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).

AAPL vs. GOOG: battle of the titans (II)

Judging by their stock charts, Wall Street has pretty much conceded the battle to AAPL.  In fact, there isn’t much doubt at all.  Since the ipo of GOOG in 2004, AAPL is up about 12x.  GOOG is up 4x–and that includes a big jump after an unusual, and less than successful, ipo in which GOOG tried to market itself directly to investors, cutting out Wall Street investment banks.

Yes, the S&P is just about flat over that span, so both are big winners.  And, yes, AAPL is starting from a low base in 2004, a point when some questioned its survival.  But the big separation between the two names has come between the beginning of 2007 and now, a time period when AAPL tripled and GOOG has been flat.

AAPL has also pulled significantly ahead in simple balance sheet metrics like working capital or accumulated cash holdings.  The balance sheet number read as follows:



cash                  $8.0 bill.                           $15.8 bill.                  $7.8 bill.

wc                      $8.3 bill.                           $17.9 bill.                  $9.6 bill.


cash                  $11.9 bill.                          $24.8 bill.                $12.9 bill.

wc                     $9.4 bill.                            $20.2 bill.                 $10.8 bill.

At first glance, it looks like AAPL is pulling away from GOOG, but not opening up an insurmountable gap.  But AAPL has recently begun to divide its marketable securities into those with a life of a year or less and those with more.  The latter, $15 billion at 12/09, although cash-like, are listed as non-current assets.  Adjusting the figures, AAPL’s cash is up by $27.9 billion over the past three years, or 3.5x the cash generation of GOOG.  The main driver of this surge is the phenomenal success of the iPhone.

In addition, AAPL has set up a business, iAd, to sell iPhone ads through the apps downloaded from its store, a move calculated to fence GOOG out of the mobile ad business.  Ironically, however, the FTC has citied iAd plus AOL’s purchase of mobile ad specialist Quattro Wireless as reasons of giving the anti-trust green light to GOOG’s proposed purchase of AdMob, a Quattro rival.

The are are other signs as well, that the contest may not be so one-sided from now on.  According to the Financial Times, sales of smartphones using GOOG’s Android operating system were higher than those of the iPhone in the US market for the first three months of 2010, taking 26.6% of the market vs. 22.1% for AAPL.  Android phones were about 10% of the worldwide market over the March quarter vs. 1.6% during the year-ago period.  The gains come 40% from MSFT, the rest from everyone else.

Since the start of the year, GOOG has released version 2.1 of Android (Eclair), which increases the speed of phone apps significantly.  This week it announced version 2.2 (Froyo), which gives the operating system another big overhaul.  The following upgrade, Gingerbread, has a name and a potential release date of late this year, but no version number and few details.

Chrome os netbooks, at  one time scheduled for release during the second half of this year, appear to have dropped off the radar screen.  After the surprisingly strong sales of the iPad, they seem to have been replaced by a bevy of android-based tablets that are claimed to be hitting the market in time for the year-end holidays.

Suppose, then, that the next year or two show a reversal of trend, in which GOOG products gain market share over their AAPL counterparts?

Will this mean a significant increase in the growth rate of GOOG’s profits vs. what it is presently showing?  Only time will tell, but my guess is that it won’t.  Success of Android phones and Android tablets will allow GOOG to take its business into the mobile arena, but I think this will only erosion of revenue and profit expansion that Wall Street seems to now sense in the company.  That’s probably worth a few points of price earnings multiple expansion, however.

On the other hand, GOOG success would also have the potential to stop the momentum of the AAPL earnings freight train that is currently barreling down the tracks at an extraordinarily rapid clip.  As is the case with any growth stock, a slowing in growth from the pace the market expects has two negative effects on the stock.  It lowers the stock price by the extent to which earnings fall short of Wall Street expectations.  And it causes the price earnings multiple to contract.  This happens both as investors project forward a new, lower rate of profit advance, and as the open-ended “dream” that the stock will always surprise on the upside becomes tarnished.

For me, this means that, as stocks, AAPL has much more to lose than GOOG has to gain from Android success.

Tis is a situation to monitor closely.

a technical breakdown

It was only a couple of days ago that I was writing in Current Market Tactics that I thought the correction we’re now in was just about over–and that the charts suggested to me that the S&P would likely hold around 1130.

Well, so much for that.  As I’m writing this, S&P stock index futures are indicating the market, which closed yesterday around 1070, will open ten points or so lower.  How should we think about this?

First of all, although I’ve been pretty good at calling the twists and turns of the stock market road over the past over the past 14 months, I’ve been seriously wrong this time.  That’s not so surprising to me, since professional equity investors quickly get used to being wrong on a regular basis.  And in the grand scheme of things, laying out a coherent investment strategy to meet your saving goals is much more important than doing the investment equivalent of predicting the weather–fun as that may be to try.

Second, the fact that the market has broken down below the floor of the channel it has been in since the bull market began means that something has changed in a negative way about investors’ perception of the market.

I’ve often thought of managing a portfolio as like being in a small sailboat out in the middle of the ocean (the closest I’ve come to this in reality is being in a runabout in the middle of a lake  or being on a ferry on the way to school).  You’re going along with lots of sail out when a storm comes up.  What do you do?  If you think it’s just a summer squall, you may take a little sail in but still proceed as you were before.  On the other hand, if you think this is the leading edge of a hurricane–or, worse, the start of monsoon season–your actions may be a lot more defensive.

That’s the fundamental question–have we changed direction from bull market to bear market–we all have to decide about now.  My answer is that we haven’t changed into the rainy season, we’re just in a particularly ugly squall.

Two things bother me about the current correction:

–I’m a growth stock investor, so I have a relentlessly bullish outlook.  So if we have radically changed market direction (earnings are too good, valuations too reasonable, the recovery has barely started for me to believe this), I’ll find it harder to recognize than a value investor would.

–I usually get progressively more worried as the market goes down.  I don’t mind this.  In fact, I welcome a little angst.  I figure that I have enough scars on my body from prior market downturns (being a global investor means having a chance to be beaten up three times a day, in Europe, the Americas, and in Asia).  So when I get really worried, I figure most other investors are in worse shape and have probably already acted out their fears by selling.  That means we’re close to the end of the downturn.

Today I’m more bewildered than anything else, not worried–which would suggest there’s more selling to come.  As I’ve demonstrated this week, however, I’m not currently a good indicator.

Many market commentators are saying the downdraft is due to worries over the fraying at the edges of the euro.  That may be aggravating what would otherwise be a “normal” correction, but I don’t think this is the key issue.  For one thing, the fall in the euro will add 1.5%-2.0% to EU economic growth in the coming year (subtracting it from emerging markets–which won’t miss it much–and the US).  For another, let’s say that earnings from Europe or ownership of European assets made up 25% of the value of the S&P a month ago.  I don’t know the exact number, but I don’t think it can be much higher than that.  If the 13% fall in the S&P since is due to a belief that European earnings/assets are permanently impaired, then the market would be saying that those earnings/assets are worth slightly less than half what they were in mid-April.  A 20% impairment would mean a 5% fall in the market.  That’s still too high, I think, but I can imagine people feeling this way.

what to do?

If this is a correction, then the best thing to do is to try to upgrade your portfolio by trading clunkers, which go down less, for market leaders, which get beaten up the worst in a time like this.

The second-best thing is to have faith in the structure you have built and do nothing.

If you believe the market has fundamentally changed direction, you should plan what a defensive portfolio should look like and begin to implement your new strategy.

Auction Rate Securities (ARS)–in the news again

what they are

Auction-rate securities are a type of variable rate financing invented by Lehman, popularized by Goldman and used mostly by charities and governments.  The idea was to sell long-term bonds, but pay interest on them at (much lower) short-term rates.

Periodic auctions, of the type the US Treasury uses to set the coupon on its bonds, but conducted by the brokers who sponsored the offerings were the means for performing this magic trick.  Auction periods varied, but would typically be either weekly or monthly.

The issuer would sell uncollateralized bonds with a long term–even 20 or 30 year–to an initial set of investors at a fixed interest rate.  At each auction, the holder would in theory either decide to keep the bond until the following auction, and collect the interest determined in the auction, or sell it to someone else, who would take his place.   Because the presumed ARS holding period was either a week or a month, ARS interest rates would arguably not be much higher than money market or commercial paper rates.

The marketing pitch to issuers was that they got 20-year money but would pay a very low rate.  Buyers were told that, although these were in fact long-term bonds, one should look at them as pretty much like cash but with a higher-then-cash yield.

ARSs differed from the Variable Rate Demand Obligations that this kind of issuer might otherwise use, in two main ways:

–ARSs have no put feature, that is, no way to return them to the issuer for payment at par (the auctions were supposed to provide all the liquidity holders would need);

–ARSs were cheaper to issue, with most of the fees going to the broker running the auctions, rather than to a bank, as was the case with VRDOs, for a letter of credit to make sure the put feature could be exercised.

Most ARSs were rated AAA, not necessarily because the underlying credits were this strong, but because the issue purchased insurance from one of the large monoline municipal insurers.

what happened

In early 2008, auctions started to fail, that is, not enough buyers showed up to absorb the bonds that existing holders wished to sell.  In hindsight, it’s not clear how much third-party demand there was at the auctions versus how much of the activity was done by the sponsoring brokers.

This had several (bad) consequences:

–the interest rates the issuers had to pay for the ARSs skyrocketed;

–holders began to realize that these instruments had become highly illiquid;  the bond prices also fell.  So much for “just like cash”;

–everyone sued.

why are ARSs in the news again?

It may be just a coincidence, but two revealing stories about the ARS fiasco have just popped up.

1.  Thomas Weisel Partners, the last of the line of Silicon Valley technology boutique investment banks, is being accused of securities fraud in connection with ARSs, according to the Financial Times.  (Actually, I was originally going to use Weisel as a jumping off point for talking about the fleeting phenomenon of the San Francisco area tech boutiques, but thought that ARSs, as a crazy bull market kind of security that made no sense but everyone bought into, was more interesting.)

Weisel reportedly was advising clients to sell ARSs early in 2008 over fears market liquidity would soon disappear.  At the same time, in order to raise money for executive bonuses, it allegedly removed $15.7 million from three clients’ accounts without their knowledge or consent and replaced the money with ARSs it had tried–and failed–to sell on the open market.  Weisel asked the clients to okay the transactions after the fact, but were refused.

2.  Gretchen Morgenson (a name that makes CEOs shudder) detailed yesterday in the New York Times instances where Goldman Sachs has acted in an ethically dubious fashion–like helping Washington Mutual resell packages of sub-prime mortgages while simultaneously shorting the company’s stock.

In the same article, she recounts the experience of the University of Pittsburgh Medical Center, a non-profit, with ARSs that Goldman helped it issue.  In mid-January 2008, UPMC became worried about ARSs and asked Goldman whether it should withdraw from the market.  Goldman told UPMC to “stay the course.”  But a few weeks later, Goldman itself fled the ARS market.

Because interest rates on the UPMC ARSs rose sharply, UPMC decided to redeem the securities.  Of the three ARS sponsors UPMC employed, only Goldman refused to allow the redemption to occur.   And Goldman continued to collect fees even though it was no longer sponsoring the auctions that the fees were supposed to be payment for.

So, take out your pencil and add ARSs to the list of zany bull market securities that sounded good while the champagne was flowing but had little investment merit.  Maybe between hybrid bonds and contingent convertibles would be a good place.