Yearly Archives: 2011

thinking out loud about Euroland (I)

November 13, 2011 By in Current Market Thoughts, economics, emerging markets, Foreign markets, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , , , Leave a comment

recent trading

During this latest iteration of the Eurozone existential crisis, we’ve dropped from 1350 on the S&P 500.  We’ve visited 1074 and seen 1284, both within weeks of one another.  We now seem to be generally moving sideways, but bouncing between 1215 and 1270.

What is the market saying?  This trading pattern says to me that the market is highly emotional but no one has a clue to figuring out what’s going on in the Eurozone.

thoughts on Euroland

As a first step toward developing a (hopefully) intelligent stance to take toward the Eurozone in building an equity portfolio, I thought I’d try to list the points I feel confident about.  That may be enough for me to use;  at the very least, I may be able to highlight what other information I really need to know.

Here goes:

1.  Matters would be worse on Wall Street if the US economy weren’t recovering.  While not thrillingly optimistic, the view of Jim Paulsen, Wells Fargo’s chief investment strategist, is an interesting–and, to me, a completely plausible one.  He terms the current sluggish recovery as normal for the US in today’s world.  It only looks bad when we compare it with recoveries from thirty or forty years ago, when economic circumstances were very different.

2.  The Eurozone won’t be generating much economic strength for years, I think.  If so, as investors we should regard Europe as a special situations market and be very choosy about what stock we own.  If we take it as given that we don’t want much exposure, our biggest concern has to be that the economy there gets bad enough that it punches a hole in the bottom of the world’s economic boat.

Why do I think European prospects are dim?

–Japan hid the banking problems that resulted from its late-1908s speculative bubble for a decade.  Its economy stagnated during that time.

–The US fixed the worst damage to its banks almost immediately and the economy began to perk up 18 months later.

–Euroland?  So far, it has followed the Japanese example.  The result has been little growth and creation of the only negotiating chip places like Greece and Italy have.  Even if the EU recapitalized its banks tomorrow, we wouldn’t see the positive economic effects until 2013, at the earliest.

3.  Euroland’s investment importance comes from the accumulated wealth its citizens hold, not its size or growth prospects. 

How so?

Look at the Eurozone’s (small) size.

Using Purchasing Power Parity calculations from the World Bank (I got them on Wikipedia), global economies break out as follows:

Brazil, Russia, India, China         25% of the world

US, Canada, Mexico          23%

Eurozone          15%

rest of EU          5%

Japan          6%

everybody else          26%.

I draw two conclusions from this list:

–Euroland isn’t that big in world terms any more.  The fate of the “other” 85% is hugely more important than what happens in Europe.

–One possible outcome for the Eurozone is that it fades into insignificance in the way that Japan has during the past two decades.  I’m not sure this is the most likely outcome, but it’s a good possibility.  After all, the EU has many of the same cultural rigidities that have helped to sink Japan, and it hasn’t fixed its banking system.  Japan’s economic collapse didn’t stop the 1990s from being a very profitable decade for investors elsewhere.

4.  The worry isn’t a deep recession in Europe–it’s uncertainty about unanticipated consequences.  At least, I don’t think it should be about Eurozone recession.  According to the Conference Board, a US-based economic consultant, the world is likely to grow by about 3% in real terms (that is, after subtracting inflation) in 2012.  The agency thinks  the EU is most likely to grow by 1%;  its “pessimistic” scenario has the area little better than flat for the next half-decade.

What does Europe mean for overall world economic expansion, in the Conference Board’s view?  Realistically, nothing.  In the base scenario, the EU chips in .15% to world growth–more or less a rounding error.

Let’s assume that somehow the bottom falls out of Europe next year and the Eurozone has a horrible recession where output shrinks by 5% in real terms.  That would subtract .75% from world expansion.  The globe would still grow, but by 2%+ instead of 3%.

 

That’s it for today.  More on this topic tomorrow.

Citigroup, Jed Rakoff, MF Global and the SEC

November 11, 2011 By in Banks, Derivative instruments, Industry Analysis, Investment firms, Securities regulation, Where are the customers' yachts? Tags: , , , , , , , 1 Comment

There’s an odd asymmetry to the way the SEC works.

For example, it put Martha Stewart in jail but ignored Bernie Madoff.   It pursued Michael Milken vigorously after the junk bond market collapsed.   But it has, so far, left the heads of the major commercial and investment banks untouched, despite the fact that the toxic derivative securities they created were much more widespread and–as we continue to see–have damaged the world financial system much more severely than anything Milken did.

Raj Rajaratnam’s insider trading recently drew an 11-year prison sentence and a $93 million fine.

But the other side of the SEC has come to light again recently in the court of gadfly judge Jed Rakoff.  Judge Rakoff is being asked to approve a settlement of a case in which buyers of a Citigroup mortgage product lost $700 million.

The deal the SEC is offering?

–pay back $160 million, plus $30 million in interest and a $95 million fine;

–Citi doesn’t admit it did anything wrong;

–only low-level Citi employees are sanctioned.

–oh  …and the SEC wants to include an admonition to Citi not to do stuff like this again.  But, as Judge Rakoff points out, Citi appears to have violated such orders issued in prior settlements at least twice in the past decade and the SEC has done nothing.

You’d take a deal like that all day long.

A cynic might say that this behavior is related to the fact the current head of the SEC used to be in charge of the brokerage industry trade association.  On the other hand, I believe much of the toxic derivative activity was deliberately organized by the banks out of London because that put them out of the reach of US prosecutors.  So there’s not much the SEC can do.

…which brings me to MF Global.

There’s certainly a danger to generalizing from a small number of instances.  But, to me, what connects Martha Stewart, Michael Milken and Raj Rajaratnam is tha: t the issues are easy to understand, the names are high-profile, none were deeply plugged into the financial industry establishment and, although wealthy, none had the near-infinite resources of the large investment and commercial banks.

One of the issues that the Occupy Wall Street movement gives voice to is that after nearly destroying the world economy and forcing a high-cost financial rescue that all of us will be paying for for many years, no high-level financial commercial bank or brokerage executive has been prosecuted for anything.

What this adds up to, I think, is that the SEC will be scrutinizing the role Jon Corzine played in the demise of MF Global very carefully.  He’s a former head of Goldman Sachs but no longer an industry insider;  he’s an ex-senator and ex-governor; he’s wealthy–but not Bill Gates.   And, the question of whether the firm illegally took money out of customer accounts and used it to stave off margin calls is pretty clear-cut.  It may also be hard to say you didn’t notice an extra $600 million plopping into a portfolio you manage–especially so if you really needed it.

It will be interesting to see what happens–both whether the SEC finds a reason to prosecute and whether that will satisfy OWS.  My guess on the second count is that it won’t.

lessons from Olympus Corp (7733:JP)

November 10, 2011 By in Asian economic development, economics, Japanese development, Portfolio management, Stock ideas Tags: , , , , , , , , Leave a comment

the latest chapter in the Olympus story

In an earlier post, I’ve written about the events that led up to the firing of Olympus’s newly-appointed CEO Michael Woodford.

On Halloween, according to the Wall Street Journal, long-time Olympus executive Hisashi Mori revealed to replacement CEO Shuichi Takayama–who had been defending Olympus vigorously against Woodford’s accusations–the truth about the situation.

That is, the apparently bizarre investment banking activity Olympus had engaged in was a sham.  The excessive payments, the shell companies, the subsequent writedowns, were all designed to funnel hundreds of millions of dollars out of operations.  The cash was used to cover massive losses run up in speculative portfolio trading.   A small coterie of company insiders had kept them from public view for as much as twenty years through fraudulent accounting.

My immediate reactions?

Two of them:

Wow!   …like a bad novel.

–and–

Wow!  …welcome to Japan.

on further consideration

As to Olympus itself, I think there’s lots more to come.  You don’t need a half-billion dollars to fix inflated balance sheet entries.  Writedowns do that.  This isn’t about paper losses that haven’t been recognized.  It’s about active investment accounts that can’t be closed until debts are paid off.   Who are the lenders?  Was the debt collateralized by, say, Olympus plant and equipment?  How was this all hidden for years?

In general, Olympus illustrates how traditional Japanese companies have one foot–and perhaps both–firmly planted in a samurai-like world that’s governed by a rigid system of rights and obligations among insiders.  In this world, shareholder value has no place.

Companies like this can trade at far below the value of their assets.  But that doesn’t mean they’re cheap.  Nor is it, in my opinion, because investors think the books of such companies are as cooked is Olympus’s seem to be.

I think they trade at prices that make a Western value investor salivate because experienced market participants understand that the company won’t use its assets for the benefit of shareholders.  Managements are happy to destroy the assets, if need be, so they can preserve the jobs and relative status of management and employees.  Outsiders, including holders of the company’s equity, don’t count.

investment implications

One is to avoid these apparently asset-rich companies.

More important, it seems to me there has been a wholesale rejection of this modus operandi by younger Japanese citizens.  The “counter-culture” companies the latter run operate along profit-maximization, shareholder-friendly principles.  They also find their samurai-generation rivals easy pickings.  That’s where I think any investor interested in Japan should look.  Many are worth considering even for those with no need to be in Japan, because they then to be really good companies.

why is Qantas so cheap? …two reasons

November 9, 2011 By in foreign ownership limits Tags: , , , , , , Leave a comment

Qantas is an undervalued stock

In a Halloween commentary in its Lex column, the Financial Times points out that the Australian airline Qantas is unusually cheap compared with regional rivals.  By the newspaper’s reckoning, Qantas trades at .7x book value and 9x earnings per share, vs. its competitors’ average of 2.5x book and 12x eps.

labor problems

The FT attributes this substantial discount to the labor problems that plague many Australian firms, and Qantas in particular.  I’m sure that this is part of the issue, but I don’t think it’s the entire explanation.  The other factor that the FT is overlooking is the type of foreign ownership restriction Australia has imposed on the airline.

foreign ownership restrictions

It’s not just the fact of a limit on the percentage (49%) of the outstanding shares of Qantas that can be held by foreigners, although that is really a relic of a past that’s long gone.  The way in which the restriction is enforced is considerably more important, in my opinion.

When I first became involved in global investing in the mid-1980s, limitations on foreign ownership of companies a country thought had strategic, national security value–like telecom, media or transportation–were commonplace.  Some still exist.  In addition, however, many smaller countries restricted the ability of a foreigner to own more than a specified percentage of many other–or even all–companies, for another reason.  They feared that wealthy outsiders would snatch up a nation’s birthright for a song.

The Switzerland of post-WWII Europe did so to protect its industry against acquisition by US companies.  In the Pacific, when I began investing there in 1984, dual share systems were already in place in markets like Singapore and Thailand.

This distinction is a relic of a bygone era in most wealthy countries and has been eliminated as an impediment to equity capital raising and to generally having the stock price go up.  I think Australia should follow suit in the Qantas case.  More about this below.

how you implement ownership limits matters

The most widely used method of implementing foreign ownership controls in the Pacific was to allow foreigners to buy ordinary shares in the market.  On settlement day, these shares would be recorded and designated (in the old days, share certificates were physically stamped) as foreign-owned.  Once the ownership limit was reached, the company would no longer register the new ownership of ordinary shares bought by foreigners.

But the “foreignness” of the shares already purchased by non-citizens remained an enduring characteristic of those shares.  This gave new foreigners a legal way of buying stock in a given company.  They could purchase shares already designated as foreign from another foreign holder; the place on the foreign register would transfer to the new owner.  Typically, the stock exchange would make this easy to do by setting up a separate quote for foreign shares.

I remember buying foreign shares of Singapore Airlines, for example, in the mid-1980s for either no premium to the local shares or maybe 0.5% extra. The premium of foreign to local eventually breached 100%.

This was partly due to the indifference of local citizens to equities in general and to airline stocks in particular.  Global investors saw a different picture–stunning growth prospects for Asian airlines, which were trading at far cheaper prices than their much less attractive home-town alternatives.

Australia’s choice

Australia deliberately chose not to take the conventional route with Qantas.  The “foreignness” of foreign shares in Qantas doesn’t stay with the shares.  When the company sees that foreign ownership has reached the 49% level, it stops allowing foreigners to register share ownership (which is legally required, and in any event is necessary to collect dividends).  All foreigners can do at this point is wait for enough other foreigners to sell, making room for them to buy.  But since Australian investors show limited interest in stocks in general and in airlines in particular, once the foreign ownership nears the 49% level the Qantas stock price stops dead in its tracks.

This system makes life more difficult for Qantas.  A relatively low valuation makes it more expensive for the company to raise equity capital or to use stock as a method for compensating employees.  To my mind, this puts the airline at a substantial disadvantage to international rivals.

why?

Why would Australia do this?  And, how would I know?  It turns out that at the time Qantas was being prepared for its IPO I was managing a large portfolio of Australian equities (the Kuwaiti Investment Office held the only larger foreign portfolio I was aware of).  I remember discussing at length with a fact-finding commission the defects I saw in the Australian approach to foreign shares–basically predicting what has occurred.  I also said that although I admired Qantas as a company I wouldn’t participate in the offering.

The officials I spoke with said they didn’t care.  New Zealand Air had listed shortly before, using the conventional structure.  The foreign ownership limit there was quickly reached.  Foreign shares began trading at a substantial premium to local.  New Zealand investors were outraged and complained bitterly to their politicians.   Canberra’s highest priority was to avoid the same outcome.

Yes, a higher foreign-share price is a problem.  In most cases where this has occurred, like in Singapore, the authorities eventually end the foreign-local structure.  The unified share price typically settles at a level much closer to the foreign price once the limits are lifted.

My guess is that ending the two-share structure for Qantas would easily add 10% to the stock price.  I think +20% is more likely.

dark pools and Pipeline Trading Systems

November 8, 2011 By in dark pools, Vocabulary Tags: , , , , , , Leave a comment

dark pools: what they are

the traditional brokerage system

Twenty years ago, virtually all trading between professional investors was conducted through stockbrokers as middlemen.  This traditional system had three big advantages:

–brokers are constantly in touch with a large number of potential buyers and sellers–including other brokers–of a wide variety of securities.  This means that orders can be executed quickly and in large size.

–in some cases, brokers may use their own capital to buy less liquid securities from a customer right away–securities that would otherwise be hard to sell–hoping to trade out of the positions at a profit over a period of time.

–because brokers see lots of orders from very many customers, they may be able to spot trends in the markets faster than an individual investor.  So they may be a source of market intelligence.

Using a broker has one big disadvantage and one smaller one:

–the smaller one is that they’re more expensive than dealing directly with another professional investor would be,

–the larger one is that your broker knows who you are and what securities you’re transacting in.  The more you deal with a given broker, the more insight he will gain about your plans and methods of operation.  In a sense, he gradually comes to “own” them.  He can use this information in his proprietary trading or pass it on to your rival investment managers.

The bigger the institution, the savvier the investment manager, the more valuable this information is–and therefore the more likely it is to be passed on to others.

anonymous trading networks…

Advances in computer technology, both software and hardware, allowed entrepreneurs to create the first anonymous computer trading networks, or “dark pools” for institutional investors about a decade ago.  Investors register with the network operator, but place all their buy and sell orders on the network without revealing their identity.  Nor can they find out who the other side of any transaction is.

The advantages of dark pools are:

–anonymity, and

–very low commission costs.

The main disadvantage is:

–liquidity in a given issue may be low, meaning that execution of a large order may take a considerable amount of time.  An institution can mitigate this problem somewhat by placing orders with a bunch of dark pools at the same time.

…have become very popular

As time has passed and investors have become more accustomed to the concept, the use of dark pools has increased to where some estimates have them accounting for more than one trade in four in the US.  Three reasons:

–more users means better liquidity

–SEC-regulated investors have a positive obligation to seek the lowest-cost executions in their trading.  Using electronic crossing networks demonstrates they’re doing so

–as brokers have deemphasized stock research as a way to cut costs, the need to do enough business with brokers to get full access to research information has diminished.

where Pipeline Trading Systems comes in

Pipeline (PTS) is a broker- dealer who decided to cash in on the dark pool trend by creating one of its own.  It intended to make money, as any dark pool operator would, by charging a fee to anyone using its service.  It opened for business in September 2004.

In its advertising, PTS touted its anonymity and its ability to provide “natural” buyers/sellers for the other side of any trade.  Although, as the SEC notes in its recent cease and desist order, natural doesn’t have a precise legal definition, its use is meant to convey that the other party is another institutional investor, and not a financial intermediary like a broker or short-term trader.

Despite this claim, even before opening, PTS created a wholly-owned trading affiliate to take the other side of trades.  Its idea appears to have been that liquidity in the dark pool would thereby appear bigger than it actually was.

PTS didn’t disclose this to clients.  Quite the opposite.  It continually assured them that this was not the case.

As it turns out, the PTS dark pool was a bust.  In the early years, PTS itself provided well over 90% of the other sides of institutional members’ trades.  And it lost a lot of money doing so.

So PTS decided to put its head trader in charge of the brokerage affiliate, with the task of whittling down the losses.  The in-house broker promptly began to act in a way I see as being against the interests of its institutional clients.  Contrary to what it was telling clients, PTS gave the broker privileged access to the dark pool’s trading data, so it could study customers’ trading patterns; traders were given bonuses for money-making trades; the broker gave suggestions to its parent on how to tweak the dark pool rules in the broker’s favor.

PTS continued to lose money, however, though at a lower rate.  And then it was caught by the SEC.

PTS and two principals were together fined $1.2 million.  They also agreed to stop their illegal behavior.

Although the PTS crew were a hapless bunch, the SEC administrative proceeding against them shows that the agency is finally beginning to examine the operation of dark pools.  At the same time, the case shows that an enterprise like PTS can operate for the better part of a decade without being detected.