The Stock Market Is Getting Less Efficient–Good News for Individual Investors

The Financial Times reported today that the Capital Group, one of the largest money managers in the US, and one traditionally strongly dedicated to in-house research, is cutting jobs for the third time in six months.  Here’s the link:

It’s not hard to understand the reason.  Given a roughly 50% decline in world stock markets from the top, plus possible redemptions by mutual fund or institutional shareholders, management fee revenues for this month could easily have dropped to 40% of their level at the top two years ago.  Profits could now be a quarter of their high water mark.  The situation is doubtless worse at smaller firms.  Companies less dedicated to doing their own research than Capital will likely lay off proportionally more analysts and portfolio managers.

The equity market downturn is only the latest in a number of developments that have tended to reduce the amount of sophisticated analysis in the hands of institutional investors.

The most important are:

 *Many years ago the question of which brokerage house employee gets credit for generating commission revenue from clients–the research analyst or the trader–has been decided in favor of the latter.  As a result of their diminishing share in company profits, seasoned analysts have been gradually leaving the brokers for a long time.  This movement has accelerated over the past few years as hedge funds have sought this expertise for themselves.

*At the same time, it seems to me there has been a long-term tendency among institutional money managers to deemphasize in-house research.  This has two short-term benefits.  It makes the business simpler.  It also means part of the cost of obtaining specialist investment information is no longer borne by the manager and paid for from fee income, but is paid for by the manager’s client through “soft dollar” “research commissions” that the manager directs to brokers and third-party research services.

Why is any of this good?  The breaking down of established institutional information gathering an analysis networks, long in train but accelerated by the market downturn, will probably make world stock markets less efficient.  But this gives the serious amateur the best chance he’s had in the past twenty years at finding out and acting on information before the market does.

About AIG’s Business Products

Early in my career I remember hearing stories about a fellow portfolio manager who fancied himself an expert billiards player.  He regularly trounced the salesmen from brokerage houses he dealt with when they met socially for dinner and a game or two.  Then he changed jobs, to become an investment strategist for a broker, that is, a colleague of his billiards buddies rather than a client.  As I heard it, he never won a game again.

Stunningly Large Losses…

I don’t know very much about AIG other than what I’ve read in the  news.  But the sheer magnitude of the losses AIG’s Business Products division rolled up implies operating ineptitude of heroic proportions.  As my story above suggests, it’s a standard strategy for a trading counterparty to downplay his own competence and inflate your ego.  After all, you trade more often and less cautiously if you think you’re outsmarting the other guy, rather than worrying that he knows more than you.   But everyone on Wall Street should know this and try to apply a little objectivity in assessing business relationships and one’s own job performance.  Apparently AIG didn’t. 

If AIG was such a bad trader, why did counterparties overload it with losses and kill the goose that was laying golden eggs?  It’s possible they saw the big bonuses AIG traders were collecting and misread the extent of its losses.  It’s also possible they thought the AIG people were so bad as to be beyond saving, and that if they didn’t take AIG’s money someone else would.


..But A Bonus Plan Where Losses Hardly Counted

I’ve also just skimmed, courtesy of the government, the AIG bonus plan.  (Here’s the link, if you’re interested:

Several things strike me about it:

1.  The plan is called a “Retention” plan.  Employees were to share 30% of Business Products’ profits, with no cap set on the maximum paid, and with a minimum guarantee.  That guarantee, which presumably was the amount paid out for 2008, was set somewhat below the amount paid out for 2007.

Any realized losses above $225 million are not applied against 2008 earnings.  Instead, they’re carried over to following years and reduce a given year’s bonus pool by a maximum of 30% of that number, or $67.5 million.  The minimum guaranteed bonus is also reduced by the overhang of past years’ losses, again at a rate of $67.5 million per year.  Given that this unit appears to have realized losses of, in round numbers, $200 billion in 2008,  the guarantee shrinks to nothing in at most two or three years.  The overhang of losses looks like it lives on, depressing bonuses, into the twenty-fourth century.    All the plan really seems to do is to allow one more round of large bonuses, before encouraging anyone who can get another job to leave.  So it is a “Retention” plan only in the sense that it “retains” a final year of undeserved incentive pay.

2.  The plan is dated December 1, 2007, and replaces an earlier plan.  The differences are not described.  I would bet, however,  the main change is that the earlier plan did not limit, as this one does, the extent to which realized losses could shrink the bonus pool.

3.  Bonuses are based, not on economic profits, but on realized gains and losses, that is, on transactions that were closed out during the year.  I find this very unusual.  The bonus pool can easily be inflated by cashing out profitable trades and keeping losers on the books.  The plan specifically states that unrealized losses are excluded from the bonus calculations.

4.  It’s hard to see why AIG’s management would okay a plan like this, other than that 70% of the Business Products’ so-called profits become earnings of the parent company, on which presumably top management’s bonuses are calculated.

5.  It’s also hard to see how former Secretary of the Treasury Paulson, a veteran Wall Street manager, did not hear the alarm bells that this bonus plan sets off.

An Ugly Story

The losses are huge.  The bonus plan is shameful.  No one in government or new management caught on.  Retroactively changing the tax code may be emotionally satisfying, but  it doesn’t seem to me that punishing Wells Fargo or JPMorgan employees for something AIG did helps the country a lot.  A better direction of attack might be maintaining that in trying to “game” the system with this bonus plan, AIG violated its obligations to shareholders.

One more thought on the House action.  Is the House really being as hysterical as its rhetoric and voting make it appear?   Doesn’t it realize it is putting at risk any future private-public cooperation in rebuilding the financial system?  Or is it calculating that it can be as bombastic as it wants, because the retroactive tax increase doesn’t have the votes to pass in the Senate?  My guess is that our representatives are relatively unaware of the risks, but are actively betting that nothing they resolve will survive the Senate.  The coming week will most likely tell.


HSBC is raising equity through a rights issue (see my Basic Concepts post on rights issues).  At over $17 billion, it is the largest in the history of the UK stock market.  Given this size, the damage any rights issue can do to a stock’s price and management’s denial of the need for a capital raising last October, the issue must be of utmost importance to HSBC.  Why is the company raising this massive amount of new capital?

Cynics say that the true reason is that the damage from buying subprime consumer lender Household International (including Beneficial Finance, too) is far greater than the bank cares to disclose.  It’s worth looking at why the bank says it’s raising money, however, since their reasons would have important implications for the banking sector over the coming decade.

First, HSBC points out that the banks rescued by their home governments will likely end up with the strongest balance sheets in the industry.  They will, in theory at least, have a powerful competitive advantage over banks which have not needed rescuing, unless those banks also strengthen their capital–as HSBC is now doing. 

The second reason has, I think, a lot more implications for investors.  HSBC figures the governments which have ploughed huge amounts of money into their banks (this includes the US, UK, France and Germany) are not going to allow that capital to be used as the the foundation for loans outside the home country.  And they are going to armtwist the banks to lend, not just keep it parked on the balance sheet for just in case.  

Two implications:

The rescue markets may turn fiercely competitive, as newly-healed banks strive to keep out of the regulatory hot seat by making loans  (we’re already starting to see how ugly the US hot seat can be).  This will be great for non-financial enterprises in those countries.  Ready availability of credit at low prices will make the areas preferred destinations for any global business to set up manufacturing or service operations.  But it’s not so great for bank profit growth.

Also, assume we thought the major commercial banks that might have a history of and might want to lend overseas have roughly zero capital apart from what their governments have given them.  Therefore, those banks would have roughly zero ability to do so.  This leaves the field wide open in the developing world for banks like HSBC.  In fact, these markets may be more profitable than before because there will be less competition.

A professional investor will ask himself three questions in response to what HSBC is saying:

       1. Does the market believe this is true?

       2. Do I believe this is true?

       3. (Probably the most important!) Do I need to have an opinion about this?

I think the answer to #1 is no.  I think the market is still trying to sort out which banks will live and which will die.

#2?  I have no idea, although what HSBC is saying sounds plausible.

#3.  There are really two issues here.  Do I need to own a bank?  Maybe I can just avoid the industry or, if I’m a relative performance person, mimic the index, thereby eliminating stock-specific risk.  If I do have to own a bank, however, then, all other things being equal, I should own a bank in an emerging market.



“Discounting” or the “discounting mechanism” or the “discounting process” is Wall Street jargon for the idea that the stock market is a futures market, which reflects in today’s prices consensus beliefs about future events.   The general idea is that the current price will move only when surprising new information about a company or its stock emerges, and the market reacts by bidding the stock up or down.  Maybe the most common factor being “discounted” at any given time is expectations about future earnings, although this is by no means the only one.

Discounting is a fuzzy concept.  The real trick, which only comes with effort and experience, is to be able to make a good guess at whether the information you have that makes you want to buy a stock is already factored into the price.  It may be that the person on the other side of the trade doesn’t have your information yet.  It may equally be he thinks it’s last week’s news.

My discounting rules Continue reading

Growth vs. Value: V. What’s Your Style?–a test

The Rules

I’ll describe two companies.  Both are retailers, operating in the US and selling identical merchandise.  They are located far enough away from one another that there is no chance of them competing in the same markets for at least ten years.  

Both have first year sales of $1,000,000.  

Both have an EBIT (earnings before interest and tax) margin of 15% and pay tax at a 33.3% rate.  

Therefore, both have first-year earnings of $100,000.  

Each firm is publicly traded and has 100,000 shares outstanding.  Earnings in year 1 are $1/share for both companies.

Money reinvested in the business is currently generating $2 in sales for every $1 invested.  There’s no lag between the decision to invest and the generation of new sales.

Both can borrow up to 20% of earnings from a bank at a variable rate that is now 7%.  

Earnings and cash flow are the same (just to keep it simple).


Company 1:  Bill’s Stuff

Bill’s management wants to take a conservative approach to a new business.  It decides that it will:

                reinvest half of its cash flow back into the business,

                pay a dividend of $.50 a share ($50,000/year),

                keep any remaining cash in reserve in a money market fund.

So,  in year 2 Bill’s generates $1,100, 000 in sales, earns $165,000 in ebit and $110,000 ($1.10/share) in net income.  It reinvests $55,000 in the business, pays out $50,000 in dividends and keeps $5,000 in reserve.

Let’s assume the company can continue to operate in this manner for as far as we can see.  Then, the company’s investment characteristics are:

                        10% earnings growth rate

                        $.50 dividend payment

                         no debt; small but growing amount of cash on the balance sheet

Let’s assume Wall Street is now willing to pay 10x current earnings for the company’s stock.


Company 2:  Joe’s Things

Joe’s management believes that expansion opportunities are extraordinarily good right now.  It decides that it will:

                reinvest all the company’s cash flow back into the business,

                borrow the full 20% of earnings that the banks will provide and reinvest that in the business as well.

In year 2 Joe’s generates sales of $1,240,000 and ebit of $185,000.  After interest expense of $1,400 and tax, net income is $122,400 ($1.22/share)..  

For year 3, Joe’s can borrow another $4,500 and does so.  Therefore, it reinvests $126,900 in the business.  It generates about $1,500,000 in sales and ebit of $225,000.  After interest and tax, net income is about $149,000 ($1.49/share).

Assuming that Joe’s can continue to expand in this manner indefinitely,  the company’s investment characteristics are:

                  22% earnings growth rate,

                  modest and slowly-rising bank debt,

                  no current income.

Let’s assume Wall Street is willing to pay 18x current earnings for the stock

The question:   Which one would you buy?  (Don’t turn the page until you decide!)

Continue reading