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.