Inside info?–Is DIS selling ABC?

Offer one:  earnings data

Last week, authorities arrested the assistant to a high-ranking DIS communications official and her boyfriend.  The boyfriend allegedly sent a cold-call form letter to a large number of hedge funds earlier this year, offering to sell them advance copies of  DIS March quarter earnings information, which the girlfriend has presumably agreed to provide.

To even a criminally minded recipients of such an offer, several allied threads of reasoning must have gone through their minds:

–the writer wasn’t particularly bright to put the offer in writing and send it to a complete stranger,

–could this possibly be a pathetic attempt at a sting operation by the SEC?

–in the case of a mature, large-cap company like DIS, would any earnings surprise be large enough to move the stock a significant amount?

–who else got the letter?

–was this a colleague’s idea of a joke?

Having a strong sense of ethics, or maybe seeing nothing but downside from the offer, the recipients turned the boyfriend in to the SEC.

Offer two:  asset sales

The boyfriend also allegedly said he could provide details of advanced negotiations between DIS and private equity firms to sell them ABC television.  As the story came out, DIS denied it (which means nothing.  It could be there are “discussions” under way but no “negotiations,” in DIS’s mind, or that there are discussions, but they’re not “advanced,” or some other such equivocation).

The possible sale of ABC is much more interesting information than whether DIS will report eps of $.60 a share or $.61 in any given quarter.  And the fact that something is brewing, which was being offered for free (DIS stock temporarily rose by 5% on the announcement of the arrests and the reasons for them), is probably more significant than the names of the private equity firms.

Why would selling ABC be good news?

Traditional network broadcast TV is moving down the internet-created road to oblivion already trod by music sales, newspapers, books and magazines.  Content creation for viewing on home screens will doubtless survive, but it’s likely that over-the-air delivery won’t.  ABC has both.  It’s not clear what parts of ABC are supposed to be being sold; although my guess would be gaining the content creation business would be the inducement for someone to take the network.

DIS seems to me to be running ABC in a reasonable way, trying to maximize the cash flow it generates for investment elsewhere in DIS, while retaining some degree of profitability.  ABC is small in the scope of overall DIS, both in terms of contribution to operating income and in potential value as a sale at maybe $1 billion.

If ABC is so tiny a part of DIS, why should investors be interested one way or the other about what happens with ABC?  The answer is the real, and—I think—non-obvious, concern of investors about ABC.

The real investment issue is, to coin a phrase, the profit asymmetry of the ABC business.  Wall Street firmly believes that there’s a ceiling, and a gradually downward-sloping one at that, for the earning potential of ABC.  It’s not plausible that anything surprisingly good, and enough to move the DIS stock price up, is likely to emerge from normal ABC operations.  So there’s only downside.

One possibility is that profits continue a gentle decline to the point that one day ABC simply isn’t there anymore.  That’s the good case.  On the other hand, it’s possible that we wake up one day to find that ABC is spouting red ink like the BP well in the Gulf of Mexico is spouting oil, and that it will cost, say, $3 billion to shut it down.  Think: music, or newspapers.

I’m not saying that the second case is likely.  I have no opinion.  But it’s a common pattern with companies that an apparently insignificant business an investor decides to give little research effort to suddenly turns into a black hole of losses that begins devouring the profits of the rest of the company.

The good news for an analyst, then, would be the removal of uncertainty surrounding a complex business that adds little to DIS but could lose it a lot.

I’ve just updated Keeping Score for May

Here’s the link –or you can just click the tab at the top of the page.

Martin Wolf: the ants and the grasshoppers

Martin Wolf, one of my favorite economic commentators, recently wrote an update of the fable of the ant and the grasshopper (actually a cicada, but…) in the Financial Times.

Aesop

In the original story, attributed to Aesop, the ant works all summer to store up food for the winter while the grasshopper plays.  When the weather turns bad, the grasshopper asks the ant for aid.  He is rebuked for his idleness and left to die.

Wolf

In the Wolf version, there are industrious “ant” countries (China, Germany and Japan), which produce goods and export them to lazy “grasshopper” countries (like the US, UK and the PIGS) who dabble in activities like real estate, which by and large generate no economic return.  (that is:  if you build a factory, you can make stuff in it that you can sell at a profit.  If you build a beach house, it just sits there.  It’s like buying a very expensive home entertainment system.)

The grasshoppers get the money to do this by borrowing from the ants’ banks, using their real estate as collateral.

At some point, the ants figure out what’s going on and realize they’ve made a very bad deal.  The grasshoppers are never going to repay and the collateral is not particularly useful.  On occasion, the grasshopper economies weaken as real estate prices wobble and then fall.  Does the grasshopper government learn the folly of its ways?  No.  It simply lowers interest rates and borrows more from the ants to pump up the real estate market and keep the party going a while longer.

The ants help out because they don’t want to admit that they’ve made all these horrible loans.  So they end up throwing good money after bad.

In the Wolf fable, there are two sets of ants/grasshoppers:  Germany/rest of the EU, and China/EU + US.

me

I think the grasshopper/ant metaphor is a very useful way of framing the structural problems that the US and Europe face today.  In particular, it highlights the fact the Europe is in double trouble:  it’s China’s largest trading partner, and the EU faces the internal Germany/Greece dilemma as well.

I think the story needs a couple of nuances to make it a better reflection of today’s global economic situation, though.  For instance:

a post-WWII phenomenon

The first “grasshopper” was the US and the first “ants” were Japan and Europe.   The original relationship benefitted the US, of course, but it was also essential in enabling the rest of the developed world to rebuild after the destruction of their industrial infrastructure during WWII.  Two of todays ants were the initiators of this devastation.

After the fall of the Berlin Wall and the reunion of the two Germanys, that country faced enormous economic difficulties:  the west’s outdated plant and high-cost labor, the pitiful state of the east after almost a half-century of Soviet rule, and the consequences of the inflated exchange rate at which the merger was done.  So Germany really needed grasshopper counterparts to alleviate what would otherwise have been a decade of even greater misery.

not just good and evil

There’s a wider point.  Like the sadist and the masochist (maybe not the best analogy, but the only one I can come up with at the moment), the relationship may not be healthy but both sides do get something out of it.  The ants get technology transfer and the opportunity to radically raise their standard of living.  The grasshoppers get a chance to invest directly in the fast-growing ant economy.  They also get cheaper foreign-made goods.

China is a very unusual ant

For one thing, it’s much larger than any of the others.

It also doesn’t have the hangups of its fellow ants:  Germany’s commitment to make the one-Europe project work, and Japan’s history of extreme deference to the wishes of the US as a result of having lost WWII.

China gets what’s going on.

To me, it gives every indication that it thinks it has gotten all the value it can out of the grasshopper/ant dynamic and is determined to move on.  It has already started to convert its dollar foreign currency reserves into physical assets through foreign acquisitions by state-controlled companies.  Unlike Japan, which has never wanted the yen to be a world currency, China is taking steps to make the renminbi a vehicle of exchange among emerging countries.  It is also trying to grow its way out of its grasshopper problem by strengthening economic ties with other emerging nations.  China won’t thereby reduce the size of its problem of being a creditor to grasshoppers, but it may be able to reduce the significance of these liabilities if it can expand its trade in a healthier way with non-grasshopper nations.

margin trading and margin calls: is this what’s happening now?

It’s possible, in every market in the world I’m aware of, and in any asset class–stocks, bonds, derivatives–to borrow money from your broker to fund investments that are collateralized by the “equity” you have in your investment account.

The minimum amount of collateral you have to have to support a given level of borrowing is set by regulation in each country and varies by the type of assets you own in the account.  Brokers are usually free to apply more stringent standards to their customers and to change those standards as they see fit.  In some countries the financial regulator has the power to change margin requirements as a way of regulating the rise and fall of asset markets, much as regulators routinely do in changing short-term interest rates to try to control the credit markets.  This isn’t common, but the US did this routinely in the first half of the last century, Japan in the second.

The main characteristic, for good or ill, of margin buying is that it amplifies returns.  Let’s say you have a $1 million margin account that’s $500,000 of your own money and $500,000 of borrowings.  If the assets you have bought double overnight, then you have $1,500,000 of your own money and $500,000 in borrowings.  Your equity has tripled.

If, on the other hand, markets decline by 25%, you have $250,000 of your own and $500,000 in borrowings.  Given that the emotional tendency of most investors is to buy high and sell low, this latter outcome is more common.

If your “equity” declines enough in value that it reaches, or breaks below, the required minimum, you receive a “margin call”  from your broker, apprising you of the situation.  You have two choices:  either add enough assets to the account to restore the minimum equity balance, or have the broker liquidate enough assets to do so.  If you opt to add assets, you may have anywhere from a few hours to a day or two to accomplish this.

If you choose the second option, your broker will immediately begin to liquidate assets.  He will not be a careful seller.  His main concern is to reduce the margin debt exposure his firm has to you as quickly as possible.  He will simply dump the assets on the market to get whatever price he can.  Since every other margin account is probably in the same position, a massive wave of relentless selling will hit the market all at once.  Because this selling will depress asset values, the liquidation itself will likely engender more margin calls the following day.

This is a really ugly process to be caught up in, but is usually washes out any excesses in the markets where this happens.

One more thing:  selling doesn’t necessarily occur in the assets that caused the problem.  When the idea is to raise cash quickly, you sell:  (a) stuff you own, and (b) what is most easily salable–namely, commodities and  stocks.  By the way, I’ve always thought that, following the unconscious suicidal tendencies that margin traders exhibit, they never sell the “bad” assets that have caused their problems; they liquidate the “good” ones they own.  Sort of like–your dog keeps you awake all night with his barking, so you give away your cat.

Why am I writing about this?

Margin call liquidation is what the trading in global equity markets over the past week or so reminds me of.

In today’s world, the main margin participants are hedge funds, not individuals.  Their assets under management are very large.  Therefore, any forced selling would be correspondingly big.  It would also likely come as a result of changes in brokers’ rules on extending credit, rather than clients’ hitting statutory minima.  Also, given that the EU, and Germany in particular, are blaming their current woes on hedge funds and beginning to legislate/regulate against them, it would be very surprising if they weren’t privately telling the banks under their control to cut back on the supply of ammunition they are supplying to this enemy.

I have no direct evidence that this is the case.  But the current selling seems excessive to me.  In particular, yesterday’s trading–massive early decline followed by recovery–doesn’t seem to me to have been driven by fundamentals (yes, recent escalation of tensions between the two Koreas always causes an immediate selloff in Asia, but that should only create minor ripples elsewhere).  As you cross off more and more items on the list of possible reasons for selling, forced margin-related selling appears to me to be prominent among the reasons left.

Margin liquidations typically don’t last very long.  Rebounds are typically sharp.

closing the books on the Dubai World debt restructuring

At a time when investors around the globe seem to be in panic mode, it’s nice to know that at least one mini-crisis has been resolved.

the Dubai World crisis

Last week, with little fanfare, Dubai World and its creditors reached an agreement on restructuring the company’s finances.  As you probably recall, the crisis was touched off by Dubai World’s unilateral announcement, issued on the eve of religious and secular holidays that would keep many of the parties involved away from their desks until the following week, that it would be unable to pay at least some of its obligations on time.   It therefore wanted to restructure everything–about $25 billion.

Complicating the issue was the fact that these obligations were a mixture of western-style bank debt and publicly traded sukuk, a  form of sharia-compliant Islamic finance.  In the case of the latter, some parties seemed to think that a dispute over failure to repay was an issue for English courts, others that it was one for sharia compliance boards–an ambiguity brushed under the rug in the bull-market enthusiasm to get the instruments sold.  Given that we have only been seeing over the past couple of years the first high-profile cases of sukuk “default,” there were no precedents to say what sharia authority would decide the case or administratively how it would proceed.

On top of all that, creditors believed that the obligations were guaranteed by the Dubai government, although as far as I can tell none of the documents for the bank loans or sukuk issues specified this.  Investors also took the Dubai World announcement as a signal that the entire $100 billion+ that emirate entities owe would eventually need to be restructured as well.

What a mess!

the outcome

Abu Dhabi lent Dubai $10 billion, which Dubai then relent to Dubai World.  DW used these funds to pay off maturing sukuk. Dubai subsequently converted the loan into equity.

Last week, bank creditors agreed to convert their existing $14 billion in loans into new 5-8 year (i.e., longer) maturity obligations at lower interest rates.  The new loans also carry an explicit sovereign guarantee.  Although the present value of these loans is likely substantially less than that of the previous ones, the form of the agreement is in harmony with sharia guidelines on risk-sharing and repayment of the nominal amount of the original obligation.

After a bad start last November, the Dubai World saga seems to have worked out as well as could have been expected–and certainly far better than pessimists had feared.

Paul Krugman: we’re not Greece in the making, we’re Japan–is this likely?

Paul Krugman, Nobel prize winner in economics and professor at Princeton, gave his view of the coming shape of the US economy yesterday in one of his regular opinion columns in the New York Times.

According to Krugman, the idea that Greece, a country which has maxed out its ability to borrow from the rest of the world, and whose major problems are a gigantic government deficit, non-competitive labor and the threat of devaluation/inflation, is in effect a crystal ball in whose interior we can see the destiny of the US, is very wide of the mark.

Instead, he sees the US of the next ten years as paralleling the “lost decade” of Japan in the 1990s–exhibiting very sluggish economic growth and persistent high unemployment.  In support of this thesis, he cites the high unemployment the US is showing now, as well as the continuance of extremely low interest rates–signaling that deflation, not inflation is the malady we should fear the most.  He also sees recent falls on Wall Street as evidence that the stock market is beginning to factor in the likelihood that his view will prove correct.

Is there any way we can avoid this fate?  Yes.  Fiscal policy in Washington has been unduly restrictive so far.  Congress, too, has bought into the Greek model and is trying to avoiding (non-existent) inflation that it thinks additional spending would induce.  What the economy in reality desperately needs, though, is more fiscal stimulation.  But even if legislation to do so were proposed, it would stand no chance of passing, given the national mood and the posturing of (mis-guided) deficit hawks.

There is some chance that a self-sustaining economic recovery will emerge in the US, despite inadequate fiscal stimulus.  But it’s by no means a sure thing.

I think that Krugman is directionally correct.  His conclusion is grim news for investors seeking to support themselves on interest income from cash or bonds, because it implies that interest rates will stay low for a l-o-n-g time.  But, shock value aside, I think the comparison with Japan is a big stretch.  But even if Japan is an indication of the future for the US, this is not as bad as it sounds for holders of stocks.

maybe it’s nitpicking but the US isn’t Japan

There are lots of points of difference between the US now and Japan back then.  For example,

1.  The median age of the Japanese population is much higher than that of the US.  Japan allows virtually no immigration.  As a result, as the “lost decade” unfolded Japan’s work force began to flatten out in size and then shrink–meaning the country began to depend on solely increasing worker output to produce economic growth.  That’s bad.  Absent productivity gains, the trend will be for GDP to contract!

2.  Japanese companies spent heavily on new plant and equipment during the second half of the Eighties, knowing the demographic story meant they would have to become more capital intensive to make their workers more productive.  Unfortunately, rather than buy more advanced machines or invest in R&D, they seem to have somehow just duplicated what they had already–meaning their costs went up but productivity didn’t.

3.   Japan had (and still has) no effective mechanism for dealing with failing companies.  Change from within is culturally very difficult to achieve.  In addition, government policy actively discourages replacement of even the most ineffective management, as many value investors have learned to their sorrow.  On top of that, for many years banks were pressured to prop up otherwise-bankrupt companies through new lending–thereby eviscerating the profits of better-managed rivals.  Foreign takeover of Japanese firms is virtually impossible.  Prospects for domestic entrepreneurs to do the same are almost equally dim.

The result of policies that preserve a traditional lifestyle at the expense of economic growth mean that in Japan there is little of the “creative destruction” that spawns new businesses.  Loads of economic resources are perpetually tied up doing nothing.

possible commonalities are political

1.  Japan did have a number of big fiscal stimulus packages during the Nineties.  But they were focused mainly on pork barrel public works projects for the rural constituencies of powerful members of the Diet.  These roads and bridges to nowhere did provide temporary jobs for construction workers, but they had virtually no multiplier effect and thus no lasting positive impact on the economy.

One of the goals of prime minister Junichiro Koizumi (2000-2006) was to redirect public works spending toward urban areas to promote productivity in service industries.  But he was only partially successful.  And one of his signature achievements–privatization of the national postal service, which had long been a source of funding for pork–is now in the process of being reversed.

2.  Japanese voters have from time to time elected “reform” slates to the Diet.  But, at least so far as I can see, although the names have changed, the policies haven’t.  PM Koizumi managed to clean up the bad debt problems of the major banks, and a previous Socialist government made the election process more democratic.  Otherwise, though, a case of “same old, same old.”

what about stocks?

For the stock market in Japan, the “lost decade” began with two+ years in which everything went down.  With even such mundane companies as cement plants trading at 100x earnings, this is not surprising.  The market then stabilized, and traded in a wide range for the rest of the decade, ending the next seven+ years basically unchanged.

There were two types of stocks that did particularly well during the decade.  The first were companies with substantial operations outside Japan, many of them global brand names like Canon, Honda, Toyota or Nintendo.  The second were smaller, domestically oriented, niche firms that benefitted from the unresponsiveness of their larger, hide-bound rivals to customer needs.  Some of these rising stars were discount retailers.  Others were service companies, many related to mobile phones and/or the internet.

For a while, foreign investors were intrigued by the extremely low valuations of badly run, but asset-rich, firms.  Gradually, it became clear that Japan had no desire to allow incumbent management to be replaced, whether by new ethnic Japanese executives or by foreigners.  My impression is that there are still a few hard-core activists trying to make social change, but that most have lost interest in this class of companies.

implications for the US?

Even under political and cultural conditions so adverse for investors as Japan has been, it has still been possible to make money in the stock market there.  The situation in the US will without doubt be far more supportive for stocks, even if Mr. Krugman is completely right in his analysis.  After all, the US continues to be a hotbed of internet and other technology innovation.  Washington, for all its faults, is infinitely more business friendly than Tokyo.

The key to outperformance, even in the weak economic environment Krugman envisions, will be the same as it was in the lost decade in Japan:  focus on two areas–the strongest companies domestically, and firms that cater to customers in regions of the world that are growing quickly (in this case, meaning emerging markets generally and the Pacific in particular).