories.

But there is something else in these stories that is relevant to investing. The winner took all, but at a time, the non-winner had even, may be better, chances to win. Something to keep an eye on with the smartphone wars, Defense Dept. orders, battery technologies, exploration permits, drug approvals, patent approvals, gambling licenses, toll infrastructure projects, radio frequency auctions and other apparent "winner takes all" competitions.

Appearances might be deceiving and a fundamental investor should be highly paranoid about competitive threats and the prospects of industry-wide profitability.

Air transportation "won" the long-distance passenger business but has been a losing investment proposition. Automobiles "won" personal transportation but only one non-bankrupt US manufacturer has survived. There is more information now than ever, and yet the information carriers of yesterday are near-dead. So are physical bookstores. So, go ahead, challenge those who assure you that their company has the winning model: they are the ones most likely to be asleep at the wheel.

Two for One Posts

2010-01-09T19:49:00.005Z

Dear Readers: at least for the month of January I will be posting my articles first at the Davian Letter blog section. They will continue to appear on here with a delay at least until the end of the month. DL is an up-and-coming site for investors and traders with various styles. I was invited to post there; otherwise I have no relationships with the site or the people running it.

How to Select Assets for Inflation
So let's chat about inflation, and investing for inflation (this blog is not investment advice).

If you listen to the eggheads, there are many ways to define "inflation." The more academic one is the increase in overall money supply (inclusive of credit). On the other hand, the esteemed Garage Logic University School of Economics defines inflation as the increase in the overall price levels, much like Yogi Berra's famous "a nickel ain't worth a dime anymore." There are quite a few shenanigans in the headline CPI number which I am not going to discuss here (substitutions and adjustments) so I personally keep track of my own inflation in different expense baskets. I recommend that you do that too: housing, food, transportation, utilities, sales tax, education, and others. You should track items that do not change across the years, such as a gallon of milk, gallon of gas, a NYC subway ride, price per kWh, tuition credit cost at the local school, men's haircut, whatever. Healthcare costs are a little trickier because it is difficult to assign values to coverage and deductible changes, but it is still a good idea to keep track of it. You can do it once a year, or twice a year, and compare your basket to the "official" CPI. I can almost guarantee you that you would be surprised.
So let's do a rundown of the more popular ways historically (or currently) for protection of your purchasing power. I will try to give a balanced view on each as there is no silver bullets (pun intended). Also please note that I am discussing a "manageable" inflation level (that is, no complete societal breakdown).
Gold: on the positive side, widely recognized as money. Durable material. No industrial (jewelry) demand above certain prices. On the flipside, it can be the ultimate "greater fool" trade. Once there is a belief that inflation will be controlled, the stampede for the exits will be ugly. Additionally, gold provides no current income. Having GLD is actually costing you (you read the prospectus like a good boy, right?).
Silver and Platinum: not dissimilar to gold but also have legitimate industrial uses that play a role in supply/demand.
TIPS: if the government determines the CPI to which its interest expense is indexed, what do you think are the incentives?
Foreign bonds/Foreign TIPS: similar story here. No country will let its currency appreciate too much versus the other currencies.
Stocks: one has to be very, very careful. Some of the things to consider here are: discretionary vs. staples (and Coke is NOT a staple; neither are iTunes); capital structure (interest rates are rising in an inflationary environment so look at the debt maturities for refinancing risks, fixed vs. floating, and property-level/non-recourse); pricing power (lots of factors here); "hard" assets/general asset quality. Also pay attention to the commodity cycles: farm and energy will likely outperform base metals/other materials.
REITs: while "real estate" has been a good play traditionally (especially if they can pay debts in "old" dollars and charge rent in "new" dollars), pay attention to the refi risks. Some REITs (office, industrial) are heavily linked to the overall economy as well. Also beware of mortgage REITs with debt duration mismatch (if you pay floating and short but receive fixed and long during a rapid rise in rates, you're in a tough shape once the rates move up).
Residential RE: has been one of the trades of the century for people who bought in the early 1970s on fixed rate. My caution here is that too many people take the availability of mortgages for granted. The 30-year, fixed-rate is something rare globally and it will be very expensive/not available at high rates, so once your house is less leverageable than before, it loses "real" value. See what happened to RE prices in emerging markets once mortgages (a new product) appeared in the late '90s/early 00's: they shot up not based on productivity but based on people being able to pull forward 15-20-30 years of future income. This can reverse just as quickly.
Productive land: again think whether current prices are influenced by leverage and productivity that cannot be sustained if fertilizer prices are too high. I think one of the safer plays.
Timberland: also a "classic", one can even choose the harvest timing over years. The issues there are (1) unlike prior inflation episodes since Gutenberg invented the press, pulp demand is in a secular downtrend, (2) new housing may not be coming back for years and (3) again, what happens if you try to exit when buyers have no access to credit.
Food, personal care, tobacco, alcohol, medical supplies, ammo, heating oil/wood/coal, useful stuff: good bets; works for bartering, too
Livestock: my bet is on poultry. Easy upkeep, small space needs, eggs without a "bull" unlike milk, and best feed-to-weight gain ratio. Goats and donkeys live long and are easy to keep though milking the latter is not recommended by farm experts. Farm ponds with carp are also good feed-to-weight investments.
1st Class Stamps: have been reflecting inflation well but (1) email has displaced mail and (2) the services will likely change (e.g. less delivery days) so the real "value" will be less.
Children: the timeless retirement plan. Cash-flow neutral by year 20-25. Some economies of scale and quantity discounts.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

The "If You Have to Ask/If You Have to Say It" Principle

Here's something to ponder. I call it the "if you have to ask" principle: if you have to ask, chances are, it is not for you. Similarly, if you have to say it, chances are you are not "it."

What got me thinking is this (automatically placed) Google ad above one of my posts: "Prestigious Healthcare MBA from XYZ University"
Well, if you have to say it...
I have never seen any top 10 program advertise itself as "prestigious." Marketing for the bonafide prestigious brands (both products and services) is substantially more subtle. It often targets the top of the Maslow pyramid: self-actualization. The "brand ambassadors", if used, are people who have either explicitly or implicitly reached a very high level of achievement in their field. Kimbo Slice will never (I think) market Patek Phillipe.
How many people "say it" and describe themselves as "confident" or "smart" or "a winner" when these qualities are, at best, at the aspirational level for them? How many schemes market themselves as "the real deal"? How many day trading systems "really work"?
Similarly,
if you have to ask, it is not for you.
A lot of learning comes from osmosis: simply picking up pieces from your environment, or, alternatively, from being in an environment where the answer process is structured. If you have to ask, you might be from the "wrong" background, and you will be treated as such.
I spent some time on an associate-level front-office recruiting committee at a major Wall St. institution (I think I am still paying the wages of that sin, but this is another topic all together). "Non-core" school resumes are
not
considered via the official channels. Period. If you (or your dad) knew someone important at the firm who then passed it on, it would be considered but otherwise, no. One level above "us" were the "relationship hires": the no-questions-asked hiring decisions for the daughter of the CFO of client X and the like. Do you think they had to ask about "the process"?
Most career "authors" advise you to "network": well, just trying to reach out to an associate puts you in the "if you have to ask" category. Because the system works with feeder schools and if you are not invited to the dance to begin with, then your resume is destined for the shredder. You would not need to "network" if you belong in the network; you'd be networked by default (at least at this situation: I can see the value of the advise in some other fields).
Similarly, how many potential buyers of high-end brand "timepieces" are concerned with the price? How many people walk into an exotics or a yacht dealer wondering if they can "make the payment"? How many NYC coop boards do not allow mortgages (if you're thinking twice, it is not your kind of a building)? If you are concerned that the menu has no prices, then you are at the wrong restaurant.
So how does this all tie together? One of my favorite topics on DL is the smidiot discussion. Smidiots almost always have all the right labels (the right high school, the right undergrad, the right grad/law; the right mega co's on the resumes; the right vocabulary; the right tastes, hobbies and interests; the right UES/UWS "residence") but these labels came to them without much effort or original thinking, or, in some cases, even without an acceptable IQ level.
Unfortunately, smidiots are often gatekeepers of desirable resources (FoF managers, headhunters/HR chicks, MDs, PMs) and use a variety of mental shortcuts to see if you're from the herd. It is important not to ask the wrong questions.
So when you are surrounded by them, make sure you've done your homework so that you can do your best mimicry to further your ends.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Early January Mental Potpourri

2010-01-02T00:08:00.008Z

Here are some more thoughts. I hope you all had a good New Year's celebration, and wish you the best for the new one. A few years ago I gave up hoping for specific outcomes: I just hope for the best as it would be arrogant of me to assume that I know for sure what is best in aggregate, in the long-term for me and for the people I care about.

* How to tell if WMT is killing a certain competitor? Well, consider this press release "Weis Markets, Inc. today announced it has lowered the prices on 2,600 staple items, effective December 31, and frozen these lower prices for 90 days through April 1, 2010. It has also moved to freeze the prices on an additional 624 products...Founded in 1912, Weis Markets, Inc. (NYSE: WMK) is a Mid-Atlantic food retailer operating 165 stores in five states: Pennsylvania, Maryland, New Jersey, New York and West Virginia."

Just a reminder, businesses, no matter what the ads say, do not like lowering prices (unless there is some sort of a network effect or an exponential threshold to cross).

If I had to guess, in 10 years, most mid-sized supermarkets (think WMK GAP RDK WINN SPTN ARDNA VLGEA) will be either a part of the larger chains or not be around at all.

I'd be concerned longer term about the pharmacy chains, too (CVS, WAG, RAD), especially the latter two.

Also think about what this (and AMZN+EBAY) mean longer term for retail CRE.

* The connection between low and falling interest rates and outperforming equities. The first level of the relationship is pretty obvious to everyone: equity benefits from lower borrowing costs; also lower coupons make dividends more attractive. But there is another level of the relationship. Equities are like a perpetual call option on earning. Options' values, if priced by Black-Scholes, have an e^(-Rf) element in them. In other words, they are more valuable with a lower risk-free rate.

* Then there is the discussion of stocks as a protection for inflation. The Inoculated Investor has found something interesting. Read the whole thing but here is a snippet:

"In this issue Colin Moran and Geoff Gentile of Abdiel Capital discuss their study of the impact of inflation on stocks:

“The U.S.’s last stretch of high inflation was between 1973 and 1981. In the early 1970s many equity investors, as they do now, imagined generally rising prices would make earnings grow faster, sending stock prices higher and giving investors a good real rate of return.

It didn’t work out that way. Inflation turned out to be a kind of neutron bomb that left revenues and profits standing while decimating the free cash flow available to owners. Even if a company’s GAAP earnings kept pace with the general level of prices, higher working capital needs and increased prices for capital spending meant that free cash flows failed to keep up with the price level.

Overall, inflation and taxes together stripped public-company owners of more than 100% of their reported profits from 1973 to 1981. We measured that by tracking the book value per share of companies in the Fortune 500, which compounded at 10% per year over that period, adjusting for share repurchases and including the after-tax value of dividends paid out. Someone who bought a business in 1973 and sold it in 1981, in both cases for book value, would have actually lost ground. After capital-gains taxes, the investment would have doubled, but over the same period the overall price level more than doubled."

Something to keep in mind. Remember that you get taxed on nominal gains. There are a few more interesting things about how other instruments performed.

* In one of the more popular articles in this blog, I made a number of scatter-shot predictions as to how healthcare services will change under the current POS HCR that is being pushed through.

Quoting myself:
(4) Since the bill does nothing to address supply and demand, HC costs continue to outpace inflation to the politicians' surprise
(5) Attempts at cost-fixing in healthcare lead to rationing
(6) Rationing leads to a two-class health care system: one for the "rich" and one for the "masses". The "rich" pay cash to providers who do not want to deal with insurance companies or the government.
(7) The cash-only providers are banned because it is not egalitarian. End result: Royal Caribbean retrofits a few cruise ships into healthcare centers/hospitals, parks them in international waters near the big coastal cities and operates heli/ferry services lifting cash customers for treatment.

Well, it is already starting.

I strongly urge you to go read Yves Smith's whole article and commentary here. Interesting discussion in the comments, too. I recommend you read them, too.
"More than 3,000 patients eligible for Medicare, the government’s largest health-insurance program, will be forced to pay cash if they want to continue seeing their doctors at a Mayo family clinic in Glendale, northwest of Phoenix, said Michael Yardley, a Mayo spokesman. The decision, which Yardley called a two-year pilot project, won’t affect other Mayo facilities in Arizona, Florida and Minnesota….
Mayo’s hospital and four clinics in Arizona, including the Glendale facility, lost $120 million on Medicare patients last year, Yardley said. The program’s payments cover about 50 percent of the cost of treating elderly primary-care patients at the Glendale clinic, he said."
For the benefit of my non-US readers, the Mayo Clinic is a major cream-of-the-crop R&D and treatment clinic with several locations across the country. Also, Glendale, a Phoenix, Arizona, suburb, is a popular retirement destination for people from the northern mid-West, much like Spain and Southern France are popular with UK/Northern Europeans. Retirees are also a large voting block with high participation (which enables the current wealth transfer via borrowing from the younger folks to them).

So what is happening here? It must not have been an easy decision: Mayo is cutting a large chunk of its patient population because the government reimbursements (which are due for a cut this year) do not cover the costs of treatment by far. This is particularly true for primary care physician services, so no doc wants to do primary care (unless they are foreign grads slaving away for their green cards in some forsaken location).

As you can notice, cash patients are welcome. What is the conclusion? Despite some people's insistence that healthcare is a right, not a good, we have reached the natural state of affairs. Healthcare is a good that costs money. The money/coverage from the government is no longer accepted. Now at Mayo Glendale, soon at other places. This will lead to huge waiting lists (a form of rationing where one pays with his time) at the places that do accept Medicare patients.

This is not all bad, BTW. Cash customers are smarter customers and will shop around actively (right now medical services pricing in the US is rather hard to find). More clarity should lower costs. The "break" in the imaginary "social contract" with regards to elderly and poor healthcare will hopefully lead to real reforms that aim to address supply and demand, like I suggested, rather than the stinkers in discussions now. We are also going to see some forced austerity in care provision, such as not treating life-threatening conditions on otherwise terminally ill patients. We are also going to see more inter-generational strife playing out.

* On to some more seasonally appropriate topics.

Finding a true "independent" spirit brand is increasingly difficult. Producer and retail consolidation and shelfspace wars make it tough, so do the tons of federal and state regulations which act as taxes disproportionately borne by small businesses. Case in point, Big Tobacco supporting tobacco regulation by the FDA thus effectively crushing any potential entrants.

So I was rather happy some time ago, when I discovered and blogged about an independent French cognac brand: Jules Gautret. Yesterday, I came across a similar product states-side. This is Elijah Craig 12-year Old Bourbon. I enjoyed it neat. It is 47% alc. (94 proof) and has a surprisingly mild taste. I seem to have developed a taste for brown distillates, such as bourbon, armagnac, calvados, cognac, scotch and, to a lesser extent, rakia, and, to a much lesser extent, rum, so I have been enjoying my trips in the premium bourbon space.

Elijah Craig is owned by Heaven Hill Distilleries, which is a family-owned business. Most US bourbons are either owned by Fortune Brands (Jim Beam and extensions, Booker's, Knob Creek, etc.), Brown-Forman (Jack Daniel's-- not a bourbon, Southern Comfort, Woodford, etc.) or one of the other "majors".

Heaven Hill's master distiller is Parker Beam, whose grandfather was the brother of Jim Beam (yes, that Jim Beam).

So, there: Elijah Craig is another brand you can have an honest relationship with. If you're into brand relationships.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

Sunday Thinking

2009-12-27T17:15:00.005Z

* A year ago when I started this blog, I commented on the insanely low long-term bond yields. The 30-year was at 2.6% or something, and now it is at 4.7%. Whether this is the bond vigilantes or the market simply frontrunning the expected maturity extension in the government's borrowing remains to be seen. I think this time is "for real" barring a major equity crash or an event with a similar impact. In 1981, the 30-year yield was (had been?) over 15%. We are in a worse shape now as 29 years of kicking the can down the road, growing spending and debt at unsustainable levels, and handing out unfunded promises make the matters much worse.

* Here's something else that makes no sense: California housing prices rose on a YoY basis by 6%, and there is anecdotal info that the flippers are back. California is like Greece, but the Greeks smelled the coffee while the Governator is asking for a bailout from the taxpayer. Who's the "girlie man," Arnold? California has outmigration of taxpayers and businesses, powerful public employee unions, a large underclass, highly business-unfriendly climate and dysfunctional politics. Official unemployment in the state is over 12%, and yet, housing prices- which never went down to proper income-based levels, are going up.

*2008-2009 were the years of the corporate bailouts (when the government decided that failure is not an integral part of capitalism), 2010 will be the year of the state bailout. CA is already asking the other states to fund its deficits, can NY, IL and MI be far behind? Newsflash for the states: if you can't cover your spending with taxes, then increase taxes or reduce spending. Surprisingly for me, NY's Gov. Patterson here has been a breath of fresh air coming from the Albany cesspool. He sounds like he gets it unlike most pols who still think it is politics as usual. The simple truth is that the government costs too much to run.

* I already wrote that one should be aware not only of the news as it comes out, but also the context of the news, such as the date and time the news was released. I pointed out that the House voted on the healthcare legislation on a Saturday at 11 pm, and interpreted it as a bad sign. The Senate voted on their version in the early morning on Christmas Eve. This, along with the partisan nature of the vote and the incremental cost of the last vote (the NE senator), is bad news. The other news that came out in the afternoon is that the Fannie and Freddie bailouts are now unlimited. This is correct: unlimited. And instead of having the past board and management of the companies in jail, and keeping the current management on an $1 salary while they wind down the portfolio, Little Tim is giving them $6 mm of your money.

* One can only speculate as to why the FNM and FRE news was released on a holiday afternoon. My thoughts are that they will be forced to grow again (which means credit losses) as the FHA is about to blow up. Because the bank bailout via housing market inflation sure ain't gonna get done by itself. But this is just me, a cynical guy sipping his coffee at home with the keyboard on my lap.

* In June, I declared that POTUS is a failure. By now BHO completely "owns" Iraq, Afghanistan, the economy, the twin deficits, Bernanke, Geithner and healthcare "reform". He has failed on the first six, and is about to fail on the last one.

* Keeping up with the political streak, if I were running against an incumbent in 2010, I would run on repealing most legislative initiatives (passed or proposed) by Pelosi, Reid and the like. Few incumbents are safe, and I am looking forward to possibly having more reasonable, thinking people in both chambers.

* Is the US going to "emerge stronger" the way "we've always done it"? In a word, no. To qualify, very likely "no." I recommend reviewing Taleb's story of the turkey (figure 1 in the essay). The "growth" has been funded by debt just like the turkey's weight gain has been funded by the farmer. The turkey is happy because, see, every day things move up. The farmer has other things in mind, of course.

So how likely is that the debt gets called one day? I don't know. If I knew, I would not be writing about it. Some of the signs will be rapid currency debasement (vs. hard assets) and rapidly rising interest rates on government bonds.

Speaking of turkeys, here is a nice clip of Idiocracy's poster girl, Sarah Palin, trying to use multisyllable words while some guy is beheading turkeys in the background.

Comments on Some News from Today

2009-12-22T03:11:00.003Z

One of the topics I discuss on this blog is what I view as a permanent shift in US consumer preferences towards value/private label. There are several reasons for it, global wage arbitrage suppressing the living standards over the last 20-30 years, more recently, high unemployment, retailer consolidations, and others.

I have written about the private label growth in food several times: most recently here (discussing the top growing categories, BrandWeek declaring '09 the year of the private label and CVS consolidating its battery offering to PL and 1 brand), earlier here, (amazing expansion of the PL offerings at a number of retailers; very wide consumer acceptance) and, earliest here (some firm names and initial thoughts).

Nice to see that at least one branded food company does not have its head in the sand. Heinz (NYSE: HNZ) seems to be with the program. Here are some excerpts:

"[HNZ] sees a long-lasting consumer shift to thrift and must carefully balance its business strategy in response, the ketchup maker's chief executive said on Monday...Heinz Chairman and CEO William Johnson told Reuters in an interview the company will have to weigh its approach to promotional trade spending, such as coupons, and other types of marketing as consumers continue to focus on price even as the economy in the United States and Europe improves.

"To say that consumers will return to historic norms is disingenuous," he said...

"What we're seeing right now is an industry that in some cases is grasping for volume and, as a result, has ramped up trade spending," he said.

But Johnson said the maker of Heinz ketchup, Ore-Ida potatoes and Smart Ones frozen meals would not keep resorting to that one strategy to keep sales aloft."

So, to translate in English: we have a problem. We have been selling undifferentiated products at higher prices thinking we are protected by the brands we have. We were wrong. We are getting killed by private label. Since we have huge fixed costs, some in the industry have been lowering prices to keep the volumes. We have been doing the same thing but would like to signal to the industry that we think that it is time we stop, and come up with something else. We just don't know what yet but will signal once we figure it out. HNZ is not in the worst shape, in my view, from the food majors. No one else can make ketchup of the same taste, and (as far as I know) with the same margins. They also have a good variety of higher value add products.

***********************************************************************

Today two of my favorite staples companies were involved in deals today.

One, TreeHouse Foods (NYSE: THS) is acquiring a major player in private label hot cereal and drink mixes called Sturm Foods. I already complimented heavily TreeHouse's management in the articles above, and this deal is supportive of my viewpoint: accretive to EPS in less than a year! The market definitely liked it, and the stock was up 15-16% (mind you, this is a sleepy staple stock) following the deal announcement and increased guidance on top. Not a bad way to start Christmas week.

Two, Chattem (CHTT), a major player in OTC remedies and personal care products with a "drug" twist, is being acquired by Sanofi, a pharma major. CHTT has been a top performer in the staples area (the stock was at $3 in 2000, the deal is at $93.50/share). I already wrote in the last post that I see the possibility of a substantial drop-off in new blockbuster prescription drugs in the future. On the other hand, with healthcare becoming a worse mess by the day, one can see the argument for growth in self-medication (webMD is a pretty high traffic portal: it can't just be hypochondriacs, right?). It seems to me that Sanofi- again, a pharma major- is voting my way by acquiring CHTT and expanding their consumer OTC portfolio. If they were seeing a better future in R&D, they'd be spending that $2 bn someplace else. Though I wonder what the Parisiens think of Chattanooga, TN: "the birthplace of the tow truck, Chattanooga is the home of the International Towing and Recovery Hall of Fame and Museum" (from Wikipedia).

Thoughts on What Can Go Right Long-term

2009-12-11T16:50:00.005Z

Most of this blog is about what can go wrong. Upsides generally take care of themselves. After spending some time on the bike this morning, the windchill got to me, so, quite uncharacteristically, I started thinking about what can go right long-term.

There will be big things that go right, for sure. I just don't know what they are so I can speculate: this blog is free to read which should give you a reasonable estimate of my ideas' real worth.

Things that will go right, almost by definition, are ones that are going to happen without requirements, directives, management or supervision by the government. Think about things like digital music, digital books, e-commerce, social networking, software, "brute" computing power or mobile communications: on average, great advancements that have succeeded in a large part because they are not heavily regulated, or regulated at all. The FTC does not require Intel to make faster chips. The market does. The competition does.

At a different level, Kuwait and Mali happen to be desert countries, and yet one is many times richer than the other (~35x on a GDP/capita PPP basis). Did it have anything to do with either government? Largely, no.

So, with that in mind, what are things that can go right?

(1) Shale gas is more commercially viable than previously thought. Gas replaces gasoline and diesel for fleet needs (similar to "The Pickens Plan"). This lowers petroleum prices for everyone else, resulting in a big tax cut effect. Compare this to government-hatched initiatives, such as ethanol or "clean" coal. Both are absolute malinvestments.

(2) Baby boomers do not retire as planned. The "not exactly greatest"(TM) generation does not exit the work force en masse for various reasons, including insufficient savings and fear of/actual inflation that makes it harder to live on fixed income. Higher middle class taxation also hinders savings. As the biggest chunk of the government obligations are future benefits, this works very well towards reduction as less people are eligible and more people continue to pay taxes.

(3) Baby boomers do downsize en masse, lowering housing costs for everyone (and shooting themselves in the foot, thus delaying the mass retirement even further). This is also a "tax cut" effect. Imagine the average household going from 33% of spending on housing to 27%.

(4) In many ways, "we" have already killed the pharma industry. As they reduce R&D spend, the drug pipeline dries up. This means that in a few years, all these expensive blockbuster drugs will become generics, and there won't be new expensive blockbuster drugs. While this is undesirable at one level, at another level, this should lower healthcare costs as say 90% of the drugs consumed are now priced as generics vs. a substantially lower percentage now.

(5) The population actually loses weight on average and smokes less on average, again lowering health care costs. Smoking rates, save for last year, have been on the decline for most of the decade. This is good news for healthcare costs (yes, I know there are estimates that smokers are "beneficial" in aggregate for tax purposes; I do not buy the argument for a few reasons). The obesity "epidemic" can also take care of itself: I have been reading reports that there has been an uptick in liposuctions as the job market has gotten more competitive. Is this a permanent change in the average views on obesity? I hope so.
Interestingly, the two states with a soda tax (W Va and Arkansas) also happen to have some of the highest obesity rates.

(6) Inflation lowers the real cost of government employees and retirees. Underreported inflation over a decade gradually lowers the real cost of government payrolls, and more importantly, the "guaranteed" pensions. Generally, private businesses can respond faster to inflationary pressures that the government can. Private businesses also have a better view on the "real" inflation as they have incentives to monitor their costs. Government managers have incentives to maximize their budgets and employees under supervision.

(7) EU, China and India gradually assume more "world policemen" roles. This lowers US defense spending thus alleviating the deficit. Defense is by far the largest expenditure in the federal budget, and the Ministry of War does a great job at ensuring that cash keeps flowing to it and its top management's future employers, the military industrial complex.

(8) "College education" stops being universally accepted as something of value to everyone, especially with costs going up, which makes the basic cost/benefit analysis more difficult. A reduction in the college-bound population leads to lower educational costs for everyone college-bound, less malinvestment by people who'd be better of not even trying, and less losses borne by the taxpayer on the student loan guarantees by the government.

As you can see, most of these require little to no action on the part of the government and require little to no inventions. These things can "just happen" without any scientific advancements or "public policy decisions", and nearly everyone would be better off.