Tuesday, September 30, 2014

Pimco Executives Hit the Phones

The Wall Street Journal says that executives at Pimco are hitting the phones trying to staunch the outflow of more than $10 billion from the Total Return fund. The CEO is even talking to brokers himself!

Maybe this is the kind of "all hands on deck" connect with the customers tactic that wasn't implemented when more than $65 billion left the fund before.  Perhaps this is why BG got very upset with the marketing executive and the CEO himself?

Seems like a reasonable hypothesis, doesn't it?

Monday, September 29, 2014

Missing the Mark on Medical Device Marketing

The Wall Street Journal headline says "Medical Devices Lack Safety Evidence" according to a study, not from an academic medical center or high powered clinical research group, but from yet another policy think tank.  It is very disappointing, and it isn't up to their usual journalistic standard.

Safety and risk profiles are reflected in the Class ranking of medical devices: Class I (bandages and surgical gloves, for example), Class II (e.g. infusion pumps and surgical drapes) and Class III(e.g. heart valves, stents, and orthopedic shoulder replacements).

The story reports the following:
"Most devices can get FDA clearance simply by showing that they are roughly equivalent to another product, called a predicate device, that is already on the market. The theory is that if the older device has proved safe and effective, the new one should be also."
"Most devices?"  Yes, a new surgical drape or a guide catheter won't require a full fledged IDE study; that would make no sense, there would be no reason to ever change an old technology, even if materials improved or manufacturing methods allowed miniaturization.  "Roughly equivalent" is the term of a bad journalist.  The FDA guidance says,
 "If FDA agrees the new device is substantially equivalent to a legally marketed device for which premarket approval is not required, the manufacturer may market it immediately."
Were the rule otherwise, the accidental company that came first to market would argue that everybody else required a full fledged IDE study for their improvement or enhancement.  Patients and innovation would suffer for no reason.

Class III medical devices rarely fall under the 510(k) labeling, because of their risk category.  The nature of the clinical study may be different.  All of this falls under the review of FDA staffers, aided by medical consultants, and in the case of companies pushed down the IDE path, a long, expensive, arduous and risky clinical trial path.

The 510(k) substantially equivalent pathway can involve bench data, lab studies, computer simulations, animal studies, or some combination of all.  Reviewers often add more questions and require additional data after the study process has begun.  Having been through it a few times, it is a bit arcane, and having "the public" read a bench study about laminar flows for a company's device adds nothing to the quality, cost or safety of patient care.

Post-market surveillance of cleared devices is definitely one area that needs to be improved, with more burden placed both on the device developer and the medical institutions that use them.  The premarket approval process itself could be made a bit more consistent.

And, a really significant problem is turnover and under staffing at the FDA itself, which I can say from experience, is widely acknowledged but not successfully addressed.

Saturday, September 27, 2014

A Final Word on Bill Gross

Well, it is too bad, but as always happens in the world of Wall Street finance, it is all about personalities.  Wait, that describes politics too, but that's another discussion. Some final thoughts.
  • As a fixed income investor, a CFA charter holder, Bill Gross has proved his mettle more than any investor as his industry. His industry awards are testament to this, as any unbiased observer would have to admit.  
  • The statement in the press release outlining his departure from Pimco was petty and small minded.  Objectively, without the personal investment management and asset attracting talents of Mr. Gross, there would have been no blockbuster, mega-sale to Allianz, which made his allies and detractors very rich.  This should have been acknowledged, and this shows that the CEO doesn't have a generous spirit, no matter what the simple business decision taken. 
  • The culture at Pimco involved, according to the press, lots of shouting and berating of subordinates, colleagues and superiors.  Except for the superiors part, anyone who has worked on Wall Street knows that this is part and parcel of the everybody culture. Were Hunter S. Thompson still alive, he might have written "Fear and Loathing on Wall Street." 
  • For Bill's part, it's not a good idea to yell at your CEO or your board members: definitely a lack of EI, likely under duress. Inexcusable, unproductive, not worthy of him as a person or as an executive.  
  • It is hard to understand the outflows from Total Return given its long-term track record, and it should have been a matter of the institutional sales and marketing teams getting behind this to prevent it. Corporate buyers of investment management services are very sticky, even in the face of bad long term performance.  The pension consultants needed hand holding to head off the outflows.  The stories of yelling at these functions seems understandable.  Was there accountability here?
  • I didn't know that the equity funds launch was Mr. Gross' idea, according to the press. This is unsubstantiated and hard to believe, a side issue nevertheless, as he wasn't responsible for managing their ineptitude.  Again, the marketing of these funds was terrible.
  • It will be interesting to see what happens to the management of Harbor Bond Fund.
  • If all of this inner turmoil was going on for so long, then the board and CEO were not up to their tasks, which was to bring back unity and stability in the locker room.  They failed.
  • Working for Jeff Gundlach, who himself left his employer in a huff without anywhere near Bill Gross' track record, was a non-starter.
  • Janus may be a non-starter, unless Bill Gross does better with his yoga and re-centers himself. He and I had a short correspondence way back when about yoga and meditation.  I think he disconnected the asanas from the spiritual development piece.  They are inseparable. 
  • It's all unfortunate, but in the end, nobody is indispensable.
  • Pimco should lose assets, as whoever takes over Total Return or a clone, can't really claim the historical performance record of Bill Gross, according to how I read the II performance reporting standards.  Instead (s)he will have to articulate their own investment strategy and improve transparency, which was always frustrating when reading the Total Return fund's reporting.
Sayonara, Mr. Gross.  Less time in headstands and more perhaps in seiza. Investors start checking your quality bond fund alternatives.  The universe isn't as big as it should be.  

Friday, September 26, 2014

Bill Gross Leaves Pimco

Back in January we posted our answers to the question of "What's Wrong with Pimco?"  One of the issues was succession for Bill Gross, and that was answered today as the author at the top of our fixed income reading list for the past several decades is leaving to go to Janus.

Again, it has little to do with fund outflows and all to do with organizational issues at PIMCO and perhaps a heavier hand being exerted by its German owners.

We wrote about Pimco's astonishingly inept roll-out of equity mutual funds, and the wave finally hit their bellwether product the Total Return Fund and its high profile manager.

Janus was a hugely mismanaged organization for decades, but perhaps it is living up to the name of the Roman god of new beginnings with the hiring of Mr. Gross.  Love your essays, Bill!  Keep 'em coming.

Revisiting Marissa Mayer

Calls by some shareholders to receive most of the money from Yahoo’s sale of a stake in Alibaba could limit the options for Marissa Mayer, chief executive.

Jason Alden/Bloomberg via Getty Images and the New York Times.  

I thought Yahoo's appointment of Marissa Mayer as CEO a few years back was a great move for the company and would bring a sharp, decisive, enthusiastic leader to the company and perhaps to other corporate boards.  The first thing I notice from this New York Times photo and story is that the gleam has gone from her eyes when compared to her taking the reins at Yahoo.  There is clearly a look of weariness, perhaps even resignation.

The articulation of a clear direction for the Yahoo turnaround, milestones and a fast pace of change have all been missing.  One analyst says that Yahoo needs to be "rewired."  But everybody knew this years ago, and it seems incredible that so little has seemingly been accomplished.

I also guessed that her having been in the Google inner sanctum would have been a source for inspiration, guidance, and even partnership in some areas.  Yahoo seems like the armadillo walking slowly down the center line on a Western highway while the semis roar by.  

The acquisition game from here is riskier than a few years ago. For Yahoo to move its needle, a big acquisition is required, but those will have a variety of suitors, all of whom are stronger financially and organizationally than Yahoo. The limited track record so far hasn't been good.

As the Yahoo CFO points out, shareholders don't need to whine incessantly because $1.3 billion has been spent on acquisitions in the past two years, versus returning $6 billion to shareholders.  Ms. Mayer shouldn't obsess about a fifty-fifty split in free cash flows, but she needs to start articulating her playbook in greater detail.

I wonder if her management team has the right roster with the right incentives. I would guess not, otherwise you would read more about them in the press.  I don't want to look up their board members, because they clearly haven't been doing their jobs if the CEO looks wan and beleaguered by shareholders after the stock has bounced off the bottom due to the Alibaba stake. 

Here's hoping for some positive changes and good news. 

Monday, September 22, 2014

Fed Policy Risks

Back in 2011 we were pretty lonely writing about the future risks of the unprecedented monetary accommodation that became today's monetary policy. We noted this comment from Minneapolis Fed President Kocherlakota,
"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."
He was right and he was early: it made perfect sense to me, but this view was quietly squelched with assurances that the Great Unwind would have several tools in its armamentarium.  Hold this thought as we summarize the Fed's policy risks from Dr. Ward McCarthy of Jefferies.

Ward says that the Fed's recent parsing language meant to say that it is "in no rush to raise rates."  We have long said that there is no fundamental economic case for raising rates.

To the point above, McCarthy says "unwinding this extraordinary accommodation carries...risks that policy makers had not previously had to consider."

He says that if the Fed waits too long to raise rates in response to rising inflation, the markets would overreact and a subsequent move would be roiling to bond markets.  This risk, in my opinion, is one of the lower ones.  There are many data points for inflationary changes, both real and in expectations. At present, there is almost no sign of economy-wide pressure from commodities, wages, or capacity constraints, which are the traditional harbingers.

If the Fed were to remove its accommodation too early, and the economy were to again enter a recession, it would very few options.  Negative rates, Dr. McCarthy says, are not politically or institutionally feasible in the U.S.

The Fed has now defined the federal funds rate as the key policy rate.  Dr. McCarthy agrees with us in saying that the reverse repo facility tool is not the best solution resetting the floor for interest rates. He notes that Fannie, Freddie and the Federal Home Loan banks are not eligible to collect interest on their reserves at the Fed.  Given their continuing enormous influence in the housing market, this makes the RRP program of limited reach, not to mention risky to the system, as others have written.

The IPO market's backlog will comfortably start coming to market given the benign outlook from the Fed.

The Chinese Government as Partner for Alibaba.

In yesterday's post, we made the point the smartest thing Alibaba CEO Jack Ma did was to cut the Government of China in as a partner, but we also cited the risk of their exercising a Godfather-like call on shareholder assets at a time in the future.

Today's Wall Street Journal, coincidentally, picks up that very same point and expands it.

Watch for that unanimous panel of Buy/Strong Buy reports from Wall Street.  Look for significantly under valued assets like the payment system and the opportunities of building their own fulfillment system in China.  Expect the same investor behavior as in the halcyon days of Mary Meeker and the earlier dot com frenzy.

Sunday, September 21, 2014

Looking at Alibaba 38% Higher

Alibaba's IPO predictably blew the doors off, up 38% after the first day close with market makers doing their best to rein things in from super heating. Aside from the scale, which is inevitable from the passage of time with markets, it was all pretty much according to the Wall Street script.

Of course, things should go swimmingly for a time, otherwise lynch mobs would be seeking the bankers with malice in their hearts.  But, a quick look at Alibaba's press says that the story has legs in the medium term.

The Wall Street Journal curiously takes the position that "this time it's different." Shareholders needn't worry.
"But shareholders can choose whether to live under these limitations (structure, governance, no voting power for the common....). They understand the convoluted workaround was dictated by Chinese law, which restricts foreign ownership. And, let's face it, when investors begin to worry about the actual rights specified in a share agreement, it usually means something has already gone seriously wrong.
True comfort for shareholders comes not from legal boilerplate, but from incentives. Alibaba founder Jack Ma could take the $22 billion raised Friday and stiff his foreign partners. That's a risk. But his self-interest is otherwise. He wants a strong stock as a currency for acquisitions. He wants stock options to motivate his increasingly global management team. He wants easy liquidity for himself and other insiders.
Of course, a lot can go wrong with a company, and Mr. Ma told a road show audience last week that his most important task was government relations back home. That's another risk. But Chinese officials have incentives too."
Common shareholders claims on their company are residual.  They don't have the covenants, protections, clear judicial means to exercise their claims, and even claims on specific assets, as some other investors do.  Something clearly has gone wrong in this structure, for the common equity investors, but they don't care because everybody knows the short term outlook should be a lay up.

I wonder if the Journal remembers the agency problem.  Incentives existed for the managements of AIG, IndyMac Bank, Bank of America, Countrywide Financial, Metris, Green Tree Financial and so on endlessly, and that's just for financial services.   The boards did not represent shareholder interests and rein in their managements.  I would bet that few shareholders of Alibaba could name one of their corporate board apart from Mr. Ma.

"A strong currency for acquisitions."  The management of every public company wants the same thing.  It's no magic elixir.  Remember HP? Remember Compaq and other failed acquisitions before their currency became seriously devalued?

The smart but inevitable move that Mr. Jack Ma made was to cut the Chinese government in on his deal. The selected list of Chinese officials was not created by accident.  It is why Mr. Ma spends so much time on government relations back home.

The payment network may be an undervalued jewel.  The money market mutual fund may revolutionize investing in China.  Unless the Chinese government decides at some point that this capitalism thing needs to have its model adjusted. Years from now?  Probably, but at some point inevitably.

At some point when Mr. Ma is the wealthiest man ever in recorded history, will the siren song of marginally more money still attract him?  What if he decides to invest money, perhaps with the encouragement of the Chinese government, on Chinese tourism to Mars?  What if  his vision and attention wanders to personal causes?

Governance often becomes boilerplate because that makes careers for politicians and their cronies, but it is really about meaningful, properly defined rights and obligations, the right people and the right processes to manage a company in which shareholders get a strong say.

Prediction: 100% of the analyst reports will be Buy or Strong Buy.  There are no new tricks on Wall Street: only the names, dates and scale changes.

Thursday, September 18, 2014

Alibaba: Open Sesame To the Uber Humongous IPO

In a recent post about emerging markets as an asset class for foreign equity investors, we wrote about some things they should look for in selecting their markets and their issuers:
"In order to translate these into growth in corporate earnings and portfolio returns, investors need: political stability, strong respect for property rights, effective dispute resolution, a predictable regulatory and tax regime, a positive foreign investment climate, efficient markets, strong corporate governance, reliable corporate auditing and financial reporting, ethical managements, transparent corporate structures, and economies balanced between exports and internal consumption. Divining the strengths and weaknesses of an EM in these areas can only be done by active management, with experience in the markets, boots on the ground and a disciplined investment process." 

Despite the fact that the Alibaba IPO will be a record breaker in all investment banker metrics, it seems to lack these basic, critical features and it seems ripe for momentum investors and flippers, aka hedge funds.

A June 2014 staff report of the U.S.-China Economic Security Review Commission goes into the issues clearly and raises the potential legal, investment and governance issues for U.S. investors.  The Chinese government itself makes it a public policy to keep foreign equity investors in disadvantaged positions in their companies.  Yet, Chinese Internet companies have pursued foreign listings with a structure called Variable Interest Entities, which the report says may in fact be illegal under Chinese law.

Templeton's Mark Mobius points out the two-tier equity structure that clearly entrenches management and gives it and the preferred class effective control over corporate assets.  Disputes, he notes, must be settled in Chinese courts, despite the overseas listings.  Good luck with that venue for the poor common equity investor.

The reporter interviewing Mr. Mobius notes that Hong Kong regulators passed on allowing Alibaba to list on their exchange, in part because of the opaque corporate structure.  Asked why U.S. regulators allowed the listing on NYSE, he quietly notes several points, which I may paraphrase a bit:

  • U.S. markets have never reformed, post-crisis.
  • U.S. regulators serve their customers, namely the broker-dealers and their investment bankers.
  • Out equity markets are driven by short-term investors who will flip the shares.
Ironically, some part of Templeton may get a few shares and flip them too.  If they are passing out free candy, why not take it?  But, the comments are sobering coming from one of the oldest companies in the emerging foreign equity investment business. 

Professor Anant Sundaram of Tuck Business School has made comments on the deal from the governance standpoint that worth reading, published in Barron's and the New York Times. 

When Ali Baba opened the door, it was to a wonderful land.  It will remain so until the door closes and investors long to return to the other side.  

Wednesday, September 17, 2014

CalPERS Throws in the Towel on Hedge Funds

In organizing the posts on this blog, I've favored the label "alternative investments," as opposed to, for example, just "hedge funds."  In the past, we've written one of the most widely read posts about the public's "Two Faces on Private Equity." Rereading this, it is ironic that Warren Buffett, a vociferous critic in print at the time, has now thrown in with Brazilian private equity partners 3G on major investments.

The Yale endowment fund, led by Dave Swensen, has been one of the institutional models for successfully using alternative investments, including hedge funds, private equity, and real estate. Harvard's endowment has been in the news recently because of its falling down repeatedly in its once legendary investment management.  This post makes good background reading for today's issues about CalPERS.

CalPERS has assets of $298 billion in its investment portfolio to support 1.6 million members, either currently working or retired,or a stunning $186k per member, most of whom are working so the retirees should be quite comfortable.  The trouble is that for all their shareholder activism, self-promotion, and expensive internal management, CalPERS cannot select, construct and manage an alternative investment portfolio, in this case specifically hedge funds.

According to the Wall Street Journal, the fund's fiscal year-ended June showed its hedge fund portfolio of $4 billion returning 7.1% versus Vanguard's Balanced Index return of 12.5%.  The prior year too showed dramatic under performance at 7.4% versus 10.8% for Vanguard's Balanced Index.

The Journal notes that HFR's index of 2,000 hedge funds has been under performing its benchmark since 2009.  It points out that even in the down year of 2008 hedge funds lost 19%, not much less than traditional equity investors who lost 22.2%.  So, the $24 trillion hedge fund industry doesn't protect the downside in any significant way.

However, just to note that I got an interesting post from AQR's Cliff Asness which raises a very interesting point on which he has hammered for a while. To paraphrase, much of the institutional investor's market-like performance for hedge funds comes from the fact that their positions, whether in outside funds or in funds-of-funds, have too much of a net long position and therefore shouldn't be expected to perform too differently from traditional longs, like balanced funds. CalPERS and Harvard and others suffer from this disease of not being short enough in their hedge funds.

Proponents of hedge funds claim that there are good managers out there who can point to long-term out performance.  Who are they?  What's the basis for this claim?  What are the strategies and processes in this opaque world that can produce this alleged out performance?

Even Morningstar rates hedge funds for individuals.  If CapPERS concludes that hedge funds are too complex to manage, produce little diversification benefit, are too expensive and not scalable at their asset level, how can a small investor ever hope to benefit from these investments.  You can guess my answer.

Thursday, September 11, 2014

Fed Announces Upcoming Clarification of Monetary Policy Outlook

Fed's rate guidance on chopping block, new exit plan nears

Thu Sep 11, 2014 1:02am EDT
By Ann Saphir and Michael Flaherty
(Reuters) - The U.S. Federal Reserve is facing perhaps its most pivotal meeting of the year next week, as it debates a potential overhaul of its guidance on interest rates and seeks to nail down a plan for exiting its extraordinarily easy monetary policy.
It remains to be seen whether decisions will be taken on either, but it is clear that details on a so-called exit plan are nearly complete, while discomfort is growing internally over a pledge to keep rates near zero for a "considerable time."
Investors will parse the central bank's words closely for any clues on the timing of the first U.S. rate hike in more than eight years. Any major tweaks to its policy statement could cause ructions in financial markets as investors recalibrate bets on benchmark rates in the world's biggest economy.
A strong run of U.S. economic data has led Fed Chair Janet Yellen and other top officials to acknowledge the possibility they may need to raise rates sooner than they thought just a few months ago, although a surprisingly soft reading on jobs growth in August could provide some breathing room.
"The discussion itself is a testament to the underlying shift in monetary policy," said TD Securities analyst Gennadiy Goldberg. He said ditching the "considerable time" phrase would open the door to a rate hike as soon as March, several months earlier than most investors currently expect.
The Fed has kept overnight rates near zero since December 2008 and has more than quadrupled its balance sheet through a series of bond-buying programs designed to push down borrowing costs and boost investment and hiring.
Fed policymakers have said they do not expect to raise rates until 2015, and their meeting next Tuesday and Wednesday looks certain to end with no change in policy beyond a well-telegraphed reduction in the central bank's asset purchases.
But officials will release fresh economic and interest-rate projections, extending their forecast horizon through 2017. Those, coupled with even minute changes in the Fed's post-meeting statement, could reshape expectations for how soon and how fast the central bank is likely to raise rates.
Fed officials from both ends of the policy spectrum have stepped up calls recently to change what Cleveland Fed President Loretta Mester termed the "stale" language on the likely timing of the first rate hike.
The Fed has said since March it expected a "considerable time" to elapse between the end of its bond buying, which is now slated for October, and its first rate hike. "I believe it is again time for the (Fed) to reformulate its forward guidance," Mester said last week.
A few hours after Mester's remarks, Boston Fed President Eric Rosengren, a stalwart backer of the central bank's aggressive monetary policy easing, also called for ditching the calendar-related guidance, while Philadelphia Fed President Charles Plosser, who dissented against the language at the central bank's last policy session in late July, reiterated his concerns on Saturday.
Top economists at a number of Wall Street firms, including Michael Feroli at JPMorgan, Paul Ashworth of Capital Economics and Lewis Alexander at Nomura, now see at least even odds that the Fed will drop the "considerable time" phrase.
It could simply note that it can be "patient" in determining when to raise rates or could emphasize, as Yellen did with a speech in August, that the timing of a rate hike could move forward if economic data comes in stronger than expected.
The guidance is only one of the tricky questions facing the Fed. Officials also need to finalize details on how they plan to move rates higher and keep inflation from igniting, given the extraordinary liquidity sloshing around the financial system from their purchases of government and housing-related debt.
Minutes from their July meeting show officials now generally agree on several important changes to a set of exit principles first published in 2011, including steps to prevent the Fed's balance sheet from shrinking before rates rise. Most of them also now think the Fed should hold on to most of the housing-backed securities it has purchased.
Still under intensive discussion is how to use a newfangled tool developed by the central bank's New York branch to help sop up excess liquidity when the Fed starts tightening policy.
Minutes of the last meeting show it is increasingly likely the Fed will relegate the new overnight reverse repurchase facility to a supplementary and maybe temporary role, in part due to worries it could spark "runs" from more risky markets in times of financial stress.
Agreement on that matter could pave the way for public release of an exit blueprint as soon as next week.

(Reporting by Ann Saphir in San Francisco and Michael Flaherty in Washington; Editing by Tim Ahmann and Paul Simao)
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Wednesday, September 10, 2014

Dodge and Cox: Views on Fixed Income Markets

We recently received the periodic report for the quarter ended June 30, 2014 from the managers at Dodge and Cox Income Fund (DODIX), with $28 billion of NAUM and a performance record built on a long-standing investment process, a well defined process of internal employee development and portfolio manager succession, and a tradition of all the partners putting their money in their own stable of funds.

DODIX outperformed its benchmark, the Barclays U.S. Aggregate Bond Index by 70 bp, with the fund generating a total return of 4.6% for the six months ending 6/30/14.

"Demand rose for U.S. Treasuries which as a sector returned 2.7% in the first half, reflecting growing expectations that the Federal Reserve will raise the Fed funds rate at a slower pace compared to previous tightening cycles. with a lower end target."
So, with the new paradigm of Fed Presidents and the Chair thinking out loud about monetary policy philosophy, tools and targets, this is how savvy, conservative, low turnover fixed income managers interpret the Fed's future policy pathway unfolding.

It is hard to understand a fundamental, economic case for tightening in 2015.  Indeed DODIX managers wrote about, ",,,the somewhat confounding environment of the first half of 2014--with a brightening macroeconomic outlook coinciding with rates declining to one-year lows--we reversed the duration extension of mid-2013."

The managers believe that the market rate structure fails to incorporate "the more positive underlying fundamentals of the U.S. economy or the possibility that Fed policy could deviate from the glacial pace of tightening currently reflected in market expectations."  We'll have to see whether this is true or not, but the folks at Dodge and Cox are always worth listening to.

This fund made a brilliant move several years back when they positioned the fund massively over weighted corporate credits relative to the benchmark, with the issuers' strong cash flows, clean balance sheets, and strong management teams providing equity-like returns early in the economic recovery.

Today, they are making a more nuanced comment about corporate credits.  DODIX has been reducing the corporate sector weighting on an issuer-by-issuer basis while shifting the sectoral composition of corporate credits away from Financials, for example.  With regulators making comments about mega-banks "choosing" to get smaller, this rebalancing might be very prescient.

Mega-cap, global technology companies are outdoing each other with big share repurchases and rapid dividend increases.  We've written many times about the formulaic, value insensitive manner in which these buybacks have proceeded.  Dodge and Cox fund managers write, "This (higher amounts of leverage at a low cost) is a source of down side risk for holders of investment-grade corporate bonds."  Further, they write that credits pruned from the portfolio will include those companies which "are likely to alter their capital structure in a manner adverse to current bondholders." (read buybacks and other financial engineering)

Monday, September 8, 2014

Conflict Minerals and Costs to Shareholders

Here is the story from the Wall Street Journal:
"Good morning. Conflict minerals reporting can’t seem to get a break. First, the rule itself, required by Dodd-Frank, was found unconstitutional because it amounted to compelled speech, a ruling that forced the SEC to water it down. As a result, companies don’t have to declare whether conflict minerals are in their supply chains, but instead merely confirm that they’ve looked into it. But now the government has had to admit that it isn’t up to the challenge of figuring out which smelters are financing the violence in the Congo either.
The Commerce Department already missed its January 2013 deadline under Dodd-Frank to list “all known conflict-mineral processing facilities world-wide.” But on Friday, though the department published a list of 400 sites from Australia to Brazil and Canada, it also conceded that it “does not have the ability to distinguish” which are being used to fund militia groups, CFOJ’s Emily Chasan reports.
Companies including Intel Corp. and Apple Inc. said they spent years and millions of dollars investigating their supply chains for evidence of metals from mining operations that are paying for violence. A dozen companies acknowledged their suppliers may have obtained minerals from such mines, but the vast majority said they simply didn’t know. “At the end of the day, the conflict minerals rule creates the worst outcome—it has not helped lessen the conflicts in the Congo and creates economic harm in the U.S.,” said Tom Quaadman, vice president of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness."
With all the potential benefits from improving disclosures that could meaningfully help investors assess the value and governance of their companies, our legal, accounting and political elites force the entire market apparatus to focus on things like disclosures on conflict minerals.  Irrationality is said to invade the market psyche in bubbles, but what about our normal regulatory processes? Regulatory capture is not something that happens only from 'big corporations' lobbying for their own narrow interests.

Institutional investors and fund managers have to pick their battles, and they don't choose to fight many. (see our post on the Sequoia Fund) Any institution that came out in opposition to these disclosures would be tarred as being insensitive, hostile to developing nations and poor miners, or worse.  The impact on their marketing and potential loss in net asset value make opposition a bad trade.  Just agree to pay tens of millions as a group, nod your heads in silence, and move on.

Legal firms and accounting firms have no downside to playing along, after all their billings increase from formulating, helping to create 'systems' and monitoring the meaningless disclosures.

Politicians love this, because they can take credit for addressing a real issue, which indeed 'blood diamonds' and 'conflict minerals' have been for many, many decades, without having to break a sweat or taking any interest in the real problems, which are not about disclosures.

The regulatory arena, in which players on all sides act rationally from a financial risk-reward point of view highlights the dead weight losses absorbed by our financial system from an incoherent, growing web of arcane regulations surrounding accounting standards and financial disclosure.

Saturday, September 6, 2014

Royal Dutch Picks A Page Out of Exxon's Playbook

Royal Dutch Shell plc appeared to be one of the relatively cheap stocks among the global intergrated majors; at the start of 2014, the share price of 20 EUR was below the 52 week low as of today. For the rest of 2014 year-to-date, the share price has rallied to the upper end of the 52 week range.

Why? Exciting new discoveries in existing territories?  Another super giant oil field in the Saudi Empty Quarter? A huge new gas field in the U.S. Gulf?  None of these.

No, it was probably a couple of speeches by new CEO Ben van Beurden in which the WSJ has him saying,
"We cannot deny that our returns are too low," Mr. van Beurden said. "We don't have a [production] volume or capital-employed target. What I want to show is that we can grow free cash flow."
The new message has resonated with Wall Street, as the Journal writes again,
Since he said in January that Shell needs "better operational discipline," the company's shares have climbed 5.8% and hit a two-year high last week. Shell's 2013 earnings fell 38% from a year earlier to $16.8 billion, while its capital spending was 15% over initial projections, at $46 billion. Shell's refining profit was "simply too low" and the company's performance in North America wasn't acceptable, Mr. van Beurden said at the time."
The emphasis on ROIC is a page right of Exxon's top corporate board, management, and operators' metrics. which we have written about for years.  It's one thing to talk about 'operational excellence,
but pushing a return on invested capital mentality, translated down to the operating company level is something else entirely.

If RDS gets the Exxon playbook into its DNA, it will go from a stock that always looks relatively inexpensive to one that is 'fairly valued," which is a good thing.

A NATO Quick Reaction Force: Good Idea in Principle, But Caveats Apply

The news story about the creation of a NATO quick reaction force for Eastern Europe is a much better idea than that of moving underutilized U.S. troops from Germany,

Similar caveats apply, though. It will take time.  Objections and 'concerns' have already been raised by Russian mouthpieces.  This move, however, almost had to be made given prior statements by President Obama.  Once a force is in place, count on the same Russian strategy of provocations and objections to the response and moves to protect those of Russian ethnicity wherever they may reside. The Polish government, in this case, as opposed the the Wall Street Journal scenario, has offered to provide bases and logistical support.  This move is hopeful, but there's a long time from the press release to the implementation.

Whatever weaknesses there are in NATO, and they are significant, will be subject to exposure over the coming months.

Friday, September 5, 2014

US Troops to Poland: An Empty Gesture Now

The Wall Street Journal Opinion column makes an impassioned plea for putting our American troops in Germany into Poland:
"NATO would have done better to move the thousands of American troops sitting idly at German bases forward to Poland and the Baltic states. This would have sent a clearer message to Moscow of NATO's seriousness by creating a tripwire against a Russian attack."

This won't happen for several reasons.  If something like this were to be implemented without any kind of coherent international foreign policy strategy around it, this would be inviting President Putin to call yet another of our many foreign policy bluffs. The strategy he would use is the same one he used in Ukraine.  It works!

The fundamental issue regarding our German-based U.S. troops is a bilateral issue between our President(s) and the German Chancellor(s).  Germany is a big, productive economy with a significant impact on world economic progress, but in the matter of foreign policy--national, through the European Union, and through NATO--Germany has been getting a free ride and they just have to pick up their own tab and act like big player on the world stage. Don't count on this.  Yet, by not confronting them directly on this issue, a unilateral move would further confuse our allies around the world.

Finally, our military brass in Europe and our troops and their families are enjoying the status quo, thank you very much.  They would be the first to lobby against this move, or at least to plead for a fifteen year ' phased draw down' to make it an empty gesture.

In case, the Journal hasn't noticed President Putin doesn't respond to gambits from weaklings, which is how he perceives our President and his foreign policy advisers.

Our brass, their troops and their equipment can certainly be put to a much better economic uses than vacationing in Germany. Asking the Poles to sign off on this meaningless gesture is an insult to their collective intelligence, because the strategy guarantees a loss for them, the only question would be how big.

Wednesday, September 3, 2014

Draghi and the Euro: Low Rates Haven't Changed Fundamentals

From an October 2013 post, we noted:

  • The European monetary system still has fundamental design and execution flaws that make it unstable in most environments;
  • It offers peripheral members few real benefits except access to easy credit; 
  • Unless the peripheral countries undertake real economic reforms, the austerity medicine may make the patient better, if it hasn't killed him first;
  • French, European and Italian banks need to take their medicine and acknowledge the diminished economic values of sovereign debt on their balance sheets;
  • The continuing struggle for EU power between France and Germany is very analogous to the struggle between our two sides in Congress.  Despite all the nice rhetoric and the ECB posturing, their divergent interests still limit the effectiveness of the monetary union. 

Today's financial press acknowledges that "Europe Crisis is Resistant to Medicine of Low Rates."  Really! How could anyone but the eurocrats, the IMF, and their press cronies have seriously believed otherwise?  

Meanwhile, the same article notes,
"While some borrowers (global multinationals) are benefiting from ultralow or even negative interest rates, it does not appear that the easy money is reaching the struggling businesses in countries like Spain and Portugal that need it most. That is why the European Central Bank may still need to do more to unlock credit to those countries and avert deflation, a ruinous downward price spiral."
The peripheral countries have gained little from trying to please the ECB, which they thought in turn would please private lenders, who in turn would give them easy credit to continue business as usual.  There has been no benefit to the peripheral countries dancing with the ECB and the IMF, but they really do need to sit down, perhaps directly, with private, non-bank lenders and have a serious conversation about regulatory, tax and fiscal reforms that would generate capital on the appropriate terms.  Continuing to believe in the ineffective European experiment as it is will only generate political turmoil in the periphery.

Meanwhile, in Poland and in the Czech Republic, there are outside investors who are noting manufacturing capabilities, trained workforces, and an openness to foreign trade.  There are some shoots of spring in these economies, but not because of any ECB experiments.

Some of the banks have had bombs go off in the basement, and no amount of ECB regulation and oversight saw any of it coming.  Banco Espirito Santo is the laughable example, with Credit Suisse and Goldman Sachs having their eyebrows singed by the opaque structure.

France appears to be acting like a patient with congestive heart failure, still alive and moving around, but seemingly incapable of rising to its domestic economic and foreign policy responsibilities.  This leaves Germany as the strong voice, for the moment.  Don't expect Mr. Draghi to produce anything useful apart from press releases for the current economic crisis.