Mitt Romney’s presidential candidacy has created a new wave of interest in the mechanics of private equity.

The debate has so far primarily been about whether what private equity does–take control of companies that are not making much money, reorganize them and sell them on–is socially useful.  The answer is generally “Yes.”

A secondary question is whether investors in private equity funds, primarily pension plans and university endowments, are getting a good deal. The answer here is generally “No.”  In a recently conducted study for the Financial Times, for example, professors at Yale (whose endowment has been a bastion of such “alternative” investments) and Maastricht University conclude that the vast majority of profits go to the organizers and promoters of private equity schemes, not to the investors who bear almost all the risks.

hedge funds

The same is true of hedge funds, which incidentally are putting the finishing touches on a decade of underperformance versus an S&P 500 index portfolio.  And that conclusion is based on the data the funds themselves voluntarily report.  There’s lots of evidence that some hedge funds routinely overstate their: investment performance, assets under management, and the size and qualifications of their professional staffs.

these are illiquid investments

…oh, and in addition to less-than-stellar profits, these vehicles can be highly illiquid.  In the Great Recession, investors in hedge funds learned to their dismay that the contracts they signed (which they apparently hadn’t read) allowed their managers to refuse requests for redemptions–even for years.  Recently, stories have also been circulating about failed private equity projects that refuse to liquidate, presumably because that would put an end to the management fees the organizers are collecting.

but they’re in high demand

That such a P.T. Barnum-esque situation should have developed with exotic investment vehicles isn’t that strange.  What is, however, is that despite a long period of lackluster performance, institutional investors want to put more of their money into hedge funds and private equity, not less.

Why is this?

correlation

The standard answer that institutions will give is that these “alternative” investments aren’t correlated with the movements of stocks and bonds.  Therefore, they’re a diversification.   That lowers the risk of the overall institutional portfolio.

This, of course, is not true.

Generally speaking, the fact that the returns on two assets aren’t correlated doesn’t mean that the risks of one partially offset those of the other.  It just means that you’re exposed to two different sets of risks.  The fact that in bad weather you speed in a racing car and pilot a small plane doesn’t mean you’re safer than if you just did one of the two.

Also, in the case of alternative investments, there’s no public market and holders have no independently verified information about their returns.  So they have no way of determining if risks are correlated or not.

political pressure

A second, less talked-about reason is that hedge and private equity funds hire powerful, politically connected, salesmen who wield influence over the pension plan managers.  There have been scandals about payments to such sales agents in California and New York.

damned if they don’t

To my mind, the main reason institutional investors are attracted to alternative investments is simple arithmetic.  Traditional pension plans don’t have all the money on hand today that will be needed to pay their future obligations to present and potential retirees.  They assume that they can invest the funds they do have to earn a specified return, usually around 7%, so that today’s assets can grow enough to meet future obligations.  If they can’t do this, the plan is underfunded and the employer has to eventually kick in enough to make up the difference.

Is 7% a reasonable annual rate of return in today’s world?  Not if you’re limited to publicly traded stocks and bonds.

Let’s say that you have a 50/50 mix of the two asset categories.

–Stocks can probably have a nominal return of 8% a year (inflation +6%).  History says that in the aggregate the managers you hire will deliver somewhat less than that.

–The 30-year Treasury is yielding about 3%; the 10-year yields about 2%; the return on cash is practically zero.  Interest rates are now at emergency-low levels.  This means chances of a capital gain from holding bonds are slim; chances of a capital loss on your bonds as the economy recovers and rates rise are high.  Let’s be super-optimistic and say you can collect a 3% coupon and make no losses.

With a 50/50 mix of stocks and bonds, then, a pension plan can achieve a return of about 5% annually.  That’s nowhere near enough to meet the 7% goal.  Even if the plan went to an allocation of 100% stocks,  it might not achieve a 7% return.  And doing so would give up all protection against the possibility that another year like 2008 rolls around–as one sooner or later will.

How does the executive in charge of the pension plan deal with this problem?

Does he go to his boss and say he needs an extra $10 billion or so to fund the plan–taking the risk that the boss will shoot the messenger?   …or does he take the chance that, against the testimony of experience, alternative investments will deliver what they promise–big enough returns to get to the 7% goal?

The latter is certainly the path of least resistance.  And this fact also probably makes the political pressure from the hedge fund/private equity salesman that much harder to resist.

moral hazard

Moral hazard in finance is the situation where the existence of an agreement to share risks causes one of the parties to act in an extra-risky manner, to the detriment of the other.   In a sense, the willingness of the party who ultimately gets injured to enter into the agreement causes, or at least allows, the bad behavior by the other to occur.  He inadvertently sets up a situation where the bad behavior is rewarded, not punished.

examples

–Systematically important banks have been able to take very big proprietary trading risks, knowing that they are “too big to fail” and will ultimately be bailed out by the government if their risky bets don’t pan out.  The rewards of such risk-taking go as bonuses to the bankers; the cost of bets gone bad is borne by the general public.

–One of the reasons Germany is so hesitant to bail out Greece is that doing so rewards the latter country’s reckless borrowing behavior over the past decadeand shifts the costs of cleaning up the resulting economic mess onto the citizens of the rest of the EU.

the Rakoff case and moral hazard

Judge Rakoff has just rejected a proposed settlement of a case involving Citigroup and the SEC, on what appear to me to be similar moral hazard grounds.

The settlement involves Citi’s creation and sale of $1 billion in securities ultimately tied to a pool of sub-prime mortgages selected by the bank.  Citi neglected to tell the buyers of the securities that it wasn’t simply an agent.  It was making a $500 million bet that the securities would decline in value sharply–which they subsequently did.  Investors who bought the securities from Citi lost $700 million.

I don’t know precisely how much money Citi made on this transaction.  But I think I can make a good guess.  To make up rough numbers, collecting a 2% fee for creating and selling the issue would bring in $20 million or so.  A 70% gain on its negative bet on the issue would yield $350 million.  If so, the much more compelling reason for creating the issue would be to design it to fail and then short it.  In any event, let’s say Citi cleared $370 million before paying its employees who thought up and executed the total deal.

The proposed settlement?

–fines and penalties totaling $285 million

–Citi doesn’t admit or deny guilt, which means

——the settlement doesn’t create any evidence to support a lawsuit by the investors who lost money, and

——the settlement doesn’t trigger the sanctions against future illegal conduct that are contained in prior settlements with the SEC.

–only low-level Citi employees are reprimanded.

Assume the SEC allegations are all true.

If so, what a deal for Citi!  The SEC “punishment” is that the bank keeps $85 million in profits and gets a slap on the wrist.  Who wouldn’t agree?

What would make this moral hazard is that this is is the worst case outcome for Citi.

And, if you figure that the SEC looks at one suspicious deal out of ten, the situation is even less favorable for investors.  The decision whether to create another issue like this one is a layup.

Would it be so easy if Citi stood a chance of losing money?  …or of triggering clauses in prior settlements prohibiting illegal behavior?

What about the legal team that decided what he minimum disclosure in sales materials should be?  Would they have insisted that Citi must reveal its proprietary trading position in those materials if fines were larger, or if they could be held professionally liable for the information’s exclusion?

What if the Citi executives that okayed everything risked being barred from the securities business for a period of time–would they have acted in the way they did?

grandstanding?

I don’t think critics are correct that Judge Rakoff is trying to raise his public profile by insisting that the SEC either obtain a better settlement or go to trial with its case.  Others are saying that the SEC takes settlements like this because it doesn’t have the legal skill to get anything better.  But these are ad hominem arguments  –like saying the parties are wearing ill-fitting clothes, they’re distracting, but irrelevant.

But it is true that this case comes at a time of growing public anger that bank executives are showing few ill effects from the devastating economic damage they helped cause.

It will be interesting to see what new settlement the SEC and Citi come up with.

Stay tuned.

Mr. Miller was once the envy of equity portfolio managers everywhere for the fame and fortune his beating the S&P 500 for 15 years in a row brought hi.  In recent times, he has become the embodiment of very pm’s worst nightmares, however.

His previously hot hand–which had earned him designation by Morningstar as a “Manager of the Decade” turned icy-cold in 2006.  Ensuing weak performance erased the gains in relative performance his portfolio had made since “the streak” began in 1991.  The assets in his fund fell by almost 90% from the peak of $21 billion +.

my thoughts

I should say at the outset that I don’t know Mr. Miller and that I haven’t studied his portfolio composition carefully.  And I’m not interested enough to look up his past SEC filings to try to document my impressions.  With that warning, here’s what I think:

1.  It took Legg Mason a very long time–and the loss of the vast majority of Value Trust’s assets–before it made the change.  At the asset peak, the fund was generating management fees for LM at a $140 million annual clip.  It’s now generating under $20 million.

Why not act sooner?

Part of the reason is likely that after sagging in 2006-2008, the Value Trust outperformed in 2009.  More important, I think, is that the fund’s marketing has been all about “the streak” and the extraordinary investing prowess of Mr. Miller.   It’s a good story and an easy sell.  But it’s a risky strategy.  If it’s all about the numbers, and someone with even better results comes around–and invariably someone will–what do you do? You’ve already made the argument to your client to switch into the Value Trust because of the numbers; how can you now argue against numbers that tell him to switch out?

This selling direction also gives the manager himself a huge amount of power.  What’s the Bill Miller show without Bill Miller?  So if Mr. Miller wants to continue to run a concentrated portfolio with a strong emphasis on financials, despite steady underperformance, how do you stop him not to?

2.  I’ve never regarded Mr. Miller as a typical value investor, although he’s always described as one and the Value Trust (note the name) is classified with other value vehicles by rating services.  I have two reasons:

–Value investors are belt-and-suspenders kind of guys.  They run highly diversified portfolios, typically with 100-200 names–sometimes more.  Growth investors, in contrast, typically hold 50-60.  Looking up the Capital Management Value Trust on Google Finance told me it has only 46 names. (By the way, in my experience ratings services never pick up high concentration as a source of risk.)

–Both value and growth investors look for “undervalued” securities (only shortsellers want to find overvalued stocks).  That isn’t what the “value” in value investing signifies.  It means a certain approach to finding undervaluation.

Value investors look at the here-and-now.  Their holdings are typically asset-rich companies that have encountered temporary difficulties, which have been crushed by Wall Street and which are now trading at unduly depressed valuations as a result.  Growth investors, in contrast, look for companies whose future earnings prospects are being underestimated by the market.

In this sense, too, I don’t think Mr. Miller is a plain-vanilla value investor.  He has been happy to hold large positions in stocks like Amazon or AOL (in its heyday)–names I think other value practitioners wouldn’t give a second look because the whole story has been the rate of future earnings growth.

I have no idea how Mr. Miller squares this circle.  (The fund’s largest positions are now in technology, according to Google Finance.  But it’s not the same thing.  Today’s stocks are eBay and Microsoft.  Apple, the largest holding, is still a growth stock, unlike the others.  But AAPL trades at a very low PE multiple of current earnings.)

3.  Despite this flexibility, and the issue of heavy concentration aside, it seems to me that classic value behavior has been the Value Trust’s recent problem.  Relative to history, financials were trading at low price to book value (i.e., the balance sheet value of shareholders’ equity) ratios when Mr. Miller bought them.  In hindsight, that was a mistake.

There may have been a second.  If the stocks a growth investor buys underperform, he typically stops buying or lightens up.  Value investors tend to do the opposite.  They regard such stocks as being even cheaper than when they initially bought–and double up.  I suspect the latter is what Mr. Miller did.

two oddities

1. In the early part of my career, alternating cycles of outperformance by value and growth stocks were relatively brief.  Given a year, or two at the most, there would be little to chose between the numbers generated by one style or the other.  The 1990s, however, saw a multi-year value cycle in the early part of the decade, followed by a massive multi-year growth cycle–culminating in the Internet Bubble–at the end.  Despite the fact that the tide was running strongly against value during the latter years, Mr. Miller continued to outperform the S&P 500.  If he did so with value stocks, that’s his crowning achievement.

2.  After creating a strong business franchise under the Miller name, neither he nor Legg Mason did much to protect it.

For example, it put Martha Stewart in jail but ignored Bernie Madoff.   It pursued Michael Milken vigorously after the junk bond market collapsed.   But it has, so far, left the heads of the major commercial and investment banks untouched, despite the fact that the toxic derivative securities they created were much more widespread and–as we continue to see–have damaged the world financial system much more severely than anything Milken did.

Raj Rajaratnam’s insider trading recently drew an 11-year prison sentence and a $93 million fine.

But the other side of the SEC has come to light again recently in the court of gadfly judge Jed Rakoff.  Judge Rakoff is being asked to approve a settlement of a case in which buyers of a Citigroup mortgage product lost $700 million.

The deal the SEC is offering?

–pay back $160 million, plus $30 million in interest and a $95 million fine;

–Citi doesn’t admit it did anything wrong;

–only low-level Citi employees are sanctioned.

–oh  …and the SEC wants to include an admonition to Citi not to do stuff like this again.  But, as Judge Rakoff points out, Citi appears to have violated such orders issued in prior settlements at least twice in the past decade and the SEC has done nothing.

You’d take a deal like that all day long.

A cynic might say that this behavior is related to the fact the current head of the SEC used to be in charge of the brokerage industry trade association.  On the other hand, I believe much of the toxic derivative activity was deliberately organized by the banks out of London because that put them out of the reach of US prosecutors.  So there’s not much the SEC can do.

…which brings me to MF Global.

There’s certainly a danger to generalizing from a small number of instances.  But, to me, what connects Martha Stewart, Michael Milken and Raj Rajaratnam is tha: t the issues are easy to understand, the names are high-profile, none were deeply plugged into the financial industry establishment and, although wealthy, none had the near-infinite resources of the large investment and commercial banks.

One of the issues that the Occupy Wall Street movement gives voice to is that after nearly destroying the world economy and forcing a high-cost financial rescue that all of us will be paying for for many years, no high-level financial commercial bank or brokerage executive has been prosecuted for anything.

What this adds up to, I think, is that the SEC will be scrutinizing the role Jon Corzine played in the demise of MF Global very carefully.  He’s a former head of Goldman Sachs but no longer an industry insider;  he’s an ex-senator and ex-governor; he’s wealthy–but not Bill Gates.   And, the question of whether the firm illegally took money out of customer accounts and used it to stave off margin calls is pretty clear-cut.  It may also be hard to say you didn’t notice an extra $600 million plopping into a portfolio you manage–especially so if you really needed it.

It will be interesting to see what happens–both whether the SEC finds a reason to prosecute and whether that will satisfy OWS.  My guess on the second count is that it won’t.

In mid-2007 the glow of a multi-year bull market had not yet begun to fade.  That’s when the Man Group, the London listed hedge fund group, divested itself of its brokerage arm, which was renamed MF Global.

Looking back, this seems to me to be a standard move of a firm that is in both a fast-growing business (hedge funds) and a slow-growing one (brokerage):  split them apart to create two pure stock market plays.  That allows the strength of the fast-growing business to be seen more clearly, and hopefully gets that stock a higher PE multiple as a result.

As for the mature business, who knows.  There may be investors who want to hold it.  And in any event, the timing of the split-up seems to have gotten MF Global an initial valuation that was relatively high.

Sometimes these splits work out well for the apparent ugly duckling.  Coach, for example, was a spinoff from cakes and tee shirt maker Sara Lee, where it was starved of capital.  Free of a bureaucratic parent, that company has been a rocket ship ride for a decade.

Not the case here, however.  (For anyone who knows the Man Group well (not me), it might be interesting to go back and see how the management talent was apportioned between Man and MF Global.  My hunch would be that, if anything, MF Global was stocked with lesser lights.)

spreading its wings

MF Global appears to have intended from the outset to reinvent itself as an investment bank.  An early trading stumble highlighted management control deficiencies and brought in private equity firm, J C Flowers, as a shareholder.

So far, while things could have worked out better for MF, nothing so out of the ordinary.

the strange stuff

1.  the Corzine hire

In early 2010, MF installed a new CEO.  The new guy had built a reputation as a very aggressive and successful bond trader during the 1980s.  He’d been booted out of his two previous management jobs, reportedly for being unable to get along with others.  The most memorable moment of his public service career was when he survived a 90 mph crash in his New Jersey state car, which he habitually rode in without using a seat belt.

Tidbits of gossip aside, Mr. Corzine had been an individual star in a young man’s business.  But he’d been out of the industry for over a decade.  And whether he possessed any management talent was at least open to question, though New Jersey voters rendered their verdict forcefully in 2009.

Picking him, it seems to me, is like selecting a 60-something ex-athlete to be the star player on your team, not the manager.  The broad of MF seems to have had no problem with this.  Mr. Corzine himself appears to have been blissfully unaware that it might take some time to shake the rust off talents he hadn’t employed in the current century;  he appears to me to have committed the cardinal sin of underestimating the other side of the trade.

According to Reuters, MF paid Mr. Corzine $14 million + to drive the company into bankruptcy in under two years.

2.  the “Goldman” recipe

Robert Rubin, former Goldman partner, advised Citigroup to dive into proprietary trading when he joined the company board.  Disastrous results.

John Thain, former Goldman partner, expanded Merrill Lynch’s proprietary trading when he took over as CEO.  Disastrous results.

Jon Corzine, former Goldman partner,…     Sense a pattern here?

3.  where were the compliance people, or the CEO for that matter?

Press reports, including this FT post, indicate that a last-minute deal to save MF Global by merging it into another financial firm foundered when MF couldn’t account for large amounts of customer money.  As I’m writing this on Thursday morning, it sounds like someone in MF diverted $633 million out of customers’ accounts and into its own last week in order to cover trading shortfalls.

It’s hard to believe this is true.  Things like this might happen in Madoff- or Enron-land but they simply don’t occur in reputable firms.  Nevertheless, this is what the CME Group, MF’s regulatory supervisor is accusing MF of.

I also find it hard to believe, although I guess it’s possible, that Mr. Corzine didn’t have a detailed daily (if not real-time) report of MF’s overall trading positions.  It seems to me that the “magic” appearance of over half a billion dollars in the company’s accounts should have been evident to MF management almost immediately.

I don’t think the entire story has been disclosed yet.  The Wall Street Journal, for example, is pointing out the mismatch between Wall Street analysts’ research and Mr. Corzine’s public statements vs. what we now see as the underlying reality.  Stay tuned.

two objectives

Basically, you analyze your portfolio carefully and at regular intervals to do two things:

–so you know for sure how your portfolio plan is working and what quantify which stocks or ideas are adding to or subtracting from your performance, and

–so you gradually learn about your investing personality.  By this I mean what things you typically do well and which ones you aren’t so good at.  You want this information, as painful as it may sometimes be to find out, so that you can emphasize the former and minimize the latter.  After all, the main goal is to earn/save money–not to massage your ego.

#1  figuring out performance

There’s a purely mechanical aspect to this.  You have a benchmark like the S&P 500, by which you judge your performance (you could achieve this return by buying an index fund.  You should only spend time and effort to select individual stocks or focused ETFs/mutual funds if you expect a return higher than the index fund will give you).

Over the past three months, the S&P 500 is down about 7.5% (ouch!).  Over the past month, it’s up about 9%.

Your first task is to calculate how your portfolio has performed vs the S&P over the interval you’re studying–both as a whole and each individual issue.  (For what it’s worth, after a long period of doing well, my stocks have been clobbered over the past month.)

what to do with this data, once it’s collected

a.  look for outliers, especially big losers.  Everyone has losers.  Everyone, even the most seasoned professional, also has an almost infinite capacity for denial.  My first mentor as a portfolio manager used to say that it took three winners to offset the damage that one big loser can do if it’s left to run amok and not caught early. So finding losers and eliminating them is important.

b.  ask if your plan is working.  This presupposes you have a plan.  A checkup may well bring out that you’re not bringing your intelligence, knowledge and experience to the party but are, so to speak, mailing it in and hoping that’s good enough.  (We all find out quickly that it isn’t.  Although individual market participants may not be the sharpest pencils, the collective entity is extremely acute.)

For example, in general my plan is:

–world economies are still expanding, although slowly.  So I’m still positioned for an up market.  The EU has me worried.  I’m thinking about shading toward larger, stodgy sort-of-growth stocks as a defensive measure but haven’t done anything much yet.

–there will continue to be a sharp separation between haves (mostly meaning having a job) and the have-nots (the 10% or so long-term unemployed in the US).  I want to own stocks that cater to the former and want to avoid stocks whose market is the latter.

–Asian, especially Greater China, exposure is a good thing, because that’s where most of the world’s economic energy is centered

–I think the continuing proliferation of smartphones, tablets and e-readers plus the rapid development of cloud computing mean there’s money to be made in at least some tech stocks.

For me, the relevant question is how this is working out for me overall.  The answer is:  great, until about a month ago.

A second aspect of figuring out performance is to look, stock by stock, at plan vs. performance.  Reading any of my posts about TIF will get you my stock-specific plan since I bought the security about a year ago.  Again, until about a month ago, things were working well  …since then, not so much.

c.  acting on this information

Even in the best of times, the stock market is always a process of two steps forward, one step back.  Also, all stocks, even the long-term winners, have periods of underperformance.  There’s a real experience-and temperament-based art to deciding how to react to the data that show your stocks are underperforming.

In my case, I’m thinking so far that this is a temporary adjustment phase.  But I’ve also got to at least begin to consider how I’d rearrange my holdings if the underperformance persisted.  This thought process–and the possible move to action–is partly a question of risk tolerance, partly of conviction in the correctness of my analysis of individual stocks, and partly a judgment, based on experience, of what is a normal trading pattern vs. a fundamental change in market direction.

More tomorrow.

Where We Are

Economic setbacks come in many different forms. Some are self inflicted – like those caused by over-investment in business assets (inventories, plant
and equipment) or excess spending by individuals. Others are caused by higher interest rates and tighter lending practices in response to inflation
fears or credit risks. Over a relatively short time, the excesses can be worked off and, as inflation and credit fears abate, credit begins to expand again.
The economy recovers. Wealth and the total value of goods and services quickly surpass their old high water marks.

Then, there are economic declines that fall outside the realm of the usual business cycle downturns. These are the ones that occur after a debt-
fueled boom goes bust – the bubble pops. We have just experienced such a pop – caused largely by over investment in housing, not just in the U.S.
but in many other countries. The resulting credit losses and credit contraction will persist over an extended period. And while the root cause can be
traced to one sector of one economy, the resulting credit contraction will trigger shocks in unexpected places. So, the collapse of the U.S. sub-prime
housing market causes banks in Iceland to default. Then, investors worry whether the financial extended countries around the edges of Europe will be
able to pay their debts. Maybe, you shouldn’t even put much faith in paper currencies at all.

It takes a long time to clean up the aftermath of credit cycle bubbles. For example, in the wake of All-Time Depression, it took over a decade for
Gross National Product to reach the level recorded in 1929.   Japan experienced a credit crisis in the late 1980’s caused by over expansion in the
manufacturing sector. Since 1990, that economy has grown on average 0.8% a year and ten year Japanese government bonds yielded just 1.3%. So, it should come as no surprise to investors that ten-year U.S. bond yields recently dipped below 2% especially since the Federal Reserve recently stated that they plan to keep short term interest rates near zero for two more years.

Few are predicting a Japanese style period of malaise for the U.S. economy. They cite the flexibility of the U.S. labor market, the willingness of
American consumers to borrow to support spending, an entrepreneurial spirit, and actions by the federal government and central banks to spur
spending. Perhaps they’re right but the jury is still out.

Housing

At the core of the recent economic collapse is housing – or specifically, housing speculation that encouraged people to leverage in order to
maximize their gains from rising home prices. Buyers had both solid reasons and strong incentives to play the game. According to data from the
National Association of Realtors, housing prices rose 85% between 1996 and 2005. The Case-Shiller Index of home prices advanced 12% a year from
2001 to 2005. Interest rates were low, home ownership received favorable income tax breaks, and the government mandated rules that made it
easy to qualify for mortgages regardless of income level, assets, or down payment amount.

The U.S. housing sector is very cyclical. In fact, by raising interest rates and choking mortgage credit, the Federal Reserve used housing as a swing
factor in regulating economic growth during most of the post-World War II period. But this housing downturn was different. It wasn’t caused by a
contraction of credit and a reduction in building activity. It was caused by a price collapse. The Federal Housing Finance Administration produces an
index of housing prices based on same home sales extending back to 1975. While there have been slight price declines over a short period, the 16%
decline that occurred during the four years ended June 30, 2011 is an anomaly.

Real estate is a major component of household wealth in the United States. It totaled $18.1 trillion on June 30, 2011. As per statistics compiled
by the Federal Reserve, owners equity in household real estate was $13.2 trillion in 2005.  By June 30, 2011, the equity in homes had fallen to $6.2 trillion. Meanwhile, stock prices were tumbling and interest rates were falling. Both factors eroded the value and earning power of most consumers’
financial assets, like their 401k’s.

The natural reaction to these forces was to curtail borrowing. And that’s just what happened. The borrowing binge of the early 2000’s has been followed by the borrowing bust of the last few years. Since the consumer accounts for two-thirds of the total economy, it’s no surprise that this new found spirit of frugality produced first, a sharp recession and second, a weak recovery.

The housing sector led the way into the current financial quagmire and that’s the place to look for the route out. Higher home prices would do much
to improve consumer sentiment and balance sheets. Recent data from Case/Shiller indicate the price decline in housing is moderating, but we have
seen false signs of a recovery before.

A New Twist…

…on an old theme. The Federal Reserve’s got a new dance and it goes like this. They plan to sell a bunch of the $1 trillion worth of notes they bought
during Quantitative Easing I and QE II. With the proceeds, they will buy a bunch of longer term government bonds. The plan was announced on
September 21st, but was rumored to be in the works since August. The goal is to drive down the spread between yields on long term securities –
those with maturities beyond ten years – and those on shorter dated items. They figure this will stimulate economic activity. (It’s more likely to
stimulate speculative activity and push up the price of “risk” assets like stocks. But the Fed probably would settle for that, too.)

Based on a Federal Reserve study of an earlier twist operation in the early Sixties, they estimated the new twist would narrow the spread by fifteen basis points (the study) or thirty basis points (Chairman Bernanke’s comments in September). The market – ever the efficient discounting mechanism – took the guess work out of these estimates. Between mid-August and the end of September, it narrowed the yield spread between 10- and 30-year U.S. Treasury bonds by forty basis points, helping to spur a huge rally in longer dated bonds.

This occurred even as the year over year increase in core CPI reached 2.0% compared with 0.8% last December. In fact, core inflation has risen every
month this year. The same is largely true if you add back food and energy to get the full inflation picture. The year over year total consumer price
index is up 3.8% through August. These inflation numbers compare with zero yields on money market securities, a 2% yield on ten-year notes, and a 3% yield on thirty year government bonds. Obviously, the goal of Federal Reserve policy is to push investors into riskier assets by creating negative yields in safe securities. They hope such investments will promote stronger economic growth. It might – or it might just create another mini-bubble somewhere.

Still Lost in the Woods

In the last few weeks, there has been some encouraging news. Recent employment data in the U.S. have put to rest fears of a renewed economic
contraction. Based on the number of new hires and hours worked, we’ll probably see 2% GDP growth for the third quarter. In Europe, the French
and Germans have put together a number of plans to keep Greece from defaulting and dragging the European banks with them. One Belgium bank
has been successfully pulled from the brink – even as that meant splitting it apart. When the positives became news, investors flocked to risky
assets – like equities and industrial commodities – and sold safe investments – like U.S. Treasury bonds and the Swiss franc.

Unfortunately, many of the positive developments are rooted in an ever growing mountain of public debt. It remains to be seen whether this is
sustainable either politically or practically. Some reversal of the recent bond price gains is likely before year end and there may be an opportunity
to profit from such market volatility. But any significant rise in long term interest rates will require a turnaround in consumer sentiment and home
prices in the U.S.

Note:  This Market Environment reflects the views of the Investment Advisor only through the date of this report. The Investment Advisor’s views are subject to change at any time based on market and other conditions. September 30, 2011.

reason #6

In my post from yesterday, I titled this reason “making dumb mistakes.“  I’m not sure what else to call it.  Let me illustrate with two examples of recent huge misses by analysts who should have known better.  They’re the June quarter results from two high-profile companies with plenty of Wall Street coverage, WYNN and AAPL.

Let’s take WYNN first.

WYNN’s 1Q2011

In 1Q2011, WYNN earned $173.8 million, or $1.39 per fully-diluted share.  Look one line higher on the income statement, and you see that the $173.8 million figure is after deducting $52.5 million in “income attributable to non-controlling interests.”  That’s minority interest.  It’s income that belongs to the 27.7% of Wynn Macau that WYNN doesn’t own.  (Wynn prepares its financials as if it owned 100% of Wynn Macau, and then subtracts out the minority interest at the end.)

From the minority interest figure and the magic of long division, you can calculate ($52.5 /.277) that Wynn Macau’s total net income was $190 million. WYNN’s share was $137 million.  Therefore, WYNN, ex its interest in Wynn Macau, earned $36.8 million for the quarter.

One unusual feature of 1Q11:  gamblers at the WYNN tables in Las Vegas had bad luck by historic standards during the quarter.  They lost a bit over 30% of what they wagered vs. historical loss experience of 21%-24%.

Any analyst who follows the company could have found all this out in five minutes of studying the 1Q11 income statement.  Given that the analysts’ consensus for 1Q11 was wildly low at $.73, you’d assume they’d do so to try to figure out where they went so wrong.

turning to 2Q11

In 1Q11, 80% of WYNN’s income came from fast-growing Macau, 20% from slowly-recovering Las Vegas.

From figures the Macau government posts monthly on its Gambling Coordination and Inspection Bureau website, we knew on July 1st that gambling revenue for the market as a whole was 12% higher in 2Q11 than in 1Q11.  If we assume that Wynn Macau grew in line with the market, and that a 12% increase in revenues produced an 18% jump in income (basically, adjusting for normal operating leverage and the fact that Wynn Macau “adds” gambling capacity by raising table stakes), then Wynn Macau would have earned about $225 million in 2Q11.  Of that, WYNN’s share would be about $165 million.  That translates into around $1.35 a share for WYNN in eps during the quarter.

What about Las Vegas?  It chipped in $.25 a share to first quarter earnings.  “Luck” at table games returning to historical norms would probably push that figure back to zero.  On the other hand, room rates at both Wynn and the Encore are gradually rising, so zero might be too low.  But let’s stick with zero from Las Vegas is the most reasonable guess.

In other words, a sensible back-of-the-envelope guess for WYNN’s eps in 2Q11 would be $1.35 + $.00  =  $1.35.  This isn’t necessarily the most conservative forecast, but it is one based on factual data about the Macau gambling market and the assumption that nothing much goes wrong (or right) in Las Vegas.

What did the professional analysts say?

The median estimate was $1.01.  The highest was $1.25; one analyst had the dubious distinction of saying eps would be $.69.  For this last estimate to have come true, WYNN would have had to break even in Las Vegas (it earned about $.25/share) and to have revenues in Macau drop by 25% quarter on quarter, while the market was growing at 12%.

Given that WYNN’s results are so strongly influenced by Macau, even the median was predicting a relative disaster for the company there.  What were they thinking?

(True, they might have been assuming a disaster in Las Vegas, not Macau.  And, I’ll admit, I thought WYNN has done surprisingly well in Las Vegas so far this year.  But Las Vegas isn’t big enough to move the eps needle down to $1.  And the situation is a little more complicated than I sketched out above:  Wynn Macau pays a large management and royalty fee to the parent, almost $40 million in 2Q, so the better Macau does, the better ex Macau looks.)

APPLE

AAPL’s 2Q11 (ended in March)

During 2Q11, AAPL earned a profit of $6.40 a share.  Its business broke out as follows:

Macs     3.76 million units     $4.98 billion in revenue

iPod      9.02 million units     $3.23 billion (includes iTunes)

iPhone     18.6 million units     $12.3 billion

iPad     4.7 million units     $2.84 billion

Other                                         $1.3 billion

Total                   $24.7 billion

turning to 3Q11

Let’s try a back-of-the-envelope forecast for AAPL’s 3Q11.  To make things ultra-simple, we’ll ignore operating leverage, which will bias our estimate to the low side.

Macs  growing, but slowly in a developing world where overall PC sales are flattish.  Let’s say $5 billion in sales.

iPod  flat, $3.2 billion in sales

iPhone     industrywide smartphone unit sales are growing at 80% year on year.  All the growth is coming from half the market, Android and iPhone, with Android growing faster; Nokia and RIM are taking on water and sinking fast.  Let’s pencil in 19 million units at $660 each = $12.5 billion.

iPad  this is the tricky one.  We know that AAPL is capacity constrained, is adding manufacturing capacity as fast as it can, and sold 4.7 million units in 2Q11.  Let’s put in 6 million units at $600 each, the average price from 2Q11.   That’s $3.6 billion.

Other Leave it flat at $1.3 billion.

Add all these numbers up, and we get $25.6 billion.  If we assume constant margins–i.e., no operating leverage (which a really terrible example to set–working with margins instead of unit costs, but I’ll do it anyway), then earnings will come in at $6.60-$6.75 a share for the quarter.

As events turned out, my guess is way too low.    …oh well!   AAPL reported eps of $7.79.  The big difference?  The iPad sold 9.2 million units and brought in $6 billion in revenue.  That alone adds more than $.60 a share in earnings.  The rest is bits and pieces.

So I missed badly.  That’s not really the point.  The real question is how my ten-minute approach stacks up against the work of the 45 professional analysts who follow the company for a living–and for whom AAPL is probably their most important stock.  Check them out and I’m starting to look pretty good.

the analysts

The median estimate of the 45 was $5.82 a share.  The low was $5.10, the high $6.58.

How could they consensus be projecting an almost 10% quarter on quarter drop in earnings?

APPL’s main business, smartphones, which accounts for 50% of total company revenue, and a higher proportion of profit, is exploding. The category is growing by 80%.  Rivals NOK and RIMM are not only going nowhere, they’re getting worse by the day.   In fact, NOK’s smartphone sales in the June quarter fell year on year–probably by a third. So AAPL’s continually taking market share from them.  Quarter on quarter sales were likely up.

We don’t know what 2Q11 iPad revenues could have been, only that they flew off the shelves as fast as AAPL put them on.  So product sales had to be up, maybe substantially, in 3Q11.

If both iPhone and iPad were flat, quarter on quarter, the only way to get company results to be down 10% would be if Mac sales, which represent about a fifth of the company’s business, were cut in half.  Hard to fathom, given that the PC industry is growing, if only slightly, and Macs have been gaining significant market share from Windows-based PCs.

what did I do differently?

I think everybody ignored AAPL’s “guidance” of $5.03.  WYNN doesn’t give guidance.

I did five things:

I gathered industry information from the internet.

I read the prior-quarter results carefully.

I used a line of business table to make (very primitive) quarter on quarter projections.

I ignored macroeconomic forecasts of slow growth for the US, since both firms target the affluent here–AAPL more so than WYNN, I think.

I didn’t worry about missing on the high side.  I didn’t want an estimate that was deliberately too conservative.

What didn’t the analysts do?

I only have guesses.

It’s possible that they were influenced by downbeat general economic news.  Even so, I don’t see how you could have gotten to the consensus figures for either APPL or WYNN if you did a line of business table.  But that’s one of the first lessons in Security Analysis 101.  Maybe the analysts in question were out that day.

It’s earnings season again.  As companies report their results for the quarter, investors watch carefully to see whether they match, surpass, or fall short of, the consensus estimates of Wall Street securities analysts.  As has been the case since the bull market began over two years ago, a majority of companies are beating the consensus figures–some by a mile .

Why don’t analysts do a better job of forecasting?   

I have six reasons (five of them today, the final one tomorrow):

1.  Some companies are very hard to forecast, because they’re so complex.  They may have a lot of divisions, many suppliers and a large variety of finished products that they sell.   

Alcoa, the first of the big publicly traded US corporations to report each quarter, is a case in point.  You’d think that the main variable for Alcoa would be the price of aluminum, which you can see every day in commodities trading.  …but no.

Alcoa can get its raw materials from many sources.   Some sources are joint ventures that Alcoa’s a part of, which often have complicated profit-sharing arrangements that are not publicly disclosed.

Miners deliberately change the grade of ore they mine, depending on price, to maximize the life of the ore body.  Ore can be processed in different locations, some company-owned, some not, depending on the price of electric power and other factors.  So expenses are hard to gauge.

On top of all that, differing accounting conventions at each step of the way can play a big role in what cost figures eventually appear on the income statement.

In a case like this, it’s hard to imagine anyone outside the company having a good handle on what reported earnings will be.

2.  Some companies demand that analysts stay close to “official” guidance.  CEOs understand that having earnings per share that exceed the consensus is a good thing for their company’s stock  (a positive earnings surprise), and that missing the consensus can be a very bad thing  (a negative surprise).  So most firms that issue next-quarter guidance to analysts give out numbers they believe they have an excellent chance of beating.

Some firms go further than that.  They make it clear they will punish any analyst who deviates from guidance more than a little bit.

What can a company do?

Lots of bad stuff.  From descending order from worst to not-as-bad, the company can:

–stop using the analyst’s firm for any investment banking services, like underwriting debt or equity offerings (which is likely to get the analyst fired),

–not appear at industry conferences the analyst’s firm may organize, or send the investor relations guy instead of the CEO or CFO,

–avoid using the analyst to organize the company’s visits to powerful investment management companies,

–refuse to give the analyst access to top company officers to ask questions about operations,

–delete the analyst from the queue to ask questions during earnings conference calls (petty, it’s true, but not unusual).

There have been cases of stubborn analysts who have stuck to their guns in print, against company wishes.  Their stories  usually end badly.  For most, they’ll show the number the company wants in their written reports and “whisper” their best guesses to clients.

3.  Some analysts aren’t good with numbers.  That’s not always a fatal flaw.  The analyst may have other pluses–a deep knowledge of the inner workings of an industry, an ability to  sense new trends quickly, or very good contacts with the companies, or customers and suppliers.  Or maybe they just know where to take clients to lunch.  After all, when you get down to it, sell-side analysts are paid for their ability to generate commission business  for their trading desks and to attract/keep investment banking clients–not necessarily for having the best numbers.

4.  Sometimes analysts don’t do the spreadsheets themselves.  An assistant does them instead.  Analysts may spend half their time on the road visiting companies and clients.  Much of the rest of the time, they’re doing the same thing on the phone.  And the analyst may not be so great with numbers, anyway.  So that task is relegated to an assistant.

An aside about assistants:  in my experience, many analysts pick assistants who are articulate, look good in a suit and are smart–but not too smart.  Why?  A sell-side analyst may earn 10x-20x what an assistant does, in an industry that suffers a severe downturn in profits about twice a decade.  The analyst may worry that having a top-notch assistant means the analyst becomes a cost-cutting victim during recession.

5.  Many experienced analysts have been laid off over the past few years.  Doing good estimates doesn’t require a genius, but it does require some training and experience.  A lot of that has been lost on the sell sidesince the Great Recession began.  In addition, as I suggested above, the assistants who have been promoted into the principal analyst jobs may not all be the brightest crayons.

That’s it for today.  I’ll write about #6, making really dumb mistakes, tomorrow.

The Boston Consulting Group just released its ninth in a series of analyses of the global asset management industry.  This year’s is called Building on Success: Global Asset Management 2011.

BCG’s conclusion:  the industry is in long-term decline, despite a bounceback in profitability during 2010 caused by rising markets and an investor shift out of low-fee money market funds into more expensive products.

Reasons:

–the industry is mature everywhere except in emerging markets, so growth isn’t going to come from finding new customers.

–existing products aren’t good enough, with active managers typically offering one-size-fits-all products that don’t beat their benchmarks.

–competition is intensifying.  It takes two forms–price competition among industry participants; and the development of competing offerings, like hedge funds or private equity, that siphon assets under management away from the industry.

–there’s a steady flow of money away from high-fee active and equity products  and toward  lower-fee passive and fixed-income ones.

–in both the US and Europe, a small number of firms have established extremely large relative market shares.  This gives them economy of scale advantages that let them lower prices and still maintain their own income.  In US equities, for example, 5% of the funds took in 53% of the new money in 2010.  The bottom 50% of the market took in only 4%.  The European equity business is even more concentrated than that, as is the US fixed income sector.  In European fixed income, where concentration is somewhat less, the top 5% took “only” 38% of the new money.

my thoughts

I agree with BCG that we’re seeing a sea change in the asset management business.  I’d put the situation slightly differently, though.

Before Black Monday in 1987, investors tended to buy individual stocks rather than packaged products and to rely for advice on savvy registered reps employed by traditional (read: high cost) brokerage houses.  The market crash changed all that.  The antiquated NYSE system of having monopoly market makers (good for their profits, not ours) froze up; volume disappeared and bid-asked spreads became very wide.  Put in a market order and your execution could differ by 5% from the last price you saw on a screen.  And it seemed that the 5% was always in an unfavorable direction.

This experience, and the sense that the world was getting to be too complex for non-specialists to decipher, sparked a change in investor preference away from individual stockpicking toward buying professionally-run mutual funds.  At the same time, 401ks were becoming more in vogue.  Brokerage houses decided to limit their legal liability by turning their reps into marketers of computer-generated financial planning advice and mutual funds. The Baby Boom was just coming into its peak earning years.

I think the Great Recession and the accompanying sharp decline in world stock markets have triggered another sea change.  This time it’s a return to do-it-yourself for individuals, based on the assessment (right in most cases, In think, but wrong in some) that brokers are professional marketers, not trained investors, and add little value.  In any event, their firms limit what they can say and do.

The Baby Boom is starting to enter retirement.  Investment results are more critical than they were before; losses are more painful.  So boomers are dialing down their risk profiles by selecting passive products–through ETFs–and fixed income.  On top of this, on retirement Boomers are becoming their own Chief Investment Officers as they take charge of managing their 401ks or other defined contribution pension plans.

For institutions, which have long known that their favorite active managers underperform, it’s a switch to “alternative investments,” despite evidence that for the past decade managers of the latter have performed worse than traditional active managers.

For both classes of investors, it seems to me the change has the character of rejecting the devil you do know, figuring the one you don’t can’t be that much worse.

There are obvious issues with this change, assuming I’m correct.  Personally, I think pension sponsors are crazy to be building up their allocation to alternative investments.  The risks are high, the reported numbers aren’t that great, and there’s lots of anecdotal evidence that some of the reported numbers don’t stand up under more than cursory scrutiny.

For individuals, which is my main focus in writing this blog, the issues are somewhat different.  They’re how to get the information you need to make intelligent decisions, and who do you trust. Personally, I think that the investment management industry will follow the same pattern as traditional bricks-and-mortar retailing.  It, too, will morph (is morphing) into diffuse internet-connected collections of professional investors working in small groups and selling research or advice at reasonable prices.