Tuesday, June 28, 2011

Cisco and Microsoft: Two Takes on Value

Two of my favorite value-oriented money managers as an analyst and investor are Tweedy Browne and Harris Associates, which runs the Oakmark Funds. Reading the managers' semi-annual report for the Oakmark Equity Fund for the period ended March 31, 2011, we see, "The quarter's largest detractors were Cisco Systems, Microsoft...We clearly have covered ourselves with something other than glory with our investments in large-capitalization technology companies. Cisco continues to suffer profit margin erosion...Microsoft's problems appear to be more strategic, and we exited the stock."

Tweedy Browne broke its somewhat long-held aversion to technology stocks when it initiated a position in Cisco. They wrote in their most recent report,"Cisco is financially strong and we think statistically cheap." In other commentary the managers talk about not being able to understand whose router technology will prevail in the market place, and they appeal to the cheapness of the stock in relation to enterprise value which it says gives them a 30% margin of safety relative to its intrinsic value. It is a dissapointingly tepid reason for buying the stock for a shop that I've always known to be confident about having done their homework.

What's tellingly missing from Tweedy Browne's commentary is any kind of endorsement of the Cisco management, either their track record, commitment to adding value, or their having finally got the "old time religion" about working for the benefit of shareholders. In the end, an equity investor is investing in management, and hopefully alongside of management if they had significant ownership positions themselves.

Cisco may be statistically cheap, and I know it shows up on a lot of value screens. However, I suspect that's how Microsoft looked to Harris Associates when they initiated their position. What made them give up? Problems of a "strategic" nature, which are the bread and butter of management: to formulate and execute a strategy that creates shareholder value above the cost of capital. It will be interesting to watch how these two bellwethers perform in the months and years ahead.

Friday, June 24, 2011

Arab Spring: A Columbia Forecast

The Columbia University Club of Minnesota sponsored a talk on "Change in the Ruling Systems of the Middle East." Richard W. Bulliett is Professor of Middle Eastern History at Columbia University. Given that his discipline was history, Professor Bulliett's context for his outlook began in the 11th century, but I'll definitely telescope a lot of that material. He had some interesting remarks about foreign policy issues beyond the current turmoil in the Middle East.

Arab governments do not generally attack each other. In 1991, this fundamental principle was breached when several Arab states gave assistance to the U.S. coalition in invading Iraq. At the same time, Egypt made peace with Israel. Bulliett sees these events as laying the seeds for the current unrest.

In the eyes of the Arab populace, this violation also de-legitimized the ruling systems of the states that provided aid to another foreign infidel, namely the United States. The most stable ruling systems in the Middle East are those based on the "neo-Mamluk" model. The Mamuluks were the slave-soldiers of the Ottoman Empire, primarily Circassians, Kurds and Turks. In the military tradition that took hold in the Middle East, military leaders came from the lowest social and educational classes, a totally different model from the elite models of Britain and the U.S., where leaders come from Sandhurst and West Point.

Once the neo-Mamluks come into power, their goal is to tap deep roots, through appropriating assets, government monopolies, and widespread nepotism. A kleptocracy is their modus operandi. That is how, for example, the Egyptian military controls most of the prime residential and leisure real estate in Egypt. Once the neo-Mamluks are established, their ideology is very flexible. They are relatively indifferent about secularism, Islamism, socialism, capitalism, or fascism, as long as nothing affects their finances and life styles. While both U.S. political parties may long for an nineteenth century ideal of a secular democracies in the Middle East, this is not even in the political calculus of the neo-Mamluks.

Unlike our Wall Street Journal narrative, Bulliet says that Facebook and Twitter were marginal as far as their impact on the Arab street demonstrations. Good communication tools, no doubt, but they were not the axes of any real revolution.

Mubarak's fate in Egypt was determined by Egyptian generals in a smoky, Chicago-style backroom meeting, though probably in a luxurious palace. "Free and fair" elections will not occur, but rather "credible" elections in which Bulliet says that the Muslim Brotherhood may even achieve a plurality. However, they too understand the rules. Don't go overboard with any reforms that bring the eyes of the world on Egypt, take the counsel of the generals and protect their privileges.

In the many parenthetical sidebars that occur in an academic speech, Bulliet notes that U.S. foreign policy careerists, advisers, consultants, and academics have no idea what is going to transpire in Egypt, or Libya or Syria, for example. That is pretty distressing to hear. He also notes that the Israelis too have no clue what is happening, and they too were totally blindsided by the events leading to the street demonstrations and regime instabilities. This goes against the self-perpetuating mythology of the all-knowing and all-seeing Mossad.

This means that President Obama's call for fresh negotiations between the Arabs and Israelis is hopelessly misguided. Given that the Israelis have no idea what the future political map will look like, they would be ill-advised and irrational if they undertook any substantive negotiations in the current environment.

Professor Bulliet says that the Syrian regime has maintained the highest degree of legitimacy in the minds of Arab peoples, despite economic paralysis and political uncertainty. The reason is that the Syrian regime is the only that is consistently viewed as being anti-American and anti-Israeli from 1991 through the current turmoil. The younger Mr. Assad may likely survive, and then he may embark on some reforms, but nothing will effect the portfolios of the military leaders who lend him their legitimacy. He is not so optimistic about Libya, because, among other things, Mr. Quadaffi has brutally pruned his own military in order to secure his own interest and that of his chosen successor. It looks like it may not work, but what comes after no one knows.

There have been some gains in issues we like to read about, such as women's equality in places like Iran. Fifty percent of the university population in Iran are now women. Their role and power, though, will hardly have changed unless these graduates emigrate. Iranian university students have read classics of the Western canon because they have all been translated into Persian by university faculty looking for reasons to make themselves relevant during the Khomeini ascendancy. By contrast, Bulliet says that no Western works are being translated into Arabic at all, and so secondary and university students in their schools have absolutely no exposure to Western thoughts or ideas, except as filtered through propaganda sources.

So, there won't be many buds on the trees in the Arab spring, and the summer won't be lush. There won't be an outbreak of democratic, modernist states. Bulliet says it may take FIFTY years for any movement beyond the neo-Mamluke model, and even then it may not be the secular, tolerant democratic model that we crave in the West. Not great news, but it's something that our politicians, academicians, intelligence community and citizenry need to understand and study objectively, beyond the lens of the Cold War and anti-terror.

Thursday, June 23, 2011

Parsing the Fed: Pass the Ouzo

I sat next to some pretty good Fed watchers at Merrill Lynch Capital Markets, and so I couldn't resist taking up my magnifying glass today, reading Louise Story's report in the New York Times. Fed Chairman Bernanke says "a disorderly default in one of those countries would no doubt roil financial markets globally." This seems like either big news or a faux pas.

Most of the press talk from the IMF, the ECB, global banks and rating agencies takes the position that any sovereign issuer default, by Greece, Ireland, Spain, or Italy, would be verboten because of the potential contagion. What Chairman Bernanke's statement says to me is that there is such a thing as an "orderly default," and that such orderly default would not roil financial markets globally. If he and others believe that, then there must be more going on behind the scenes than is public.

He continues, "It (a disorderly default) would have a big impact on credit spreads, on stock prices, and so on. ...I think the effects in the United States would be quite significant." Please hold that coffee, and get me an ouzo!

Echoing sentiments from our last post, Christopher Whalen of Institutional Risk Analyst characterizes the recent European deal announcement as "ridiculous." We then return to the world of derivatives markets, and we find Darrell Duffie of Stanford University opining that regulators "may not have adequately studied what contagion might occur among swaps holders, in the case of a Greek default." (quotation from NYT paraphrasing Duffie) Like the last crisis, it appears that we've learned nothing, and again no one seems to know what's at the end of the burning fuse.

Someone needs to come clean on this. The European Central Bank's statement that " This is much too sensitive...for us to have a conversation.." is totally inappropriate. Until then, our markets will be under downward pressure, as they are yesterday and today.

Monday, June 20, 2011

Euro Standoff: Not Good News

U.S. stocks are up this morning, after a confusing and contradictory hash of press releases from European governments, the IMF and private research groups. Germany has been calling for private bondholders to take their haircuts, for periphery governments to implement meaningful austerity, and finally for Germany to lead a bailout financed by the sovereign Euro-North and the IMF. Instead, nothing of any consequence happened this weekend.

The Centre for Economics and Business Research Ltd. forecasts the demise of the Eurozone by 2013. The IMF communiques chiding Germany's conditions for further bailouts seem wildly out of touch; they also speak to the value of having a non-European in charge of the Fund as soon as possible. The Greek establishment realizes that it many ways, it holds the cards simply because it owes so much to so many; why would investors expect meaningful action from them in light of the IMF's finding fault with the Euro-North countries for not being more accommodating?

It's virtually impossible to forecast the trajectory of a meltdown in the Euro-zone. All in all, how could it be good for the world economy and for stocks? In a perverse way, U.S. Treasuries could benefit again as a safe haven, the least bad of a lot of worse alternatives.

Thursday, June 16, 2011

More Virtues of Dividends

Jesper Medsen, CFA is a portfolio manager at Matthews Asia Funds, and he made some interesting points about Asian companies that pay dividends. Jesper noted that 20 Chinese companies whose shares were issued on foreign bourses have been the subject of recent financial scandals and frauds; only one of these companies paid a dividend. Having to pay a quarterly dividend, he feels, generally gives an investor like himself confidence that the accounting is a bit more reliable, simply because the company has to come up with the cash. He also notes that when he asks the managements of his Asian companies about their dividend plans and target payout ratios, he finds that these managements are much more focused on capital allocation, in part because of the discipline imposed by having to pay and grow a dividend. Good points indeed.

Reinforcing our point made in an earlier post, investor Ken Feinberg of Davis Funds argues at a Morningstar Conference that the huge cash balances of Cisco and Microsoft are somewhat illusory. Given the history of their managements' proclivities to spend foolishly on projects and acquisitions, an investor should look through these balances in making an investment decision. IBM, by contrast, seems to be better at allocating capital, despite having made some horrendous strategic decisions in the past. After the shakeups of Lew Gerstner, the company refocused and exited businesses like the PC, which it invented, because it felt that it could create much better returns elsewhere. Despite having lower cash balances that Cisco or Microsoft, IBM looks to many portfolio managers to be the better company and the better investment.

Rethinking Share Buybacks

One of my 2010 posts, "Black and White," has been generating quite a few views recently. In it, among other things, I discuss share buybacks, which are in the media again as the market swoons and companies have excess cash.

As CFO of Possis Medical, once our downsizing, business model realignment and strategic focus had taken hold, the company was generating substantial free cash flows, in excess of business needs. We decided to embark on a share buyback program, not for financial engineering purposes, but primarily to use some of the excess cash to offset dilution from options grants to executives and key employees as the company continued to grow. Unlike most corporate programs which are announced but expire unfulfilled, we bought back about 10% of the outstanding shares. It was a good trade overall too--we didn't buy high!

Especially for the companies in the S&P 500, whose stocks are hyper-actively traded in native and derivative forms, I'm not sure that buybacks are the best thing for rewarding all shareholders. Increasing the dividend, when stocks like Intel are already yielding almost 4%, may also not be the best, as then the new level cannot be reduced without price consequences. I believe that one-time, special dividends are a good answer to using excess cash and for rewarding all shareholders, those who stay and those who collect and move on later. Hawkins, Inc., a company whose board I served on as audit committee chair, used this special divided in a response to some positive, one-time events. The permanent payout level stays the same. I think that this tool ought to be used more often.

Thinking about the one-day announcement effects of a share buyback, behavioral market analysts have posited a good explanation. Shareholders are so relieved that their managements are not immediately announcing a mega-value busting acquisition, they bid the stock up in the short term! It's not an unreasonable explanation.

Wednesday, June 8, 2011

What Arab Spring?

I don't know who can claim coinage of the phrase "Arab Spring," but the phrase needs to be hit with weed killer because it's superficial, inappropriate and misleading. The echo of course is to "Prague Spring." But, let's take a quick trip back and remember what happened in 1968.

Alexander Dubcek became Communist Party leader in Czechoslovakia on January 1, 1968. What became the original Prague Spring began in April 1968 with an "Action Programme" of political, cultural and social liberalization. Dubcek's plans included a federalization of the Czech Republic into Czech and Slovak entities. Long moribund cafes, salons, and theater groups came alive. This looked like a long winter had indeed given over to new life. But, remember what happened next?

By late August, Soviet tanks rolled into Czechoslovakia and a very brief, Prague Spring ended! The real playing out of the historical drama took many years. Our journalists have created a narrative more akin to "Law and Order" than to 21st century politics. In a television drama, the bad guy goes to jail in 46 minutes. It didn't happen in Czechoslovakia and it won't happen in the Arab world.

Dubcek was replaced in April 1969 by Husak, the Communist Party leader to whom Vaclav Havel addressed his famous 1975 Open Letter, by which time a reform movement had started to resurface some seven years later.

In the Arab world, Tunisia and Egypt have gotten rid of their despots, and they would seem on the surface to be the states with some political, cultural, and political infrastructure to support modernization. But, in the words of Rashid Khalidi, the Edward Said Professor of Arab Studies at Columbia, "...despots have gone, but a real transformation (in Tunisia and Egypt) has barely begun."

We have no idea where the current process of sequential, out-of-phase, cycles of unrest will resolve itself. If Tunisia and Egypt have the potential to become roses, our positions in Libya and Syria may have us grasping nettles.

Groupon IPO: I'm Forever Blowing Bubbles.

Brett Arends of MarketWatch says he has waded through the 280 page prospectus for the Groupon IPO. Normally a fairly circumspect type when he wrote for the Wall Street Journal, he describes the transaction as "one of the most ridiculous things he's seen."

One fact he cites caught my eye relative to my earlier post on Ask Jeeves. Founded in November 2008, Mr. Arends says that Groupon has run up a total of $522 million in losses. Ask Jeeves had run up $765 million in losses two years out from its IPO. Groupon looks like it should surpass this pace, based on some of the basic statistics Arends presents for subscribers, purchasers, and conversion rates.

In a direct marketing business, executives and security analysts always looked to calculate "lifetime value" of a twelve-month customer, or a repeat buyer. In these Internet businesses, the difference between a subscriber and a purchaser gets glossed over, and since there is no barrier to entry for these businesses, and little "site loyalty" it seems impossible to justify the current valuations based on any reasonable hypothesis about lifetime value of their customers.

From its inception, Amazon put a great deal of emphasis on building customer loyalty and repeat business, and that was something that Jeff Bezos focused on as part of their identity. Now, with the Internet having become an overcrowded, noisy bazaar, it is going to be much more difficult to engender loyalty and sustained, repeat business.

I love the idea of Open Table, for example. However, I know that for a new restaurant, the economics of Open Table can be very onerous. I often use Open Table to see what's available on for a restaurant I've chosen, and then call the restaurant directly to make the reservation, saving the entrepreneur a few critical bucks. How does the Open Table model continue to justify its lofty growth assumptions? There are already competing systems out there, many of which are local.

It just feels like this euphoria for these types of businesses has to end badly.

Sunday, June 5, 2011

The Tech Bubble: This Time It's Different

The financial press shows up at investor conferences and picks up quotes from investors who are busy unloading their investments in social media companies and international search engines: "I don't think this is a bubble at all!" Boy, let's take that unbiased opinion to the bank.

The other refrain is that this group of companies have revenue and an "open business model." The first comment is irrelevant. At the multiples being paid by the IPO investors, the stocks are more than priced for perfection. I believe that an "open business model" means that the company hasn't yet decided on how it will make money. How do the IPO investors make money? Any hiccup in revenue growth or any delay in profitability and they take a shinai across the kneecaps. No, I'd have to say that all of this has an eerie familiarity.

Remember Ask Jeeves from the last Internet bubble? Here's some highlights from the web archive ( source: www.fundinguniverse.com):

  • Technology pundits and VC masters-of-the-universe laud Ask Jeeves' natural language search engine, and the ability to use full sentences for queries. Wow! Can a cure for cancer be far behind!

  • October 1998 searches per day at 300,000 and said to reach 2,000,000 per day by October. Probably every executive and their relatives had set their computers set to robo-query their site, but who's counting?

  • All this leads to July 1999 IPO.

  • Third most successful first full day trading in IPO history. Stock price soon hits $190 per share.

  • Company begins a spate of acquisitions: Net Effects, Direct Hits...can any reader claim to know what these companies did?

  • Revenues increase exponentially from $23,000 in 1997, to $800,000 in 1998, and $22 million in 1999.

  • Profitability relative to post-IPO projections is delayed. Losses reach $765 million in 2001.

  • Technology gurus and the next vintage of VC masters-of-the-universe declare that "natural language" based search is dead.

  • Ask Jeeves goes on life support, and is acquired by Barry Diller company for more than $1 billion.

  • Diller declares that Ask Jeeves has the potential to become "one of the great brands on the Internet and beyond."

  • NOT!

Perhaps there are some winners among the Class of 2011 IPO Bubble graduates, but what is different about their stories from Ask Jeeves? This year's version of the bubble has the additional complexity of foreign issuers registering in multiple markets, deceiving their own auditors, and the opiate of growing foreign markets for growth-strapped investors.