Southeastern Asset Takes Its Dell Investment Seriously

Southeastern Asset Management, which is the largest outside shareholder of Dell, has written a letter to Dell's Board of Directors opposing the proposed transaction to take the company private.  Unlike some other professional shareholder activists, SAM isn't proposing any self-serving transformation of the company or cosmetic sale of some business.

Instead their letter makes simple, but astute arguments, using some of the company's own statements, to show that the proposed buyout price is larceny in broad daylight.

If Dell's board hasn't thrown in the towel figuring everything is a go, they should wake up and do their job, as the letter asks them to do.

I've read shareholder letters and commentaries from SAM for decades.  As far as their own mutual fund shareholders go, they treat them well by providing a consistent investment process, with moderate expenses, and diligent oversight of the portfolios. Best of all, the fund management "eat their own cooking."  That is, they all have significant portions of their wealth tied up in their own funds.  So, when they call Dell on the carpet for management ennui in not wanting to deal with their public shareholders any more, it is exemplary shareholder activism.

Hopefully, other long-term shareholders will wake up from their slumber and take an hard look at this transaction.

Fed Governor Stein on Credit Market Overheating

Jeremy Stein, a member of the Board of Governors of the Federal Reserve System, made some remarks at the St. Louis Fed Research Symposium.  His talk was titled,  "Overheating in Credit Markets." 

One of the subsidiary themes in Stein's paper was hedge fund performance.  As of June 2010, the Ivy League university endowments had forty percent of combined assets in non-traditional ("alternative") investments, versus about two percent in the global investment industry portfolio.

A raw performance comparison between hedge fund indexes and the Standard and Poors 500 equity index over 59 quarters ending Q3:2010, shows hedge funds returning 9.2 percent per annum versus 7.5 percent per annum for the 500 index, with hedge funds having lower volatility and higher Sharpe ratios.

Ivy League university endowment funds, led by Harvard and Yale, pioneered large portfolio allocations to alternative investments (hedge funds, private equity, and real estate).  Dave Swensen of Yale became the public face for popularizing the use of alternative investments.

As of June 2010, Ivy endowment funds had 40 % of their combines assets allocated to alternative investments, whereas global institutional portfolios has only about 2% allocated to these investments.

According to a March 2011, Prequin survey cited by PwC, public pension plans had increased their allocations to hedge funds from 3.6% at the end of 2007 to 6.6% at the beginning of 2011.

So, what's not to like about hedge funds?  The current consensus among financial planners is that every investor needs to have exposure to alternative investments, particularly hedge funds, in their portfolio.  Morningstar even rates long/short equity funds among their mutual fund universe, although this category had a tough 2012.  Unfortunately, hedge funds are truly "black boxes," which should always be viewed with skepticism.

A 2007 paper by John Griffin (University of Texas at Austin) and Jin Xu ( Zebra Capital Management) looked at whether or not hedge fund managers were smarter equity managers than their traditional portfolio manager counterparts.  Hedge funds, they found, tended to deal in smaller, more opaque equities.  According to the multifactor APT models, small caps are an equity sector that has historically provided excess return.  Hedge fund managers also had higher turnover than mutual fund managers.  Because these smaller cap, more opaque equities often trade by appointment, this had to mean the hedge fund managers made extensive use of derivatives.  Their key finding was rather surprising.

"Decomposing returns into three components, we find that hedge funds are better than mutual funds at stock picking by only 1.32 percent per year on a value-weighted basis, and this result is insignificant on an equal-weighted basis or with price-to-sales benchmarks. Hedge funds exhibit no ability to time sectors or pick better stock styles. Surprisingly, we find no evidence of consistent differential ability between hedge funds. Overall, our study raises serious questions about the perceived superior skill of hedge fund managers."

So, why would investor agree to pay a 2/20 (2% per annum management fees; and 20% of portfolio profits) for an investment strategy which, when measured appropriately, may not add value?

According to the New York Times,

"In September 2012, the average hedge fund still charged 1.6 percent annually in management fees and collected 18.7 percent of any gains, according to data provider Preqin. Through November of that year, the average global hedge fund investor earned just 2.6 percent, according to the HFRX global index maintained by Hedge Fund Research. In 2011, investors lost nearly 9 percent. The average annual return from 2009 to 2012, supposedly recovery years following the losses of more than 20 percent in 2008, was a measly 3 percent."

Behavioral economists would say (1) investors are greedy; (2) individual investors, and even public pension funds, are forced to reach for returns in a low return environment precipitated by Fed policy; (3) investors are easily seduced by the black box, APT argument that free lunches of excess returns available to smart managers, and (4) since the fee and trading cost structures are opaque, it is nigh impossible to get an estimate of the true value added by hedge fund managers above their risk-adjusted cost of capital.

Now, in 2012 Governor Stein references papers by Jurek and Stafford who present some interesting data that seeks to decompose hedge fund outperformance.  Overall, they find that hedge funds as a category are not market neutral, which is one of the features their brokers and sales people trumpet when funds are sold to institutions.

Jurek and Stafford find that they can mimic hedge fund performance with a replicating portfolio of cash and a short position in single equity index put options.  In a recovering market uptrend, a manager could easily outperform the SandP by inexpensively replicating the index and by selling out-of-the-money put options on the index; these would expire out-of-the money and the manager would earn the option writing premia, assuring outperformance.

In both severe and mild market declines, the authors show that their replicating portfolio generates the same non-market neutral performance displayed by hedge funds over their research period.

The authors results appear in Table V in the appendix to the 2012 SSRN paper linked here.  The sample period is 1996-2010, and the gross return to hedge funds is the Hedge Fund Research Institute Composite Index plus an estimated average annual fee of 350 basis points, equating to a gross return of 13.1% per annum.  The risk-free rate is 3.14%, and the required risk premium is the mean, annualized excess return attributable to the put writing strategy, which is 9.79%.  The total hedge fund alpha in this model, accounting for a required return/cost of capital is 17 basis points.

Remember that we have progressed from the 2007 paper which showed that hedge fund managers don't have any demonstrable advantage in stock picking or market timing acumen compared to their mutual fund peers.  Yet they appeared  to outperform traditional equity or balanced fund investment strategies.  Now, when the sources of their excess return are decomposed and an attribution is made for their "cost of capital" then their alpha is essentially zero, according to the 2012 research cited by Fed Governor Stein.

So, of course, investors are now rushing like lemmings into hedge funds.

Governor Stein notes that the 2012 historic new high inflows into high yield mutual funds and new issue spread compression suggest an overheating in the high yield market. He, however, stops short of calling it a bubble, because of some historical precedents for the spread behavior.

I thought that the hedge fund material, buried in some references was at least as interesting as the discussion of high yield and leveraged loans. As opposed to financial industry economists, academia and the Fed seem to be producing the most interesting, and disinterested, research.  A reader has to dig for it, though.

Breaking Up HP: A Bad Idea Rears Its Head Again

Back in October 2012, with HP's stock price testing the 52 week lows, we made two points:

1. HP's customers are telling the company that separating computing hardware and printing from the rest of the company was not something desirable from their point of view, and
2. The company's lengthy analyst day presentation and the multi-year turnaround make little sense if the company were contemplating the classic Wall Street breakup.

Today, based on one report from Quartz Media, recycled by the Wall Street Journal, the idea that the HP board is reconsidering the breakup has resurfaced.  

One of the fundamental arguments for declaring the end of the PC era is the "tablet."  Have you ever watched what people do with their iPads?  They take low quality videos of their child's band concerts or soccer games.  They look up useless information on Google and search for restaurant reviews, or check NBA box scores.  These are certainly not "value added" activities.  

There are certainly interesting and useful apps for specific tasks, like running a virtual sound board for a concert band.  However, to say that corporate users will all migrate to tablets is a bit premature. Before that happens, the tablets themselves will have to become more powerful.  And, at the end of the day, users who want to work on data analysis will need more than touch screen typing.  If they want to collaborate across geographies on a new prototype in a software application, it won't be done on an iPad. 

Tablets will evolve and converge towards something farther away from an iPad and closer to a notebook.  Look at some of the reviews for the Microsoft Surface Pro with Windows 8. The hybrid of the future shouldn't require a hard disk drive, as storage should be on something like Sky Drive; applications can also reside on the Web, being accessed in a SaaS mode, again doing away with a drive.  Business users won't require a DVD drive.  

Whatever this device looks like in the future, a company that has a long history with a corporate client in delivering devices and software, will have a decided sales advantage.  It will also have a global supply chain in place, and it will also have be able to redeploy cash flows to develop these future products.  

The Enterprise Business, which would be left over after HP ostensibly got rid of PCs and Printers, would face its own challenges from declining hardware margins for servers.  As HP software grows, the margin rates could stabilize before eventually turning north.  For now, the HP software business is too small, and it needs time to grow.  Again, all of this can happen by reallocating cash flows from within the large leviathan. 

Paying down debt and restoring the credit rating should be a high priority, and share repurchases should move to the bottom of the list. A split of the company with the current structure would not be considered a "bondholder friendly" action.  Research and truly new product development expenditures have to be carried out efficiently and with a sense of urgency.  

The sales organizations will hold the key to putting a face on the company's strategy with customers. 

Walt Kelly's Pogo said it best.

Historically this has been the case for HP management and its board of directors.  Let's hope things have really changed.  

Au Revoir Alcatel-Lucent?

 Alcatel-Lucent came to our attention in July 2012,

"Finally, a good former institutional customer sponsors a successful international equity mutual fund, and looking over their holdings, I noticed Alcatel-Lucent, S.A., owned in the Sponsored ADR form.  I haven't looked at this company since Carly Fiorina was working her magic at Lucent in 1999.  You don't have to be an electrical engineer to understand these businesses, although much of the foggy commentary about these companies, like Juniper Networks, is replete with capitalized acronyms.  I read the press release and was a bit distraught.  I then went to the company's website and listened to the conference call.  Wow!  This was truly a dismal performance, and the cash flows in the quarter were awful, especially given the reduced outlook for 2012, a large debt load, upcoming rollovers, and loss of revenues as the company leaves behind "legacy" technology and moves to "new platforms."  I went back to my fund's annual report, and they've taken a forty percent hit from last December to date.  Value investors may not get it right very time, but they probably can demonstrate their thesis with some numbers.  I may have to call my fund and find out."

Now tonight's Wall Street Journal online updates the story, and it's not encouraging.  My fund clearly missed on this investment, and a large, reactionary employment downsizing isn't at all encouraging. Technology gear for the guts of networks is a commodity business, and the evolution of companies like Huawei has hastened this shift.

Investors will hear echoes of this theme as proprietary servers start moving down this road too.  Historical margins for companies like Dell and HP in servers may prove to be artifacts too.

Smoking E-Mails and More From Standard and Poors

Journalists from the New York Times report today that Federal prosecutors have subpoenaed 20 million pages of emails from Standard and Poors in relation to Federal investigations about the company's ratings of structured finance vehicles.  That sounds like prosecutorial over-reaching, but that's the climate of our political environment, I guess.

Just as in every Wall Street crisis, there are smoking emails, and the Times reports these two:

“Rating agencies continue to create an even bigger monster — the C.D.O. market,” one S.& P. employee wrote in an internal e-mail in December 2006. “Let’s hope we are all wealthy and retired by the time this house of card falters.”
Another S.& P. employee wrote in an instant message the next April, reproduced in the complaint: “We rate every deal. It could be structured by cows and we would rate it.”

 The original 2010 Senate hearings on the credit ratings issue feature a high level cast of characters from the rating agencies.  A student or reader who wants a laugh, or a headache, can listen to the audio.  Like most hearings on the Hill, they are not enlightening.

One expert's testimony, I found today, was enlightening and educational for me.  He is Dr. Arturo Cifuentes, a Professor of Industrial Engineering who also earned his M.B.A. in Finance at NYU's Stern School of Business.  When Dr. Cifuentes testified in 2008 and again in 2010, he was Managing Director in the Structured Finance Department of R.W. Pressprich and Company in New York.  He also writes with a sharp sense of humor.

In relation to my post from yesterday, Cifuentes told the Senate Banking Committee in 2008,

 "A study should be conducted by an independent internationally-recognized statistical consulting organization (there are well-established mathematical methods to conduct this type of analysis) to see if the ratings have been “independent.”  Take, for example, all the CDO ratings given in a specific time period by Moody’s and S&P (to the same transactions) and compare them to see if they are “statistically different” or not.  This is a much needed exercise"

The point I was making yesterday is that this exercise is the first, objective "smell test" which would show if in fact the global financial system had three independent credit rating agencies or not.  Professor John Coffee  concluded the evidence shows a "race to the bottom" as the three agencies competed for market share and for large consulting fees.  They had nothing to gain by giving appropriately lower ratings to CDO's, since this would automatically exclude them from being considered for an investment bank's business.  Issuers needed AAA ratings from two agencies in order to go forward marketing to their institutional investors, who had to be rating driven by their charters.

If was very clear, as Cifuentes points out, that once these CDO's were trading in the secondary market, buyers and sellers looked right through the published ratings and priced the paper appropriately.  He cites the example of two CDO's issued in March-April 2007, both rated (BBB/Baa).  One was trading at LIBOR +1000 and the other at LIBOR+120.  Cifuentes says this situation is "unheard of."

The much more technical paper by Cifuentes and Katsaros convincingly demonstrates a problem facing rating agency analysts and investment bank analysts.  As we said before, the performance of the CDO depends on the credit risk behavior of the underlying pool of assets.  The analyst has to determine the probability of default, for which market proxies like CDS spreads are available.  In addition, there are ratings and fundamental analyses of assets which can provide guidance.  The big problem is how to estimate the default correlation, for which there should be relatively few events from which to make an estimate.  Then, as Cifuentes points out, the default correlations proved to be time-dependent, which is not a usual model assumption.

Rating agency analysts turned to a specific model to solve their problems, the One-Factor Gaussian Copula, which allowed a modeler to use asset correlations as proxies for the unknown default correlation.  Using this model derives implied default correlation values that are tranche-dependent, something that should not happen.  Just to give the punch line from their interesting paper,

"To sum up: the one-factor Gaussian copula method is a flawed technique to
model something that does not exist -- two very good reasons to move on
and leave all this correlation/copula nonsense behind.  Future efforts should
be focused on estimating default probabilities better.  Period.  End of story."

I believe that when one thinks about the flawed model and how it propagated itself through all the rating agencies, it explains something about the behavior of the investment banks.  Their analysts and quants are, like it or not, of a much higher caliber than those of the rating agencies.  I would guess that they knew relying on the Gaussian copula was fine for generating the AAA rating the banks needed to move the paper into the market, but they also knew that a rating based on this flawed model was unjustified.  Thus, it's no surprise that investment banks like Goldman shorted CDO's in the secondary market. Just a thought.

It really is a shame that five years after these problems were clearly identified, essentially nothing has happened to hold the culprits and their enablers accountable for a crisis whose after-effects still permeate our economy and our financial system. Politicians of both parties and our regulators are squarely to blame.

Standard and Poors Takes Some Punches

The earliest and best exposition of the role of the rating agencies in the mortgage debacle dates back to 2009. I posted a blog entry about Professor John Coffee's analysis of the drama and its bad actors. Here's the relevant excerpt:

This begins Act II of the tragedy in Professor Coffee's presentation. The investment banks bought loans because they knew that they could securitize them on a global basis if they could get "investment grade" ratings from two of the critical gatekeepers, names the rating agencies SandP and Moody's. Two ratings were needed for investor acceptance. So why did the gatekeepers fail to do their jobs?
When Moody's and SandP were focused on corporate bond issuance, no one client accounted for more than 1% of their business. When structured finance overtook corporate bond issuance, their business mix changed dramatically. In 2006, for example, 56% of Moody's revenues came from the top investment banks for structured finance product ratings. In addition, now the rating agencies generated consulting revenues from the same investment banks, counseling them on how to design a marketable structure. This concentrated their business and reduced their independence.
An additional wrinkle came with the acquisition of Fitch, and the new French owner's decision to grow its market share. Now, instead of a duopoly, you had three firms competing for the two ratings that had to accompany every "investment grade" deal. Professor Coffee had a dramatic slide that showed significant grade inflation for both investment-grade and below-investment grade securities

Standard and Poors' argument that its ratings were not motivated by "commercial considerations" seems to a weak one, although the issue of proving that the ratings were made in "bad faith" will be difficult for the government, unless there are a load of "smoking e-mails."

In 2012, we wrote about the Australian judge who wrote that investors could sue Standard and Poors for assigning AAA ratings to a CPDO structured finance vehicle.

Like judging the performance of the audit firms, the argument has to stay on technical and process grounds.

• What models did Standard and Poors use to evaluate the performance of the mortgage pool underlying the structured finance vehicle?
• Did SandP rigorously analyze a sample of underlying types of mortgage loans in the pool, especially the higher risk loans? 
• Did their modeling, analytical process, and historical experience with these products provide a reasonable basis for their AAA rating?
• Was the high percentage of AAA deals and the absence of split ratings among the three competitors a reasonable statistical outcome?  

Standard and Poors predictably argues that (1) Their opinions are just opinions, like me opining on the Oscar-winning movies; as such they are protected by free speech.  They are not to be relied on for investment decisions.  

(2) Their opinions were not motivated by commercial considerations.

The rating agency contention that it was being held accountable for not foreseeing the credit meltdown is a red herring and nonsensical. 

The Justice Department has to be pushing for a settlement, since they probably can't win at trial. SandP would be foolish to admit to any wrongdoing, because none of the other bad actors in the mortgage meltdown--from IndyMac,Countrywide to Bank of America, to Fannie Mae, Angelo Mozillo and Franklin Raines-- have done so.  

If Standard and Poors gets harpooned for a few billion dollars, then Moody's and Fitch would also probably be caught in the nets of Justice.  Let's see if some cosmetic accountability is better than none. 

Markets Continue Their Economic Disconnect

It's always nice to look at a daily portfolio update and see the equities portion of a portfolio going up, but I've never found it comforting when I can't put a finger on why.

Unfortunately most of the economic talking heads commentaries are just political propaganda in a poor disguise.  Paul Krugman: enough said.

Jeffries Economic Forecasting group, headed up by Ward McCarthy, has consistently tracked the fundamentally weak numbers from the labor market.  The divergence between payrolls data and the establishment survey has always been a statistical feature for analysts to deal with, but the current divergence is striking.

As JEF notes in their current bulletin, the establishment survey shows that since the recovery's start in the first quarter of 2010 , the private sector has added 6.11 million jobs, with public sector jobs shrinking net by 610 thousand, for a net jobs addition of 5.5 million.  This sounds good, but the household survey is less encouraging.

The bottom line is that 8,786,000 jobs were lost during the horrific financial downturn, and 3,297,000 more jobs have to be added before the economy gets back to where it was pre-crisis, never mind employing new or returning labor force entrants.  Movements in the unemployment rate, as the authors point out, are dominated by changes in the participation rate, which is down to 63.6% versus 66% at the start of the recession.

What about the rising equity markets, you say?  Surely, they are discounting higher expected streams of corporate profits from a stealth, but improving recovery.  Look at the housing sector.

David Rosenberg, the Chief Economic Strategist for Canadian firm Gluskin Sheff has an illuminating current presentation, which could be called "bearish" in this ebullient market.  I found an older version of it, with the same essence, on Business Insider. This particular slide shows the sharp upticks in the U.S. stock market have coincided with the announcements of  QE1, QE2, and Operation Twist.  The search for fundamental economic underpinning goes on.

Meanwhile, the distortions for business decision making caused by the unconventional monetary policy continue apace.  Jeffries notes the "insatiable" investor demand for yield: Mohawk Industries priced a ten year offering at a paltry 30 basis points over Treasuries.  Mohawk is a split-rated (Ba1/BBB-) issuer with a cyclical business exposed to residential construction and remodeling.  But, the "good news" about housing is old news and surely should have been discounted.  Mohawk is not a strong issuer, which is what a 30 basis point spread would seem to suggest, but this is a desperate investor market.

The Jeffries team also notes the weak bidding for Treasuries, apart from the Fed. As they say, "...both the price action and customer flow at the long end are troubling...The long end is effectively being propped up by Fed purchases."  No good fundamentals here either.

Finally, remember those corporate coffers filled with cash to invest in business expansion?  Large chunks went to special dividends and irrational share buybacks.  Today, we're told that the distorted yield curve from the Fed's policies is forcing corporations like Ford to spend $5 billion for this year's contribution to its corporate pension funds.

As we begin the week, let's hope that the markets re-equilibrate.  In so doing, perhaps they can send a signal to Washington--including the Fed--that feel good asset markets are not a drug of choice for a sputtering economy.