Monthly Archives: October 2009

Are hedge funds honest?: an NYU study

October 16, 2009 By in hedge funds, Strategy Tags: , , , , Leave a comment

The short answer is–not so much.

The study results:  one in five hedge funds misrepresent themselves to investors

The study, led by Prof. Stephen Brown of NYU, looked data on 444 hedge funds complied by a hedge fund due diligence firm, HedgeFundDueDiligence.com.   The researchers found that about a fifth of hedge fund managers misrepresented themselves to the due diligence firm–even though they knew HFDD had been hired by potential clients to verify all the statements the hedge funds made.

In particular:

–in 21% of the cases, hedge funds misrepresented prior legal or regulatory problems,

–in 15% of the cases, failed to disclose some or all of their prior legal or regulatory difficulties,

–in 28% of the cases, hedge funds provided incorrect or unverifiable assertions about assets under management, performance or other investment issues,

—20% of the managers lied to HFDD during interviews ( the researchers euphemistically call this “bad recall”),  that is, they misstated either their performance, assets under management or their own experience or education.

Liars talk big and then fail

The study found that firms where HFDD detected misrepresentation tended to report better investment performance their peers  (No surprise here.  If someone is going to lie, why would they say the results were bad). They also tended to be more likely to fail.

The biggest indicators of possible trouble…

The only clear indicator of potential problems that the academic researchers found was not having a Big 4 auditor (think:  Madoff or Stanford).  There were other, less statistically significant, signs, as well.  Suspect firms tended to price their assets themselves and to switch support services frequently (presumably because the incumbent support firms had discovered misrepresentation and wouldn’t tolerate it).

…and of “clean” firms

Non-problem firms tended to have several common characteristics:  their results were priced by a third party, they were audited by a Big 4 accounting firm, and they kept the same support vendors for long periods of time.

Investors typically hired HFDD in several instances…

Clients normally asked for a HFDD report when a hedge fund was large, had a record of superior performance, charged high fees or didn’t have a Big 4 auditor.

…but the reports made no difference in whether clients invested or not…

The study shows that making false statements in the due diligence process didn’t deter investor interest or slow down flows of new money into a hedge fund.  One exception:  having a manager exhibit “bad recall” in an interview was a negative.

..and clients invested at just the wrong time.

Previous studies have shown that the bulk of the superior performance for most hedge funds comes in their formative years, when they are trying to make a name for themselves and attract clients.  By the time money comes rolling in, however, the best days for performance are already gone.  This study shows the same thing.  Clients request the due diligence studies right at the zenith of fund performance and of money inflows.  The chart in the NYU study that shows performance for the two years following a due diligence investigation goes straight downhill.

What Intel said: 3Q09 earnings conference call

October 14, 2009 By in Current Market Thoughts, earnings conference calls, Industry Analysis, Stock ideas, Strategy, Technology Tags: , , , Leave a comment

I listened to Intel’s 3Q earnings conference call yesterday afternoon.

The company was upbeat, with good reason.  The results were higher both than analysts’ estimates and the company’s guidance, which had been upwardly revised during the quarter.

The positive news for the overall IT industry is that demand for INTC’s products was significantly above seasonal patterns in all regions of the world–except Europe, where demand was only slightly above the seasonal norm.  INTC expects this above trend performance will continue into next year.

Consumers are the big PC buyers.  Server demand from corporations and from “cloud computing” middlemen is also good.  The big surprise, to me anyway, is that INTC is seeing companies warming up to buy new laptops and desktops next year.  Why?  Their existing machines are on average 5-6 years old, so repair costs are rising.   So, too, are support issues for the XP operating system they’re running.

Normally, it’s consumers, not companies, who buy machines where a new, potentially buggy, operating system is installed.  But apparently corporations are willing to take a chance on Windows 7.  My guess is this is more a reflection of how badly the old machines currently in use are, than a ringing endorsement of the new MSFT product.

I’m no INTC expert.  I’ve generally preferred to own smaller, niche companies with faster earnings growth prospects.  But the company gives the impression of being much better organized than I remember it.  And the fact that the company has tightened its belt significantly while beginning to experience sharp increases in demand for its products suggests we’ll see positive operating leverage from the company for a while yet.  I can understand why investors might prefer to hold INTC shares while it’s growing so rapidly rather than take the risk of owning a smaller, less well capitalized firm.

I was also to interested to hear some of the sell side analysts asking questions on the call express skepticism about the durability of the netbook category.  Their idea seems to be that consumers have traded down to netbooks during recession and that they will trade back up to traditional laptops as their economic circumstances improve.  I think that’s wrong–that netbooks address a new market segment–that, by the way, is growing very fast and will continue to do so.  INTC agrees with me (for whatever that’s worth).

In fact, INTC has recently announced that it’s configuring its Atom microprocessors for netbooks so they’ll work with Linux as well as MSFT operating systems, and will open apps stores (like APPL’s) in conjunction with Taiwanese netbook makers.

What are Purchasing Power Parity (PPP) and Purchasing Power Parity GDP?

October 14, 2009 By in Basic Concepts, Purchasing power parity (PPP) Tags: , , , Leave a comment

Purchasing Power Parity (PPP) is a name that covers a number of loosely related ideas.  The most important, I think, are:

–PPP as a theory of predicting long-term exchange rate equilibria, and

–the calculation and comparison of country GDPs using PPP.

In the first sense, PPP answers the question of  what exchange rate would prevail in an ideal world where workers in different countries all have equal compensation.  In the second, PPP says what country GDPs should really be if the value of non-traded goods were factored into the calculation–not just traded goods.

PPP and currency values

PPP is a labor theory of value.  The basic idea is that the average worker, no matter what country he works in, should earn enough money to buy stuff that will give him the same standard of living as a worker in any other part of the world.  This is the equilibrium condition.  If, at any given time, this condition does not hold, currency exchange rates will realign themselves so that equilibrium is established.

I first encountered PPP as a practical thing when it came into vogue in the mid-Eighties, a period of great instability in exchange rates.   It was for a while the preferred method of currency forecasting.  It didn’t work very well, however.   Apart from the more general question of whether value of a good in trade is determined by the amount of labor expended in its making, there were three practical issues:

1.  tastes may differ from culture to culture, so determining “equal” baskets of goods and services across countries isn’t as easy at it sounds,

2.  in the real world, prices subject to local cartels or government regulation may change only very slowly, and

3.  other factors, like the emergence of substitutes or a significant change in the price level (think:  Japanese deflation in the Nineties) can do the work ascribed in this theory to currency movements.

Purchasing Power Parity GDP

GDP calculated under PPP is a different matter.  The issue first arose, I think, in connection with the rapid growth of the mainland Chinese economy during the Eighties, when it averaged double-digit annual expansion of real GDP.  This compares with the US, which averaged, say, 3%.    Whatever imprecision there may have been in the actual numbers reported by the two countries, it was clear that China had grown much, much faster than the US during the decade.

The conventional way to compare countries’ GDP is to take the local currency number for each economy and translate the result into come reference currency, typically the US$.  The common sense result guess for the Eighties would have been that China had doubled in size relative to the US during the decade.  But when the conventional calculations were done, China had actually shrunk in relation to the US.

The problem?–the conventional calculation uses market exchange rates, which express the relative price relationships among traded goods, like cars, and uses that relationship as a proxy for the value of all goods in an economy.  That doesn’t work well.  In an emerging economy, a haircut, a bus ride, even cellphone service will typically be much cheaper than in a developed economy.

Seeing the US/China result was enough to prompt the World Bank to attempt to make GDP calculations that included non-traded goods as well.  These are the 2008 World Bank figures.  The results are startling, though less so than they would have been two or three years ago, when Brazil, India and Russia would have had their approximate PPP rankings but would have been out of the top ten in the conventional ones:

—————–rank   % of world GDP         —–  rank    % of PPP GDP

US                         1                 23.4%                       1              20.3%

Japan                  2                    8.1%                        3               6.2%

China                 3                  7.1%                        2               14.3%

Germany             4                     6.0%                     5               4.2%

France                 5                     4.6%                     8               3.0%

UK                        6                     4.3%                     7                3.0%

Italy                      7                    3.8%                   10               2.6%

Brazil                  8                     2.6%                     9                2.9%

Russia                9                     2.6%                      6                 3.3%

Spain                10                     2.6%                    12                 2.0%

Canada             11                      2.3%                   14                1.7%

India               12                     2.0%                     4                 4.9%

Mexico             13                     1.8%                      11               2.2%

Note that China and India are together about the same size as the US as a percent of world GDP when measured by PPP, vs. less than 40% of the US when measured conventionally.

The “New Normal” (IV): final thoughts

October 13, 2009 By in Constructing a Portfolio, Current Market Thoughts, Strategy Tags: , , , , , , , , 2 Comments

I think whether the New Normal idea is right or not will end up being a crucial question about the future course of stock and bond markets.  Like most investment questions, it’s not so important to have the answer definitively and right now.  It’s more important to keep it in mind and keep coming back to it.

Ideally, one would develop a strategy that avoids having to answer the question–one that will do okay no matter how events turn out.  But I’m not sure that’s possible in this case, other than through the difficult task of building a portfolio full of secular growth stocks, since the alternative outcomes to NN are so sharply different.  Failing the avoidance strategy, it’s only important to have an answer before most investors have made up their minds and acted on their new beliefs.

This means, I think, the New Normal will be a topic of investment discussion for at least the next year, with continuing revisions to investment strategy as new pertinent data are developed.

The two alternatives, in polar form, are:

“New Normal”–the US and UK economies take years to recover from the financial crisis and show little growth over that span.  Thirties-like deflation is the biggest economic problem.  The apparently superior economic performance of developing countries shows itself to have been radically dependent on demand from the US.  Growth in these countries collapses as they are unable to develop alternative customers (each other, for example) for their goods and services.

“BRICs to the rescue”–heads-in-the-sand observers in the US and UK radially underestimate the size and economic power of emerging markets, which will be a key support of world economic growth in the years to come (more about this in a post tomorrow).  Not only will these economies readjust quickly, but, combined with continuing depreciation of the dollar and sterling, will ultimately serve as a more important destination for exports of US and UK goods and services.  Domestically-oriented businesses in the US and UK may have suffered a serious setback, but internationally-minded firms, especially in the services industries, will continue to go from strength to strength.  Also, the US overall may prove more resilient than pessimists expect–as it has typically done in the past.

The investment conclusion of the New Normal is that bonds and stocks both stagnate and deliver annual returns of, say, 3% for bonds and 5% for stocks for a long time.

If BRICs do come to the rescue, stocks go up.  Bonds go down as interest rates rise by maybe 200 basis points.  After that, bonds become a reasonable investment. yielding maybe 5%+ for long-dated governments.

The most aggressive proponent of New Normal is PIMCO, a leading bond manager in the US.  PIMCO seems to be staking its reputation on NN being correct.  It certainly has a lot to lose if NN turns out to be wrong and bonds suffer multi-year losses as global growth resumes.

I’m sure the company is trying not to think of this when formulating its strategy.  But for anyone who has seen bonds make almost continuous, surprisingly strong, gains over 25 years may have trouble believing that the party is over–even temporarily.

Support for the more optimistic case seems much more diffuse.  It comes from experts on developing economies and from Goldman Sachs, which coined the term BRICs (Brazil, Russia, India, China).  The former group have the same kind of self-interest issue as PIMCO, the latter seem to me more professionally indifferent to the outcome.

As for me, my bias is toward the optimistic case.  It would be surprising if it weren’t, since growth investors are serial optimists.  But it also seems to me that the data are beginning to show stabilization in the US and unexpected strength abroad.  More on this too in subsequent posts.

One other thing:  One aspect of the current situation comes as a surprise, at least to me–the extent of the greed of the financial industry, the corruption of legislators and the ineptitude of regulators.  The combination of these factors have made the financial meltdown much larger that I believe almost anyone expected.

But several others do not:

–the gradual aging of the US workforce and slowing in the growth of the working population is well-known–new twenty-somethings don’t just magically appear;  also,

–the large number of graduates pouring out of universities in the developing world, willing to work for far less than their US counterparts;

–the deterioration of the US education system in its standing in the world;

–the surprising–to most people in the US–size and power of the economies of developing nations, which the World Bank has been stressing for many years.

Contrary to what the man in the street might think, planning and action by corporations in the US to reorient themselves to a new world order is not just beginning now, in reaction to the drying up of domestic growth after the financial crisis.  The transition has been going on for some time.  And even large hidebound corporate dinosaurs like GE and IBM have been moving in the past couple of years.

This movement, initially bad for US employment, has been masked for a while by the explosion in housing demand during most of this decade.  But, as stock investors, we have to consider the possibility that the de-linking of US domiciled corporations from the domestic US economy may be much farther along than we expect.  If so, corporate profits for publicly-traded firms could be equal to, if not better than, an (always too) optimistic brokerage house consensus expects.