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.

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.

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?

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. 

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. 

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. 

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.