Tuesday, January 31, 2012

Economic Expansion and Access To Credit

There's always a suggestion that banks' reluctance to lend has been a factor in lackluster GDP growth.  Domestically, leading middle market lenders like Wells Fargo have said that their better tier clients are flush with cash and don't need access to credit.  The issues for bank customers are risk aversion and a lack of confidence.  Wells Fargo said that middle market commercial lenders would generally like to grow their asset bases.

Now comes an interesting study of export behavior in Peru, based on an analysis of real-world customs data from that country.  Professors Paravasini, Rappoport, and Wolfenzon of the Columbia Business School write:
"Out of the total decline in exports from Peru, only 15 percent was driven by credit shortages. The other 85 percent was due to a drop in consumer demand. “Our 15 percent figure is a lower bound as it refers only to the decline in exports due to lack of finance to exporters. Finance can have a bigger impact as it surely also affects importers at the other end,” Wolfenzon says.

While trade is clearly based on supply and demand, it’s important to understand the relative importance of these both forces. To this end, Wolfenzon suggests a general takeaway. “The Peruvian government could not have done much to improve the country’s export performance,” he says. “The problem was a lack of demand from importing countries.”

Weak demand from developed countries in the United States and Europe is and will continue to be the issue for the resuscitation of the global economy.  On the domestic side, whether for the production of goods for domestic consumption or for exportables, the issue continues to be weak demand and a lack of business confidence.  Lack of access to credit doesn't seem to be the big issue.

Monday, January 30, 2012

Jeffries Sees Little Inflation Risk

Ward McCarthy's group at Jeffries, commenting on the latest FOMC communications, noted the following:

"Also, by setting a long-term target for unemployment of 5% to 6%, the FOMC is also acknowledging that labor market conditions are not likely to improve enough to allow inflation to take hold for years. YoY average hourly earnings have held to a range of roughly 2% to 4% for the past thirty years. Historically average hourly earnings have not moved toward the upper end of that range until the unemployment rate is below 6%. With the unemployment rate at 8.5% and average
hourly earnings growth at 1.9%, there is a long way to go before labor market conditions will support a persistent rise in inflation."

Good news for holders of financial assets, particularly bonds, but not good news for middle class workers and for new entrants into the workforce.  Ironically, just when the risk-reward profiles for most corporate investments are also getting a boost, CEO's continue to be reluctant to invest in new product development and market expansion, according to McKinsey. 

Capital investment against this kind of labor market backdrop would have the potential to raise labor productivity, which would be good for both earnings of the corporation and its workers. If productivity picked up, then a rise in earnings would itself not have to be inflationary. The difference between projected GDP and potential GDP levels is considerable.  There seeems to be little potential for energy or commodity driven inflation either.  So the difference between nominal and real returns will also be small.  There's little room for a rise in inflationary psychology either.

Going into the cycle, executive compensation schemes probably induced too much risk taking, especially in financial services.  One wonders whether we've flipped psychology on its ear.  By cutting expenses, standing still and using excess cash to buy back shares while not having a long term vision for creating value, perhaps some of those same CEO's are being too risk averse here.  

Sunday, January 29, 2012

A Sanguine Consensus From Investment Experts

The Minnesota Chapter of the Association for Corporate Growth co-hosted its annual forecasting dinner with the CFA Society of Minnesota, and it was a full boat with about 450 people in the audience. 

The investment recommendations too were things I have heard before from Merrill Lynch's CIO list to many others.  The Fed's recent pronouncements may have taken the edge off investors skepticism.  The recent uptick in 4th quarter GDP, which brings output about equal to pre-recession levels seems also to be making investors less glum. 

Fourth quarter earnings season has been mixed, so far.  GE's announcement about its core industrial businesses was disquieting. Other industrial companies have fared better, especially on the top line.  I wonder if some of this wasn't timing of orders. 

Dean Junkins, the Chief Investment Officer of Wells Fargo Private Bank noted some interesting facts about the strength of corporate balance sheets.  A consensus equity recommendation is that investors hold a large stake in dividend paying stocks, either with a high dividend growth rate or with a high yield and a sustained record of increases.  Even with the strength of dividend increases in 2011, Junkins noted that the overall payout ratio for SP500 companies is at its  lowest levels in 140 years!

On the fixed income side, another consensus recommendation is to include high quality corporate debt, and indeed there are several funds which have been in this strategy for two years already, enjoying substantial gains.  Higher quality High Yield (an oxymoron?) also got the nod from participants as a quasi-equity play and as a source of additional income for a portfolio.

According to one panelist, in 2007 there were $20 trillion in high quality credits worldwide which would be considered qualified investments for large institutional accounts.  Today, the panelist said, the number is now about $12 trillion in high quality credits.

It's surprising how the outlooks all seem to converging around the same central tendencies.  That's usually a cause for concern.  The argument for high yield debt was made from the point of view of spreads and of default rates.  Europe was something to be monitored, but no panelist felt that a Euro nation bankruptcy was in the cards. Investors are piling out of commodities, which suggests a benign inflation outlook.  Pretty sanguine again.

Volatility and correlation among asset classes will likely remain high.  This, coupled with an almost zero cost of funds, suggests that high turnover, risk-based strategies should be where the really money is made.  Some commentators mention that corporate cash and the low cost of debt will help fuel mergers and acquisitions in the first six to nine months of the year. 

The old saw goes, "the market climbs a wall of worry."  If that's true, I didn't hear any worries from this panel.

Schools Can't Force Better Choices on Students

Schools have been enlisted into the vanguard of society's fight against obesity, by revamping their cafeteria  lunches.  Cafeteria managers are being told to eliminate "fast food options" and to substitute healthy alternatives, whatever that means.  The first problem has been that the customers don't like the changes.  Newspapers  report of students rebelling against their tofu wraps with Swiss chard.  They taste  "yukky," and students don't eat the stuff. Those with cars head out to Subway and smuggle in contraband.  The costs for the new menus are, of course, higher, since the food service companies have developed their lowest cost options around the traditional fare, which has been in place since I went to school.  A chicken nugget is a chicken nugget.  Pizza continues to be a "go to" alternative, because it is the number item in "food away from home," even though we all know it has too much fat, too much salt, and too many carbs for a balanced diet.

Now comes the worst news from social science research: exposure to nasty foods like sugar-sweetened colas, candies and snacks during middle school has a statistically weak and insignificant relationship to weight gain among these populations, regardless of ethnicity, gender or income, in a longitudinal study

Students are already taught in a variety of courses--nutrition, health science, biology, conservation--about the costs of our food system and about the perils of too many calories from sugar, fat and meat.  Regulating their food over the relatively small number of food interactions the students have over a calendar year apparently doesn't have a discernible effect. Let's stick to the academic route, improve the alternatives without putting off the customer, and hope that the current generation starts to make better choices when they are out of school. 

Thursday, January 26, 2012

Two Faces on Private Equity

source: yahoo.com/movies.  Batman Forever
Warren Buffet's terse characterizations of private equity investors in his shareholder letters were on point: he portrayed bad PE actors who destroyed companies by drowning in them in debt while sucking blood out in management fees and special dividends.  Today's Star Tribune trots out the case of Buffet's Inc., which was beset by a predatory private equity group which also sucked blood out of a turnip and put the company into bankruptcy for the second time. 

So, as part of the  Presidential re-election propaganda machine's aiming at Bain-alumnus Romney, voters can  conclude that all  private equity firms are vultures, no investments ever add jobs, and all just feather the nests of billionaires.  It's certainly a great mantra for election time.

Now, however, go to the interesting case of Calpers, the monster public employee retirement fund of California, which is an institutional gorilla that can command preferences in the market place, but which is also deeply caring and crusading against all forms of corporate opacity, fraud, social insensitivity, environmental degradation, inappropriate political speech, and so on.  Calpers is just like Tommie Lee Jones' character "Two-Face" when he was a crusading district attorney. 

Ironically, many public pension funds are now plowing into alternative investments, principally private equity, chasing the performance enjoyed by Calpers in 2010 when private equity was their best performing asset class, returning 21.5%  and bringing AUM to $226 billion.  On the Calpers site, it appears that in their measurement system, all vintages of private equity investments have returned positive IRRs since their inception.  So, as investors(left side of Two-Face), Calpers is happy to take the outsize returns, but as crusaders for truth and justice, they are his right side and madder than Hades. 

So, which is it?  Private equity investments do create value and sustainable employment. They do no always employ slash and burn strategies in their portfolios.  Some firms, as we know, are bad actors.  Public employees, fresh from their Occupy Wall Street and other protests, can enjoy their enhanced returns from private equity.  It is amazing that Candidate Romney, who above all can speak knowledgeably from experience, about private equity, chooses not to educate the electorate with an informed and balanced view of private equity's role in corporate development. 

How to get justice for private equity?  How about flipping a coin?

Monday, January 23, 2012

Euro Sovereign Bond Investors Get a Raw Deal

IMF Managing Director Christine Lagarde, speaking in Berlin, said, "It (stepping up to a bigger bailout fund) is about avoiding a 1930s moment, in which inaction, insularity, and rigid ideology combine to cause a collapse in global demand."

These profound insights are said by the Wall Street Journal to constitute a "dire" warning.  We've been talking "dire" since last summer.  I must say that before watching the behavior of sovereign bond investors, I had always thought of bond investors as being more the "green eye shade" types than manic-depressive equity investors.  Now, I'm not sure at all. 

European sovereign bond investors, particularly Greek bond investors, include many European banks.  They are apparently willing to accept interest rates on new Greek bonds of 3% max, with a fifty percent haircut on the principal value of their old bonds, plus some unspecified higher rates in future years if the Greek economy does better than a baseline number.  The IMF and the ECB have drawn a Maginot Line at 3%.

My question is the following: why on earth would any rational investor take a 20-30 year risk for 3% from a country that will not realistically ever be able to repay? The investors must not have any realistic mechanism for pursuing a default, but it's probably more rational to bite the bullet now, take the write downs, file perfunctory lawsuits, and wait and see what the ECB would do. The banks would be short regulatory capital, but it's hard to see the IMF, ECB and other alphabet soup regulators pushing the banks over the edge; that would be bad for everybody.  Someone has to lend Greece money, but surely a 3% rate is irrational.  Who's going to win this game of chicken?

The longstanding low interest rate environment which central banks have institutionalized globally has completely distorted capital prices, forcing investors to take more and more risk in search of returns.  For example, stories abound about hedge funds that leveraged their Japanese sovereign bond purchases at three-to-one yielding them an annual return of 12.5% per year; the lenders who gave the money to the hedge funds didn't earn very much for taking this risk. 

C. Fred Bergsten, formerly of the Brooking Institution and late of the Peterson Institute for International Economics ("PIIE")  predicts that European leaders will dither until the last minute, pull a rabbit out of the hat, end the euro/Greek/European periphery crisis and Europe will emerge from the crisis "much stronger."  I've followed his work since I was a graduate student, and he has thirty years of professional and emotional investment in the euro currency experiment.  If the bondholders are irrational and give in, nothing fundamental will have changed: the weak players in Europe will still be weak, will be further eroded by ongoing recession and debilitated by internal political crises. 

When MD Lagarde talks about rigid ideology and a collapse in global demand, that is very disingenuous.  The growth in demand was driven by artificially low rates and the ability of EU periphery countries to borrow with impunity while running fiscal deficits in violation of their treaties.  Now, the absurd suggestion is put forward that Germany should run fiscal deficits in order to purchase goods and services from Spain, Ireland and Greece.  Not agreeing to do so would be "rigid ideology," according to the IMF. 

PIIE authors Boone and Johnson take a more normal economic approach to the crisis, suggesting that it has to deepen unless ongoing fiscal issues and bank insolvencies are addressed.

If the bondholders are irrational enough to go along with this charade, then I might just go and rip up all my teaching materials about the Capital Asset Pricing Model and Efficient Market Theory.  This stage is not filled with economic actors, for sure.

Saturday, January 21, 2012

Shiny Pennies in Microsoft's Quarter

We wrote in July 2011 about how Microsoft shouldn't give up its foray into search with Bing!  Looking at the most recent quarter, the WSJ notes a few items from the corporate earnings release:

  • Revenue for the company's servers and tools products, which form the backbone of enterprise networks and private clouds, jumped 11%, as the unit's income improved 17%.
  • At the business division, which earns most of its sales from Microsoft Office, sales rose 2.8% as profit climbed 1.6%.
  • Sales at the entertainment-and-devices business, which houses the top-selling Xbox video game console--advanced 15%.
  • In online services, revenue climbed 10%. Microsoft has invested heavily in the unit, launching a splashy advertising blitz last year to promote Bing, which is the second-most-popular search engine in the U.S. behind Google, according to comScore Inc.
The market focused on the negatives of slower PC shipments and on slowing sales for disc-based Office.  We know, we know!  Servers and tools, whether for the cloud or not, are critical, along with the related consulting services, for corporate IT's support of global business, and Microsoft is clearly a player.  Xbox has become a solid platform from which to run family entertainment, television, and multimedia.  Finally, Bing which was to have been sold off according to Wall Street wisdom, is now a distinct and viable number in two in search engines.

We also wrote recently on our perceptions about Windows 8, which if successful should begin a meaningful cycle of laptop replacement for machines that can optimize the new operating system. 

The stock has had a terrific run off the financial crisis low of $16 or so, but it continues to bear watching. 

Good News From Ecolab

Back in July, we felt that Ecolab was being overly conservative about potential 2012 synergies from the integration of Nalco.  We wrote,

"Nalco management gave itself a target of $75 million in annual cost savings from streamlining its operations. Nalco recently embarked on a hub-and-spoke operation for its water treatment offices in the Midwest in order to squeeze smaller, local and regional competitors. This build out can probably be stopped or reversed to fit into Ecolab's structure, depending on the most efficient way to serve the new customers. Nalco also looked to enhance its sales people's offerings by partnering with companies like U.S. Filter and Johnson Diversey. These partnerships can either be scaled up, or rationalized with Ecolab's partnerships. Buying power is now substantially enhanced. ECL management is looking for $150 million in synergies, of which $30 million are said to be gained in 2012. If Nalco's targets of $75 million were real, then the $30 million should be a slam dunk."

In last week's news release, the company gave detailed adjustments to their earnings forecast for 2012 and for the effects of the post-merger restructuring.  The company noted, "...Ecolab has increased its cost synergy target for 2012 to approximately $75 million from the previous forecast of $35million."  It seemed fairly obvious that Ecolab's first estimate was too conservative. 

The company also acknowledged the benefits from the combined purchasing power of both organizations.

There was also a trade journal release about the sales forces of both Ecolab and Nalco winning awards for the top rated sales organizations to sell for. Back in July we also noted that ultimately the success of this merger wiould rest on the effectiveness of the combined sales force.  We take this as a confirmation that the integration of two strong sales forces shows great promise and longer-term upside. 

Overall, the financial update to 2012 estimates is very helpful for analysts in building their models to account for all the moving parts, including restructuring charges, other one-time items, share buybacks, and tax rates.  Everyone is suggesting headwinds on raw materials prices, so this shouldn't be a negative surprise to estimates as the year unfolds.  This company makes it easier for analysts to develop their GAAP and non-GAAP estimates of corporate performance, which is a judicious use of effective disclosure. 

Wednesday, January 18, 2012

Picking A Mutual Fund: The Madness of Crowds

I was reviewing the New York Times mutual fund performance tables, which are based on Morningstar performance numbers, and then I went to Smart Money and used their screen to find the "best" Large Cap Core equity funds, based on one-year performance.  I hardly recognized any of the funds.

There are some well demonstrated propositions about mutual funds and about retail investor behavior:

  • Most mutual fund managers under perform their indexes, with the number ranging from 60-70%, depending on the study.
  • The top performing asset class (high yield bonds, Treasuries, large cap equities) in a given year generally doesn't show up as the top performer in the following year.  Even with randomness in returns, runs of top performance do occur, as with international equities were the top performaing asset class from 2004-2007.  As they say in the boiler plate mutual fund disclosures, "Past performance is no guide to future performance." 
  • All things equal, it's immensely more difficult to achieve stellar performance with a jumbo pool of assets than with a small pool of assets, assuming the manager stays within investment policy guidelines. 
With these in mind, it's also well established that:
  • Retail investors rarely know why they are buying an individual mutual fund, and they almost never look at an asset class in the context of their total portfolio risk and return.
  • Since they don't know why they bought a fund, they usually sell when there is a period of under performance relative to the market, even though their fund manager might be pursuing a proven, consistent strategy which historically wins over time.
  • When they sell, they chase performance and pile like lemmings into the hot performing mutual fund based on historical, not expected returns.  This is what happened with the Fairholme fund.  
  • So, individual investors sabotage themselves and benefit only their brokers with high turnover, usually incurring fees.  
Over past five years, the market, as measured by the Fidelity Spartan 500 Index Institutional Class fund, was up 0.20%, the benchmark for large capitalization funds.  The Fairholme fund was up 0.30% over the five years, with assets of $6.9 billion, according to the Morningstar data reported in the NY Times. 

The American Funds Growth Fund of America, with $53.2 billion in assets, a popular large cap offering in defined contribution plans, turned in a comparatively lackluster performance, gaining 0.1% per annum over the five years, despite having experienced managers, a consistent philosophy, and a good infrastructure to support the investment process.  

The Dodge and Cox Stock Fund is also a fund that I've used in corporate plans as well as in SEP plans: it posted an absolutely dismal -3.30% per annum loss over the trailing five years compared to a broad market which averaged 0.2% per annum over the same period; the fund had $36.6 billion of assets managed in the strategy.  We've talked about the firm in other posts, noting that their funds have low expenses, long management tenure, a very consistent investment valuation process, a value orientation, very low turnover, and the lion's share of partner assets invested in Dodge and Cox funds. These are all critical factors for me as a personal or institutional investor.  Even so, mistakes happen or the index's performance itself can diverge from fundamentals; the five and three year performance numbers are not good.  With this kind of fund and others, if an investor believes that the strategy, portfolio management, valuation process, and corporate culture are still consistent and robust, then the poor historical performance may be a good buying opportunity looking forward.  This is the opposite approach to chasing performance.

If an investor were chasing performance in the large cap core equity fund, a good choice might be Sequoia, which we've written about before also.  The fund's average annual rate of increase was 4.30% for the past five years, with $4.9 billion under management.  The fund, which had high cash levels for several years, finally redeployed much of the cash and diversified the portfolio; however, the formerly large cash position had insulated the fund's relative returns during the financial meltdown, which in turn helped attract yet another huge inflow of investor cash, giving the portfolio managers a new challenge in how to reconfigure the portfolio from here.  Ruane, Cunniff and Goldfarb, the investment management company, have a long and distinguished track record, and they'll figure it out to the benefit of shareholders.  

Fidelity had two funds worth noting, for different reasons.  Magellan, which was the original mutual fund darling of the financial press from Peter Lynch's tenure, returned -2.70% per annum for the five years, with $12.9 billion in assets.  This fund, once the core of Fidelity's offerings, has gone through too many manager changes, along with significant instability in the portfolio strategy, design and investment process.  NYU Stern's Antti Petajisto, used a measure called "active share" to identify fund managers he called "closet indexers,"  who charged high fees in relation to index funds for essentially mimicking the index.  Magellan under a previous manager had been a closet indexer for several years, a far cry from its history as a growth fund with a value orientation and strong stock selection.  

On the other hand, Fidelity's Contrafund returned an average of 2.80% per year over the five year period, compared to 0.20% for the Standard and Poor's Index.  Remarkably, it did this on an asset base of $54.7 billion, with the portfolio manager Will Danoff probably managing around $100 billion in total assets for Fidelity.  Will Danoff was a great analyst who became a stellar portfolio manager.  He clearly can develop and deploy a strong supporting team of analysts and portfolio managers to help him deliver results with the appropriate level of risk.  This is way too much money to manage with a "Lone Ranger" approach used by managers we've all read about.   The cultural problem at Fidelity seems to be that success or mediocrity with a fund seems to rest less with Fidelity's organizational strength and culture than with the abilities of the individual managers.  This makes it tough for the individual investor, especially the trend driven one.  

disclaimer: Nothing in this post should be construed as investment advice or as a recommendation to buy or sell a particular fund or family of funds.  I have recently taken a small position in DODGX, but do not have a position in any of the other funds mentioned in the post. 

Tuesday, January 17, 2012

Smug About Europe?

Bret Stephens in the Wall Street Journal has a witty, barbed piece about the recent cruise ship sinking as a metaphor for the sinking of a politically mismanaged Europe.  Readers of this blog know that I've been a skeptic on the notion of European political leaders Merkel and Sarkozy being able to rescue the flawed euro concept.  However, my approach has been to look at it through the regular analysis of political economy.   Unlike Stephens, I don't see what's happening as an indictment of the welfare state or of the flawed economic model there.  We seem to be evolving in a similar direction. We have no reason to be smug, given our lack of any political leadership and our failing institutional memories.

Four years into the global meltdown, we haven't reformed our financial system, and the leaders of the system which brought world markets to their knees continue in place with the healthiest compensation among all public company executives. Instead of any meaningful reform, we have the regulatory spaghetti of Dodd-Frank. Our state government finances are a mess, and the issue of their pension liabilities remain unresolved.  We haven't figured out how to regulate derivatives.  Things are so bad in housing that the Federal Reserve is coming up with a white paper on how to fix an economic sector.  No, whatever is happening in Europe was quite predictable, but we have absolutely no reason to cackle.  Our financial markets are doing better mainly because they continue to profit from being a safe haven as participants try to insulate themselves from a European currency meltdown.

Thursday, January 12, 2012

Microsoft Making A Move?

Microsoft's stock price performance over the past 3 and five years has about equalled that of the SP500, while it trails that index significantly over ten years.  Any way you look at it, the share price performance has been dismal, except as a trade here and there. 

My most recent posts took the position of not "piling on" as market negativism suggested some foolish strategies for the company to take.  Microsoft has  kept plugging away, to their credit.  I got a recent, contrarian data point on the company from a very small, well regarded tech service company in the Twin Cities.

This kind of company is usually way below the Microsoft radar screen, and of little interest to their partner development marketing efforts.  This time, as I was retching about the performance and vulnerabilities of Windows Explorer on my machine, the tech was extolling the virtues of the upcoming Windows 8.

I sharpened my verbal knives and talked about my experiences with Windows ME, Windows 97 and so on.  I don't think it was therapeutic to get my blood pressure up, and the tech kindly interrupted me to talk about how totally different in look-and-feel, functionality, design and performance Windows 8 was going to be.  He wasn't proselytizing yet, but he said that it was going to be "one of the best things the company had ever done."  This definitely got my radar up, because it was not coming from a Microsoft fan, to say the least.

Right around the same time, there was an item on Bloomberg News about Steve Ballmer's leadership of Microsoft, and about how the company had changed, along with Ballmer's leadership style.  It also made the point that Ballmer had totally turned over many levels of the company's leadership since founder Bill Gates had stepped back from day-to-day leadership at Microsoft.  Hmm.

It wasn't long ago that Windows Mobile was having scorn heaped on it.  However, most recently industry trade journals have reported estimates of Windows SmartPhone sales from Nokia and HTC projecting Microsoft mobile operating systems into the number three position behind Android, and Apple. Considering where Microsoft was, this is remarkable.  It also suggested that the product was developed under a completely new paradigm, with development groups sharing information and assets, rather than protecting their own empires.

So, it might be time to freshen up how one thinks about this company.  The one announcement that still gives me pause: Microsoft retail stores competing with Apple stores.  Apple's customer experience in their stores is without peer.  Best Buy's mobile stores are very mediocre, and they have a retailer's DNA.  Microsoft is a tech company that might finally be regaining its footing after years of stumbling around blindly.  I would be very wary about the leadership team for the store project, and how such a foray in retailing will be executed before getting excited about it.

Tuesday, January 10, 2012

Reforming the Auditor Payment Model

The Public Company Accounting Oversight Board's Chairman James Doty made a speech last December entitled, "Auditing in the Decade Ahead: Challenge and Change."  As someone whose career has involved using and issuing public company financial statements, I find the current reform discussion a bit arcane. We have lawyers in Congress writing abstruse regulations which are translated into plain English for managements by in-house or external SEC lawyers; we also have accountants at the PCAOB auditing the work product of the audit firms, all the while engaging in non-value added, tit-for-tat debates. Small companies bear a disproportionate burden from all of this alleged reform, and it's not clear that these procedural and process reforms have a positive cost-benefit ratio.  Maybe there's a better way.

Access to the public capital markets is not a right, but a privilege.  A qualified listing company obtains a real-time price for its securities, based on the voluntary meeting of many buyers and sellers in a transparent market place. The information playing field should be level for all market participants.  This liquidity for corporate securities  is a valuable service to management, whose options can then also be valued, and to all other shareholders, current and prospective.  One of the costs for this access to capital markets is the requirement to issue audited financial statements that fairly and accurately represent the current financial condition of the issuers. Investors use these financial statements, along with other industry, economic, and financial information, filtered through their emotional states to price the issuer securities appropriately.  In well regulated, deep and liquid markets investors can have confidence that they have made their buy and sell decisions on a reasonable basis.  If there is a cost for good regulation, then investor confidence, perhaps expressed by volumes and relatively low volatility, is the tangible benefit.

As Doty writes, "The financial audit is the linchpin for this confidence.  In a world of hyper-charged incentive compensation to ignite management initiative, fraught with risk of self-promotion if not outright self-dealing, the auditor stands apart. Independent, objective, skeptical."

Here's the fundamental problem, "...the auditor is hired and fired by the company itself.  This creates perverse incentives for the auditor not to call the fouls."  No amount of regulation can remove investor risk in the market place.  The auditor's job is not to produce an alternative set of financial statements and then compare them to those prepared by the management.  An audit means a sampling of transactions, with the background of understanding the issuer's business, its processes and controls, and its management's tone at the top.

Here's a solution that applies market prices to audit risk: require all public companies to purchase audit insurance from established, well capitalized insurance companies with extensive records in underwriting commercial lines.  The insurance companies would certify the issuer's financial statements and defend the issuer against lawsuits arising from fraud and material misstatements.  The insurance company, in turn, would contract with audit assurance companies to carry out the actual audit of the issuer's statements.  Investors would have confidence based on the financial strength (A.M. Best Rating) of the issuer's insurer and on its general corporate reputation.

How do the market prices come in?  Insurance companies are fundamentally in the business of appropriately pricing and managing risks for all kinds of perils, and then turning a complicated actuarial analysis into a quoted premium.  I heard a presentation from an insurance actuary about coverage for a client's use of corporate jets.  After going through detailed structures of hazard models, risk mitigation and the like, the actuary said that "we know that if one of our (client's) jets goes down we are looking at about $9 million per seat in costs."  Of course, this is not the premium charged, because this risk is underwritten within a broad portfolio of risks.  The point is that insurable risks are quantified and priced every day. Global property and casualty companies compete vigorously for business, so a lack of bids shouldn't be a problem for most companies.

The insurance company would then hire audit assurance firms based on fees that were appropriate for the scope of the audit, the risks, and on the insurance company's buying power.  If the issuer had other business with the insurer, such as general liability, D&O insurance, or property and casualty on facilities, there would be opportunities for the issuer to benefit from bundling.

In this model, insurers, who are risk averse and skeptical, would more than likely expect their audit contractors to be the same.  The way for auditors to retain business in this setting would not include kowtowing to management, but it would mean protecting the insurance premium by being skeptical and objective. The auditor's client is no longer management but rather the insurance company.

If an auditor were to be fired, then it would be the insurance company that did it, but the management of the issuer wouldn't care, as long as the insurance was in place.  Firms with a history of restatements or misstatements would presumably see very high premiums for their audit insurance.  Investors would be able to draw their own conclusions from these disclosures of the insurance premiums, which of course would be disclosed in proxies and financial statements.

I am not going to claim credit for this idea, as a former controller of mine mentioned it to me almost ten years ago.  He can't remember where he heard it, nor can I find a literature reference.  It is very definitely a worthy idea. Thoughts?

Monday, January 9, 2012

Euro Dithering Continues

From: Wall Street Journal Online Edition.  Credit to Zuma Press. 

What do these two EU leaders have in common, and why are they smiling?  Answers are : "Very little," and "Mandatory Photo Op." 

After a year of meetings in hotels, beach resorts, chateaux and medieval castles, nothing of substance has changed.  Ostensibly, the German and French leaders are trying to (1) restore European competitiveness and create job growth; (2) implement last year's 130 bn euro Greek bailout, as the Greek government tepidly tries to impose austerity and negotiate with private bondholders; (3) keep the European Union from crumbling, while simultaneously, (4) creating a regime of sanctions for profligate members who run persistent budget deficits. 

What countries would want to be  members of this kind of union?  The former Eastern European nations are on the sidelines wondering, as is Sweden. The Wall Street Journal points out,  "Mr. Sarkozy, who faces a tough election in May, was also pushing ahead of the meeting (Tuesday with the IMF) to stress the need for promoting economic growth and jobs, rather than belt-tightening and austerity."  Solving the euro crisis under the current framework is all about fiscal pain; it's not about competitiveness and jobs with available policy instruments. 

 Economist Robert Barro of Harvard writes today in the Journal, "I suggest that it would be better to reverse course and eliminate the euro. ...The euro is a noble experiment, but it has failed."  A European Union running fiscal policy for its member states out of Brussels was never in the cards--that could not have been a noble experiment. 

Thursday, January 5, 2012

Merrill Lynch Bullish on Europe. Huh?

Merrill Lynch's Chief Investment Strategists are trying very hard to sound bullish on European investment prospects for 2012, in their most recent report.  How do they come up with this thesis, which might kindly be called counter intuitive?

ML opines that the initial auction of the LTRO, or the $500 billion bazooka, being oversubscribed by a factor of two is a positive sign for investors.  Say again?  ML feels that this is a clever mechanism for moving bad sovereign debt from the balance sheet of individual banks to the ECB balance sheet. 

It's one thing for Citigroup, as a private entity, to wall off questionable assets in a "bad bank" called  Citi Holdings.  It is another thing entirely, and not desirable, for a group of nations to create a "bad central bank."  Furthermore, ML claim that it's a good trade for European banks to borrow at 1% to acquire sovereign debt at 3-4%.  Really?

This questionable LTRO mechanism has kicked the can down the road.  I don't believe that it addresses any of the fundamental economic issues within the EU, nor does it build confidence in the future role of the euro.

Look instead at some of the private capital market developments.  UniCredit's shares fell 14% after announcing their rights offering sporting a 43% discount  to the previous day's closing share price; the discount is significantly larger than that of Commerzbank or HSBC's offerings.  Clearly, the capital markets are not sanguine about the outlook.

Italy floated a ten year note on 12/29/11 with a yield just south of 7%,  the LTRO notwithstanding.  Another no confidence vote from the market. 

Austerity in the face of recession will not make it easy for European incumbents who campaigned on the the "We've got it under control" platform.  And as we said right from the start of the European crisis, the interests of France and Germany would diverge, and they clearly have, perhaps wounding the political prospects of both national leaders.

ML's investment recommendations are large, European multinational equities: those companies with global business portfolios, limited need for access to capital markets, and good dividend yields.  These are defensive plays, not bullish trades, and they are last year's plays too. 

Wednesday, January 4, 2012

Higher Oil Prices in 2012: Goldman Sachs

I heard from a friend in New York that the most reasonable scenario he heard for higher oil prices in 2012 came from Goldman Sachs.  Unfortunately, she didn't have the report at hand, and I can't get a copy either.  The argument, she said, was that OPEC, and particularly Saudi Arabia, had lost its idle production capacity. This has long been a rumor about Saudi Arabia, normally the swing producer in OPEC.  Industry sources like API and government sources like EIA don't seem to document this phenomenon, but it continues in the financial market place. 

Goldman apparently had a chart that showed worldwide production versus worldwide capacity, and those two lines came close to converging in 2012, which buttressed a Goldman forecast for higher prices in 2012.

First, this kind of supply constraint, if you can call it that, would come into operation if there were either a supply disruption (like Iran blockading Hormuz) or a price spike for other reasons, such as speculation, and OPEC wanted to restrain the spike but couldn't.  I'm not an oil trader and don't pretend to be one. Goldman Sachs are premier traders.  Instead, I like to focus on fundamentals as an analyst and investor.

"Economic growth drives energy demand," as Exxon Mobil writes in its latest global energy review.  Other things equal, if we are hitting a global slowdown, driven by recession in Europe, and slowdowns in the U.S. and China, compared to both last year and to earlier forecasts, then energy demand should not be driving oil prices higher.

Another thing to note is that there have been long-term, sustained gains in energy efficiency in OECD countries, according to the Exxon review.  Their projections show the OECD economies being 50% larger in GDP terms in 2030 compared to 2005, while their energy demand in 2030 is flat to down!  Average energy efficiency gains are 1.5% per year in their forecasts.  This takes pressure off the need to increase domestic production and imports, or to access new sources of supply.  In 2030 oil and natural gas are still the dominant energy fuels, according to Exxon, so there is no real supply issue and no "peak oil" before 2030, if Exxon knows their business. 

So, it seems as if forecasts of $140 a barrel oil in 2012 must be driven by supply interruptions of some kind, and closing the Hormuz choke point is the one that is on the mind of the market now. I don't have any inside information about supply interruptions, but a blockade of Hormuz seems a remote likelihood.  If it really happens, the world may have other, more serious worries.  Remember, though, if a Hormuz blockade were to be sustained, then GDP forecasts will have to be revised downward again, which won't be good for the financial markets or the economy. 

Let's keep our fingers crossed that Iran can be allowed its braggadocio, the West can have its sanctions, and cooler heads will prevail. 

Tuesday, January 3, 2012

More on Oil Forecasts

My good friend, Phillip Gary Smith--serial entrepreneur, successful private investor, and Zen snowshoer-- suggested that I check out George Soros' pronouncemnts on oil.  I've seen some huffy pronouncements from Mr. Soros about dictatorships and oil, but I couldn't find any detailed numbers to work through.  I appreciate the suggestion, Phillip. 

Looking back on 2011, here are some crude oil stats from the Wall Street Journal:
  • High for crude was $113.93 a barrel on 4/30/2011 when U.S. forecasts were still at 3%+ for GDP, China continuing to grow, and the world sanguine about any issues with the euro.
  • Low was $75.67 on 10/5/2011, with GDP forecasts cut, downward revisions in third quarter and full year corporate earnings, lowered guidance for 2012, issues with China on the front page, and attitudes about the euro now mentioning breakup of the EU.
  • Closing 2011 crude price on 12/31/2011 was $98.83!
There is the $20 "risk premium" for supply constraints for Middle Eastern oil from a supposed Iranian blockade of Hormuz

In the EIA short-term energy outlook published on December 6th, worldwide consumption of crude oil and liquid fuels was projected to grow modestly  in 2011 over 2010, to 88.1 million barrels per day ("mbd") from 87.1 mbd.  In this 2011 worldwide total, OECD consumption was projected to decline by 0.4 mbd and remain relatively flat in 2012.  With European recession likely in the cards, it would be reasonable to expect revised 2012  projections of OECD oil and liquid fuels consumption to decline year-over-year rather than remaining flat. 

Most of the 2012 growth in crude oil and liquid fuel consumption was said to be driven by Chinese demand, which should now moderate because of reduced export demand in its major markets, which should lower oil usage by the Chinese export sector. 

U.S. liquid fuel consumption was projected to increase by 0.6% to 19 mbd in 2012 in the December 6th forecast.  It would seem as if there should be some downward revision here also. 

Supply constraints at OPEC don't seem significant, and such as they are, they would be offset by Libyan capacity reentering the export market in late 2012. 

We're still looking for reasons why the consensus 2012 oil prices shouldn't be closer to $80ish than $100+ for 2012.  The revised EIA short-term projections are due out in mid-January.  Keep those cards and letters coming.