Saturday, December 31, 2011

$100 a barrel oil in 2012 Seems Unreasonable

  Everyone in the economic forecasting business is admitting that they had the 2011 worldwide GDP growth forecasts all wrong, and that goes from the Federal Reserve to established investment bank and private forecasters, and to all the talking heads on television, who crib their numbers from others anyway.

China is slowing significantly from its 8% rate of GDP growth, Europe as a whole may be slipping into an actual recession, and U.S. forecasts for 2012 are moving towards a 1-1.5% GDP mid-range estimate.  The auto industry commentators are noting fewer miles driven by domestic motorists.  Truck miles are not really growing, partly because of growing efficiency by the largest operators and retail owners like Wal-Mart, and by economic factors in 2011. 

I understand that Iran is threatening to block shipments through the Strait of Hormuz, but this seems like empty saber rattling, since the entire world knows that too much energy flows through the strait for this to be permitted.  In fact on December 28th, a communique from the U.S. Fifth Fleet said the following: "Anyone who threatens to disrupt freedom of navigation in an international strait is clearly outside the community of nations; any disruption will not be tolerated."

Meanwhile, a few propaganda pictures allegedly of Iranian submarines on naval maneuvers appeared on Internet news sites.  Honestly, the pictures reminded me of my eighth grade history book which had charcoal and pencil drawings of the Monitor and the Merrimack at the Battle of Hampton Rhodes.  I don't believe that these vessels provide a credible threat that would justifyr the "20-$30 a barrel risk premium" some analysts suggest are in oil price projections. 
Again, what exactly is driving a forecast of $100 a barrel oil in 2012?  A reasonable hypothesis?  A world awash in liquidity and market speculation.  Another interesting issue is the collapse of natural gas prices in the U.S., driven by high inventories and a mild winter.

The above graph comes from Professor Mark Perry's blog, Carpe Diem.  It inputs the record low prices reported in today's press, such as the New York Times.

We've talked about natural gas in many previous posts as being a fuel that should gain market share, particularly in electricity generation, for several reasons, including price and lower greenhouse gas emissions associated with using the fuel.  Now the price differential borders on incomprehensible, even before the 2012 petroleum forecasts. What gives?

If there are intrepid forecasters out there who could explain $100 a barrel oil for me, I'd love to hear from you. 

Thursday, December 29, 2011

A Lump of Coal for the Fed

 A blogger at Wall Street Rant called attention to a full release of the Federal Reserve's Emergency Lending Program 2007-2009.  The charts he shows were from a Bloomberg analysis of a half trillion dollars in currency liquidity swaps which did not identify the borrowers who used this facility. Soon after this, the Wall Street Journal carried both a video and and article by Dr. Gerald O'Driscoll, formerly a VP of the Federal Reserve Bank of Dallas, in which he triangulates about $100 billion in currency swaps which most probably went from the Fed via the ECB to reeling European banks in the period from early December to about December 21, 2011.  Joyeux Noel to our European brothers and sisters from our Federal Reserve!

After all the monetary Three Card Monte which the Fed has played to keep interest rates low, make bank bondholders whole, pad the compensation of global bank executives, reward the risk trade, penalize savers and force them to risky assets in search of return, I say " a lump of coal, Bob Cratchett!"  It is heartening to know that the Fed promises to be more transparent, which is just as valuable as the Federal Government promising to be more fiscally prudent. 

Dr. O' Driscoll says in his video interview that we probably don't know which European banks are the most vulnerable, and that's true.  However, we can make some educated guesses.

The V-Lab Group at Stern School of Business runs their global risk list in two ways: (1) simulating the effects on the global financial sector of a a 40% semi-annual market decline, and (2) without the cataclysmic simulation, measuring  the change in risk profiles assuming a 2% daily market decline.  Without the simulated cataclysm, the biggest risk banks are European banks: Deutsche Bank, BNP Paribas, Credit Agricole, Barclays, followed by Bank of America to break the European streak, and then HSBC, ING, and Societe Generale.  None of these names are too surprising.

With the cataclysmic simulation of a market meltdown, the ultra high risk banks are the US, global TBTF ("too big to fail") banks: Bank of America, JP Morgan Chase, and CitiGroup.  Nothing much is too surprising here either.

So after all the meetings, the trans-Atlantic shuttle bank diplomacy, and all the posturing among European leaders and the IMF, it seems that the global system is just as risky, if not more so, than we were at mid-year 2011.  Our markets had a Santa rally, and finished with a hangover.  "God bless us all, every one!"

More Blues at Sears

Back in February, in a post about the dubious benefits of shareholder control, we noted Sears as an example:

"The recent case of Sears comes to mind. Much was made, rightly so, of the fact that the management simply couldn't run or merchandise stores very well. Shareholders voted with their feet and sold the stock. The story then became the value of the underlying prime real estate that Sears owned or controlled. Meanwhile, another terrible cast of executives were busy fiddling while Kmart burned slowly. Enter hedge fund manager Ed Lampert who took control of Sear merged it with Kmart, while confusing both sets of customers, who were distinct segments of consumers. Years later, Sears' repeated experiments with soft goods have failed miserably, but we didn't need to a change of control to know they couldn't execute. The appliance and home and garden segments are still the reason most people enter the store. An iconic brand of American retailing seems on the precipice of going the way of Woolworth, W.T. Grant and Montgomery Ward. Last year ended with Sears comps down 6% for December and 3.8% for the year. The environment in Sears stores is positively funereal. Most of the analysts have downgraded to neutral or under perform, with a few sells. Has shareholder control been beneficial in this case? I don't believe so."

Recent results, along with a relatively small number of store closings, raise more questions than answers for me.  It seems clear to me that Ed Lampert has no real interest in turning Sears around, which will require investment in systems, store remodels, and a savvy, motivated management, which means more lousy quarters until a turnaround could take effect.  By the way, CBS MarketWatch "Lump of Coal" winner Bruce Berkowitz initated his large purchase of Sears for Fairholme Fund because of the investment by Lampert.

Here's what Berkowitz had to say about Sears back in 2008:
"I (Berkowitz)  think that he's (Lampert)  going to do it. And it's very reminiscent of what happened with Warren Buffett and Berkshire Hathaway in the early days (a laughable analogy!). If you play back the tape, Warren Buffett bought into Berkshire Hathaway, a textile mill, and he took many years to try and turn it around. He had deep respect for the employees; he really gave it his best shot. And then when he realized it wouldn't work, he then started to redeploy the assets and the free cash that was coming out of this industry that was destined to die. And that's how Berkshire Hathaway started.

Sears is the same situation. Sears has a great real-estate portfolio, and people are behaving as if it can only be used as retail space. And they have brands; some of them are quite good. The company has over $50 billion of revenue and is making money, and people are acting as if it's a company that's bleeding to death. People aren't looking at it in the right way. They are measuring it based as a retailer, and they are measuring it based on short-term net income profitability. But there are many more dimensions to Sears. Real estate can have a higher and best use. Today's anchor to a mall can be tomorrow's multipurpose, multiuse building where you can have office buildings, retail, and residential spaces."

Of course, the best thing that could happen would be that he turns around Sears and Kmart and it's a grand-slam home run. The worst thing that happens is he gives it his best shot and starts to find higher and better uses for all of the assets, from land to trademarks to online. If you can see three or four different ways where you can make an awful lot of money with a guy who has a record of making an awful lot of money, it's not such a bad thing."

What's the end game here? As a retailing story it has the familiar feel of Mervyn's or Monkey Ward's before they succumbed to liquidation.  I can't help but feel, without doing the analysis, that it has to be a vulture real estate transaction at the end game.  Right now, for example, we are just beginning to hear about rising demand for non-hospital medical real estate, for all sorts of specialty clinics and diagnostic centers.  There is also some suggestion that demand for non-conventional educational space may spill over into traditional shopping centers.  Sears still has lots of visible, high traffic anchor locations with good parking facilities. 

If traditional institutional shareholders throw in the towel and become apathetic, that's the perfect environment to prepare for a series of maneuvers that creates value for those who bought the stock right and who are willing to wait. 

Wednesday, December 21, 2011

Deutsche Telekom: Still Nobody Home

U.S. markets are in an uproar about the failure of the ATT-DT deal for T-Mobile.  The management of Deutsche Telekom has, in our opinion, bungled its US investment right from the start.  An acquisition of Sprint by one of the U.S. wireless behemoths has already been deemed anti-competitive, as has now the acquisition of T-Mobile.  If maintaining some semblance of competition is important then some sort of partnership between T-Mobile and Sprint would seem to have the best potential for regulatory approval, as well as offering opportunity to add value. 

In all the talk, the fundamental problem is being overlooked: the U.S. wireless industry is killing itself slowly with its irrational pricing paradigms.  New customers are lured in with money-losing deals, while the most profitable customers are left to themselves, with the option of switching to get one of these deals.  Much of the movement to Sprint among people I know was driven by their irrationally priced "all in one" plans with unlimited data access.  Most of these people complained about the phone coverage but suffered it for the data plans.  Not surprisingly, Sprint gained lots of prepaid subscribers, but lost money, which is not a recipe for sustainable value. 

Surely, data plan users should be charged by the volume, time period, speed, and types of data that they are downloading over cellular networks.  Gas and electric utilities charge by the time period and time of year, since everyone accepts that it is the cost of building and sustaining the peak load capacity that has to be paid for at the margin. Cable is different because of the monopoly status of local carriers and the fact that their networks were built with generous subsidies.  Wireless is really just another utility.  Credit Suisse too notes the elephant in the room: "declining profitability of the whole U.S. (wireless) market." 

Sprint's disastrous commitment to buy 30.5 million i-Phones for $20 billion will keep the company in the red until 2014, according to the Wall Street Journal and other sources.  T-Mobile, by contrast, is projected by Credit Suisse to generate $5 billion in EBITDA or better in 2011, which would meet or exceed early 2011 guidance. Credit Suisse, which has recently reinstated coverage of DT, projects 2012 EBITDA of about $5 billion for T-Mobile, despite negative industry fundamentals and economic weakness.  This is pretty good performance in the face of strategic and operational mismanagement from the parent company.  An acquisition of Sprint would not make financial sense nor would it pass regulatory muster. 

Performance of the DT parent is another story altogether.  DT sports a 7.9% dividend yield today, and the German government's large stake in DT precludes management from pursuing any strategies that might add shareholder value but that would require reducing the dividend.  According to Credit Suisse, the ROIC for DT will be in the 5% range for 2012 and 2103.  The stock is rated by Credit Suisse as "Underperform."  All of this complicates the future of T-Mobile and puts its valuable franchise at risk.  U.S. regulators should be working proactively to ensure that corporate inaction or irrationality does not inadvertently make the U.S. wireless industry anti-competitive. 

However, a partnership makes sense, with perhaps Sprint differentiated as the "Wal-Mart of Wireless" and T-Mobile as the preferred brand for price conscious, loyal postpaid customer who wants a global network.  Data hogs should be priced so they either pay their freight or go to Verizon where they will generally pay more for their plans anyway.  A partnership would only work, in my opinion, if (1) it went away from encouraging adverse selection and churn by only talking price; (2) stopped letting the data hogs crowd profitable users out of the trough, and (3) the partnership didn't cut costs to the point where the service culture of T-Mobile disappeared.  Good people are leaving T-Mobile in droves.  This would have to stopped and the company would have to find a way to become a "hipper" organization to work for as opposed to say, ATT. 

Credit Suisse opines that after the failure of the ATT-TMo deal, TMo is left with "more spectrum, less debt, and a bigger range of U.S. options." We have always believed this to be the case, as it certainly is now.

Monday, December 19, 2011

A Lump of Coal For Fairholme

MoneyWatch's Bruce Jaffe today bestowed a 2011 "Lump of Coal" award on  Bruce Berkowitz of the Fairholme Fund.   It's a funny piece, and it's tongue-in-cheek, but this is serious business.  Both retail investors and 401(k) programs can wind up putting bad investment options into their portfolios because of the inordinate market influence of  ratings from Morningstar and Lipper. 

Any investment manager, even the good ones, can have bad spells, sometimes prolonged.  However, if their discipline and process are consistent, and they learn from the mistakes, investors may choose to stay the course and not lose their shirts. Ratings ought to talk more about fundamentals than personalities.  MarketWatch notes that Fairholme is down about 30% year-to-date, and given the continuing uncertainty about how the fund is managed, perhaps Morningstar should consider taking back their Manager of the Decade award, just as college football programs vacate results for NCAA violations!

Footnote: Another example we cited in our earlier post was Fairholme's curious bet on Bank of America, which  is flirting with breaking $5 per share in late trading.

Sunday, December 18, 2011

Bond Stats Suggest US Economic Improvement

Ward McCarthy's Fixed Income Group at Jeffries (JEF) issued their bond market update last week.  To follow up our previous post on China's ability to forestall a hard landing, JEF had some good statistics from the U.S. Treasury on foreign holdings of Treasury securities.  As of the October 2011 reporting period, China's holdings of U.S. Treasury securities were $1.134 trillion.  The next biggest foreign holders were Japan at $979 billion and the U.K. at $408 billion.  Chinese holdings represented 24% of total foreign holdings, which might actually be an underestimate of their holdings because of the consistent upward revisions to Chinese holdings in the past. 

Total Chinese holdings of foreign assets may be in excess of $2.5 trillion, although this estimate is not  for the same period from the U.S. Treasury.  The point is the same made in the previous post: there is a lot of high powered money to be put in service should the Chinese economy be subject to severe economic stresses from a collapse of its export markets in Europe and the U.S. 

McCarthy's group was fairly pessimistic about the U.S. recovery back in August, but they note that some bond market technicals suggest that bonds are discounting modest improvement in the U.S. economy from here.  They note, for example, JP Morgan's issue of a 30 year bond with the lowest coupon of any high quality, financial issuer since 2005.  JPM's coupon of 5.40% was 250 bp above the 30 year T bond. The group also suggests that investor appetite remains strong for high quality corporate paper in the primary market, particularly from financial issuers.  Go figure, but it's interesting data as the high quality corporate market winds down until Q1 2012.

Friday, December 16, 2011

China's Future: Western Optimism and Chinese Pragmatism

Back in March, we posted about a declining phase in Chinese growth and the need for a new economic model.  Hedge funds which have made bets on a "hard landing" for China are likely to be disappointed.  The reasons are rather simple.  In Western financial markets, shocks are transmitted quickly through financial speculation, markets turn volatile and overshoot before a new equilibrium is found.

This scenario shouldn't apply to China.  Investments are controlled by the government and directed into jumbo, state run enterprises.  The government is sitting on vast hordes of liquid currencies and securities, and the currency is managed.  Financial markets are not all transparent. Numbers cannot be trusted. Look at the long running fiasco at Sino Forest, which would have collapsed within weeks on any major international exchange.  Sophisticated investors are as powerless as retail investors in a pink sheets stock. 

The Chinese landing won't be a hard landing.  It will be more like a King Air that loses both its engines.  If the Chinese government is a good pilot, the plane will continue to fly and glide to a landing, perhaps with some bumps at the end.  This isn't to say that there won't be  prices to be paid among segments of the Chinese population.  The private sector folks who have made quick fortunes on light manufacturing will be chastened by recessions in their customer countries.  Since the Chinese model is a mercantilist, managed model with humongous external balances and muted internal demand, a steady hand on the stick can bring the plane in. 

The longer run question is what happens when China continues to pursue its own nationalistic, pragmatic interests.  Isolation from the international community could be an unintended  and undesirable consequence.  We've written before about sweeping Chinese claims in Pacific waters around contested islands.  In the absence of an operative Law of the Sea Treaty, the U.S. has no basis to dispute any of these claims, except to object and refer to customary international law. 

As an example of China's thumbing its nose at Western trade management mechanisms, we have the Chinese government slapping tariffs and anti-dumping charges on SUV's exported by General Motors.

    credit: David Gray/Reuters in New York Times, 12/15/2011
Even though the Government is said to have conducted a two year study into the issue of subsidies and dumping, their results weren't shared with the Office of the US Trade Representative, even as a courtesy. 
With the already high levels of taxes and fees, GM's commitment to this potentially lucrative market is likely to yield no results in a profitable vehicle line.  Meanwhile the sight of its Buick SUV's covered in dirt and clay on a Chinese pier does nothing for the brand equity either.  Don't think that this little poke in the eye wasn't carefully orchestrated. 

Besides indignation, the U.S. has no meaningful response, except pushing papers and filing claims.  There may not be as much gold in Shangdu as hoped for GM and other US exporters.

Sunday, December 11, 2011

Mutual Fund Ratings Need Lots of Work

Morningstar and Lipper are the market leaders in mutual fund ratings, just as Standard and Poors, Moody's and Fitch are for credit ratings.  Their benchmarks for mutual fund ratings are widely used by sponsors and consultants for corporate defined contribution plans. 

Morningstar uses traditional MPT statistics in their evaluations, but the reports are still like beauty contests, formerly based on "stars" and now on a fuzzier system of "Gold," and "Silver."  Even funds which have mediocre performance and high expenses are not rated "Sell" or "Avoid."  In this way, the ratings have the same issue as sell-side equity research: too many 'buys" and few "sells."   For an illustrative example,  I want to focus on two well known funds with large asset bases, Fairholme and Sequoia.

Both of these funds have received accolades from Morningstar: Fariholme's founder and manager Bruce Berkowitz was named "Manager of the Decade," and Sequoia's co-managers Bob Goldfarb and David Poppe were named "Domestic Equity Managers of the Year for 2010." 

In the case of Fairholme, the meteoric rise in assets under management is well documented, but hard to understand. Fairholme created a catchy slogan for itself, "Ignore The Crowd."  It suggests a Warren Buffet-like value investing, or contrarian discipline. 

While Fairholme's assets were growing, I visited their website many times and even printed out the fund literature.  Besides the slogan, I couldn't understand what kind of analyst support was there for all the contrarian stock picks.  When Morningstar talks about the T. Rowe Price funds, by contrast, the Morningstar analysts often comment about the size of the analyst staff supporting the manager of a T Rowe fast-growing fund. 

Managing money, at the very root of the process, requires experienced, diligent, market savvy, financially and analytically sophisticated analysts who aren't afraid to challenge market valuations and assumptions.  Looking at Fidelity Management and Research, for example, the manager who oversees FMR's single biggest slug of assets with a long, consistent and distinguished track record is Will Danoff.  Will was Fidelity's retail sector analyst early in his career, when I called on him from the sell side.  Will Danoff, Rich Fentin and other portfolio managers who were former analysts, would always come to meetings with notebooks in which they had carefully recorded data from every previous interaction they had about a particular stock and about the company's management team.  You always had to be on your toes and remember your previous conversations with them, because they certainly did with those composition notebooks! 

Fairholme, by contrast, was always a black box.  Assets continued to pour in, the fund rode the market upward, and more assets followed.  Then came a series of peculiar investments, St. Joe, and Bank of America, which we have written about in earlier posts on this blog.  One of the funds periodic reports had a puff paragraph about St. Joe being a real estate play on the Florida Panhandle becoming the next Riviera, after a new international airport was built, on land adjacent to St. Joe holdings.  Sounds good, but it didn't pan out, and Bruce Berkowitz eventually became Chairman of St. Joe in a bizarre turn of events. 

Then, after saying that financial stocks were black boxes with poor disclosures and questionable asset valuations, Fairholme plunged into a large position in Bank of America.  What was this based on?  What changed in the philosophy towards megabanks?  This investment also culminated in a farcical conference call sponsored by Fairholme with the hapless Bank of America management.  The call was supposed to clear the air with Wall Street by allowing the skeptics to ask their toughest questions.  Nothing of the kind happened, and the stock went down right after the call. 

Soon after that, came the soap opera surrounding the departure of the mysterious Charles Fernandez, who was made co-manager of Fairholme Fund, director of the Fund, and President of the management company in 2008. I couldn't find anyone in the investment management business who knew anything about Fernandez.  This strange appointment raised no alarms among the fund rating companies.  In the fall of 2011, Mr. Fernandez left in more public, but equally mysterious circumstances to his arrival.  We'll stop here, but remember that through this long time period, Morningstar gives their rating of  Manager of the Decade to Mr. Berkowitz.

All the while, investors who rely on Morningstar got no insight into the people, processes, culture, analyst support, and compensation at Fairholme Funds.  However, reading analyst reports on other funds and fund families, those kinds of items were covered, to some extent.

Switching to the Sequoia Fund, the fund management company Ruane Cunniff Goldfarb has a long history, dating back to the predecessor company, Ruane Cunniff, co-founded by legendary value investor Bill Ruane, who I had the pleasure to meet and call on early in my career as an analyst.  The philosophy behind the Fund was, and remains, a Graham and Dodd, fundamental value approach.  Turnover is extremely low, which is beneficial both for trading expenses and for taxes. 

An interested investor, or an analyst at Morningstar or Lipper, could find decades of financial press and fund publications all telling an unchanging story about the approach and culture of the management company.  The importance of people, namely analysts, was always stressed.  Process was evident.  Sequoia had a long period of under performance relative to its peers, in the large value segment.  It held way too much cash for my tastes, something which I don't understand when you're collecting a healthy fee; its concentrated portfolio was dominated by holdings of both classes of Berkshire Hathaway. 

The bottom line is the fund continued to be managed according to its philosophy and beliefs.  Eventually, day-to-day management of the fund passed to Bob Goldfarb and David Poppe. Nothing changed.  However, when markets collapsed and valuations came in, the portfolio was transformed pretty dramatically.  Now the fund is classified as a Large Blend fund, because it has some growthy stocks in it, as opposed to down and out value plays.  People, process, philosophy, culture, analytical support, and compensation were all transparent and consistent.

I read carefully the published transcript of their Analyst Day, where the fund managers and analysts are made available to answer investor questions about their stock positions and anything else on the minds of the owners. An investor can count the number of analysts, learn their names and read about them speaking about valuation techniques and about the investment thesis for a stock they recommended. This transcript  is supplied by the management company, and so an owner doesn't have to mount a due diligence effort or rely solely on fund rating companies. 

 The fund rating companies seem to be putting out journalistic marketing pieces and are inconsistent in how they treat different funds.  There are no "Sells" in their research, which is something for which sell side equity research was castigated.  They can and should do a much better job.

Friday, December 9, 2011

Guaranteed To Fail: A Great Analysis of Systemic Risk

Guaranteed To Fail is one of the best books on the global financial meltdown and its aftermath. If you have any interest in these issues, I offer it as recommended reading. It reflects some pioneering applied research by Professors Viral Acharya, Matthew Richardson, Van Niewerburgh, and Lawrence White. It is concise and well written.  Many of the points they make have been corroborated by other reputable researchers in the field, and their final achievement is the establishment of the Stern School V-Lab, which is an analysis of systemic risk to the global financial system far superior to the banal and manipulated models  like VaR and self-administered bank stress tests.

We know now, for example, that in recent times of financial crisis, correlations among asset classes have converged, thereby vitiating the traditional benefits of portfolio diversification.  We also know that individual security betas and correlations within sectors like the banks change dramatically; yet, most published estimates of these betas and correlations are poor estimates and misleading for policy and financial management.  The Stern V-Lab does daily estimates of all these factors using a variety of powerful modeling techniques, and it uses them to generate daily estimates of systemic risk and the contribution to systemic risk by individual banks.

Acharya et al focus on the role of  the Government Sponsored Entities(GSE's) Fannie Mae and Freddie Mac in the crisis, noting that they were run as the largest hedge funds on earth.  The GSE's were run at a gearing ratio of 39:1!  The authors note that 15% of the mortgage purchases went to low quality mortgages, totalling $1.7 trillion.  These estimates are very consistent with findings of the Congressional Research Service and by Professor John Coffee of the Columbia University School of Business. 

In addition to leverage issues, the GSE's woefully undercharged for their mortage backing service.  They charged $0.20 per $100 of mortgage assets, which still allowed the entities to record revenues of $7 billion. They were also woefully underreserved by design, since this highly leveraged business model maximized executive compensation, which was built on private industry comparables. Reserves were built at $0.45 per $100 of mortage assets. Please refer to the above discussion to recall what they were buying. 

According to the CRS, "In broad terms, the GSEs purchased slightly more than $169 billion of private label subprime MBS in 2006 and 2007; they purchased slightly less than $58 billion of Alt-A MBS in the same time period out of combined total mortgage purchases of $1.677 trillion. At the end of 2007, the subprime and Alt-A MBS represented 13.5% of the GSEs’ total assets."   These assets, purchased under political pressure from Congressional leaders and by private originators like Countrywide Financial, were among the most toxic in the marketplace. 

The authors note that the 2007 vintage had 23% of loans with equal to or greater than 80% LTV and 18% with FICO scores below 660.  The 2006 vintage was composed of 23% subprime mortgages and 15% interest-only loans.  These vintages were purchased in a concentration of zip codes which had historically poor mortgage performance, according to an analysis done by the Columbia Business School. 

Former Federal Reserve Bank of St. Louis President Bill Poole, a Professor at Johns Hopkins when I was a graduate student, noted in this week's conference at the Witherspoon Institute  that the big bailout costs have been for Fannie Mae and Freddie Mac.  According to his estimate, they stand at $150 billion and counting. 

In the Stern book, the authors quote Minneapolis Fed President Narayana Kocherlakota as saying that the Federal Reserve's balance sheet in twenty years will likely still have $250 billion of mortgage backed securities on the books.  Unwinding the Fed's $2 trillion balance sheet will not be easy, as we've written about before. 

Right now, 59% of all financial sector liabilities are underwritten by taxpayers in some way.

Having at look at today's V-Lab, among the Global Systemic Risk Top 10 Banks, we find at the top in descending order, Deutsche Bank, BNP Paribas, Credit Agricole, and Barclays plc.  We find a German bank, two French banks, and a British bank.  No European capital will be immune from the ongoing stalemate in the euro crisis, whether in the currency union or not.  Incidentally, Bank of America is also in the top 10. 

It's great food for thought, and if you're so inclined, beyond reading "Guaranteed to Fail," have a look around at the V-Lab. 

Friday, December 2, 2011

Got Shale?

Let's start with a simple picture about the natural gas picture in the United States.  According to the Energy Information Administration, 2009 proved reserves of natural gas were 284 Tcf (trillion cubic feet).  Proved reserves are those volumes of natural gas that "geologic and engineering data demonstrate with reasonable certainty to be recoverable under existing economic and operating conditions."  Proved reserves are what we know is out there, and what we can recover without subsidies or experimental technologies. 

69% of the proved reserves are within the lower 48 states, of which 183 Tcf are onshore and 13 Tcf offshore in the Gulf of Mexico.  61 Tcf are said to be proved reserves in shale, or 21% of the total proved reserve base.  Shale has always been classified among "unconventional resources," along with coalbed methane and tight gas.  Shale's proved reserve totals have grown sharply in recent years, coinciding with the beginning of their separate reporting in 2008. 

It would be interesting to look at the methodology and cost estimates that went into describing the "current economic and operating conditions" for shale.  We have such patchy data and limited history, but even with all the hoopla, shale reserves are at best 21% of the proved reserve base.

When one looks at production of natural gas in the U.S., shale weighs at 14-20% of production, depending on the year and the way the data are reported. 

Let's pursue the 69% of our natural gas reserves that in the lower 48. How's that for an idea!  Let's forget BP and take the freeze off operations in the Gulf of Mexico to grow the production and reserve base out there.  There's plenty of onshore gas, according the EIA statistics, in Texas and other southwestern states. 

Imports currently account for about 11% of domestic consumption (again the number might vary slightly).  Gas prices have been flat and appear to be falling.  In an environment of falling prices, it's not good economics to produce from sources which may  have higher total costs, especially external, environmental costs like shale. 

The New York Times reports today about situations in Pennsylvania where landowners sign leases for gas production in order to get a steady monthly income stream; now the owners find their drinking water contaminated, and tailings from the drilling left on the property and simply reseeded.  The companies tell then, "It's your problem, now." These owners are at a tremendous information disadvantage when dealing with the gas companies, which are behaving almost as badly as those in the original  Pennsylvania oil rush. 

Shale, in some ways, seems just like the ethanol gold rush.  We jump headlong into an energy source of marginal economic, social and environmental value, with lots of consequences that were poorly understood while trade associations  beat the drums and regale the politicians. Sound familiar?

Even for natural gas, we may be able to be relatively energy efficient simply because the economic forecasts are for flat to down gas consumption in the coming years due to the lingering economic slowdown and energy saving efforts. There are large supplies of LNG that could be imported, for which we have the capacity and which would have few environmental issues.  Going for zero gas imports, given the alternative of ramping up shale production doesn't seem like an obvious trade-off to me. 

How about some more nuanced and thoughtful discussion of these issues?

Wednesday, November 30, 2011

Deutsche Telekom: Hello! Anyone Home?

Responding to widespread consumer sentiment, the FCC has opposed Deutsche Telekom's proposed sale of T-Mobile and its subsequent merger with ATT.  The FCC draft study released today forcefully rebuts all the benefits of the merger to US wireless services, consumer pricing, and job creation. 

I went to T-Mobile's IR site and looked over their recently reported fiscal third quarter results.  It's hard to imagine what management was thinking in their running of U.S. T-Mobile.  Overall, adjusted EBITDA for US operations increased 9.2%, which is nothing to sneeze at, and the adjusted operating margin was 27.8%.  Again, no alarm bells going off yet. 

However, the adjusted operating margin in the US compares to an operating margin of 41.5% in Germany and 36% in the rest of Europe.  One thing that jumps out notably is the investment and roll out of network investment and product innovation for German customers, essentially bringing multimedia services to smart phones and other devices.  It is very impressive, and probably accounts for revenue growth, subscriber growth and EBITDA margins in Germany and probably in Europe.

There has been essentially no such investment in the US T-Mobile network.  For full disclosure, I have been with T-Mobile as a personal customer for probably more than a decade.  I've also experienced ATT as a corporate customer a few times.  T-Mobile's early decision to build a GSM network seemed savvy to me, since it allowed a customer to be able to operate easily in Europe where GSM was the network choice, as opposed to ATT's original CDMA.  Rates per minute were always the best, and the customer service was top notch, miles ahead of any of our other providers.

T-Mobile poured millions into a wildly successful brand identity campaign with Catherine Zeta-Jones, but the campaign was focused solely on price, with no reference to the network or customer service.  One of the reasons was the DT was investing nothing in T-Mobile's network, which makes no sense.  For wireless, the network is the product.  Verizon, meanwhile, beat us to death with the "Can you hear me now?" 

Over the past five quarters, T-Mobile has had an exodus of contract customers, about 1.2 million customers lost.  But, what would one expect?  The announcement of the merger made it an open field for everyone, including the moribund Sprint to poach customers.  Plus, anyone who has dealt with ATT probably went to jump into the arms of Verizon.  So, the result shouldn't have been surprising.

On the other hand, over the same past five quarters, T-Mobile has added about 1.2 million pre-paid customers, which seem like they should be more profitable than some big users on T-Mobile data plans.  Overall, net adds were about zero for the trailing five quarters. 

US revenue for the fiscal third quarter was down to 3.7 billion euros from 4.1 billion euros in the prior year period.  Data network development expenditures by DT in the US had been flat at fairly low levels for the past five quarters.

Talking as I do with T-Mobile retailers and customer service people, you can feel the demoralizing effect of the proposed merger and the subsequent exodus of contract customers.  They were told to bombard existing customers with trade-up offers and useless text offers. It's not their fault, but the fault of poor management.

It appears during the entire tenure of DT's ownership of T-Mobile that it has been run in almost a harvesting mode.  This market is full of customers who are knowledgeable, demanding and sticky.  DT has made a mess of their investment, which is curious given their strong track record.  However, look at their competition in Europe.   That probably explains much of their monopoly-like 42% operating margins in Germany.

I hope that T-Mobile is not collateral damage in this tug of war with regulators about the ATT deal. 

Monday, November 28, 2011

Pulling Out of Afghanistan

                                                                    Source: Radio Free Europe/Radio Liberty
An Afghani mother brings her child to a village distribution center for drinking water.

Alexander Star's thoughtful New York Times Book Review article on recent books about Afghanistan quotes an observer who characterizes the situation as "a perpetually escalating stalemate."  This is a perfectly apt description of the situation. 

It's hard to think of a modern theater where our military leadership and the men and women under their command have done a better job of trying to understand and work within indigenous cultural and leadership norms.  Our model uses "Human Terrain Teams," working with embedded academics, who are often anthropologists or ethnographers.  The good news is that had we not pursued such an approach, we would have had to beat a Soviet-style retreat, licking our wounds.  The bad news is that for all the bravery and sacrifice of our troops, and for the billions in expenditures, the best we can hope for is a stalemate after the defanging of the Taliban.  It is time for a withdrawal.

Professor Noah Coburn spent two years in the Tajik village of Istalif working on what would become his Ph.D. dissertation at Boston University and his 2011 book, "Bazaar Politics."  Here's a link to an earlier 2009 presentation of Professor Coburn's at the American Institute of Afghanistan Studies.

Coburn found the village of Istalif to be relatively stable because no one was really in charge.  Westerners are captivated by stories of Afghanistan's maliks (elders).  Coborn characterizes the maliks as being the public faces of a village, which means that they meet with NGO representatives, for example. Their actual power and ability to command resources is extremely limited.  The mullahs exert influence which is restricted to within the walls of mosques in Afghanistan.  The merchants who form the Afghan business sector, often live in Kabul and are not respected because of the local caste system.  The merchants come from the caste of weavers, who are not of high caste.  Even government officials are generally not powerful, as the actual disbursement of funds is left to local councils. 

As long as no one set of actors tries to extend its influence at the expense of another, the system of leadership maintains a sort of "knife edge" equilibrium. 

NATO attempts to establish a centralized government in Kabul have clearly failed.  In President Karzai, the West is funding a presidency which is thought by the population and by international observers to not be legitimate.  It is also deeply corrupt.  President Karzai's public rhetoric about jumping directly into the arms of the Taliban are incomprehensible. The normal behavior would be to offer olive branches when funding is being discussed, but surely we have no reason to put any faith in the President's remarks now. 

The problem with Pakistan is something we have written about in this blog for a few years.  Their interests in Afghanistan have never been aligned with ours, and this will never change with the current Pakistani state.  Withdrawing from Afghanistan can reduce the amount of "aid" we need to pump in which is solely to buy support for our Afghan operations. 

One of the sadder comments Coburn makes is to say that no group is held in lower esteem in Afghan society than the cadre of publicity-seeking NGO's. I believe that the Central Asia Institute is an exception to this characterization.  Minnesota native Greg Mortenson's organization has had a tangible effect on helping to educate young women, at the invitation and with the support of local elders.  This kind of grass roots effort, which doesn't aim at reforming cultural norms about gender, religion or criminal punishment, has a chance of succeeding, though it is certainly not without its challenges. 

Let's see what happens with the upcoming international conference on the future of Afghanistan.  We shouldn't expect to hear anything that would undermine the benefits of a withdrawal from Afghanistan. 


Saturday, November 26, 2011

Russia In A Multipolar World

Fyodor Lukyanov has an interesting article in the Spring/Summer 2010 issue of the Journal of International Affairs, published by Columbia's School of International and Public Affairs.  We had a recent post about the Nord Stream gas pipeline and its importance for the growing Russo-European relationships. 

The author notes that Russia "has not acquired a new identity on the world stage since the break up of the Soviet Union."  I think this is the key to understanding why the Russo-American bilateral relationship has been foundering for the last three U.S. Presidencies. 

The old Soviet Union controlled the vast swath of the Eurasian land mass.  When the Soviet Union collapsed, 25 million ethnic Russians did not have a home in the new Russia, something that was inconceivable a decade before.  The consequences of the collapse, the author points out, are not yet known or understood.

The press images portraying President Putin as the black belt judoka capable of standing up to the weak and scurrilous leaders of  the U.S., Western Europe and China  never made much of an impression outside Russian boundaries.  Instead, there remains widespread dismay about how "modern" the new Russian republic really is.

The widespread crackdown and violent killing of Russian journalists is something that is anathema in many countries beyond the U.S. and Europe. While U.S. universities fall all over themselves establishing relationships with their Chinese counterparts, a similarly strong relationship with Russia would seem just as natural for the U.S., but it doesn't exist.  The images of Russian oligarchs duelling in a British court room about the division of billions in value to which they were not entitled seems other worldly.  None of these policies and  images are worthy of a true leader in a multi-polar world. 

For all the talk about a multi polar world, it remains just that: empty talk. Lukyanov dismisses the notion of a world of networked international relationships, without discrete polar focal points.  He rightly points out that our world has yet to find a suitable organizational replacement for the nation state model. 

The European Union was supposed to be the paradigm for the Brave New World in which national sovereignty was sacrificed on the altar of common currency and shared economic benefits.  We now know where that train is headed. Alternatively, the author notes we've had a number of multinational, humanitarian interventions, where a small number (as small as one) of states have acted to counteract evils such as ethnic cleansing. A particular nation's sovereignty was sacrificed because they were being bad actors on the humanitarian stage.  This kind of instrument, as we know, is subject to abuse, and this model has limited application.

To be fair, U.S. conduct of foreign policy has been abysmal through the past three administrations.  The author points out the lasting suspicion and distrust sown by the U.S. unilateral withdrawal from the ABM Treaty in 2001, without consultation or discussion with the Russians.  I don't know if we are capable of having a sustained, rational foreign policy position, but there's always hope.

In Asia, there are many actors vying for leadership positions, such as China, Russia, Japan, and India to name a few. Russia desperately needs a more economically modern, humane and enlightened identity in order to exert meaningful leadership in an emerging multi-polar world.

Friday, November 25, 2011

Winding Up The HP Conversation: What's Missing

Perhaps the most curious remark made by new CEO Meg Whitman on the recent HP conference call was her characterization of HP as a company that grows at GDP-like rates (it was a bit inaudible on the webcast).  While this kind of remark makes total sense from a longer-term perspective, it isn't what an institutional investor wants to hear.

Trees don't grow to the sky, and to be sure "long term growth rates" of 15% projected by most analysts for S+P 500 growth companies make little financial or economic sense.  Some of my savviest institutional investor customers spent lots of time trying to determine the "earnings power" of potential investments, i.e. what returns could they earn on the assets they had in place if volumes were growing at above-GDP rates, the company had pricing flexibility, and the economic and competitive backdrops were favorable.  For cyclical companies with significant leverage, the turnarounds in EPS were dramatic.

Stephen Penman, Professor of Accounting at the Columbia University Graduate School of Business, recently wrote a book, "Accounting for Value," in which he updates the Graham and Dodd approach made famous in their pioneering work on security analysis. He concludes that most investors overpay for growth and leave no "margin of safety" when they buy a stock.  The "margin of safety" is one of the key tenets of Graham and Dodd's approach.  Warren Buffett, a longstanding student and disciple of Graham and Dodd, recently announced a large equity stake in IBM, and not HP.  One would think that HP would show a reasonable margin of safety at current prices. 

HP was described by some analyts as trying bring expectations down as low as possible.  That's usually a tactic pursued by second rate companies.  Tweedy Browne is a distinguished value shop which has habitually avoided technology stocks.  They recently initiated positions in Google, which doesn't fit traditional value metrics.  However, they argue that given their huge cash flows, and large investments made to date in technological backbones like data centers, incremental revenue growth, acquisitions and entries in adjacent businesses can have large impacts on EPS. 

Their one concern about Google is a cultural one, namely that the management seems intent on changing the world, in their own words, as opposed to always making shareholder-friendly decisions.  HP on the face of things looks like a traditional  technology value stock.

Dodge and Cox, another traditional value shop, has a five percent or better ownership position in HP equity, between the Stock Fund, the Balanced Fund, and the International Stock Fund.  The company has a long standing position in HP bonds through the Income Fund, which has long been overweight corporates.  It looks like the Income Fund recently sold out of HP bonds because of their strong price out performance.  Aside from HP and extensive index fund ownership, we will see in coming months which other value investors may be accumulating shares in HP.

What's missing from HP in our opinion is leadership, both from the board room and from the revolving door of the executive suite.  This is a serious cultural issue, more worrisome than any cultural issue at Google.  It is the same board in place, and a CEO who came from the very same board which made any number of large, foolish decisions.  The IBM turnaround had a clear beginning with Lew Gerstner. It was fortified by Sam Palmisano and is being handed off to Virginia Rometty; the entire process had gravitas, circumspection and strong hands at the tiller.  HP has under performing assets, a portfolio of businesses with no unified vision or mission in the marketplace, low expectations and a new CEO with smaller company experience driving this very large ship.  Without a cultural transformation, it might become a nice short-term trade, when stronger 2H 2012 earnings become visible, but it's a long way from being a great investment yet. 

Wednesday, November 23, 2011

Thanksgiving and Gratitude

Last Sunday in church, the priest's homily had a long, rambling discourse about "brokenness," which for him was a broken health care system, broken roads, broken schools, a broken Catholic church and so on in the endless drum beat of the modern, secular political religion.  Ironically, he and the rest of the congregation had arrived easily by car over great roads and were sitting comfortably in a beautiful worship space, united by our belief with no reference to any divisive status. 

Looking around our congregation, I thought about my middle class friends from Argentina, Brazil and Venezuela.  As attached as they are to their homelands, they are always concerned about kidnappings in their capital cities when they go home at the end of the year.  We, on the other hand, can pick a random spot on the U.S. map, drive there and walk around without fear.  We can step out of our house and go to a market with no fear of a pipe bomb being tossed from a car, as in the Middle East.  I'm grateful for this peace and freedom that I can take for granted.

Having tutored in schools since my college days, I know that our Catholic schools are challenged more than ever by the modern immigrant influx where the students are way behind their chronological age levels in basic math skills.  Our schools don't complain of being broken. They just get on with the job and give to their students unreservedly.  Hundreds of volunteers work every day to do things from tutoring, serving lunches, providing school yard security and doing bookkeeping for the schools.  What's broken for these students are the corrupt dictatorships in their home countries which offered no hope for their parents; now their children can be educated in Catholic schools in which most of the students do not pay tuition.  Are they turned away?  No.  Does the school run a deficit?  Yes.  Is the financial model "broken?"  Yes, but it doesn't matter for today, because the schools aren't broken: they are doing their jobs which is serving the poor, which is what we should be doing. The Christophers motto is "It is better to light one candle than to stand and curse the darkness."

Taizan Maezumi Roshi, writes in his book, "Appreciate Your Life:"
"What is the I that is blocking this realization?  It is my dualistic functioning.  There is nothing wrong with duality itself, that is how our mind functions.  But as long as we remain in the confinement of duality, we are swayed by such opposing values as right and wrong, good and bad.  These are only temporary aspects. Something appears to be good or bad or right or wrong or long or short or big or small--but what is it overall?  The same thing with our life.  We must see what is beyond our duality.  Our life literally comes down to right now. Now! Here! What is it?"  That's the challenge for each of us every day.

Here in the Upper Midwest, it is a beautiful autumnal day in early winter, where the light and smells of the earth can be enjoyed  by anyone without cost.  Our families and our communities can draw nearer over this Thanksgiving holiday, enjoying each other's company in relative bounty, even as they reach out to help others.  Looking out the window, watching people come and go, makes me feel grateful. 

Tuesday, November 22, 2011

HP Conference Call Gives No Comfort For Investors

HP's 4th Quarter and fiscal year-end conference call marked new CEO Meg Whitman's debut after eight weeks on the job; it gave no comfort for investors, and analysts from Goldman, Morgan Stanley and Citigroup seemed almost comatose, not challenging the disjointed and contradictory presentation.  The stock sunk immediately after the call, on healthy volume.

One fundamental comment concerns the financial statement presentation: Big 4 auditors in my experience are usually reluctant to permit widespread use of non-GAAP financial measures in presentation of results, and they try to limit their use and keep the corresponding GAAP measures adjacent to the non-GAAP measures.  Although HP provides reconciliations in their slides (what they call a "bridge"), the management leans totally on non-GAAP measures of performance.  One of the problems with the non-GAAP measures is that they are not comparable across companies, since companies differ in what they consider one-time or non-operating items.

For the full fiscal year 2011, HP reported GAAP pre-tax income of $8,982 million, or $3.32 net per diluted share. Adding back charges for impairment of goodwill and purchased intangibles, amortization of purchased intangibles, restructuring, and acquisition related charges, produces $4,350 million of adjustments to pre-tax income.  At a 22% tax rate, non-GAAP adjusted EPS for 2011 becomes $4.88, like magic!  Similar hand-waving for the fourth quarter turned reported EPS of $0.12 into a non-GAAP EPS of $1.17.

By making these adjustments for comparability, the board and the management escape the fundamental problem that these large acquisitions now being written down were the avowed strategy of the company over a long period of time.  The adjustments are economic testimony to the fact that they were poorly conceived and executed.  Aren't these "operating" items for a company whose stated goal has been to make mega-acquisitions?  I realize that I'm mixing accounting with what the statements are trying to represent, but I hope the reader will indulge me.  In fact, CEO Whitman continued to talk about acquisitions in HP's future, saying only wanly that there might not be any more mega-deals. I certainly hope not!

In an amazing show of chutzpah, the management said that they would no longer give any forward guidance, except for EPS.  Consider what they said.  For fiscal 2012, management expects the company to earn at least $3.20 on a GAAP basis, compared to $3.32 on the same basis in the prior year, a decline of 3.6%.  I sincerely doubt that management will be compensated for 2012 on EPS, as suggested by CEO Whitman.

On a non-GAAP basis, management said that the company is expected to earn at least $4.00 per share, compared to $4.88 in the prior year period, on the same basis, a decline of 18%!  Buried in a footnote in one of the presentation slides is an item that says, "Full year fiscal 2012 non-GAAP diluted EPS estimates exclude after-tax costs of approximately $0.80 per share, related primarily the amortization and impairment of purchased intangibles, restructuring charges and acquisition-related charges."  So, the stream of "one time" items continues into 2012, and there will again be a difference between reported EPS and non-GAAP EPS.

The new CEO says that the number one question she faced when going out and talking to customers, partners and investors was "What is HP?"   She characterized the company as being No. 1 or No. 2 in all of its operating business segments.  Based on the performance of the segments and on their outlook, this statement seems inaccurate.  There was talk about how smoothly the Autonomy acquisition was going, with the companies "exchanging hundreds of sales leads," and yet the acquisition seemingly has no impact on EPS in 2012, but without any detailed guidance, this isn't easy to tease out.  Autonomy's website claims the company has 25,000 customers worldwide, many of which must be small and scattered across a variety of product offerings from social media analytics to eDiscovery.

The Personal Systems Group (PSG) which was going to be sold off by Whitman's predecessor will now be retained.  Based on its performance and outlook, it must be an industry No. 2 because there are only two horses in the race.  The company's commentary during the call was guiding strongly to single digit declines in PSG revenue in 2012 compared to 2011.  Disk drive shortages from Thailand flooding, widespread consumer spending declines for both notebooks and tablets, the failure to have an established tablet product in the market, and a decline in ASP's will all militate against revenue growth and margins may touch record lows. Fourth quarter 2011 operating margins in PSG were 5.7%, typical of a commodity business.  In the first half of FY 2012, these margins may drop as low as 2-3% before a macroeconomic industry upturn in the second half starts to raise units, price, and mix.  2012 seems like just putting a finger in the dike for this business.

We've written before about HP's being overly reliant on the printing supplies business, which is included in Imaging and Printing Group (IPG).  The company pushed too much product into their wholesale and retail channels in 2011, and it hopes to work these off in the first half of FY 2012.  Operating profit in this segment had a recent peak at 17% in FY 2010, and it may spend FY 2012-2013 in the 13-14% range.  This is an industry leading business, but to paraphrase the CEO, "Printing is a coincident indicator of economic and business confidence and sensitive to price in a downturn."  Remember how we were all going to print studio-quality photos on our printers at home?  Not!

Services 2011 revenues of $36 billion is just behind PSG's 2011 revenues of roughly $40 billion.  As I think of the industry leaders in this segment, I think of IBM and Accenture, not HP.  CEO Whitman's talk about this business was not at all enthusiastic.  She talked about a multi-year turnaround for this business, the need to hire people who "can actually deliver what the customer wants," the need to invest in better quality sales people, and margin pressure in the basic service offerings. This does not sound like a No. 1 or No. 2 business leader in the industry.

IBM Global Services Revenue, by contrast, is projected by Credit Suisse to be $63 billion in 2012, with 33% gross margins and 15% pre-tax margins.  HP's management has suggested operating margins for Services in the 10-12% range for 2012-2013 on flat to low single digit revenue growth.

The Enterprise Server, Storage and Networking Business (ESSN) The company is one of the market leaders in Industry Standard Serves (ISS), but even this segment of the business would, according to management, be facing macroeconomic deceleration in upgrade and replacement cycles, continuing problems with Oracle's move away from the Itanium chip,  Facebook, Google and others building their own servers, and a deterioration in HP's traditional storage offerings. Now that Dell has acquired Compellent, they would seem to have a more innovative and attractive set of options for large volume storage customers. Operating margins in this business should continue to be under pressure in 2012.

The company will be ramping up its R&D spending, something which does not give us comfort given that previously high levels appear to have yielded nothing, which then required the company to purchase innovation expensively in the capital  markets.

Whatever FCF the company generates in FY 2012, it will be dedicated to paying down debt related to the Autonomy acquisition, and so cash returned to shareholders, which is a healthy percentage of the free cash flow, probably won't grow too much.

The HP value creation machine may be stuck in neutral almost certainly through Q1-2 FY 2012, and time continues to be on the value investor's side to see if this is the board and management team has the ability to restore the company's tarnished luster.

Thursday, November 17, 2011

QE2 Hasn't Affected The Economy

I noted this comment from my former colleague, Dr. Ward McCarthy, Chief Monetary Economist for Jeffries:

"...the logjam in the banking system is evidence that QE2 has not filtered into the real sector of the economy to any significant degree. So long as this persists, it will be an indication that the monetary policy transmission mechanism has not worked efficiently."

Yet we continually, and with blind faith, talk about monetary policy not being out of bullets in reducing the employment rate through a QE3.  I wish that Chairman Bernanke would get on a National White Board and explain this in five minutes without any acronyms or jargon. 

Saturday, November 12, 2011

Pimco's Kashkari Gloomy About Equity Returns

Pimco has always been a bond house, but lately they've made a concerted effort to develop mutual fund products for equity investors.  The equity mutual fund field is like the favela in Sao Paulo: dangerous and overcrowded.  Neel Kashkari, a Goldman and U.S. Treasury alumnus, is leading that charge into equity.  In a recent interview with Morningstar, Neel  didn't take a sunny view of equity returns.

Instead, he says that the U.S. is in a long period of adjustment which will mean much lower economic growth and lower asset returns than historical norms.  Like our posts on the so called consumer deleveraging, he says that it has barely begun and has a long way to go.  Large corporations, and to some extent the mid-market firms, have completed their deleveraging and are flush with cash.  However, they will find precious little sales growth here at home if the consumer sector continues on life support.  It's an interesting interview.

Of course, what's the conclusion following from Kashkari's world view?  Get connected with emerging markets. Brazil is apparently fully valued.  China has already produced negative surprises and may have more skeletons emerging from the closet.  Apparently, selected Russian companies may be value plays.

How can a U.S. investor, particularly an individual investor, take these kinds of risks in a low return world without significant risk premia?  Macroeconomic data for all these countries is barely acceptable, the financial press is weak or non-existent, corporate governance is of poor quality and not monitored by strong watchdog groups, and the auditing function is hostage to low quality national partners and shielded from accountability by the structures of the major accounting firms.  Does this sound like an answer to low U.S. returns? 

Look at what happened to Southeastern Asset Management, which runs the Longleaf Funds, very successful long-term value oriented investors.  Mason Hawkins and Stanley Cates have put together the ingredients I look for in a good equity mutual fund manager: good people, an ethical culture, a sound research process and approach to valuation, and manager incentives that are aligned with shareholder interests. Their employees are the largest shareholders across their family of equity mutual funds and have been since time immemorial.  This is the way it should be, but it's rare.

Southeastern has been rattled by being a long-term 5% plus shareholder in Japan's Olympus Corporation, which may have been hiding trading losses for a decade or more.  This is a Tokyo Stock Exchange listed large capitalization company with good businesses and a long track record.  I understand the statistical issues of this being "an n of one" on the TSE or in a diversified portfolio.  My point is look what is still happening even in foreign markets which we consider "developed."

Think now about the same investor's position in a Brazilian oil company, software company, or REIT?  The outside investor is at a tremendous information disadvantage.  Even depending on analysts stationed in the country is no assurance of risk mitigation.  It depends on culture, people and processes in those local operations, which are difficult to manage from afar.  If emerging market investing is an answer, it will have to be on a company-by-company basis.  I don't think it makes sense for investors to buy into, for example, the "Brazilian Miracle," or the "Indian Miracle," or any other gold rush country. 

Reading Kashkari's piece made me lament for the eras of 8% equity returns, which are still embedded in the long-term projections of many public and private pension funds.  The maiden of high returns has vanished, as Neel suggests.   I had to turn to Bill Withers and his baleful tune, "Ain't No Sunshine When She's Gone."  I can go back to my investment statements with some comfort.  Thanks, Bill.

Tuesday, November 8, 2011

Nord Stream Is The Big News In Europe Today

The Western press front pages were replete with Italian Prime Minister Berlusconi looking heavenward as he contemplated his announced resignation. Or was he thinking about AC Milan's recent run of form in Serie A?  There was nothing new in today's tedious play-acting in Greece and Italy. 

The news of fundamental economic importance was the opening of phase I of the Nord Stream underwater gas pipeline which links Russia's vast Siberian gas reserves with Germany.  The 1,200 km long pipeline can carry 27.5 bcm of gas, and when phase II is completed in 2012, Nord Stream can supply about 10% of the European Union's energy needs with the relatively green, fuel of choice for residential and industrial consumers. 

This is a sharp stick in the eye for Ukraine, Belarus and Poland, which had earned revenue from gas transmitted by older, overland pipelines through their territories.  Ukraine's efforts at disrupting supply in the past for political reasons are now neutralized.  Russia may eventually have from 25-33% of the EU's gas market supplied from its reserves.  As Russian President Medvedev said with some understatement, "We are going to put into operation the first stage of a new partnership with Russia and the European Union."  Gazprom OAO will own 51% of the Nord Stream venture.

We've always said that Russia's proclivities were naturally towards a stronger partnership with Europe than towards a wary partnership with America.  This massive technical and financial undertaking is a good start.  Relationships have been quietly building in other areas too, like football.  Gazprom has been a prominent uniform sponsor for Schalke 04 a great Bundesliga club with a rabid fan following. 

One curious item to note about the ribbon cutting for Nord Stream was that Chancellor Merkel was joined by the French Prime Minister Fillon and not by her erstwhile political companion of recent months, French President Sarcozy.  Germany has in principle gained access to more secure natural gas supplies through the Nord Stream joint venture, which strenghtens its economic prospects for the future, given the growing convergence of interests with Russia. 

Thursday, November 3, 2011

European Central Bank May Need Life Support

Last night's post talked about the precarious nature of the ECB's balance sheet, based on a paper by a Columbia Business School professor.  I just saw this discussion in today's online Wall Street Journal:

"The reality is that efforts to leverage the European Financial Stability Facility are in disarray – and will remain so until the current political uncertainty over Greece, and maybe now Italy, has passed. And the bank recapitalizations are not due to be completed until June 2012. The only contagion defence available to the euro zone is the European Central Bank which may be reluctant to step into the breach. After all, if Greece is forced into a disorderly default, it would likely repudiate all its debt, including that held by the ECB. That would blow a €50 billion hole in the ECB’s balance sheet and destroy the credibility of its Securities Markets Program."

The balance sheet of a traditional central bank has to be above reproach.  The ECB may have short-term issues, and for it to be a factor in a longer-term working out of the Euro crisis it's balance sheet will have to undergo a wholesale swapping out for multinational, EU guaranteed bonds.  Can we get there from here? 

Wednesday, November 2, 2011

Papendreou Agonistes: Greece Throws Down The Gauntlet

For all the hectoring that Greek Prime Minister Papendreou may soon face from the German Chancellor and French Prime Minister, his gambit of calling for a referendum seems politically and economically rational.  Under a scenario of further fiscal discipline mandated by the EU, economic growth prospects are dismal which means growing political unrest and instability in Greece.  The Greek political leadership will not be able to influence the path of future events, other than to be reacting to serial crises.

If, on the other hand, a referendum goes were to go forward and pass, Greece could resurrect the drachma, gain control over its future monetary policy and have an exchange rate to adjust for differential inflation levels with the rest of the EU and for payment imbalances.  A run on the banks would have to be forestalled, but Argentina suffered through a bank run in 2001 and reemerged healthier five years later.

Asset markets would be thrown into turmoil, but everything would eventually be remeasured, and life would go on, with limited access to the capital markets for some time.  However, from the political standpoint, Greece would be in charge of its monetary and fiscal policies, as opposed to the popular perception that the country is at the mercy of Germany and France.  Short-run economic growth prospects in this scenario shouldn't be much worse than under the current euro structure, assuming that fiscal discipline continues and revenues are eventually raised through higher taxes and better collections.

The important element for a politician is that Greece is in charge of its own destiny, even if that means being a pariah for a few years.

Back in July, we wrote about the limited options for the European Central Bank. We focused on " the fundamental problem of economic imbalances within the European Union."  Professor David Beim of the Columbia University School of Business puts forward a cogent analysis in his October 9 paper, "Can the Euro Be Saved?"

The seminal formulations of the economic and currency union idea were put forward by Robert Mundell, Roland McKinnon, Peter Kenen, Douglas Dosser and others in the 1960s.  As Beim rightly points out, these models were predicated on the countries being broadly similar, especially as regards having common or similar rates of inflation. If they were not, a currency union must inevitably end in a debt crisis, driven by persistent payments imbalances.  That's where the EU is today.

We've said from the beginning that no politician on our planet will willingly cede national sovereignty over fiscal policy, because that would be either a literal or political death sentence. We've written earlier, "we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro."

Professor Beim agrees, "Greek debt restructuring and exit from the euro needs to happen in the near future and will happen with certainty in the medium future."

Professor Beim raises a really important point, which has been glossed over in all the focus on Greece, and that is the balance sheet of the European Central Bank.  He reads the September 30, 2011 balance sheet showing 2.3 trillion euros of assets, composed of 1.14 trillion of bank loans and distressed sovereign debt!

As he says, "The ECB itself needs to be bailed out, replacing its risking assets with European Financial Stabilisation Mechanism (EFSM) euro-bonds, to the extent that this can be done at this late stage." 
This recapitalisation itself will be a Herculean undertaking.

Friday, October 28, 2011

Algae Factories In Our Future?

There have been some interesting meetings about using algae as a renewable fuel source, which motivated a quick review of what's been happening with alternative fuels.  As corn-based ethanol has rightly been fading as a meaningful solution for our hydrocarbon dependency, cellulosic ethanol once seemed extremely promising. 

One of the emerging leaders was Iogen Corporation in Canada (  Goldman Sachs was an early investor in the company.  Pilot plant results using wheat straw were very promising, and the energy balance for cellulosic ethanol looked a lot better than that of corn-based feedstock.  In 2011, Goldman Sachs was hired to look at strategic alternatives. 

The company formed Iogen Energy, which is 50/50 percent owned by Iogen and by Royal Dutch Shell plc.  Plans for a full scale commercial plant in Canada are taking longer than planned for "technical design and feasibility" issues. Abstracting from the technical process issues, the other big issue for plant economics will minimizing transportation costs for the low value per unit volume feedstock while also getting the fuel efficiently to a wholesale distribution point.  Things still look promising for this fuel, but it will be part of a portfolio of transportation fuels. 

Several industry experts have pointed out that naturally occurring algae won't be able to produce on a large enough scale without having uneconomically large areas devoted to production.  Renewable biofuels fron algae will almost certainly require synthesizing some specialized organisms which produce the fuel in a manner in which it can be easily "skimmed" or recovered without necessarily breaking apart the producer organisms themselves.  This has been described by Craig Venter as requiring the "invention of a new agriculture."  Since ExxonMobil has committed to researching algae-based biofuels, there is optimism for the future.

A large NSF research grant led by investigators from Penn State University aims at developing genetically engineered bacteria for production of liquid fuels will be completed in early 2012.  This has been a four year effort and hopefully, it will advance the renewable fuels effort forward.

While this area continues to show promise and leverages our scientific, engineering and production expertise as a nation, renewables as a class of fuels will be a part of a fuel portfolio that will be dominated by hydrocarbons for decades to come. 

Tuesday, October 25, 2011

Pandora's Risk: Goodbye to Efficient Markets

Kent Osband's book, Pandora's Risk from Columbia University Press is the best book on financial markets I've read this year.  It's not an easy read, but stimulating and worthwhile.  He made a related presentation in 2005 to the Irish Society of Actuaries titled, "How to Mismanage Portfolio Risk: A Guide for the Fiducially Challenged."  I can't find a link to the slides on the Web, but it's got the same tongue-in-cheek style.

In Osband's view, one of the strangest features of financial markets is their self-absorption.  In the continuous experiment that is a trading session, the actors are also observers.  Invoking Keynes, a financial market is not like a beauty contest aiming to pick out the greatest beauty, but it's aimed at finding out which contestant the other judges would pick as the best. 

As each piece of new information comes in, including about the previous trade, market participants make adjustments in a never ending process, until the bell rings and the market closes.

When thinking about the CAPM formulation, the intrinsic value of an equity is like a port into which the market eventually puts in, through fundamental valuation and incorporation of all relevant information.  In the weaker formulations, it may zigzag its way into port, overshooting and undershooting, but the ship puts in.  In Osband's world, he models us away from the nice Gaussian distribution and takes us into beta and gamma distributions, where risk is not so neat and where uncertainty abounds. Volatility is high, trading volumes are high, and buy and hold strategies are not value producing. 

He doesn't have kind words for pension consultants who focus on tracking error to evaluate mutual fund managers.  Tracking errors, he shows, are good for fund managers' job security, but not for their clients.  Conventional indexes contain most of the market risk and reward, so clients should be taking MORE risk on the residual element not less.  His preferred model for a typical investor would be an index fund combined with a delevered hedge fund vehicle to produce superior returns. 

Most mutual funds diversify TOO much given their investment profiles, where the benefits of risk reduction are quickly outweighed by mediocre holdings and inability to monitor the portfolio quality, which means defaulting to tracking error. 

Talking about the melting of the global financial ice cap, he poses and answers the following questions:
  • "Did we measure risk incorrectly?"  Answer: Yes
  • "Did we measure the wrong risk?"  Answer: Yes
  • Did we wrongly expect too much from our risk measures?"  Answer: Yes
Of course, he's not alone here, but Osband pillories VaR models as delusional, except for the fact that every investment bank used them. 

In my continuing search to understand what we really know about enterprise risk management, I found this comment particularly insightful:  "Most risk managers have detailed knowledge of individual trade exposures, largely redundant with that of the traders they're checking on."  What the risk manager doesn't know, both for model limitations and data limitations, are how these individual risks fit together.  Given mark-to-market and Osband's model for market price behavior, the possibility of a nuclear portfolio event is never far away.  As he writes, "Mankind can aspire to mastery of the universe but never achieve it.  To err big is human." 

He doesn't have kind things to say about US monetary and fiscal policies, and in particular the endless rolling over of public debt.  We have seen the sovereign downgrade of US debt come and go.  However, domestic sovereign default is the biggest risk facing the global system, Osband says.

Although he doesn't write about this, the second biggest risk is probably the slow unwinding or collapse of the Euro. 

For state and local pension funds, his outlook is red on the Uncertainty Meter.  We should "stop exempting public agencies from private sector standards for estimating the NPV of future (pension and bonding) obligations."  Amen to that, and it's something that could be easily enacted although there might be casualties among the stampede of lobbyists in opposition. 

And so it goes.  Have a peek into Pandora's box with Osband.

Monday, October 24, 2011

Arab Spring's Prescursor: Algeria

I just finished John Kiser's fine book, "The Monks of Tibhirine," which provided the basis for the screenplay of Xavier Beauvois' wonderful movie, "Of Gods and Men."  Kiser's deft treatment of Christian-Muslim relations is depicted against the violent background of French colonialism in Algeria.

The Western press has romanticized the so called "Arab Spring," as a prelude to a golden age of Western democracy and modernity in Middle East nations oppressed by their own dictators.  Some of this is wearing off as the reality is showing something different. 

In Kiser's book, Ali Benhadj, a popular preacher who resonated with disaffected Algerian youth says,"For Muslims liberty is constrained by the law of God, not by the rights of others....rights change, and liberty is an illusion that can be trampled by the state.  True liberty comes from submission to God."  Benhadj wrote this in  the newspaper El Munguid ("The Deliverer") around 1988. 

So the Western concept of a secular, political democracy in which the state regulates religion to being a solely private matter, is anathema to the population in the Middle East.  It's interesting to read about the commonality of ideas and mutual respect between the local Algerian Muslim population and the Cistercian monks, who are People of the Book. 

In a speech at the Es Summa mosque in November 1989, Kiser writes that Ali Benhadj said, "They (the Algerian ruling elites) are just like the French before them.  They believe that God can be separated from life, visited perhaps once a week in a mosque.  They have adopted the so-called Enlightenment thinking of the French, which is at the root Greek, an insolent idea that man is the measure of all things.  Everything comes from God. Secular thinking separates man's spirit from God. Islam teaches that it is man's duty to be humble and to serve God in accordance with his commandments." 

The Syrian, Tunisian, Egyptian and other elites bring their own philosophical, political and economic baggage to the discussion about the future of the Arab Spring.  Reading about Algeria's history through Kiser's book was very instructive in thinking about the future of the countries which are trying to throw off the shackles of authoritarianism.  It will not be a short struggle.

Thursday, October 20, 2011

A Coupon For The Groupon IPO

What could be better than daily deal coupon issuer Groupon giving a rebate on itself?  Back in June, we posted on the absurd $15-20 billion valuation range  being suggested  for Groupon. Many investment bankers are probably poker wizards with the requisite "poker face," which allows them to make the most ridiculous statements without blushing or bursting out laughing.

In today's Wall Street Journal, we see that investors can get a coupon on Groupon:

"In a stark comedown for what was expected to be one of the hottest stock offerings of the year, Groupon Inc. is scaling back plans for its public debut. The Chicago company and its bankers will begin meeting with investors in the next few days to sell them on a deal that values the daily deals pioneer at less than $12 billion, according to people familiar with the matter. While that would still mark one of the biggest Internet IPOs since Google Inc. in 2004, it is well below the valuations that were bandied about when the company filed to go public in June. Groupon's IPO was originally expected to value the three-year-old company at between $15 billion and $20 billion, according to people familiar with the matter"

In the meantime, we've had IPO metrics blessed by the company and its auditors, and then the same metrics were withdrawn.  An email from the CEO suggests that investors should ignore marketing costs because they can be scaled back at any time, which could sound like "managing earnings," assuming that Groupon had earnings.

With the powerhouse banks behind the deal, a deal will get done.  Lucky flippers will have a nice payday.  The Groupon model is not healthy for most restaurant businesses, but if this industry manages to get a footing, then it will take its profits out of the hides of their small business customers.  In the meantime, I can't wait to see which mutual funds wind up listing Groupon as 2% of their fund assets. An absurd valuation is now merely ridiculous. Caveat emptor!

Wednesday, October 19, 2011

Auditor Term Limits: Another Irrelevant Idea

Arthur Levitt, former SEC Commissioner, has weighed in favor of "auditor term limits."  This will do nothing but impose costs on companies, and, as usual, those costs will fall disproportionately on smaller companies which don't have armies of people in finance, tax, treasury and accounting.  As a stockholder, already facing meager returns, I wouldn't get excited by this proposal.

It will also add to SOX expenses for no value-added, as auditors will not agree on the identity and number of key controls, which in turn will lengthen audit committee deliberations, particularly for companies which are trying to remediate already existing weaknesses and deficiencies.

This foolish idea will not:

  1. Result in higher quality audits
  2. Reduce risk for institutional investors.
  3. Improve transparency or utility of financial statements produced by issuers.
  4. Make auditors work harder on existing engagements.
  5. Have any economic benefit beyond political window dressing.
Expect to see board expenses go up because of more audit committee meetings, legal fees go up for outside counsel reviews, and watch audit fees and SOX consulting fees rise also.

As we enter the campaign season, it makes for good headlines, though. 

Monday, October 17, 2011

Tsar Bloomberg's Free Pass to Occupy Wall Street

I have nothing but admiration for Mayor Mike Bloomberg as a successful entrepreneur, builder of a global business and as Mayor of one of the world's most ungovernable cities; but in his third term as Mayor, he has stayed on too long and appears to have lost any enthusiasm for the shin whacking necessary to exert leadership in Gotham.

Inviting the Occupy Wall Streeters to be our guest and see New York on "$10 a day" was irresponsible.  The dynamics since then mirror what happened on the Columbia campus during the strikes of 1968-69. What then began early as a quasi-student protest quickly got taken over by professional agitators with no investment in the University and loyalty only to their political agendas.  Columbia College, its professors and students, and the City picked up the tab, while the "movement" got its legitimacy.

Demonstrations in New York require lots of overtime for the Police and Sanitation Departments.  How is a strapped municipal budget going to absorb this expense? Now that the OWS crowd has expanded to include professional agitators, their supervisors and videographers, municipal expenses are going way up, and since there's no deadline for clearing out the demonstrators, the sanitation expenses will be ongoing.

The choice of Zucotti Park as a focal point for the demonstrators now brings in Brookfield Properties as another target, since Zucotti is not strictly a municipal park.  The brain trust for OWS made a good strategic choice, as the City and Brookfield will now be pitted against each other to see who bears what costs.

The Mayor's debacle with his Schools Chancellor and one of his top aides demonstrates that he has gone off his game and lost interest, and it's perfectly understandable.  However, passing the buck on dealing with this Sixties-style demonstration is an unnecessary affront to NYC residents, taxpayers and property owners.

As Wall Street execs arrive at work in their livery cars, I don't think they are giving OWS any thought beyond how to make a good trade on the news stories.