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:

————————–12/06—————–12/09———–change

GOOG

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

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

AAPL

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.


I’ve added a section on fundamentals to Current Market Tactics

It supplements yesterday’s comments on market technicals.  Here’s the link–or just click the tab at the top of the page.

Should you “buy when there’s blood in the streets”? … or “not try to catch a falling knife”?

Wall Street has spawned millions of clichés.  They run from capturing the essence of stock investing, “Buy low; sell high” to not-so-useful chatter (for investors) from traders, like “Wait for a pullback,” to the inane natterings of cable TV show personalities.

Market truisms are often mutually contradictory.  But, excepting the ones from TV, they often outline possible approaches to important investment issues.   That’s certainly the case with the two I’ve cited in the title for this post, which talk about how to deal with sharp drops in the market in general, and how to play a possible upturn in the business cycle (and therefore in the market cycle as well) in particular.

the big middle

In the old days–meaning pre-Eighties, professional investors in the US customarily talked about working the “big middle.”   The idea was to avoid undue risk at potential cyclical turning points in the market.  A manager would do this by becoming more defensive as he saw three signs:  the economy beginning to expand at an unsustainably high rate, the market becoming fully valued and the Fed about to shift money policy from expansive to restrictive.

He might miss the actual market peak by months.  But he was prepared to profit from the subsequent downturn.  As he sensed the opposite signs, however–the economy flagging, the market cheap and the Fed about to reverse course–he would do nothing.  He would wait for the market to clearly turn upward again before becoming more aggressive.  Again, he might miss the absolute bottom by months, but he would avoid coming out of his defensive position too soon and he would gain performance for a year or more after he turned his portfolio more positive.

No one talks about this overall strategy anymore.  Why not?

–For one thing, as a result of deliberate policy decisions by the major governments of the world over at least the past quarter-century, individual country economies are much more closely linked in a global network than they were.  The closed economy model is a thing of the past.  Markets are affected, sometimes profoundly, by events that take place elsewhere and over which the local government has only limited control.

–The investment business is much more competitive today than it was then.  Underperforming for six months or a year may be enough to get a manager fired before the “big middle” strategy allows him to catch up.  His clients may say they’re ok with the risk mitigation his approach provides, but when the numbers fall behind the peer group, memories can be very short.  And it’s always the customer’s right to take his business elsewhere if e chooses.

–For thirty years, we’ve been seeing the creation of ever newer derivatives tools that allow the manager to change portfolio composition much more quickly than before.  In addition, volumes in the physical market have been steadily increasing as well, allowing managers whose contracts with customers bar the use of derivatives to act swiftly, too.  Maybe we’re now seeing the limits to this speed, even large market participants have the flexibility to alter their portfolio structure in a matter of a few weeks if they choose to.

To sum up, linkages with the rest of the globe mean more chances for sharp short-term market movements, which new tools and increased competition have professionals increasingly focused on.  Also, as the recent “Crash of 2:45” shows, the new tools themselves may be another source of temporary market instability.

the falling knife

Opinion is divided on how to approach sharp market declines.  “Don’t try to catch a falling knife” expresses one technique.  I’m not sure what the origin is.  I’ve only begun recently to hear it in the US, although it was already very common among British investors when I began to look carefully at foreign markets in the mid-Eighties.

The “falling knife” idea is a variation on the “big middle” theme.   The thought is that when investors are selling aggressively and stocks are dropping sharply, it’s better to wait until this energy has exhausted itself before going in to pick up the pieces.  See the bottom and watch the turn happening before entering the market.

blood in the streets

The “blood in the streets” approach is to some degree the opposite idea.  Buy when everyone else is selling, when the predominant emotion in the market is fear, and when stocks are cheap.  Don’t wait for the turn.  By the time you’ve convinced yourself that the worst is over, the best buying opportunity is long gone.

more professionals are embracing the “blood” idea…

…in my opinion, anyway, for two reasons.  The opportunity to profit from market disruptions, and by doing so to perform better than one’s peers, is too great to ignore.  Increasingly, the time period over which clients are judging professionals’ performance is shrinking.  Hedge funds, where returns may be scrutinized and evaluated on a month by month basis, are the limiting case.  But this performance pressure is also being felt by long-only managers.

What should individuals do?

The most important thing is to ask yourself two related questions:

–Are you willing to accept the extra risk of trying to trade a downdraft in the market?

–Is your financial situation strong enough that you can absorb possible losses if you turn out to be wrong?

Assuming the answer to both questions is “yes,”  these are my thoughts:

1.  Ask yourself what the primary trend in the market is.  Are stocks generally going up or generally doing down?  Are we in a bull market or a bear market?

In my opinion, you should only be interested in counter-trend movements.  Only think about buying, or about replacing defensive stocks with more aggressive ones, during a decline that happens in a bull market.  Conversely, only use a sharp upturn to become more defensive during a bear market.  Otherwise, do nothing.  During the past twenty years, the lows have typically been much lower, and the highs higher, than anyone would have predicted.  Welcome to a world with derivatives trading.

2.  Calculate probabilities as best you can.  The point is that you don’t need to find the absolute bottom in order to act.  For me, if I can satisfy myself that a stock might go down 10% but has an equal chance of going up 30%, I’m happy to buy.  Your own risk tolerances will determine what the appropriate ratio is for you.

3.  Separate market events from stock-specific ones.  In a temporary downturn, more economically sensitive stocks will typically decline more than defensive ones.  Similar stocks in the same industry should show roughly similar volume and percentage change patterns.   These patterns should also be similar to the stocks’ behavior during past declines.  An individual stock decline that is, say, twice what one should expect and that happens on much higher than expected volume can be a warning sign that sellers are acting on newly developed negative information that you may not be aware of.  In such a case, discretion is the better part of valor.  Choose a different stock to buy, or don’t transact at all.

4.  Don’t force yourself to do anything you don’t feel comfortable with.  I think it’s a characteristic of today’s market environment that if you miss an opportunity today, another one will likely occur in a month or two.

Waddell & Reed and the crash of 2:45

the Ivy Asset Strategy Fund

Government investigators have  been tracking the sell orders that were executed in Chicago on the afternoon of May 6 betweeen 2:30pm and 3:00pm, the period when the S&P 500 plummeted by 5%–and just as quickly rebounded.

According the Financial Times, they’ve discovered that a mid-Western investment firm, Waddell & Reed (ticker:  WDR), was a significant seller of stock index futures during that period.  At one point, 2:32pm, WDR constituted 9% of the total volume of one specific stock index futures contract, the “e-mini”.   WDR has issued a press release (not so easy to find on its website, but it’s there) confirming  the press stories and stressing it was just doing normal hedging transactions for its $22 billion flexible fund.

The prospectus of the fund in question, the Ivy Asset Strategy Fund, says it can invest in stocks, bonds, precious metals and currencies around the world.  It can also use derivatives to hedge its exposures.  In other words, the customer gives WDR enormous freedom in how to invest his funds.

Neither the WRD press release nor the fund prospectus spells out what the fund might have been doing on the afternoon of May 6th.  The only clues we have are that the WRD selling seems to have been triggered by the declining market (rather than vice versa) and that the selling continued even as the market was rebounding.

This suggests, to me anyway, that the selling was done in accordance with mechanical rules that were set in advance, and were to be carried out without any human intervention.  The idea would be to remove human subjectivity–feelings of greed or fear–that might lead to impulsive (and thereby usually money-losing) on-the-spot action.

dynamic hedging

the investment manager

The simplest explanation of the activity is that the managers were using a plain-vanilla technique for hedging portfolio value where the short derivatives position shrinks as the S&P rises and increases as the S&P falls (it was called portfolio insurance when it became popular about a quarter-century ago).

There’s nothing “wrong” with this technique or exotic about it–in fact, it’s ubiquitous in the hedging world–other than that it was invented by academics.  An underlying assumption is that there’ll always be someone (you can call him the “dumb money,” if you want, because that’s the idea) who will willy-nilly take the other side of the trade.  And, I suspect, when the WDR computer/trading room entered its sell orders, along with about 250 other firms who were using similar techniques and wanted to do the same thing, there weren’t enough buyers to go around.

Two points:

1.  The investment manager sees the market declining and sells S&P index futures to hedge his position.  The counterparty, who is likely the broker he is dealing with, takes the offsetting long position.  If it’s the broker, he will try to balance ( or “flatten”) his books by selling stock short in the physical market, thereby creating further downward pressure on the S&P.  In addition, if he already has a long futures position and is employing the same hedging technique for his own books as the investment manager is, he wants to sell more physical stock short to restore the level of hedging he wants against any long futures position he already had.

This means the market declines further, the investment manager wants to hedge more …  The investment manager hedging activity has a snowball effect.

2.  This kind of hedging has been around for about 25 years.  If it still works–it’s possible it doesn’t and that practitioners lost their shirts on the 6th  (warning:  my practical derivatives experience is limited to currencies and emerging markets stocks), it seems to me to depend on the assumption that the counterparty never catches on.  He never alters his behavior  He never reads the books his customer studied from.  He never tries to hire away one of his traders to learn his secrets.  He just continues to be the “dumb money” who racks up losses from this trading.

Not likely, though.  It’s possible that the counterparty makes so much money from his customers’ other, losing, trades that he writes this off as a cost of doing business.  More probable, I think the counterparties model their customers’ actions very closely–after all, everyone is doing basically the same dynamic hedging trading–and can predict with a high degree of accuracy when they will act and what they’ll do.

The counterparty has three responses that I can see.  He can charge more for trades done at times he identifies as risky.   He can begin his own hedging activity in anticipation of his customers’ acting (in effect triggering their trades).  Or he can drag his feet in executing them so that he ends up not doing them at all, or not doing as many as he would otherwise do.

the counterparties

I think there should be a debate about what obligations, if any, an exchange, or a broker who is a member of an exchange, have in a situation like this.  This is particularly so, since we are enacting legislation to force most derivatives trading out of the shadowy over-the-counter world and onto exchanges.

We do know that the NYSE partially withdrew from making markets during the decline on May 6th.  Members did so by unhooking their computers as the market was falling and starting to process trades manually.  They certainly avoided losses by doing so.   Given how they are connected to the stock index futures markets, this short-circuited the derivatives world, as well.  Should they be allowed to?

The NYSE is a particularly interesting case.  On the one hand, you could argue that they are a quasi-utility that can’t be allowed to in effect turn out the lights in tough times.  Given that it has a history that I would characterize as one of high fees and shoddy service, it wouldn’t be surprising to learn it has few friends among professional investors.

On the other hand, the NYSE is by no means a monopoly.  Professionals have been bypassing it for years, through electronic crossing networks, for instance, that offer lower costs and greater confidentiality.  The issue with ECNs is that they aren’t that liquid.

the debate should be interesting to watch

How do you reconcile the interests of a derivatives community operating with tools that presuppose infinite liquidity at all times, with a creaky physical stock trading system where the taps can be turned off at a moment’s notice?   We’ll see.

By the way, I don’t think the Ivy Asset Strategy Fund did anything wrong.  Its only sin is that its performance, along with WDR’s marketing, have grown it to such a large size that its actions are more visible than its peers’.