layoffs on Wall Street: where do people go?

The weekend Financial Times has an interesting article about the decline in financial markets employment during the Great Recession.  It says that the industry lost over 200,000 workers, of whom more than 40,000 were relatively highly paid professionals.  The article relates a number of stories of transition to other kinds of work.

That’s basically what happens in investment-related businesses during downturns–people find other, unrelated industries to work in.

Looking at the situation a little more systematically,

finance has two main branches–three if you count the often bizarre area of financial “theory” that prospective finance teachers must master.

–commercial finance, commercial banking and corporate finance.  It deals with areas like lending, capital structure, budgeting, financial management controls, investing/raising cash for corporations, communicating with investors and regulators.  It’s generally insulated from the violent ups and downs of securities markets.

–investments, which deals with the structure and practices of securities markets.  People who focus on this branch of finance are generally much higher paid and much more highly specialized.

While it’s common for a commercial finance professional to move among different areas during a career, however, there’s virtually no carryover in skills, other than at the most basic level, from the investment specialty to the broader world of commercial finance.  In fact, other than early in one’s career, there’s very little movement possible among various areas–like stocks, bonds, trading, investment banking–within investments.  Career paths are that highly specialized.

This is a recipe for big career trouble for investment people if your sub-specialty suddenly has too many workers.

buy side vs sell side; professional investors vs. investment professionals

The industry commonly splits jobs into buy-side (investment management) and sell side (investment banking and brokerage).  There’s also typically very little movement between these two.  You can also distinguish between professional investors (the people who actually make investment decisions) and investment professionals (trading, sales/marketing and recordkeeping functions that provide services to portfolio managers).

professional investor issues.  The main industry problem over the past several years has been the decline in the value of assets under management.  This is the key problem for profits, since professional investors typically charge a percentage of assets under management as a fee.  Investment firms are also highly operationally leveraged–meaning they have roughly the same costs, no matter what the level of assets is–so the loss of assets under management results in a disproportionately large fall in operating income before compensation of portfolio managers.

The moves to index products and from equity to fixed income, both of which generate lower fees, haven’t helped, either.

What do investment management firms do?  They prune the least profitable products, eliminate staff and lower the level of compensation for almost everyone who survives.  There isn’t much else they can do.  Laid-off money managers either go into business for themselves (massive layoffs of value-oriented PMs in the late 1990s formed the basis for much of today’s hedge fund industry) or find smaller, often regional or local, firms to work at.

investment professional issues.  On the buy side, firms trim their trading and marketing staffs and lower compensation for those who remain.  The investment industry is mature, however, meaning there are few new customers.  So firms gain business mostly by taking it away from other firms.  So marketing is a vital function–more important than the investment management itself.

On the sell side, it’s important to distinguish between high-value employees, who are masters of their trading or investment banking trades, and low-value workers, whose main function is to act in a sense as “overflow” capacity.  That is, they answer the phone and process orders, or visit clients and make presentations, during cyclical peaks in business.  They may not add much value, but the firm avoids losing potential profits by being unable to respond, even badly, customers’ requests.

Such second-tier workers are paid a lot, both in absolute terms and relative to the value they add.  But when business slows down, they’re the first to be laid off.

First-tier investment professionals typically earn (much) less in lean times.  They also risk being laid off, as well.  Like their portfolio manager counterparts, they may end up at regional or local firms.  Boom times give second-tier workers an inflated sense of their own abilities.  Typically, though, they’re unable to remain employed in the investment industry during downturns and eventually end up working in other professions.

where are we now?

My sense is that the investment industry is at a cyclical bottom for employment.  But the industry still has enormous idle capacity available with the staff it now has.  We won’t see the boom times of 2004-2007 again soon.

higher taxes on dividends? –implications for stock markets

the Obama proposal

President Obama has recently proposed that the current tax preference for corporate dividends paid to individuals be eliminated.  Instead of being taxed at most 15% of the amount received, dividends would be considered ordinary income and taxed by Washington at as high a rate as around 40%.

Personally, I’d prefer an overhaul–and simplification–of the current tax code instead of tweaks around the edges.  Rather than putting a foot into the  the quagmire of possible political motivations, however, let’s just take a look at what I think are likely results for US capital markets if it’s implemented.

what doesn’t change

1.  Tax-exempt and tax-deferred accounts would be unaffected.  For pension plans, 401ks and IRAs, and for non-profits, it will continue to make no difference whether they make money in the form of interest or dividend income, or of short-term or long-term capital gains.

2.  Aging Baby Boomers are developing an increasing preference for steady income over capital gains, which are sometimes there, sometimes not.  That won’t change either.

what does

3.  I think the biggest effect will be on company decisions to start making dividend payments or to increase a payout they already have.

It seems to me that most publicly traded corporations recognize the Baby Boom-induced change in investor preferences now happening in the US.  Understanding that a substantial, and rising, dividend is a positive for their stock, companies have been happy to return profits to shareholders this way.  They do this despite realizing that if you combine federal and state/local income levies, up to 25% of the payout will go to the taxman.

If dividends lose their tax preference, the percentage taken by the taxes will approach 50%.  That means a big drop in what the shareholder will retain, both numerically (a third) and psychologically.  For most companies, I suspect, it will tip the balance in favor of devoting free cash flow to share buybacks rather than dividend increases.

For my money, that takes a lot of the shine away from what I consider to be the most attractive part of the dividend-stock universe–companies with above-average dividends today and for which you can reasonably project a quickly rising free cash flow over the next few years.

4.  If the government continues to  keep interest rates at emergency lows and, by accident or design, it also removes much of the incentive for individuals to buy dividend-paying stocks, how do investors adjust?  Maybe there’s a boost in demand for junk bonds, although income-oriented investors have been buying riskier forms of fixed income for a long time.

I think biggest effect would be for investors to broaden their horizons further.  The 7%-8% yields on EU telecom stocks will suddenly look more attractive, despite currency risks.  So, too, emerging market securities, both bonds and dividend-paying stocks.

5.  Looking at #3 another way,  provided they’re large enough to lower the share count, stock buybacks raise earnings per share.  All other things being equal, that should mean a higher per share stock price.  If so, the higher share price would likely offset some or all of the negative effect of dividends increasing at a slower rate.  In other words, the mix of returns (price appreciation + dividend income) changes, and in a way that increases risk.  But the crucial investment question is whether the total return from both sources will be higher or lower than before.

No one knows the answer.  But if the total return is lower–that is, if the effect of higher taxes on dividends is to decrease the long-term value of US equities–then one would expect US investors of all stripes to look increasingly to stock markets outside the US.  In addition, on the margin, US companies might also begin to look to foreign venues to raise new capital, if they could achieve higher prices for their stock by doing so.

My bottom line:  this proposal is one to watch closely.  Like a snowball that starts rolling down a hill, its consequences could be far greater than just to raise taxes on older, upper middle class city dwellers.

there may be a real life for contingent convertibles, after all

why I don’t like co-cos…or, (more) evidence investment bankers are on the dark side

Investing is conceptually very simple but emotionally very difficult.

Under most conditions, professionals can resist the Dr. Frankenstein-like impulses of investment banks to create bizarre security hybrids.  Not at the top of the market, though.  There’s something in the air that makes portfolio managers throw away their pocket protectors and revel in the purchase of the trashiest securities.

PMs will rue these buys for the rest of their careers–which may, incidentally, be quite short periods of time if they don’t recover their senses and sell the stuff on while a market for them still exists.

One of my favorites in this genre was a convertible bond issued in 1993 by Hong Kong-based New World Development, an indifferently managed family-owned property conglomerate.  It carried no coupon and was convertible on undisclosed terms into shares of a mainland Chinese company that did not yet exist.

And you ask me why I’m not a fan of investment bankers.

As it turned out, the issue met with high demand despite its dubious character–a sure sign that the markets were in the grip of speculative fever.  Right afterward, I was chatting about it with a highly skilled colleague, who confessed she had actually taken part in the deal.  Her reasoning?  In her peer universe there might be a half-dozen offerings during the year that would make or break performance versus competitors.  She felt she couldn’t take the chance that the deal would not only be successful but would trade up strongly in the aftermarket.  She didn’t want to be left in the unusual (for her) position of eating competitors’ dust.

co-cos, the brokers’ latest creation

Contingent convertibles are more recent spawn of the investment banking tendency to birth nightmarish creatures.

The idea is that the vehicles, known as “co-cos,” would be issued by financial companies, especially banks, that are required to maintain minimum levels of equity capital.  They start out as bonds.  But if the issuer’s financial condition deteriorates beyond a certain level, they automatically convert into equity.  Therefore, investment banking proponents argued, they should be considered as equity by the regulators even before conversion.  (True to form, when the original idea was floated, the intention was to not specify in the offering documents what circumstances would trigger conversion.)

not a winner…

Co-cos have never taken off.

The obvious flaw, other than that no one would know what would prompt conversion, is that the buyers would be bond portfolios.  They’d be reeled in with the promise of higher-than-average coupons.

If the issuer’s capital ratios deteriorated, its stock would sag significantly.  If conversion of the co-cos followed, that would leave large amounts of stock in the hands of PMs whose client agreements don’t allow them to hold equities.  So they’d have to dump the securities right away into a depressed market, sending the issuer’s stock lower and making its problems worse.  In fact, anticipation of conversion might launch the stock of the issuer into a severe downward spiral.

Also, the Bank of International Settlements said the idea wouldn’t fly.  Finally, the co-co idea also came too close to the disastrous demise of their close cousins, hybrid bonds.

…until now

It now looks like co-cos may actually have a use, according to the Wall Street Journal.  The buyers won’t be private investors, however.  They’ll be the governments of Spain and Portugal, which will use the vehicles to inject money into ailing banks.

Why use co-cos? Three reasons:

–the injections of money will look like investments, not the bailouts they really are,

–Spain and Portugal will get securities in return for the money they pour in, so their government deficits won’t increase, at least on paper, and

–Madrid and Lisboa won’t appear to be partially nationalizing the weak banks, which is what buying equity directly would mean.

I’ve never seen this before–an instance where a crackpot, top-of-the-market, caveat emptor ploy by investment bankers to boost their bonus pool is actually useful.  It’s nothing like what the i-bankers envisioned, of course, but still…

searching for yield in a zero Fed funds rate world

conventional wisdom

Two traditional general rules about the appropriate allocation between equity and fixed income are:

1.  Take your age in years.  That percentage of your assets should be in fixed income; the rest can be in equities.  A thirty-year old, for example, should keep 30% of his assets in bonds and 70% in stocks.  A seventy-year old should have the reverse proportions.

2.  For a retiree, figure what your yearly expenses are.  Keep enough fixed income so that the interest earned will cover these expenses; the rest can go into riskier assets like stocks.

Neither rule applies in today’s world, however, at least in my view.

Only a lottery winner has the luxury of using #2.  Fifteen years ago, when the 10-year Treasury was yielding 8%, $1.25 million worth of them would generate $100,000 in interest income.  Nowadays, you’d need a $5 million investment to earn the same.

Both rules subject the follower to considerable risk as/when interest rates begin to rise.  My friend Denis Jamison deals with this subject in detail in his recent posts on PSI.    …his conclusions.

my quandary

One of my former employers notified me recently that I’m being removed from participation in its fixed income pension plan.  I can either take lump sum distribution or buy an annuity.  I’ve chosen the former, which I’m rolling over into an IRA.

I want to keep the IRA money in income-generating assets, to counterbalance to some degree my growth investor desire to own stocks.

Believe it or not, it takes a month for my old company to process my request.  Also, quaintly enough, it will issue a physical check and send it in the mail to my IRA account.  Looking on the bright side, this gives me some time to figure out what to do.

So I’m looking for dividend-paying stocks.  I’m not the only one, of course.  And with this account I’m starting at a time when the search for such equities by individual investors is close to entering its third year.  Has everything been picked over already?

first thoughts

My preliminary look around for information has turned up two interesting articles:

-the first comes from BCA Research, an independent organization headquartered in Canada (BCA stands for Bank Credit Analyst, its best-known publication).  BCA continues to be very fundamentally sound.  At one time it served primarily individuals and was somewhat technically-oriented and decidedly bearish in tone.  Not so much any more.  Today’s clients are mostly institutions.

In a February 2nd article titled US Equities:  The Total Return Trap,  BCA opines that traditional high income stock groups–utilities, telecom and REITS–are currently overvalued.  It recommends looking for yield among pharmaceuticals, integrated oils and hypermarkets.

–A February 5th piece in the Financial Times points out that significant dividend yields are available among stocks in the EU and in the Pacific.  The article lists the following current yields on various FT regional indices:

Europe (ex the UK)     3.80%

UK          3.40%

Asia Pacific (ex Japan)          3.16%

Global          2.70%

Japan          2.51%

US          1.96%.

my first stops

My order of preference is:  US, UK, Asia ex Japan, Europe.

I’m not so keen on Japan.  I think companies there prefer to pile up cash rather than pay dividends.  The high yield is more a function of wretched stock market performance than rising payouts.

I don’t have strong thoughts on the relative strength of the € vs. the $.  My hunch is that the € is going to be relatively weak, though, undermining the attractiveness of any dividend payment to a dollar-oriented recipient.  If we’re going to enter an extended period of economic stagnation in Euroland, much like the “lost decade(s)” in Japan, however–and I think that’s the most likely scenario–one can reasonably make the argument that, like the ¥, the € could show surprising strength.   I just don’t know.  Until I have more conviction, why take the chance?

The UK is a very income-oriented market and doesn’t carry the same degree of currency uncertainty as the Eurozone, in my opinion.

I’ve got a couple of weeks to do some research.  I’ll write more as I make progress.

profit margins: how I look at them

what they are

They’re the portion of revenue, usually expressed as a percentage, that remains after costs of s certain type have been deducted.  The most common types of margins used in financial analysis are:

gross margin, meaning what’s left after deducting the direct costs of providing the goods or services

operating margin, meaning what’s left after deducting both direct costs and sales, general and administrative (SG&A) expenses.  Sometimes depreciation is also considered an operating cost, sometimes not, depending on the convention being used.

pre-tax margin, meaning what remains after deducting all costs other than taxes

after-tax margin, meaning income remaining after all costs, including taxes–but not including preferred stock dividends, if any.

do high margins mean a good company?

Many growth investors, especially tech-oriented ones, look for high margins as proof that a company owns patents, copyrights or other intellectual property that defend it against competition.  MSFT or INTC might be good examples.

Low margins, these investors believe, are indicators that a firm is in a commodity business.  This means that competition forces revenues down to levels very close to the cost of production.  Profits accrue either to no one or mostly to the low-cost operator.  Entrants in such industries are continually in a dog-eat-dog fight to push their costs below those of rivals.  No one stays in the low-cost seat for long.

Value investors, with their customary dour dispositions, take the opposite view.  They think high margins are like waving a red flag in front of a bull.  Firms that demonstrate them are disasters waiting to happen.  Sooner than you’d expect, they opine, competition will emerge, margins will compress and the stock will implode.

I line up more or less with the value guys on this one, even though I don’t agree with them 100%.  There are some perennial high-margin firms, where competition hasn’t proved an issue over decades.  Nevertheless, it’s hard to argue that either MSFT or INTC have been anything but disasters as stocks so far in this century, despite their near-monopoly positions.

taking margins at face value is foolish, in my view

How so?

–If you assume that margins at any level are fixed, you’ll miss perhaps the crucial element in forecasting future earnings–operating leverage.  This is the idea that some costs are fixed and don’t rise in line with unit volume.  As a result, the expense involved in selling an extra unit may be much less than that of selling the average unit.

–Rising margins almost always do invite competition.   Companies like MSFT are the exception, not the rule, in my view.  In most industries, the best companies will reinvest much “extra” margin in lowering their costs, as a way of discouraging new entrants.

–High margins usually aren’t “free.”  Jewelry or furniture companies, for example, have very high margins.  But they have to maintain very high inventories, which they turn only once or twice a year.  That’s risky.  The high margins in these cases don’t signal “free lunch”; they signal risk.

–I think the distribution company model–low margin, high inventory turnover–is attractive.  Distribution companies can be very high growth, high profit firms.  They can also have lost of operating leverage.  WMT in its heyday is an example, as is any industrial wholesaler.  Anyone fixated on high margins will miss this important class of firms completely.

What do I use instead of margins in projecting the income statement?  I break down unit costs–labor, raw materials,…–as much as I can and forecast each.  Some are simple functions of unit volume.  Many, however, like advertising, administration, or sometimes labor, are relatively unchanged as volume increases.  That’s where operating leverage and earnings surprises lie.