oil at $80 a barrel–a Saudi plot?

I don’t think so  …and if the Saudis are trying to keep oil prices low in order to drive American shale oil out of business, it’s a pretty pathetic one  (Tom Randall of Bloomberg, for example, recently wrote an otherwise excellent article in which he supports the plot view).

Here’s why:

Any oil project starts with geology work to locate prospective acreage for drilling.  The oil firm then purchases mineral rights from the owner of the land where it intends to drill.  Next comes the actual drilling, which can cost $5 million – $10 million a well.  The driller also needs some way of getting output to market, which may entail building a spur to the nearest pipeline, or at least paving the local roads so that trucks he hires can get to the wellsite.

All that outlay comes before the exploration company can collect a penny from the oil or gas that comes to the surface.

In other words, the project costs are significantly front-end loaded.  This is important.  It means the economics of the situation change dramatically according to whether you’ve already made the up-front investment or not.

An example:

I took a quick look at the latest 10-Q for EOG Resources, a shale oil driller.

Over the first six months of the year, EOG took in $6.5 billion from selling oil and gas, and had net income of $1.4 billion.  That’s a net margin of 21.5%.  At first blush, it looks like a 20% drop in prices would put EOG in big trouble.

Look at the cash flow statement, however, and a different picture emerges.  The $1.4 billion in net comes after a provision of $1.9 billion for depreciation of some of those upfront expenses and after another provision of $479 million for deferred (that is, not actually paid yet) income taxes.  So the actual cash that came into EOG’s hands during the period was $3.8 billion.  That’s a margin of 58.4%–meaning that prices could be more than cut in half and EOG would still be getting money by continuing to operate existing wells.

Yes, at $70 a barrel, new shale oil projects are probably not sure-fire winners.  But oil companies will continue to operate oil share wells, even at prices below this in order to recover capital investments they have already made.  The right time for Saudi Arabia to throw a monkey wrench in to the shale oil works would have been three or four years ago, not today.

The wider point:  once a new entrant has made a big capital investment to get into any industry, it’s very hard to get the newcomer out.  Even if incumbents make the new firm’s position untenable, the latter’s goal just shifts away from making money to minimizing its mistake by extracting as much of its capital as it can.  It will be willing to destroy the industry pricing structure if necessary to do so.

 

 

 

Tesco, Coke and IBM, three Buffett blowups

Warren Buffett of Berkshire Hathaway fame is perhaps the best-known equity investor in the United States.

What made his reputation is that Buffett was the first to understand the investment value of intangible assets like brand names, distribution networks, training that develops a distinctive corporate culture.

Take a soft drinks company (I’m thinking Coca-Cola (KO), but don’t want to dig the actual numbers out of past annual reports).  Such a company doubtless has a secret formula for making tasty drinks.  More important, it controls a wide distribution network that has agreements that allow it to deliver products directly to supermarkets and stacks them on shelves.  The company has also surely developed distinctive packaging and has spent, say, 10% of pretax income on advertising and other marketing in each of the past twenty (or more) years to make its name an icon.  (My quick Google search says KO spent $4 billion on worldwide marketing in 2010.  Think about twenty years of spending like that!!!)

Presumably if we wanted to compete with KO, we would have to spend on advertising and distribution, as well.  Maybe all the best warehouse locations are already taken.  Maybe the best distributors already have exclusive relationships with KO.  Maybe supermarkets won’t make shelf space available (why should they?).  And then there’s having to advertise enough to rise above the din KO is already creating.

 

What Buffett saw before his rivals of the 1960s was that none of this positive stuff appears as an asset on the balance sheet.  Advertising, training, distribution payments only appear on the financials as expenses, lowering current income, and, in consequence, the company’s net worth, even though they’re powerful competitive weapons and formidable barriers to entry into the industry by newcomers.

Because investors of his day were focused almost totally on book value–and because this spending depressed book value–they found these brand icons unattractive.  Buffett had the field to himself for a while, and made a mint.

 

This week two of Mr.Buffett’s biggest holdings, IBM and KO, have blown up.  They’re not the first.  Tesco, the UK supermarket operator, another firm right in the Buffett wheelhouse, also recently fell apart.

what I find interesting

Every professional investor makes lots of mistakes, and all of the time.  My first boss used to say that it takes three good stocks to make up for one mistake.  Therefore, she concluded, a portfolio manager has to spend the majority of his attention on finding potential blowups in his portfolio and getting rid of them before the worst news struck.  So mistakes are in themselves part of the territory.

Schadenfreude isn’t it, either.

Rather, I think

1.  Mr. Buffett’s recent bad luck illustrates that in an Internet world structural change is taking place at a much more rapid pace than even investing legends understand

2.  others have (long since, in my view) caught up with Mr. Buffett’s thinking.  Brand icons now trade at premium prices, not discounts, making them more vulnerable to bad news, and

3.  I sense a counterculture, Millennials vs. Baby Boom element in this relative performance, one that I believe is just in its infancy.

 

 

 

ARK Investment Management and its ETFs

ARK

I was listening to Bloomberg Radio (again!?!) earlier this month and heard an interview of Cathie Wood, the CEO/CIO of recently formed ARK Investment Management.  I don’t know Ms. Wood, although we both worked at Jennison Associates, a growth-oriented equity manager with a very strong record, during different time periods.  Just before ARK, she had been CIO of Global Thematic Strategies for twelve years at value investor AllianceBernstein.  (As a portfolio manager I was a big fan of Bernstein’s equity research but I’m not familiar with her Bernstein output.)  She’s been  endorsed by Arthur Laffer of Laffer Curve fame, who sits on her board.

ARK is all about finding and benefiting from “disruptive innovation that will change the world.”

Ms. Wood was promoting two actively managed ETFs that ARK launched at the beginning of the month, one focused on industrial innovation (ARKQ) and another the internet (ARKW).  Two more are in the works, one for genomics (ARKG) and the last (ARKK) an umbrella innovation portfolio which will apparently hold what it considers the best of the other three portfolios.

What really caught my ear in the interview was Ms. Wood’s discussion of the domestic automobile market (summary research available on the ARK website).  Most cars lie around doing nothing during the day.  What happens if either ride-sharing services like Uber or the Google self-driven car, which make more constant use of autos, catch on as substitutes?  According to Ms. Wood, until these innovations reach 2.5% of total miles driven (based on the idea that on a per mile basis ride-sharing costs half what owning a car does), there’s little effect.  But at 5% penetration, the bottom falls out of the new car market.  New car sales get cut in half!

Who knows whether this is correct or whether it will happen or not   …but I find this a very interesting idea.

about the ETFs

The top holdings of ARKW are:  athenahealth, Apple, Facebook, Salesforce.com and Twitter.  These comprise just under 25% of the portfolio.

For ARKQ, the top five are:  Google, Autodesk, Tesla, Monsanto and Fanuc.  They make up just over 24% of the portfolio.

Both will likely be high β portfolios.  Both have performed roughly in line with the NASDAQ Composite since their debut.

The perennial question about thematic investors (I consider myself one) is whether the high-level concepts are backed up by meticulous company by company financial research.  This is essential.  In addition, it’s important, to me anyway, that the holdings be arranged so that they’re not all dependent on a single theme–the continuing success of the Apple ecosystem, for instance.

I’m not familiar with Ms. Wood’s work, so I can’t say one way or another (Fanuc and ABB strike me as kind of weird holding for ARKQ, though).  But I think her research is worth reading and her ETFs worth at least monitoring.  For us as investors, the ultimate question will be whether Ms. Wood can outperform an appropriate index.  The NASDAQ Composite would be my initial choice.

 

 

 

 

 

Bill Gross: a wave of (self-) destruction?

As even casual readers of the financial press know, Bill Gross, the bond guru, recently left PIMCO, the firm he founded, for smaller (everything is smaller than PIMCO) rival Janus.  Two aspects of his departure strike me as particularly noteworthy:

–Gross has been saying very emphatically, both at PIMCO and Janus, that he has absolutely no intention of retiring or of ceding any measure of control over his portfolios to colleagues.  This is despite an extended period of poor performance.  If he’s thinking at all about the impact of his statements on clients, he surely believes he is reassuring them.  However, it seems to me that the opposite is most likely the case.

What clients are likely hearing is that although he’s been charting a losing course for his portfolio for an extended period, he refuses to consider any changes or even to take any input from his 700+ professional colleagues. The way he’s delivering his stay-the-course message also makes him sound like an adolescent having a tantrum.  It’s hard not to connect this unusual behavior with the fact of extended underperformance, raising further issues about his temperament and his judgment.  This it’s-all-about-me attitude is very scary for anyone how has bet on Gross’s management prowess.

–PIMCO as a firm clearly made a terrible strategic mistake in making the idea of continuous outperformance by a single manager the exclusive focus of its marketing to clients for so many years.  Yes, the message is powerful and simple to understand, but one that’s also very risky and that invests a huge amount of power in a single individual.

PIMCO would probably have imagined any possible parting of the ways with Bill Gross to be somewhat akin to Derek Jeter’s final season as a Yankees.   …that is to say, a nostalgic feel-good farewell tour for a player who may be a shadow of his former self, but which validates both personal and institutional brands and generates large profits for both sides.  What PIMCO got instead was the unflattering glare of tabloid coverage of a messy divorce.

Bad for PIMCO.  But bad for Gross, too, I think.

As a client, how eager are you going to be to hitch your star to an apparently erratic 70-year-old who has weak recent performance, no longer has access to PIMCO’s extensive information network and whose assets under management are too tiny to have much clout in the brokerage community?    The default reaction of the pension consultants who advise institutions seems to be:  PIMCO without Bill Gross isn’t good enough; Bill Gross without PIMCO isn’t good enough.  It seems to me that PIMCO has a much better chance of changing consultants’ minds than Bill Gross does–it already has infrastructure, other managers with strong records and huge assets under management.

If I’m correct, absent a return to his form through the long period of interest rate declines, Mr. Gross appears to be in a much more difficult position than his former firm.  Much of this is his own doing.

 

Stockton, bankruptcy and municipal workers’ pensions

In June 2012, Stockton, CA entered bankruptcy, burdened, as one would expect, by two types of obligations it was unable to meet:  debt service on borrowings, and funding of pension/health care plans for city employees.

The city’s initial reorganization plan called for employee pension obligations to be met in full–as California state law mandates.  This meant most of the restructuring losses would be borne by lenders, with some suffering virtually total losses.  Naturally, these lenders, or their insurance companies complained, arguing that such treatment violated fairness provisions of the federal bankruptcy code.

Yesterday, Judge Christopher Klein, the federal judge presiding over the bankruptcy proceedings, ruled that the lenders are right.  To my layman’s eye, he seems to be saying that because it legislated a strict set of criteria that a town must meet before being allowed to seek bankruptcy, California was also implicitly releasing a bankruptcy-qualifying town from having to comply with the state law on municipal pension integrity.

The judge’s opinion is a little more complicated than that, since it also involves the position of CalPERS, a  state-wide organization that administers pension plans for both the state and municipalities in California.  But it follows a similar ruling in the Detroit bankruptcy.

This is a complex and controversial topic.  And we’re still in the earliest stages of the journey toward it resolution.  But from an investment point of view, I can’t imagine that these ruling will do anything to increase spending by Baby Boomers who are state/local employees or retirees.  Another reason to think harder about Millennials.

 

 

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.

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