massive redemptions at PIMCO? …I don’t think so

Late last week, bond guru Bill Gross, founder and public face of PIMCO, resigned from that firm to go to work for a much smaller rival, Janus.  This has led to speculation that the departure of Gross, who crafted the superior long-term record of the PIMCO flagship Total Return bond fund, would cause the loss of as much as 30% of the $1.8 trillion PIMCO has under management.

I don’t think the outflows will be anywhere near this bad, for a number of reasons:

1.  PIMCO deals in load funds, meaning that retail investors must pay a fee to buy them.  Two consequences:

–owners find the fact of the fee, not necessarily the size of it, a psychological barrier to sale.

–the load-fund client typically places a sell order through his broker.  The fact he can’t just go online in the middle of the night and redeem is another barrier to sale.  When called, the financial adviser can make reasoned arguments that persuade the client to hold on.  The broker may also convince the client to move to another bond fund in the PIMCO family, so that money leaves the Total Return fund but stays in the group.

What’s to stop a broker from using the Gross departure to call all his clients and tell them to take their money from PIMCO and place it with a different family of load funds–thereby generating another commission for him/her?  Generally speaking, such churning is illegal.  The transactions might even be stopped by the broker’s own firm.  Worse yet for the broker, this kind of call is pretty transparent as a fee grab.  It might also invite questions about where the broker was when the Gross performance began to deteriorate.

2.  My experience in the equity area is that while no-load funds can lose a third of their assets to redemptions in a market downturn.  Under 5% losses have been the norm with the load funds I’ve run.  Even smaller for 401k or other retirement assets.

3.  Money has already been leaving PIMCO for some time.

–Bill Gross’s performance has been bad for an extended period.

–He’s been acting like a loose cannon.

–Mohamed El-Erian’s leaving PIMCO was particularly damaging.  I think most people recognize that Mr. El-Erian is a professional marketer, not an investor.  But he was being paid a fortune to replace Gross as the public face of PIMCO.  Why leave a sweet job like that  ..unless the inside view was frighteningly bad?

At some point, however, PIMCO will have lost all the customers who are prone to quick flight.

PIMCO will try hard to get clients to stay.  It will presumably concede that it waited much too long to rein Mr. Gross.    But, it will argue, a seasoned portfolio manager at PIMCO, Dan Ivascyn, has now taken over the Total Return fund.  Supported by the firm’s broad deep research and investment staff of more than 700 professionals, Ivascyn will stabilize performance.  So the worst is now over.  In fact, Gross’s departure may have been a blessing in disguise.

4.  Arithmetic.  About $500 million of PIMCO’s assets come from its parent, Allianz.  Presumably, none of that will leave.  Third-party assets total about $1.3 trillion.  A loss of 30% of total assets would mean a loss of over 40% of third-party assets.  That would be beyond anything I’ve ever seen in the load world/

5.  Although individuals are prone to panic, institutions act at a more measured pace.  It would certainly be difficult to persuade institutional clients to add more money now, but it should be easier to persuade them to allow the assets they now have at PIMCO to remain, while keeping the firm on a short leash.

In sum, I can see that in the wake of the Gross departure, PIMCO could easily lose 10% of the third-party assets it has today.  I think, however, that the high-end figures are being put out for shock value and without much thought.

Bill Gross, PIMCO and Janus

Bill Gross is the (until recently) extraordinarily successful  lead portfolio manager for the bond titan PIMCO, which he co-founded and which he sold to the European financial conglomerate Allianz in 2000.

Late last week, Gross abruptly resigned from PIMCO to join Janus Capital, a much smaller, equity-oriented firm with a checkered history.  The apparently hasty departure seems to have come after Gross learned he was about to be terminated.

My take:

1.  The PIMCO brand has been built on two ultimately unsound pillars:

–a customer should buy PIMCO products because they would always outperform every other alternative, and

–the brilliant portfolio manager, Bill Gross would supply the returns..

2.  The problems with this brand strategy have certainly become apparent to Allianz in recent years:

–although retail investors don’t think of age as an issue with a portfolio manager, institutions do.  They worry that once a manager reaches, say, 60–and certainly when he/she reaches 65–that the manager will soon leave, that either retirement or illness will force a change.  So for institutions a key question is who the star manager’s successor will be.  It seems to me that, despite a deep, talented bench at PIMCO, Mr. Gross never permitted a successor to be designated.

–Mr. Gross’s string of stellar performance years appears to have come to an end at around the same time interest rates reached their lows.  Since then, my cursory observation is that Gross upped the risk level of his flagship fund, in an attempt to boost returns.  The strategy hasn’t worked, but it has added another level of worry.

3.  Allianz addressed the succession issue, not by selecting a skilled insider with a strong performance record, but by bringing in marketing celebrity Mohamed El-Erian as Mr. Gross’s successor.  This was a weird choice.  Yes, Mr. El-Erian had once been a PIMCO employee   …but he had limited portfolio experience and no public record of successful management.

It’s unclear to me whether Allianz did so because it didn’t know any better or whether the-appearance-of-a-successor-without-there-actually-being-one was all Gross would accept.  The idea may have been that El-Erian would take over many of Gross’s marketing duties, leaving him more time to concentrate on his portfolio.

4.  Mr. El-Erian resigned from PIMCO early this year.  It’s unclear why, although I can imagine several reasons:

–he was unsatisfied with his role as spokesmodel for PIMCO,

–he realized he would be held to blame for PIMCO’s continuing underperformance, even though he had no power to influence it, and

–Allianz came to understand–perhaps with help from PIMCO’s senior investment staff–that Mr. El-Erian was not a particularly good pick to become PIMCO’s lead portfolio manager.  It’s interesting to note that Mr. El-Erian, although still on the Allianz payroll, plays no role in the post-Gross restructuring.

5.  My guess is that the leadership transition at PIMCO has been completed with the appointment of a skilled veteran PM to lead PIMCO, and that the outcome is a lot better than it could have been.  It remains to be seen whether Mr. Gross can reestablish his performance record at Janus.

 

 

failing toll roads in the US-why?

I’m convinced that studying the behavior of Millennials –and in particular how it differs from previous generations’–will ultimately produce a treasure trove of equity investment ideas.

So my ears perked up when I began noticing recent reports of continuing failure of toll road investment projects that had been in vogue ten years or so.  Many were packaged by Australian investment bank Macquarie and/or Spain’s Ferrovial.

Chapter 11 filings have been attributed in the media to a sharp slowdown in total miles driven by Americans since 2007 (“…largest decline since World War II,” said one article).  Millennials’ aversion to autos and the suburbs are the supposed causes.

A quick check shows that’s not exactly right.

The Federal Highway Administration’s monthly Traffic Volumes Trends indicates that total miles driven by Americans has fallen from the peak of 3.03 trillion miles in 2007.  But the present level is still 2.98 trillion, a seven-year decline that totals only 1.65%.  Yes, this is a change from the pretty steady rise of just over 1% annually during the prior couple of decades.  But it’s hard to image that worst-case planning didn’t allow for a flattening out of traffic volume.

Two other characteristics of these deals stand out to my, admittedly cursory, glance, as being much more important:

–they’re very highly financially leveraged, and

–they contained a ton of derivative protection against rising interest rates–which backfired horribly, adding significantly to the already-high debt burden.

The deals also appear to have suffered from wildly overoptimistic projections of future road usage, although these were likely less linked to project survival and more to the possibility of above-average gains.

In any event, my main point is that this is not a story of differing Millennial behavior.  It’s all about bad project design and mistaken derivatives overlays.

 

 

 

the SEC is investigating PIMCO’s pricing of its Total Return (BOND) ETF

Another day, another PIMCO problem.

The Wall Street Journal reports the SEC is investigating whether the bond fund giant used its clout with brokers to get them to steer favorable investments to its Pimco Total Return (ticker = BOND) ETF, artificially inflating its performance in its early days.

I suspect the issue is a little more complicated than that.

background

We all know, or should know, that Wall Street likes to erase its mutual fund mistakes.  Underperforming managers get fired.  An investment management company’s week-record funds get disappeared by being merged into better performing ones, keeping the assets in house but eliminating the ugly track record.

When I entered the business, investment firms routinely used other practices, now considered unethical/illegal.

For example:

–many investment management companies used “incubator” funds, that is, they would create a bunch of mutual funds, seed them with small amounts of money and run them in-house–but not offered for sale to outsiders.  After a year or two, those with strong records were opened to the public and supported by marketing campaigns touting their sterling performance.  The laggards were simply shut down.  Fidelity Magellan, for instance, was originally one of these.  The practice is now illegal.

–big investment firms would also sometimes give a new or weak-performing fund a boost by allocating to them a disproportionately large amount of the “hot” IPO flow it, as a big commission generator, would get from brokerage houses.

I knew of a fund manager (brokers and traders love to gossip) from another organization who ran a mid-sized fund and had decided to go out on his own.  He persuaded the brokers he dealt with to feed him with large IPO allocations for several months.–in return, presumably, for future favors when he hit it big.  His performance skyrocketed–and he got Schwab to tout the fund he subsequently created.  Without constant shots of IPO adrenaline, his performance was never the same, hwever–and he was finally undone in an asset mispricing scandal during a severe market downturn.

The practice of selective IPO allocation within asset management firms was generally abandoned in the 1990s.  I’m not 100% sure why, although I can’t believe regulatory pressure wasn’t the main factor.  Hair-splitting:  I’m not sure the practice itself was the problem or the fact that fund management companies didn’t disclose what they were doing.

the PIMCO case

According to the WSJ, the issue here revolves around “odd lots” (meaning small amounts, or tag ends) of some thinly traded bonds.  They’re regarded as more of a nuisance than anything else–like you or me having 0.36 shares of a stock–and trade at a discount because of this.

PIMCO’s trading desk apparently let its brokers know that it was interested in buying any odd lots they might be able to find.  These were then funneled into BOND.

Since the junk bond collapse of the late 1980s, the daily pricing of bond funds has been handled by third parties, not by the investment management companies themselves.  The outside pricing services apparently don’t distinguish between odd and round lots.   So at the end of the day on which an odd lot was bought for, let’s say 98, it would be priced at, say, 100 or 101.

Bam!  …a “magic” jolt to performance.

That’s even though the odd lot could only be resold for 98 or so.

Pretty clever.

However, the trick can only move the needle for a small fund.  The extra returns the move appears to generate can’t be sustained as the fund grows.  So performance numbers achieved in this way are arguably deceptive.  They don’t really represent the kind of performance holders should expect as time goes on.

what’s wrong with doing this?

I can think of two possible SEC concerns, assuming the WSJ has the facts right about PIMCO’s conduct:

–that PIMCO didn’t disclose that is was using odd lots  to exploit a quirk in the ETF’s pricing rules and thereby boost returns

–all investment management firms have trading compliance rules that determine how buys and sells get distributed among the many pools of money it is managing.  PIMCO may have overridden its own rules if it diverted to BOND all/most (?) of the odd lots it bought.

why?  or what sparked SEC interest?

On the second point, what was  apparently going on would be immediately evident to any bond portfolio manager who looked at BOND’s SEC filings.  I presume a rival complained.  Or course, it may be that a disgruntled broker or trader notified the regulator.

In any event, this odd lot activity was bound to be noticed, and fairly quickly.

Why would anyone risk professional embarrassment or regulatory sanctions?   I have no idea.

 

 

 

comparing IPOs: Facebook (FB) and Alibaba (BABA)

J\Last Friday, just over two years after the IPO of Facebook (FB) in mid-2012, another major tech company, the Chinese internet conglomerate Alibaba (BABA), made its debut on Wall Street.  BABA received a warm reception.  This is in sharp contrast to the FB experience, which will certainly go down as one of the bigger stock market disasters of the decade (the century?).

The differences, as I see them:

the FB fiasco

1.  FB depended on a single lead underwriter, Morgan Stanley (MS).

2.  Morgan Stanley was unusual in that it had made a big effort to remain in touch with Silicon Valley after the collapse of the internet bubble in 2001.  It seems to me to have believed FB was its last best chance to cash in on more than a decade of visits and phone calls.  It also thought there was no follow-on business to be had.  Therefore, its tech investment bankers appear to me to have been more concerned about maximizing their fee income on FB than on ensuring that the buyers had even a mildly profitable experience.

3. Subsequent media reports, presumably based in considerable part on information provided by the underwriters, make it clear that the management of FB was obsessed with the idea of not “leaving any money on the table.”  The CFO, David Ebersman, seems to have badly misunderstood how the process of going public works–in particular, the negative effect on company morale of a failed IPO.  This is very odd, since most often a CFO is brought in precisely because he/she knows how going public works.

4.  Shortly before the IPO date,  the IPO price was boosted by about 12% and the number of shares on offer was raised by 25%.  In other words, at the last-minute the issue size was upped by MS and Ebersman by almost 50%–soaking up a ton of money that would otherwise have been available for buying in the aftermarket.  Virtually none of this went to FB; is all went to early investors, and some employees, cashing out.

5.  The FB offering was unusually highly reliant on (inexperienced) retail investors.  It appears many tried to “game” the IPO by asking for, say, 5x what they wanted to end up with (see my original post on the FB IPO).  Imagine their shock when instead of the $50,000 worth of FB they expected, $250,000 worth of stock–and the accompanying bill–plopped into their accounts.

6.  Then, of course, the NASDAQ trading computers broke down.  This made it impossible to trade, or even to get an accurate quote.  In fact, for at least several days, retail sellers didn’t know how many shares they may have bought or sold on the morning of the IPO, or at what price.

BABA is much better, so far

BABA used six lead underwriters, not one–although MS was included among them.

Retail exposure was minimal.

BABA listed on the New York Stock Exchange, avoiding NASDAQ.

BABA did price at about 5% above the high end of the announced range (apparently indications of interest were huge).  But the size of the offering wasn’t boosted, meaning plenty of buying power was still left for the aftermarket.  BABA was also arguably priced at a discount to comparable Chinese internet firms, while FB was priced at a premium–just as its business was beginning to slow.

 

analyzing sales rather than earnings (ii)

The answer the Bloomberg Radio reporter gave to the question, “Why sales, not earnings?” was that sales are harder for a less-than-honest company to manipulate.  In some highly abstract and technical way this might be true, but in any practical sense the reply is ridiculous.  Stuffing the channel is a time-honored, easy to do way of inflating sales.

Still, there are instances where an investor will want to look at sales rather than earnings.

1.  Value investors looking for turnaround situations will seek out companies with lots of sales but little in the way of earnings.  They’ll benchmark the poorly performing firm against a healthy rival in the same industry.  They figure that if the two firms have comparable plant, equipment and intellectual property, then a change of management should enable the weaker firm to achieve results that are at least close to what the stronger one is posting now.

As I see it, this mindset is what separates value investors from their growth counterparts.  The latter, myself included, begin to salivate when they see a strong bottom line; the former are magnetically attracted to big sales/no profits firms instead.

2.  Especially in the tech world, companies often go public before they become profitable.  AMZN, which didn’t report black ink for eight years after its IPO, is the poster child for this phenomenon.

Potential investors routinely look at the size of the market a given firm is addressing and the rate of its sales growth as a way of gauging its potential value.  This is a tricky thing to do, since it requires us to decide how much of the money the company is now spending is akin to capital spending–one-time foundation laying that won’t recur–and how much is spending that’s needed to generate each new sale.  Put a different way, it’s a decision on what is SG&A and what is cost of goods.  As AMZN illustrated, there’s huge scope for error here.

(An aside:  I attended an AMZN IPO roadshow presentation.  Management mostly said that during the PC era investors could have bought then-obscure companies like MSFT and CSCO and made a fortune.  The internet age was dawning and AMZN offered a similar chance.  Nothing but concept.)

3.  A simpler variation on #1  + #2, which is currently being worked vigorously by activist investors at the present time, is to find companies that may not break out results by line of business but which in fact operate in two different areas.  In the most favorable case for activists, the target firm will look like nothing special but have one high-growth, high-profit area whose strong performance is being obscured by a low-growth low/no-profit sibling.  The activist forces a separation, after which growth investors bid up the price of one area, value investors the other.

 

Obviously, no one uses just one metric.  But the way I look at it, the only persuasive case for using sales as the keystone to analysis is the value investor use I outlines in #1.

 

when to analyze sales rather than earnings

I was listening to Bloomberg News on the radio the other day, when a stock market reporter began a segment of an afternoon show by mentioning a a study he’d received of US stock market valuation based on price to sales rather than PE.

“Why sales and not earnings?” asked the show host.

The reporter had no clue. (An aside: it’s not clear to me whether this host asks probing questions of this particular reporter despite the fact he never can answer them or because he can’t.  I also sometimes wonder how aware each party is of the dynamics of their interaction–showing I must have too much time on my hands.)

Anyway, I decided to write about using sales as an analytic tool.

First, I should be clear that I’m not normally a fan of price to sales.  That’s probably because I’m a growth stock investor and am most often seeking out situations where profits are going to expand faster than sales..

To answer the host’s question as best I can:

Some companies are highly cyclical, like American autos or semiconductor equipment makers.  In bad times, they still have sales but may be posting losses.  Yet nobody pays you to take the shares off their hands; the stock trade at a price greater than zero.  In other words, at market bottoms they trade on something (i.e., sales or assets) other than earnings.  Similarly, as the economy recovers and the profits of deep cyclicals begin to explode to the upside, the PE multiple they sport progressively contracts.  In many cases, profits continue to surge but the stock price stops going up–because investors are anticipating the next dip of the cyclical roller coaster.  Again, they’e not trading on earnings.

So, at market bottoms the losses from cyclicals reduce overall index earnings, making the market look more expensive than it arguably should be.  At market tops, the stingy multiples that investors apply to peak earnings can make the market look misleadingly cheap.

Both distortions are eliminated, or at lest mitigated, by using price/sales.

Also, one might maintain that price/sales allows a better comparison between past decades, when a large portion of the market consisted of deep cyclicals, and the present, when the cyclical content is much smaller.

More tomorrow.

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