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.

Insurance Risks and Capital Markets

It's almost impossible to make a persuasive case that insurance industry companies were responsible for systemic risk in the last financial crisis.  Organizations like the OECD took that position way back in 2009.

Today, perhaps on the argument that regulation is looking forward, certain insurers, like Met Life and Prudential, are being bandied about as "systemically important financial institutions." Size would be the obvious measure to bring these companies under the microscope. Met Life's assets in 2012 were $562 billion, number one in the industry.  Number two was Prudential at $491 billion, both from the ACLI.  But, the business model, management capability, board oversight, and corporate cultures are what drove the bad actors in the last crisis to put the financial system on the brink.  Size, for the insurance business, was neither germane nor predictive.

John Cochrane of Chicago Booth and other scholars have talked about the fundamental importance of "runs" in financial crisis.  We know how banks have runs on deposits.  We now know how runs can create panic selling in asset markets, as they did in the last crisis.  Life insurers, with very long term liabilities, are unlikely to be be affected by policy holder runs, by the insureds demanding payment of cash values all at once. Fees and surrender charges provide insulation and disincentive, respectively.  Life insurance industry policy reserves were $1.3 trillion in 2012, and their share of policy reserves in total has been declining over recent years.  These reserves are built for mortality and longevity issues, not for unlikely or immaterial runs on policies.

What about AIG, though?  It is number four in assets of the life insurers in 2012, with $247 billion.  But, as we know, but sometimes forget, AIG's losses were caused by one, nominally small, unregulated, misunderstood, unmonitored renegade business called AIG Financial Products Group, a capital markets business.

Indeed, going forward, it will once again be the capital markets where the risks will be uncovered, after the fact.  The incentives and pressures for systemic riskiness are created by the continuing, artificial low interest rate environment which now cannot be unwound as quickly as it was put into place.

The low interest rate environment has put pressure on life insurers who have written variable life products with higher guaranteed crediting rates than today's levels.  The risk can be inferred from the composition of industry policy reserves.  Policy reserves for annuity products were $2.9 trillion in 2012, more than double the level for life policies, and 65% of policy reserves.

For pension fund sponsors, particularly in the public sector, enormous pressures are building from mismanagement, poor investment decisions, and mortality and and longevity risks.

Signs of a locus for the next crisis may be seen in some recent capital market and reinsurance market deals.

• In 2011, Rolls Royce transferred some $3 billion in pension fund liabilities to Deutsche Bank, which in turn transferred them to a group of insurers and reinsurers.  RR pays fixed premiums for coverage if an agreed upon longevity index exceeds a cap, in which case RR receives payment from its insurers.
• Aegon hedged its annuity portfolio by transferring 12 billion euros of longevity risk to Deutsche Bank in a swap.  
• Aegon completed a second deal in 2013 through a more complicated structure created by Societe Generale's CIB business. 

If one goes to the current financial disclosures of these companies, it is almost impossible to find much discussion of these new types of businesses and their risks.  While some observers have said that there are only $2-3 billion of U.S. deal volume in mortality and longevity transfers done annually, they also say that worldwide appetite for these structures could be as high as protection for $21 trillion in assets. This kind of deal market would strain the capacities of even the giants like Berkshire Hathaway.

Keep an eye on the capital markets players and these business structures, if you can find them, understand them, measure the risks and track them back to the counter parties.  

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. 

The Satyam Shall Set You Free

Satyam means "truth" in Sanskrit. Today, the founder and CEO of Satyam (NYSE:SAY) announced that he had unfortunately misrepresented company assets by about $1 billion, and that its cash balance was not $1 billion, but more like $16 million. The company, which is listed on three international exchanges, used Price Waterhouse Coopers as its external auditors.

The company had illustrious academics on its board of directors, and their resumes bristled with institutional affiliations like the Harvard Business School, the Kennedy School of Government, and the Indian School of Business. It's incomprehensible how any kind of financial oversight, internal auditing process, and external auditor reviews could not have surfaced an issue of this magnitude.

Remember as you consider your emerging markets mutual fund that, in most cases, you are dealing with "drive by" analysts who cover companies that are nowhere near as open and communicative as US companies, exchanges that are not efficient or liquid, and which exert minimal control over their listed companies. And, the fees for these funds are outrageous. This risk-reward ratio is not attractive going forward.

We may be in the middle-to-late innings of the flight to Treasuries. Then some aggressive institutional bond investors have staked out big bets on U.S.corporate bonds from the bigger issuers, where prices are purported to be factoring in 25% default rates. Finally, there are equities, and within equities, there are emerging markets stocks. It is really hard to make any case for being in these kinds of company investments. To some extent, companies in India, China, and Russia (to name a few markets) have taken on the trappings of attractive investments: good PR work, big agency IR, corporate governance mantras. However, few of the principles underlying good governance are in their DNA yet. It may be quite a while.