Monthly Archives: October 2012

broker wars are breaking out again

October 10, 2012 By in Current Market Thoughts, economics, Industry Analysis, Investment firms, Recent Market Action Tags: , , , , , , Leave a comment

broker wars

Although little noticed, they’re a recurring feature of the traditional “full service” brokerage business.  The Wall Street Journal reported last week that Merrill Lynch is now targeting a large number of high-producing Morgan Stanley registered reps to woo.

The fact itself that this is happening isn’t so interesting, since widespread poaching of salesmen occurs every few years.  But two other aspects are:

–the fact that this is happening now, since broker wars almost always happen when times are good, and

–that for the first time I know of, the terms of the deals offered can be seen in print.  For a MS broker who earns $1 million a year, the WSJ says ML is willing to pay a $1.5 million signing bonus.

why not grow a sales force instead?

The traditional brokerage business has enormous overheads–branch offices, administration, advertising, trading desks–to support.  So brokers constantly need revenue.  There’s no guarantee–look at the Yankees–that home-grown talent will ever reach stardom.  Recruiting already successful “free agents” is faster, and potentially produces a more certain stream of income.

the economics are favorable

Typically, a “full service” broker nets a bit less than half the gross revenue he produces for his firm.  A $1 million annual income implies a broker makes another $1 million+ that goes to his firm each year.  Assuming that he can continue to earn at the same rate for his new employer, the hiring firm will break even in 18 months.  (Typically, such recruits sign three-year contracts preventing them from moving again.)

In today’s world, the cost of financing the signing bonus is effectively zero, another plus.

retaining clients is the key variable

As soon as a broker leaves a firm, his accounts are redistributed to other registered reps–who immediately begin to contact these customers to try to persuade them not to follow the leaving broker to the new company.

Of course, the departing broker does the same thing.  Invariably, he sends a letter to his customers (probably in a form suggested by his new firm) explaining that he has made the move for their benefit and extolling the virtues of his new address.  Somehow, he always “forgets” to mention the gigantic signing bonus he is receiving.

One big key in this process is the extent to which clients own proprietary mutual funds managed by the “old” firm.

Such clients have paid a sales charge–sometimes as much as 5% of the principal originally invested-when they bought the shares.  Hopefully, they also have capital gains.  These clients tend to be more loyal to the firm than to their broker.

Even if they aren’t, they may also be reluctant to transfer the shares to a new firm where they won’t get as much information about the holdings.  They certainly won’t want to incur the capital gains tax and new sales charges that switching fund holdings would entail.

Knowing this, and planning for the possibility that a headhunter will call someday, savvy brokers will try to focus their clients’ investments on third-party mutual fund groups, which can be seamlessly transferred to another brokerage house.

investment implications

On a microeconomic level, this behavior is what happens in a mature industry.  There are few new customers, ones who have no brokerage relationships–traditional or discount.  So the easiest (only?) way to gain market share is to take it from someone else.

More important to me, if this ML recruitment attempt is successful, it will imply that the underlying tone of business is better than commonly thought.  Because it is making this push, ML must have already reached this conclusion.

 

AAPL: problems of size

October 9, 2012 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Position sizes, Securities regulation, Stock ideas Tags: , , , , , , Leave a comment

the behemoth

APPL shares now make up about 5% of the capitalization of the S&P 500.  A single share of AAPL sells for over $600.  Both characteristics present headwinds for AAPL’s performance, in my view.  The latter is a minor one, the former somewhat more serious.

Let’s start with the stock price.

the round lot syndrome

Individual investors in the US prefer to buy shares in round lots, normally 100 shares.  A generation ago, when the commission on odd lots (anything less than a round lot) was higher than for round lots, this made a modicum of sense.  Not so now, when flat $7 or $8 commissions are the norm for any number of shares bought or sold through discount brokers.

Professional investors, who think in terms of dollar amount rather than share count, don’t have this hangup.

Nevertheless, the psychological allure to individuals of buying 100 shares remains, as well as the stigma attached to purchasing 8 or 27 or some other “strange” amount.  And the reality is that AAPL has to a large extent been driven by individuals.  For investors unwilling to commit $60,000+ to one stock, then, AAPL shares are priced out of their reach.

a stock split?

There’s a simple, practical solution to this issue.  AAPL could have a stock split, something it did in 1987, 2000 and 2005.

My guess is that a 2:1 or 3:1 (or 10:1) split would add 10% to the stock price.

Why?  The shares would be more affordable to individuals with the round lot mentality.  In addition, the company would be signaling that it cares about its shareholders.

Why is AAPL hesitating?  Who knows.  My take is that management wants to be seen as obsessively focused on creating new products, not on catering to the whims of Wall Street.

professional investors’ position sizes

Growth investors in the US typically hold 50 or so stocks in their portfolios.  Their value counterparts usually have at least 100.  This means that for a professional growth investor, holding a S&P 500 index weighting in APPL requires making the position 2.5x the size he’s accustomed do.  For a value investor, a market weight for AAPL in the portfolio is a whopping 5x his average position size.

To be sure, all professionals have overweights–positions whose portfolio size exceeds the benchmark index weighting.  But these are usually a 3% or 4% position for growth investors, and 1.5% or 2% positions for value investors.

For almost everyone a 5% position is off-the-charts risky.  It’s conceptually very easy to underweight the name, but very hard to overweight it.

not a problem outside the US

Investors in non-US markets don’t have this psychological/operational problem.  Most other markets have at least one giant corporation whose weight can easily be 10% of the index.  Many times, it’s higher.

In most cases, the very large company is also very mature and slow-growing.   A typical strategy is to “neutralize” or equal-weight the stock in the portfolio (so that nothing the stock does will either harm of benefit the portfolio vs. the index) and attempt to make money elsewhere.

I suspect this is the tack US professionals are increasingly taking toward AAPL–equal-weight and forget.

the 5% rule

The 5% rule is an SEC-mandated diversification requirement for equity mutual funds.  It has two provisions:

1.  A manager can’t make a purchase of a stock that would cause the position size to exceed 5% of the fund assets.  This is only about buying.  There’s no need to reduce the position if it goes up a lot or if other positions shrink (which could happen either all by themselves or from the manager selling).  You just can’t add to a 5% position.

2. 25% of the portfolio is exempted from this requirement.  This exception is big enough to drive an 18-wheeler through.  The manager can basically do anything he wants in one-quarter of the portfolio, but is bound by the 5% rule for the rest.

Psychological issues aside, this should leave lots of room for mutual fund managers to hold a ton of AAPL. While that’s true, the other side of the coin is that the SEC has in effect linked prudent investing with having positions that are 5% of assets or smaller.  Bigger is bad.  Plus, the actual 5% rule sounds weird and is hard to explain.

The result has been that the idea of having no positions bigger than 5% has leaked into fund operating and monitoring procedures.  It’s also become part of the descriptions of investment process given to potential investors.  And it’s also in contracts with institutional investors (I don’t know how widely, though).  So the manager may be buying a lot of headaches if he continues to grow his AAPL position.

to sum up

AAPL can fix the round lot issue.

On the position size score, old habits die hard.  The 5% size is institutionalized as a maximum.  No one wants to rewrite contracts, primarily for fear the client will also want to rewrite the fee structure downward.

I don’t think any of this means AAPL will necessarily be a bad stock, either.  But I do think we’re at the point where the tailwind of professional investors having to build AAPL positions or else underperform is changing into a headwind caused by the stock’s large size.

There’s stuff AAPL can do to address this issue, too, but let’s see a stock split before taking up that topic.

the Employment situation report, September 2012

October 8, 2012 By in Current Market Thoughts, economics, employment, Employment Situation report, Portfolio management, Strategy Tags: , , , , , , , Leave a comment

the Employment Situation report for September 2012

Last Friday at 8:30 am EDT, the Bureau of Labor Statistics of the Labor Department released its monthly Employment Situation report for September.

September job gains

The main employment figures were, at best, unexciting.  According to the BLS, the economy added +114,000 new jobs last month.  This figure breaks out into +104,000 positions in the private sector and +10,000 in state and municipal governments.

revisions for July and August

More significant, in the first of the usual two monthly revisions, the results of +96,000 jobs (+103,000 private, +7.000 government) for August were revised up by +46,000 positions to +142,000 (+97,000 private, +45,000 government).

The final July figures are also in.  They’re +181,000 jobs (+163,000 private, +18,000 government).  That’s also a positive revision.  The initial report had put them at +163,000 (+172,000 private, -9,000 government).  The first revision had pared that to +141,000 (+162,000 private, -21,0000 government).

the bottom line

The US economy needs to create around +150,000 new positions each month simply in order to absorb to the workforce people just finishing school and looking for their first jobs.  Roughly speaking, that’s all the economy is doing.  In other words, we appear to be making no headway in creating enough new positions to re-employ the several million people who lost their jobs during the recently ended Great Recession.

Yet,

the unemployment rate dropped below 8%, for the first time in years.

That’s the eye-popping figure in the BLS report.

Two aspects of this number are odd.

First of all, a surge in job creation usually results in a rise in the unemployment rate, not a fall.  This is a quirk in the way the unemployment figures are calculated.  People who become discouraged by their inability to find work and stop looking for work are not counted by the government as unemployed (no, I’m not making this up).  When these people perceive that job hunt conditions have improved, they begin looking again–thus swelling the ranks of the unemployed.

Also, if we figure the US workforce is 150 million, then a 0.3% drop in the unemployment rate suggests the economy has added a net +450,000 jobs.  That’s almost quadruple the job gain figure reported for September.

Coming as close as it does to next month’s presidential election, the unemployment rate has become a focal point for politicians on both sides of the aisle.  Democrats are claiming the drop to be the first fruit of their economic policies.  Republicans are saying the administration is cooking the books.

what’s really going on?

survey differences

The first point to note is that the monthly job gains and losses and the unemployment rate figure are compiled from different sources.

The BLS conducts a monthly survey of about 140,000 businesses, from which it estimates the job gains and losses.   The sample is relatively large but the focus is narrow.  The figures don’t include agricultural workers, the self-employed and unpaid family workers.  Only changes larger than +/- 100,000 are statistically significant.

The Census Bureau conducts a monthly telephone survey of 60,000 households for the BLS, from which the unemployment rate is estimated.  This sample is smaller and contains the upward biases that come with telephone interviewing.  It does collect information about the groups mentioned above.  Changes are only significant if they’re +/- 400,000 or more.

September’s household survey

Based on the telephone interviewing, the Labor Department estimated that just over 143 million people are working in the US at present–out of a workforce of 155 million.

The workforce was up by 418,000 vs. the August report.  But there were enough new positive responses about work that 873,000 people found new jobs last month.  This follows a two month period where the number of employed had dropped by about 300,000.

Do we know anything about what these new jobs are like?  Not that much.   It looks like about two-thirds of them are part-time.  The sharp rise in this month’s household survey estimate appears to be based on positive responses by an extra 300 or so interviewees.

what to do

If there were any change in the interview questionnaire or any new instructions to interviewers that might server to elicit more positive responses in the survey, I doubt that could be kept secret for long.  As a result, I think any attempt to manipulate the survey results for political gain would backfire.

My hope would be that the household survey is correct.  My take is that this reported large employment number is a statistical anomaly that will disappear in the next survey.  That’s scheduled to appear on the Friday before the election.

From an investment point of view, I think it’s much better to continue to position holdings in anticipation of a slow but steady upward tone to the economy rather than to adopt a more bullish posture.  In fact, I’d be tempted to sell a bit into any strength–although none appears to be forthcoming so far.

Next month will be soon enough to reassess.

GRPN, ZNGA, FB: what were the underwriters thinking?

October 4, 2012 By in Current Market Thoughts, Greater Fool theory, Securities regulation, Strategy Tags: , , , , , , Leave a comment

I’ve been writing over the past couple of days about Groupon and Zynga, stocks I consider prime examples of the Greater Fool theory in action.  GF answers the question of why any investors, particularly professionals, would buy shares of either  offering, given the obvious flaws in their operating models.

Let’s take the other side of the coin today.

Why would anyone want to put his firm’s name on the red herring as a sponsor/seller of merchandise like this?

More than that, in both the GRPN and FB cases, the companies submitted initial S-1 registration statements to the SEC that the regulator rejected.  GRPN tried to define a new kind of operating “profit” that excluded major cost elements.  FB didn’t mention that its high-earning US and European businesses were being hurt dramatically by users’ shift from access by computer to smartphones.  Why would underwriters take the reputational damage that comes with encouraging/condoning such behavior?

The reason not to push these names, or to try to paper over problems, is obvious:

the stocks in question were arguably overpriced, with nowhere to go but down.  Money management clients would lose money by buying them.  This would make them unhappy, endanger their careers and generally weaken the bonds of trust that tie them to the underwriters.  The flow of commission money to the underwriters would decline.

Also, in my (long) experience, such anti-money manager behavior is highly unusual.  In fact, the only parallel I can come up with is the waning days of the 1980s junk bond market, when very weak offerings were the order of the day.  (To be clear, I don’t believe that anything like the unhealthy and unethically close relationship between Drexel and key junk bond fund managers exists today.)

So, why?

I have three thoughts:

1.  The underwriters–both the firms and the individual investment bankers–spent a lot of time and effort courting the companies.  Especially for the individual investment bankers, a payoff on this investment was much more important than maintaining good relations with money management clients.

2.  Their unusually anti-money manager behavior implies to be that creating successful (read: very high-priced) debuts for GRPN and ZNGA were do-or-die events for the fortunes of the tech bankers involved.  They apparently saw no percentage at all in considering how money managers–or individual investors–would be hurt by subscribing for the issues.  It was okay for the issues to crash and burn.  Therefore, no new social media IPOs are on the horizon.

3.  The bankers think the negative fallout on their business from these dud issues will be minimal.  Yes, some managers may lose their jobs.  So what,the bankers think  (read Liar’s Poker if you think this is too harsh).  The new guys won’t know what happened in late 2011.  Less starry-eyed portfolio managers will have short memories.  They won’t hold a grudge and will evaluate future issues on their merits, not on the present bad behavior.

 

Of these conclusions, I think the most interesting is the suggestion that social media IPOs are over for the foreseeable future.  But the series of dud offerings may also be harbingers of a more adversarial and confrontational attitude in the future between bankers and portfolio managers.

 

Greater Fool Theory (II): Zynga (ZNGA)

October 3, 2012 By in Greater Fool theory Tags: , , , , , , , , 1 Comment

ZNGA

Zynga (ZNGA) is a maker of casual social games played principally on Facebook.  The most famous of them is FarmVille.

The company follows in the footsteps of the Korean smash hit Kart Rider, which showed how immensely profitable “free” casual online games can be if they charge money for items players need to succeed (microtransactions).

going public

ZNGA went public in mid-December 2011–before GRPN shares began to give up the ghost–at $10 a share.

Shareholders weren’t as lucky on day one as GRPN IPO participants, however.  The stock opened at $11 and rose to $11.50.  It then faded back to $9, before closing the day at $9.50–below the IPO price, despite presumably the best efforts of the underwriters to “stabilize” the price at $10.

The stock did have a brief renaissance in February, when it reached almost $16 a share, before beginning its downward journey to the current $2.78.

 ZNGA as a “greater fool” stock

two investment variables

To my mind, the most important investment issues surrounding ZNGA were/are:

–whether it could follow the success of Farmville with other, hopefully bigger, games, and

–its relationship with Facebook.

on the first count,

It’s pretty easy conceptually to figure how much a given game is worth.  Games have a lifecycle that’s a function of:

–how many users it has

–how often, and for how long in each session, they play

–how long the game remains at/near peak popularity before players become interested in something else and fade away.

The detailed data may be difficult to come, but this is a straightforward discounted cash flow problem.  Figure out the value of a game–let’s say $3 a share–and that tells you how many successful games are already being presupposed in a given stock price.

Long before the IPO, industry sources were indicating that ZNGA was having trouble finding a follow-up success to Farmville.  Its subsequent games were attracting fewer players–who were playing them less intensely than Farmville, and losing interest more quickly.  Therefore, on all DCF counts, they were (much) less profitable.

To my eyes, ZNGA had all the earmarks of a one-trick pony.  Yet, to me the $10 IPO price presumed a parade of new hits.

on the second point,

experience, common sense and basic microeconomics all suggest that symbiosis can be a fragile thing in the business world.

From FB’s perspective, the fact the ZNGA games were a significant source of its revenue had to start it looking for other game makers to feature.  That would hedge against the possibility that ZNGA was a flash in the pan.  And it would diminish the leverage ZNGA would otherwise be gaining over FB if the hits kept on coming.

From ZNGA’s perspective, the fastest way for it to grow would be to tap non-FB gamers by establishing a platform separate from FB.  That, of course, would be potentially bad for FB.

The issue has two facets:

1.  Was ZNGA successful because FB steered traffic to it?; or was FB successful, at least in part, because it had preferred access to ZNGA games?  The more important partner should get the lion’s share of any profits from the partnership.

2.  The FB/ZNGA relationship had become profitable enough that the question of the respective profit shares came up.

Here again, the issue was settled pretty decisively over a year before the IPO.  ZNGA is successful because of  FB, not the other way around.

why subscribe to this IPO?

What must the subscribers to the IPO have been thinking?    …all I can see is the thought that “greater fool” had worked once with GRPN, so it would likely work again.

And, if you flipped the stock into the early strength on the first trading day, it did.

Tomorrow:  what were the underwriters thinking?