Sunday, May 29, 2011

More Reflection on Value

I got some good feedback from a reader about my comments on Microsoft and Google as value stocks. I had referred back to the original Graham & Dodd concepts, including the margin of safety. Today, I read an interview with Matthew McLennan, the portfolio manager of First Eagle U.S. Value Fund (Class A: FEVAX), which invests $1.8 billion in assets. The firm evolved in a long path from Arnhold and Bleichroeder, the distinguished German firm that once advised Chancellor Bismarck before opening offices in London. Eventually, the firm was bought and sold by Societe Generale, before Jean-Marie Eveillard launched First Eagle. Mr. Eveillard is a classic Graham & Dodd investor, with a long term, successful track record of attracting and investing assets using a disciplined process.

Matt McLennan describes the margin of safety in First Eagle's approach as paying no more than a single digit multiple of EBIT for quality businesses. He then distinguishes between commodity businesses and other businesses, and he understands the reasons for adjusting this upward to pay a bit more for franchise value, or the ability to command prices increases. Basically, he says that to avoid making arbitrary decisions about franchise values, he prefers to stick to the single digit EBIT discipline.

Looking at their portfolio, the large cash position mirrors the position of Sequoia Fund (SEQUX), another large traditional value fund using a Graham & Dodd philosophy. They have a significant exposure to gold, and some of the names, like Comcast, reflect strong cash flows and quasi-monopoly pricing power. Interestingly, the largest sector in the fund is technology, which includes Microsoft and Intel in the top 25. Intel is really a growth cyclical, and can be bought cheaply at low points in the tech cycle. First Eagle also owns Cisco Systems.

In response to my reader, a value investor can apply the margin of safety concept to technology stocks, in this case by using the proxy of a single digit EBIT multiple as a basic screen.

Thursday, May 26, 2011

A Chuckle From Ira Sohn Conference

Readers of this blog have probably become familiar with my long standing evaluations of wind energy, and to a lesser extent, solar energy. Now, I read that Jim Chanos, hedge fund titan at Kynikos Associates, made a presentation at the Ira Sohn Conference, entitled "Alternative Energy: Does Solar + Wind=Hot Air?" It drew a chuckle, something to be prized in the non-stop gloom of budget rants in Washington. His SBI (single best idea) was to be short Vestas.

David Einhorn of Greenlight Capital had a pithy evaluation of Microsoft, not inconsistent with the views expressed in our earlier post.

To some extent, the conference seems like an audience gathering on Fifth Avenue to watch a talented break dancing exhibition, but it sounds like there were some interesting presentations.

Friday, May 20, 2011

Soap Gets In Your Eyes

To paraphrase Alan Greenspan's Congressional testimony from a few years back, "You can't spot a financial bubble until you've got soap in your eyes." IPO markets are notoriously inefficient, and so it seems absurd to look at the current spate of IPOs as a measure of market health.

As an institutional analyst, I had lots of good customers who were portfolio managers at FIMR (Fidelity). I always learned something from their questions, which were rarely rote or predictable. I was wrapping up a presentation to one Fidelity's longest serving and most distinguished value fund managers, when we started talking about the IPO of the day (I forget the issue in question). The company's valuation was as absurd as those of the current Chinese social media networks and Russian search engine companies. The frenzy and the race to demand a share of the IPO from your favorite institutional salesperson was on.

I made a comment to the effect, "Well, I know this is a game you're not involved in!" The portfolio manager looked at me with some understanding and said, "Eapen, if someone standing on the street corner is handing out free Swiss candy that I can turn around and flip for a riskless profit, I should take it, right?" I was non-plussed, but it was an "Aha!" moment for me. This was early afternoon on the IPO day. I asked, "Have you flipped your allotment already?" He said, "Yes." It all made perfect sense. A totally inefficient market, under priced on the front-end from the company standpoint, and fuelled by P.T. Barnum psychology. A profit, is a profit though; the annualized rate of appreciation the Fidelity PM made on his stake was a nice bon-bon for his monthly portfolio performance.

On the flip side of the "New Tech" bubble are references to "value stocks," like Google and Microsoft. Value stocks in the Graham & Dodd parlance were selling below their fundamental, tangible asset values, with a "margin of safety." Railroads, for example, had huge assets in rolling stock which had an active secondary market, and which ultimately had scrap metal value in the worst of all cases; they had enormous real estate assets and rights-of-way. Those kinds of stocks with a margin of safety were real value stocks, where the company was selling well below its liquidation value. I confess to not knowing about Google's business or valuation, but it's not a Graham & Dodd value stock; it might be a "fallen angel," or "GARP," however.

Microsoft is another question altogether. Microsoft reminds me now of an AT&T type monopoly utility, just before the advent of wireless telephony. It may be a value stock, or it may be a value trap. The overpaying for Skype seems to be another knee jerk transaction by a management with a mediocre record of creating value. Perhaps it's different this time. Or, as the soulful Ronnie Milsap sang, Microsoft investors may be "Lookin' For Love in All the Wrong Places."

Monday, May 16, 2011

Shareholders and Corporate Blah Blah Blah

In the headlong rush to establish shareholder primacy in public companies, hedge funds and activist investors have been given license to improve returns at a company, often by forcing a transaction; in other cases, they have managed to vivisect a company for flawed financial strategies. Now, we have another madcap rush to subject "corporate speech" to shareholder vote and approval by another privileged class of shareholder. A recent article by Jackson and Bebchuk lays out the issue and recent SEC decisions.

Lets see: shareholders elect a board of directors, which appoints a management to operate the company on a day-to-day basis, under their direction, for the benefit of stakeholders, especially the shareholders. Let's say we're talking about an oil company, and that company forms a PAC which, among other things, supports efforts to extend offshore drilling rights where the company has a lease on an extremely valuable property with extensive, low cost reserves. Gaining the drilling rights are part of a process that should add EVA to the company's shareholder returns. Now, if a small, but vocal group of shareholders decides that this is a bad thing because of potential environmental damage to the rufus-sided towhee, then this decision is subject to a proxy discussion, with all its dead weight expense loss and diversion of management time. This is a good thing?

If a management's efforts were to go overboard, away from the interests of the corporation to peripheral issues, the first check and balance would be board oversight. What conceivable value does this other channel add for ALL the shareholders, not just the special interests? The management's job is make hundreds of related and seemingly unrelated decisions that over time will serve to generate value for the suppliers of its assets. That's it...isn't it? Other than generating more fees for proxy advisers, law firms, and killing more trees, these measures are not worthy of good governance efforts.

Tuesday, May 10, 2011

Dilute Carbon Capture: Great Idea, Not Ready for Prime Time

The American Physical Society released a study on direct air capture (DAC) of dilute atmospheric carbon using chemicals. It's a very interesting idea being put forward and supported by faculty and scientists of Lamont-Doherty Earth Institute. The report, unlike some others, is clear, thoughtful and not overtly political. One of the killer points against the technology is buried towards the back: in terms of net carbon saving, a DAC plant couldn't run on a high carbon fuel (coal, oil, natural gas) unless that plant has a carbon capture system itself. Otherwise, we would be chasing our own tail adding carbon from burning fuel in order to take dilute carbon out of the atmosphere.

As the press clamors for Japan to switch from nuclear to "renewables," we have to take a reasoned, pragmatic, and holistic view of reducing carbon emissions. One way which seems to have some irresistible logic would be to somehow place a price on carbon emissions ($40 or so per ton has been mentioned in early literature). Without some sort of benchmark, it is very difficult to project a commercial future for exotic technologies like DAC.

Saturday, May 7, 2011

Higher Education and Financial Flimflam

The Wall Street Journal says that the Class of 2011 will be the most indebted in history,with average indebtedness of $22,900. Actually, given the long standing estimates of the lifetime earnings advantage of a college education, I don't have a great issue with the average. I do, however, have a great deal of issue of the total lack of any scrutiny around what constitutes the "higher education," which generates that indebtedness.

In my parlance, what used to be called vocational schools, or technical ed schools have now substituted the word "College" in their names, probably driven by marketing and financial types. Former colleges have now substituted the word "University" in their names, and nothing has changed from when they were merely colleges. Online institutions advertise on late night television and infomercials about their ability to let you earn a university degree in your pajamas. The last time I tried to look at some of these offerings, I couldn't even figure out who the faculty were or where they earned their graduate degrees. Meanwhile, what all of the Presidents realized is that in the realm of higher education, there is no need to compete on price.

So, if it costs $45,000 a year to attend an Ivy League university, it should shock no one that it costs almost that much to attend Lake Winnipausaukee University. If a graduate ends up with $29,000 in debt for graduating from Yale, that's one thing; the same amount of debt from the Joshua Tree State University is quite something else. The lifetime earnings prospects of these two graduates are quite different.

What Federal agency is in charge of looking into this flimflam?

Thursday, May 5, 2011

Bon Chance, Justice Chandler!

Craig Mellow, in this quarter's Board Member, has written a thoughtful piece on the retirement of Chief Judge William Chandler of the Delaware Court of Chancery. When I was an equity securities analyst, I read many of the cases coming out of the Delaware Court, since most of the companies I followed were Delaware corporations. Subsequently, as a public company Director, I read some of the rulings like the Disney case on the Michael Ovitz severance package, through a different lens.

I have to admit that I bristled at the Disney opinion, in which the board was adjudged to have followed a reasonable process, been given sufficient information, and to have exercised reasonable business judgment in awarding Ovitz a totally outlandish severance which raided the corporate coffers and diminished the corporation's reputation. However, reading through the decision, it followed the standards of the business judgment rule as I understood it. As much as I viscerally disagreed with the equity of the ruling, it wasn't at all unreasonable.

Some of the madcap polemics now about shareholder rights does strike me as unreasonable, though. In our fractious and uninformed style of public debate, these issues are being framed as either "anti" or "pro" something. Shareholders cannot and should not be protected from bad business decisions by judicial fiat. They are at the bottom of the capital structure by design, and they accept this arrangement by choosing to buy common shares. If things go well, they can enjoy outsize rewards. Should bondholders sue in the name of fairness? "What about us?" could they say? No, they chose an instrument that put their claims at the top, and for this seniorty of claim, our system measures out for them a fixed return.

If shareholders aren't paying attention, or have misjudged the risks or misjudged the character of management, well, that's why capital losses can be offset against capital gains.

Chancellor Chandler has the qualities one would hope to find were we to appear in front of a jurist: intellectual acuity, technical knowledge, an ability to listen, thoughtfulness, a sober demeanor, the ability to integrate information from a variety of sources into a logical framework, respect for legal continuity and tradition, and abiding humility in the face of the jurist's own power over those appearing at the bench. I haven't come across this combination often, but U.S. corporations and their shareholders should be grateful.

Tuesday, May 3, 2011

What Happened to Economics?

Professors Marion Fourcade and Rakesh Khurana published a recent Harvard Business School paper on what they see as the United States model of graduate business education hijacking the discipline of economics into the model for corporate control in large industrial companies. The idea continues those expressed in Khurana's excellent book, "From Higher Aims to Hired Hands."

It got me thinking about what I see in an MBA "Investments" course I'm teaching this term. I have a slightly different take on what's happened with Economics, which is my academic discipline. Most of the foundational theoretical work in what's called Modern Portfolio Theory, Multifactor Models, Capital Asset Pricing Model, or Fixed Income was done by classical economists, from Macaulay to Lintner, Sharpe, Tobin, and many, many others. However, this work was not considered "financial economics" in college or graduate school, but all of this work was integral to microeconomics, theory of the firm, asset pricing or traditional modules within the economic toolkit.

I believe that the business schools, driven by the Ford Foundation and others as Khurana points out, merely lifted these modules out wholesale and cobbled them together into what is loosely called "Investment Theory," "Financial Economics," or "Financial Theory," taught in business schools.

This has had two effects. First, what is left in the economics curricula is insufferably dull, like national income accounting, and without the foundational framework expressed by Samuelson, Hicks, Solow and many others. Economics is rightly considered mind-numbing, because much of the meat has been picked from it. Secondly, the part that has migrated to the business school curriculum is applied mechanically and without any of the political economy or welfare economics focus that give the techniques meaning.

A real attempt to erase economic illiteracy in our children and populace would help stem abuses like dolloping out unsecured credit like crack cocaine to vulnerable segments of our population. It would help our young students look prudently at the inefficiencies and inequities in our higher education system. Some of the Federal Reserve banks have started making economics education part of their community charter--that's a great idea.