Monthly Archives: May 2010

fiduciary responsibility: Goldman, the Senate, the SEC

May 13, 2010 By in Current Market Thoughts, Industry Analysis, Investment firms, Recent Market Action, Trading Tags: , , , , , , , , , Leave a comment

possible new fiduciary laws

Legislative proposals have been floating around Congress for a while that would create national standards for the conduct of financial fiduciaries toward their clients, as well as mandate that financial planners and brokers must act as fiduciaries when dealing with individuals.  This seems to me to be in reaction to the Madoff and Stanford ponzi schemes, where financial advisors seem to have been much more zeroed in on the large fees they were collecting for recommending the schemes than on the welfare of their customers.

After Goldman Sachs’ recent grilling by the Senate’s Permanent Subcommittee on Investigations, during which questioning senators quoted liberally from the conclusions of a similar committee looking into the causes of the 1929 stock market collapse, the idea has made it into a Senate bill that brokers should be fiduciaries in their dealings with institutional investors as well (or at least any government-related entities).

what a fiduciary is

To step back a minute, what is a fiduciary anyway?

In one sense, we’ll find out if this legislation passes, since it has to spell out in detail what a fiduciary is and does.  In general terms, though, a fiduciary is:

–a trusted advisor who

–has a certain level of technical competence in the area where he is taking up fiduciary duties and who

–acts for the benefit of his client, with no thought for his own personal gain.

Doctors, lawyers and court-appointed trustees are all examples of fiduciaries.

a financial fiduciary

A financial fiduciary has to have a certain level of technical competence and must look out for the financial welfare of his client.  To do the latter, however, it seems to me the fiduciary must have a deep knowledge of the client’s financial situation–including life goals, risk tolerances and investment objectives, as well as the size and disposition of the financial assets he possesses.  How else will he be able to judge whether an investment is appropriate for a client?

retail brokers are not fiduciaries, by and large–but I think they should be

There’s no national fiduciary standard for brokers or financial planners.  This means that at the moment, except where local laws require it, retail brokers and financial planners are not fiduciaries.  They must do things that are good for their clients, but they need not do what is best for their clients.  That’s an important distinction.

An example:  A broker finds two mutual funds that meet the client’s risk/return profile.

#1 is expected to net the client 9% per year.  The fund company pays the broker’s firm 40 basis points a year in fees.  This sale will qualify the broker to attend for free a fund company-sponsored “information meeting” in Hawaii.

#2 has consistently outperformed #1 in the past.  It is expected to return 10% a year.  Fees to the broker’s firm are 30 basis points.  No free trip.

Litigation has established (remember, however, I’m an investor, not a lawyer) that the broker can recommend #1 instead of #2 to the client.  Why?  The client will be better off with #1 than without it.  Since the broker is not a fiduciary, he has no obligation to  show #2 to the client or to highlight either the differences or the extra benefits of #2 to the broker.

Personally, I’m all for retail investment advisors becoming fiduciaries.  The most highly skilled advisors probably are as well.  I think there would be lots of fallout for traditional “load” mutual fund companies from this change.  But that’s not what I want to write about today.

the institutional world is different

In order to act as a fiduciary when executing a trade, a broker has to understand a client’s current investment position and his intentions.

As an institutional investor, my investment plans and my current portfolio positioning are my competitive advantage.  They are valuable intellectual property, my stock in trade, my equivalent of copyrights and patents.  I’m certainly not going to disclose this information to the brokerage intermediaries I chose to trade for me.  In fact, I may do everything in my power to disguise my intentions from him.

As an institutional investor, I’m invariably acting in the interests of clients.  In assessing the suitability of any investment, a fiduciary probably should know who the ultimate owner will be and what his investment plans are.  Again, my client list is also valuable intellectual property.  I’m certainly not going to reveal that.  I may also have clients who have specifically required that I not reveal their identities (usually because they don’t want to appear to be endorsing my management services).

In addition, although the broker has different information from mine–he sees what a wide variety of clients are trading–it may not be better information.  In the equity world, his analysts may have more industry knowledge than mine.  But because their livelihood is so closely linked to the health of the industry they follow, they may find it hard to see anything negative.  And mine certainly know more about the individual companies we own than they do.  And mine know more about related fields, which may be important, too.

To sum up, as an institutional investor I don’t need or want the broker to be a fiduciary.  I want him to be an intermediary in trading who guards my anonymity, thus protecting my intellectual property.  I may listen to his input, delivered, not from the trading desk but from his research department to my analysts, but it will be one of many factors I take into consideration.

In fact, if I’m a value investor, it’s music to my ears if a broker hates a particular stock.  Part of my modus operandi is to buy companies that have performed badly but where I judge other investors have already acted out all their negative feelings by selling.  My biggest worry is that my buy order will tip him off to the stock’s potential.  The last thing I want is for him to come to think that this is a good idea.  Yet, if he’s got to be a fiduciary, how else can he act on my behalf?

Washington doesn’t seem to understand this

The morning after the SEC announced it was suing Goldman for fraud, the Wall Street Journal ran an editorial in which it surmised that the SEC fundamentally misunderstood what the financial instrument that formed the basis for the suit is.   Nowadays, I automatically discount what the WSJ says as being partisan support for Rupert Murdoch’s political allies.  But I’ve come to think that, in this case at least, the comment is accurate.

An Op-ed column in yesterday’s Financial Times raises this point again.  It also talks about the oddity that while in its suit the SEC is defending the interests of two European banks against an American company, Americans are suing one of the two banks for fraud and the SEC hasn’t stepped in to help.

I also found it striking in the Senate hearings about Goldman that the senators didn’t seem to appreciate that the rise of large multinational corporations after WWII and the emergence of large “buy side” institutions after passage of ERISA pension legislation in the Seventies have profoundly changed the landscape for institutional investing.  Many of the functions the senators seem to think are performed solely by investment banks have decades ago shifted to their clients–either the finance departments of industrial companies or to giant investment management firms.

It seems to me the Goldman witnesses did themselves no favors by somehow giving their questioners the impression they had something to hide.  They certainly didn’t get the point across that there’s a difference between an investment advisor and a trader.  Then again, reflection, self-awareness and self-deprecation are probably not high on the list of attributes a trading firm like Goldman looks for in its employees.  They were probably also scared, because Washington has a lot of power and wants to be seen as doing something.

Maybe I’m just getting old, but I find this all kind of scary, too.


Disney’s March 2010 quarter: Alice was wonderful

May 12, 2010 By in Current Market Thoughts, earnings conference calls, Entertainment, Industry Analysis, Recent Market Action, Stock ideas Tags: , , , , , 2 Comments

the eps

DIS reported its fiscal second quarter (ended April 3rd) after the close last night.  Ex unusual items, earnings per share were up 12% year over year to $.48 vs. $.43 in the comparable period of fiscal 2009.

My take is that the company’s economically sensitive businesses are showing genuine signs of life, that are not yet clearly visible in the financials due to the accounting conventions DIS has chosen to use.  There’s nothing wrong with what DIS is doing.  In fact, as I see them the accounts are on the conservative side–which is a good thing.  The company is (understandably) reluctant to provide too much information that may ultimately end up in the hands of its competitors, however.  And I think it assumes Wall Street analysts know more about what makes DIS tick than they do–I’m not sure how DIS could hold that opinion after even one earnings conference call, but I think it does.  So it doesn’t provide a lot of help in explicitly connecting the dots.

In any event, Wall Street reacted to what I thought was a pretty encouraging quarter by pushing the stock down by about 3% in after-market trade.

segment results

studio entertainment

Alice in Wonderland, despite iffy reviews (51% from Rotten Tomatoes), was a huge winner for DIS.  The film has grossed $962 million worldwide, almost all of that in 2Q.  That ranks it as the #7 movie of all time.  DVD sales will begin on June 1st, earlier in the film’s life than usual, which will likely stimulate sales.

Iron Man 2 has been out for two weeks internationally and one week in the US and is so far outpacing IM1 by grossing $334 million to date.   Toy Story 3, another likely blockbuster, is also in the hopper.

On the success of Alice, DIS reported 2Q operating income from films of $223 million, up from $13 million in 2Q09.

Yes, there’s an accounting issue in this business segment–how DIS has apportioned production/marketing costs for Alice (my guess is that the company has been very conservative, wiring off almost everything against theatrical release–meaning the possibility of a positive surprise if DVD sales go well).  But the real question is operational.  Is Disney’s (non-Pixar) filmmaking, which has shown itself out of touch with contemporary America, getting itself back in touch.

parks and resorts

Operating income for the quarter was down by $21 million year on year at $150 million.  The decline comes from the Disney Cruise Line, where the company benefitted a year ago from having its fuel costs hedged vs. being unhedged this year.  domestic theme park results were flat, as were international–which strength from Hong Kong offset by weakness (what else is new?) in France.

Three points:

1.  DIS’s books have the week as the basic unit, not the month.  Because a calendar year is 52 weeks + 1 or +2 days, every once in a while the New Year’s holiday, which typically yields a whopping $60 million in revenue for the parks, falls in the December quarter.   The current fiscal year was one of those times.  So something like $40 million (my guess) in operating profit was shown in the December quarter that would usually be recognized in the March quarter.  About a third of this negative effect was offset by having the first week of Easter fall into the March quarter.

In other words, on an apples-to-apples comparison the parks and resorts were up about 10% vs. last year.

2.  DIS is steadily raising its prices with the aim of eliminating recession-induced discounting by next fiscal year.  The company could be posting higher short-term profit numbers by continuing bargain-basement rates.  But for the long-term health of the brand, it’s important that DIS reestablish premium pricing as soon as possible.

3.  Leisure travel bookings are like an accordion.  In good times, vacationers reserve far in advance.  In bad times, they look for the best prices and book at the last minute.  In March 2009 quarter, we probably saw the last of the pre-Lehman demise “good times” reservations.  In the March 2010 quarter we are likely seeing the last of the post-Lehman “deep fear” bargain bookings.

In fact, somewhat exasperated by an analyst’s (misguided) analogy with business travel (which leads the economy, while leisure travel lags), DIS blurted out that it was seeing a sharp uptick in bookings recently.

media networks

As usual, it’s a tale of two cities.  Here are the figures, in millions:

Revenues

Cable                     $2412       +9% yoy

Broadcasting       $1432      +1%

Operating income

Cable                 $1183       +3%

Broadcasting     $123      -24%

Cable is basically ESPN.  Broadcasting is ABC TV Network + Studios.

I think Wall Street mostly ignores Broadcasting, figuring the best it can hope for is that ABC will not turn into a black hole that damages overall results.  So the focus is on ESPN, where revenues look ok–but not great–and operating income was uninspiring.

Again, the situation is a little more complicated–and more favorable for DIS, I think–that it seems.  Points:

1.  Revenues from 12 big college bowl games played on New Year’s Day were part of first quarter results this year and second quarter last year.  On an apples-to-apples basis, ESPN revenues were probably up 12% year on year.

2.  ESPN is trying to build up a sports presence in the UK.  To do so, it has to acquire sports rights first and subscribers later.  Startup equates to losing a lot of money.  DIS isn’t saying how much, but I think it’s safe to assume that this expense is offsetting the operating leverage that existing operations should be showing.  If DIS were building a manufacturing plant, these costs would be “capitalized,” meaning they wouldn’t be recognized as costs until construction was complete.  DIS can’t–and shouldn’t/wouldn’t do this.  But the fact that startup costs are being expensed obscures the profitability of the existing business.

3.  Advertising revenues are now rising by about 20%.  There will be a significant uptick in affiliate revenue starting in the third quarter as contractual minimums are achieved–some months sooner this year than last.

consumer products

This segment was up by $36 million year on year to $133 million, based on strong sales of Iron Man and Toy Story merchandise.

interactive media

Revenues were up by $26 million and losses cut by $6 million to a $55 million deficit.  This is the company’s new media, internet, video game division.  It’s almost like the inverse of ABC–losses now, with the hope of big profits later on.  As long as the losses stay in the current range, about 3% of overall DIS operating income, Wall Street won’t care.

my thoughts

I thought the news from DIS was very encouraging.  It sounds like economic energy is building in the US in a way that’s benefitting DIS but is not yet seen in the financials.  Recognition will likely come in the next quarter or two.  Success of IM2 and TS3 are expected, but will nevertheless prompt Wall Street to take a somewhat more favorable view of the DIS film business.  And if another one of DIS’s traditional films turns into a box office winner, so much the better.  I also think earnings will surprise on the upside as accounting oddities even themselves out.

What caused the “Crash of 2:45”?

May 11, 2010 By in Current Market Thoughts, ETFs Vs. Mutual Funds, hedge funds, Portfolio management, Recent Market Action, short selling, Trading, uptick rule Tags: , , , , , , , Leave a comment

The short answer is that anyone who knows the details isn’t telling.

what happened

Last Thursday, May 6th, was a generally bad day on Wall Street.  What makes this session worthy of not, however, is the Tower of Terror-like plunge that the market took at about 2:45 pm, followed by an equally swift rebound several minutes later.

visiting the SEC

Representatives of the major exchanges met with the SEC yesterday to discuss the situation.  All reportedly professed to have no idea what caused the sudden decline and rebound.  That’s not really much of a surprise.  On the one hand, no one wants to take the risk of becoming Congress’s latest whipping boy if they admit to having had even an innocent hand in the debacle.  On the other, its track record in cases like Madoff suggest that the SEC doesn’t have the knowledge or interest to pursue the issue by itself.  So anyone involved would likely be calculating that, absent a public declaration of repsonsibility, they will never be found out.

rumors

There have been two persistent stories about the trigger for the mid-afternoon drop.  One, offered by CNBC, is that a trader from Citigroup made an input error that generated a sell order that was 1000x the amount intended.  Citi denies this.  The second, more detailed–and therefore, I think, initially more plausible–comes from the Wall Street Journal. According to the newspaper, the initial trigger was a relatively small sell order placed in the Chicago options market by hedge fund Universa Investments.   However, the Journal may have been attracted to this trade as much by the fact that Universa is linked to Nassim Taleb, who popularized the idea that disruptive “black swan” events are much more numerous than academic theories allow for.

what we do know

Several things are clear:

–as the computer-to-computer selling got more intense, the NYSE turned its machines off and reverted to manual processing of trades.  Apparently, although I wasn’t aware that this was the case, this is the NYSE’s publicly stated policy.  This action effectively eliminated one of the main ways derivative holders could hedge their positions with offsetting exposure in physical stocks.  It caused trades to be redirected to other middlemen, who buckled under the added pressure.  It isn’t clear whether the others took defensive measures similar to the NYSE’s or whether they were simply overwhelmed by volume.

–ETFs were hurt unusually badly in the selloff.  According to the Financial Times, two-thirds of the securities where exchanges subsequently cancelled trades were ETFs.  ETFs themselves represent only about 16% of the total number of securities traded on US exchanges.  I don’t think there’s any great significance to this, however.  In a “normal” stock trade, the market makers matches a third-party buyer and seller–who have already decided they want to transact–and charges a bid-asked spread.  In an ETF trade, however, the counterparty is often the market maker himself, who is constantly calculating the NASV of the underlying ETF and his hedging possibilities and deciding whether to transact at a given price or not.  To let the market know he is potentially a buyer or seller, he typically has “placeholder” bids of, say, $.01, that under normal circumstances let the world know that he may be interested in transacting.

Last Thursday, a lot of those $.01 bids were hit before the market makers could withdraw them.

–as mentioned above, the exchanges unilaterally decided to cancel transactions they considered to be anomalies.  This presumably leaves a lot of unhappy individuals who had placed low-ball limit orders.  Perhaps not by coincidence, the counterparties–that is, the losing side–to those canceled trades are the same exchange members who canceled them.

what happens next

The SEC is under political pressure to do something to prevent a recurrence of anything like the near-instantaneous decline of 5% that happened last Thursday.  Some of this pressure likely comes from proponents of having a stronger “uptick rule” (see my post on this topic).  Although the current uptick rule seems to me to invite sudden plunges in stock prices of the type we had last week, no one is publicly suggesting that this is the cause of last Thursday’s meltdown.

Whether needed or not, a new trading halt mechanism is probably the “solution” the SEC will opt for.

I have two related thoughts:

–added volatility may just be a fact of life in a modern stock market, where computer-to-computer trading and monthly performance measurement of the type hedge funds undergo are prevalent.  In other words, get used to this.

–the first time something like this happens, it’s a surprise.  Even now, I’m sure that investors are beginning to devise strategies to cope with–and take advantage of–increased volatility.  Understanding what’s going on and planning for it, investors will enter the market as buyers sooner and more aggressively. By doing so, they will temper volatility.  For their part, sellers, learning that there’s a penalty for being aggressive on the downside, will adjust their behavior as well.

That’s why I think canceling money-losing trades made by people pushing the market down is a really bad idea.

–no one so far is questioning the behavior of the NYSE (admittedly, not my favorite organization).  It’s kind of like switching from big fire hoses to small ones as soon as the fire starts.  What good is that?  In fact, if this incident isn’t the accident that I think it was, short-sellers may have been counting on the NYSE to remove liquidity from the market.

April 2010 US Employment Situation Summary

May 10, 2010 By in Current Market Thoughts, economics, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , Leave a comment

the employment situation

I think Wall Street is overlooking the substantial good news contained in the Employment Situation Summary released by the Bureau of Labor Statistics last Friday.  The report shows a steady improvement in the employment situation in the US over a number of fronts.

highlights

Specifically:

–the US economy added a surprisingly strong 290,000 non-farm jobs during April.  Of these, 66,000 were temporary positions working on the national census, leaving 224,000 “real” jobs gained.

–February new-job figures were revised up by 53,000 (to 39,000 added, no census) and March numbers were revised up by 68,000 (to 230,000, 48,000 from the census).  This means the economy has created a robust 445,000 new jobs in the past three months (+114,000 census-related positions).

–True, the unemployment rate rose from 9.7% to 9.9% during the month.  Given that this is because workers who had given up hope are sensing the economic situation is better and are out looking for work again, this too is a positive.

–Job gains are starting to be led by manufacturing and services, not by health and education.  The latter groups are still rising, but the gains in employment are now being driven by the sectors that were hurt the most during the recession.

–Less-educated workers appear to be beginning to find work again.  From a purely economic point of view, this may not be such a key development, but for social and political stability it is.  In a country where growth s increasingly driven by knowledge workers, one would think that high school dropouts will tend to be chronically unemployed.

one exception–long-term unemployed

In fact, the one sour note in the report is the composition of the group classified as unemployed.  Of the 23.6 million Americans in this pool, the only category that is not shrinking is those out of work for the longest time (27 weeks or more).  That subgroup has risen from 6.1 million (40% of the total) last December to 6.7 million (46%) in April–a timeframe in which the overall unemployed group has shrunk by about eight hundred thousand.

conclusions

We’re not in a boom.  But the economy is in better shape than the consensus has been thinking.  And the upturn in hiring appears to have started in February-March, which is earlier than previous government reports had shown.  It’s also hard not to notice that the hiring pickup coincides neatly with the end of the January-February correction in the stock market and the subsequent steady march upward of the indices.  Assuming the emerging more favorable trend in employment continues–and I don’t see any reason to believe it won’t–we should expect it will support resumption of a gentle rise in stock market indices, once the correction we’re in plays itself out.

Activision’s March 2010 quarter–very strong

May 9, 2010 By in earnings conference calls, Industry Analysis, Stock ideas, Technology, Video games Tags: , , , , , , Leave a comment

the results

ATVI reported 1Q2010 financial results after the close last Thursday.  Revenues were $714 million vs. company guidance, given on February 2, 2010, of $525 million.  EPS was $.09 vs. guidance of $.02.  Of the $.07 per share difference, $.05 comes from stronger than expected results from Call of Duty: Modern Warfare 2 and Worlds of Warcraft. The remainder comes from deferral into the June quarter of expenses ATVI had thought it would incur during the first three months of the year.

The company bought back 8.5 million shares during the quarter at an average price of $10.84, under its new $1 billion buyback program authorized on Feb 10th.  This buying, by itself, won’t support the stock.  But it does give an indication of what management considers a cheap price to be.

new guidance

The company raised its full-year earnings guidance, which is usually conservative, by $.02/share to $.72.  This is effectively a reduction in eps guidance for the remaining nine months of 2010 by $.03, since 1Q already came in $.05 better than forecast.  The reason?  Recent industry experience is that licensed properties, like Spiderman, Legos or Shrek, which appeal to casual gamers and mainly to children and young adults, are selling more poorly than they traditionally have.

ATVI will doubtless make up the “lost” $.02 through strength in its core businesses, so the company could easily have left its guidance for the rest of the year unchanged.  Lowering it simultaneously emphasizes the extraordinary strength of ATVI’s main franchises and underlines the weakness in the overall retail environment.

the main points of the conference call

—Starcraft II: Wings of Liberty will launch on July 27th, in 11 languages on 5 continents.  Retail preorders are already very strong.  Even though the game is in closed beta testing (and therefore not widely available), it is the second-most played PC game, trailing only Warcraft III.  WOL is the first of three installments of SCII, each focused on one of the three races, Terrans, Protoss and Zerg, of SCI.  WOL is the Terran game.  ATVI expects sales of WOL to be enough to produce the first up year for sales of PC games in a decade.

Success of SCII and its eventual development of an equivalent to subscription-based Worlds of Warcraft is a major part of the positive case for ATVI.

–ATVI took great pains to point out that it has had three development studios working on the Call of Duty franchise, not just  Infinity Ward, whose heads have left the company and are now being sued by ATVI.   Sledgehammer, and Treyarch, developer of the next installment of COD, called Black Ops, which will be released late this year are the two others.  The majority of Infinity Ward professionals remain with ATVI, at least for now, and the company is already at work rebuilding staff.

The major competition for Black Ops will be the latest installment of Halo, called Reach, from MSFT.  ATVI expects Black Ops’ sales to outpace Reach’s, which seems a pretty safe bet, considering that Reach is only available for X-Box and Black Ops will have a version for PS3 as well.  By release time, there will probably be 40 million X-Box 360s in Europe and North America, the main markets for this kind of game, plus 32 million PS3s.  Even if we assume half the PS3 owners also have X-Box and all of them buy the X-Box version (decision:  better graphics on PS3 vs. better online with X-Box Live), that still leaves 40% more potential buyers for the ATVI game than MSFT’s.

–ATVI also gave a few details of its 10-year contract with Bungie, the creator of Halo–the main one being that it expects the association to be accretive to margins from the beginning.

The Halo game still belongs to MSFT.  But the studio, its 200 professionals and a new concept already under development, are now ATVI’s. Reason for the Bungie switch?–ATVI’s market power aside, it’s the chance to sell to–and earn royalties from–all those PS3 consoles.

bits and pieces

–Worlds of Warcraft has begun to see increases in its number of subscribers again.  ATVI expects further gains as it launches the Cataclysm expansion pack later this year, overhauls the older areas of the site and gains permission from Beijing to add the Lich King expansion pack in China.

—WM2 players have logged 2+ billion hours of use on X-Box Live so far.

—ATVI had 1+ million downloads (at $15 each) of its latest COD extra map pack in its first 24 hours of availability.  Another one is planned for the second half.

–The company still doesn’t see mobile as financially attractive enough to commit resources to, despite its fast growth.

my conclusion

The stock, trading at about 13% this year’s earnings and yielding 1.4%, seems cheap to me.  The loss of the Infinity Ward executives could easily turn out to be a tempest in a teapot.  But I think for the stock to advance significantly, WOL has to be a smash hit.  I’m a long-time Starcraft fan, so I think it will be.  But that’s the bet.