Monthly Archives: March 2012

Apple, book publishers and the Justice Department

March 9, 2012 By in e-readers, Industry Analysis, internet, Publishing, Stock ideas Tags: , , , , , , Leave a comment

the investigation

Media reports yesterday indicate the US Justice Department is investigating five of the top six book publishing firms (Random House is the exception) and Apple for price-fixing in the e-book market.  Settlement talks aimed at avoiding litigation are apparently going on, at least with some of the publishers.  A parallel investigation by EU regulators seems to be happening, as well.

what’s at issue

It’s all about trade books.  Publishers have traditionally wholesaled physical bestsellers to bookstores at 50% of the suggested retail price.  The store owners then figured out how much to mark them up–or whether to sell them as loss leaders.  A hardcover with a retail price marked on it of $25, for example, would be sold to a bookstore for $12.50.  The store might retail it for, say, $16–or for $10, if they so desired.  Stores could return unsold copies for a refund.

As little as two years ago, publishers were following the same procedure in the nascent e-book market.

This created a potential problem, however.

AMZN was aiming to become the dominant seller of e-books, to be read on its proprietary Kindle device.  It was taking every e-book it paid a publisher $12.50 for and retailing it for $9 or $10.  Yes, the company lost around $3 a book.  But short-term profits have never been an AMZN concern.  And the company was shifting avid readers in droves from being physical book buyers to becoming Kindle aficionados.

Publishers began to hear the giant Perot-ish (Perotian?) sucking sound of their physical book distribution network disappearing into cyberspace.  How to respond?

AAPL, which was just about to launch the first iPad, came along with a proposal.  Publishers shouldn’t necessarily wholesale e-books to e-retailers.  Instead, they should (technically, anyway) remain owners of the e-books (with no physical inventory, what difference would it make?) and hire companies like AAPL as commission-earning agents to put buyer and seller together…kind of like the way real estate agents sell houses.  That way, publishers could set retail selling prices themselves. This wasn’t an entirely new idea.  Publishers already had similar deals with some small independent bookstores.

AAPL proposed to charge a fee of 30% of the proceeds for each sale.  And, oh…by the way…publishers would also agree not to allow their e-books to be sold anywhere else at a lower price.

Publishers said okay and then broke the news to AMZN.  No more selling e-books at a loss.  E-books had to be priced at the publisher-determined price of around $13-$14; AMZN had to take 30% of the proceeds.

AMZN said no.  The five publishers now being investigated immediately responded by revoking AMZN’s permission to sell their e-books.  AMZN took the books off its website.  But a few days later, AMZN caved and agreed to the publishers’ terms.

consequences

Saying what might have been is a little like writing an alternate history, which is rightly classified as a branch of science fiction.  Nevertheless, here’s my take on the effects of APPL/publisher deal:

–imposing what amounts to the agency model on AMZN broke the company’s momentum in the e-book business and slowed the growth of the medium.

–this gave the publishers time to try to figure out how to support the physical book distribution network.  I don’t know what good that’s done.  It certainly didn’t save Borders

–it caused AMZN to refocus its competition strategy on the price/quality of the reader

–it gave BKS time to perfect the Nook and allow it to emerge as a viable competitor to the Kindle

–it gave APPL another selling point for the iPad, although the device seems to me to be much better for magazines, scholarly journals and textbooks than for regular trade fiction/non-fiction.

what would a settlement mean?

I’m assuming that the main result of any settlement would be to allow AMZN to set the retail price of e-books wherever it wants.

Under today’s rules, a newly-released bestseller in e-book form sells for about $14.  Sale proceeds are split, with $9.80 going to the publisher and $4.20 to the retailer/agent. AMZN might reduce its e-book bestseller price to $9.99.  I think that’s an easy decision.  That was its desired price point two years ago–and one which, at least at that time, proved to be a powerful psychological motivator for customers to choose an e-book over a physical one.  Unlike the situation in 2010, AMZN could pay the publisher $9.80 and have $.19 left over.

What about $7.99?  That would put AMZN back into roughly the same the loss-leader position it had adopted a few years ago.  To my mind, this would be a vintage AMZN move.  But is it necessary?  Given the much larger size of the e-book market today relative to the physical book market, are the losses this strategy would produce manageable?

Maybe a smaller form factor iPad would make AAPL a bigger player in the bestseller book business, but as things stand now AAPL doesn’t need trade e-books to spur iPad sales.

What about Barnes and Noble (BKS)?  The company seems to me to be the obvious loser if AMZN is able to lower e-book prices.  That would accelerate the demise of the BKS bricks and mortar bookstores.  Having a competitor sell e-books at cost would also appear to diminish the chances of the Nook ever becoming a profit-making device.

On the other hand, the AMZN move would likely increase pressure on BKS to sell its Nook name and technology.  GOOG has been rumored as a possible buyer, which, I presume, is the reason BKS has a market cap north of $750 million–and has been rising since the price-fixing investigation was leaked to the press.

The real question, of course, is the price someone like GOOG would be willing to pay.  I have no clue.  I also don’t have any confidence that I’d be able to come up with a meaningful estimate.  That’s okay with me, though.  As an equity investor, you’re in this position a lot. It just means I won’t get involved with the stock.

 

 

 

 

 

collective action clauses: Greece’s deus ex machina

March 8, 2012 By in Banks, Derivative instruments, Industry Analysis, Trading Tags: , , , , , , , , , 1 Comment

Greek sovereign debt restructuring under way

Greece is in the final stages of restructuring €270 billion in government debt.  Its deadline for holders to “voluntarily” exchange their bonds for new debt that’s worth only a little more, on a present value basis, than a quarter of what creditors were originally promised, is today at 8pm London time.

For the past few months, EU governments have been engaged in high stakes behind the scenes duel with their major commercial banks, which hold a majority of the Greek securities, over whether the financial institutions would agree to the Greek offer.  During the past couple of days, the banks have all been falling in line and saying they’ll take the Greek deal.  I don’t think the banks ever seriously considered doing anything else.  The discussion has all been, I think, about what quid pro quo they would receive in return.

That leaves private holders  …who don’t stay up at nights worrying that the bank examiners will be unusually thorough this year or that their applications to open new branches might be denied.  So both the threat of future bureaucratic ill will and the call to make a patriotic sacrifice of their (own and their clients’) capital fall on deaf ears. That’s where collective action clauses come in.

collective action clauses

A collective action clause is a stipulation in a bond indenture saying that if holders of a certain majority percentage of the issue agree to a given proposal by the issuer, then the rest can be forced to go along with the decision of the majority.

About one outstanding Greek government bond in seven was issued under English law and have had collective action clauses in the indentures from the outset.

The rest were issued under Greek law.  Being subject only to local law isn’t the norm for emerging markets debt, but I guess buyers weren’t concerned because Greece is part of the Eurozone.  Until a few days ago, those bonds had no collective action clauses.  Then the Greek parliament passed a new law to retroactively include them in its government bond indentures.

Not only that, but the lawmakers conveniently set a low threshold of around 60% acceptance (usually, it’s 75%) as the point at which the clauses can be invoked.  EU banks who have been arm-twisted into agreeing to the restructuring will doubtless lift Greece past that mark.  So, like it or not, private holders will be forced to accept the huge haircut Greece is proposing.  The maneuver is all perfectly legal.  The move isn’t a surprise to the bond market, no matter what you hear in the news.  It has been anticipated by bond pundits for at least a couple of years.

the English-law bonds

The case of the English-law bonds is more interesting.  From what I’ve read, their collective action clauses are set at 75% acceptance.  Early betting is that Greece won’t come close to that amount.

But Greece has already announced that if holders don’t tender in lat least large enough amounts to allow it to exercise the collective action clauses, it simply won’t pay anything.  The holders can see Greece in court.  Tomorrow we’ll see how much of this is bluff–and how successful the tactic has been.

rating agencies have already declared a Greek default

Major credit rating agencies have already declared that Greece has defaulted on its bonds.  So far, the body that decides whether credit default swaps (effectively, insurance policies against default) must be paid off is saying that no default has yet occurred.  That’s because the language of the swap agreements that describes what a default is contains an accidental loophole.  The government-inspired “voluntary” restructuring doesn’t qualify, even though holders are losing almost three-quarters of their money.   If Greece invokes collective action clauses and forces bondholders to take the new securities, however, that may change.

not many Greek CDSs?

Reports I’ve read say that Greek CDSs amount to a relatively small €3+ billion.  If that figure is correct, it’s hard to see why the EU has put so much effort into arranging a “voluntary” restructuring that avoids triggering them.  Maybe bank issuance of CDSs on Spanish and Italian debt is immense and contagion is the worry  …or the official figures may substantially understate bank exposure.

This time tomorrow we’ ll have more answers.

why do so many insider trading investigations involve hedge funds?

March 7, 2012 By in hedge funds, Industry Analysis, Investment firms, Trading Tags: , , , , , Leave a comment

where the money is

The diminutive Depression-era bank robber, Willie Sutton, was reportedly once asked why he chose banks to hold up.  His alleged reply:  “because that’s where the money is.”

Whether Mr. Sutton actually said that or not, the answer contains the essence of this post.  Hedge funds have more money to spend.  Until recently, they’ve been very far from the focus of regulatory and client attention to how investors spend client money;  even now, it seems to me they’re subject to far fewer restrictions on their trading activity than traditional long-only investors.

Finally–and this may just be my personal axe to grind–many hedge funds are the creations of professional traders, not researchers.  To me, this means they don’t have the experience or mindset to develop useful research conclusions by themselves.  Yet their own marketing claims put them under great pressure to produce superior results.  And they don’t have the compliance awareness that’s repeatedly pounded into every US-trained analyst’s head to make it clear what’s legally permissible and what isn’t.

Details:

“soft dollars”

Clients compensate money managers in two ways.  One is clear–they pay management fees.  The second is less obvious–they give their managers the power and influence with brokers that comes from controlling large trading commissions.  In my last job, for instance, in round numbers the firm spent $100 million a year in trading fees.

Managers who manage pension plans (subject to ERISA regulations) or or vehicles like mutual funds catering to ordinary individuals (subject to SEC oversight) have a fiduciary obligation to minimize the commissions and fees they pay for trading.

One exception:  they can pay extra-high amounts as compensation for research services brokers provide.  These services can come from the brokerage house itself.  Or, like Bloomberg terminals or copies of the Wall Street Journal, they can be paid for by the broker but provided to clients.  The commissions (or bid-asked spreads for OTC stocks) that pay for research services are called “research commissions” or “soft dollar” commissions.

clients’ money

The key benefit to the money manager is, of course, that the “extra” amount involved in a research commission comes out of the client’s pocket.  One might argue that the manager should pay for his own Bloomberg.  But that’s not industry practice.

Research commissions are a potential area (and, in the past, an actual area) of abuse.  So they are under increasing scrutiny.  A common rule when I was managing institutional and mutual fund money was that the percentage of research commissions for the overall asset management effort should be no higher than the average of all major money managers.  Five years ago, that was about 15%.

Trading frequency is also monitored carefully.  Managers who have above-average turnover rates risk losing their customers–and their jobs.

restrictions on use by traditional money managers…

Anyway, today’s traditional money managers have severe restrictions on the way they can use commissions to buy information.

…but not for hedge funds

On the other hand, to the degree that hedge funds manage money for wealthy individuals or non-pension institutions, they’re subject to neither asset turnover nor research commission limitations.

Hedge funds are Fort Knox to the traditional money managers’ kids’ piggy banks.

management fees

Yes, the famous ” two and twenty,” that is, a management fee of 2% of the assets per year + 20% of any investment gains, that hedge funds charge may well be fading out.  Nowadays, some may “only” collect 1.5% and 15%.  Compare that with the long-only manager charging, say, .75% of the assets annually with no profit participation.  I’m not saying we should feel sorry for traditional money managers.  But the comparison is Fort Knox vs. maybe a small-town savings and loan.

Two implications:  there’s much more at stake for hedge funds if they generate outsized returns, and here’s much more money potentially sloshing around inside the partnerships and in the partners’ pockets.

separation of research and trading

In the US, there’s a strict separation between the research and planning a portfolio manager does, and the execution of that plan through the trading room.

Typically, the PM designates the brokers he wants to receive research commissions over, say, a three-month period of time. He submits his trading orders to the trading room.  But he cannot direct a given order to a specific broker.

The idea is to prevent the PM from directing business to his friends or from taking a bribe to buy some dud stock a broker is trying to unload from his inventory.  This isn’t a cure-all.  The rules don’t end wrongdoing.  They shift the locus of possible wrongdoing to the traders, where there’s arguably less room for monkey business.  But, for good or ill, that’s the way the system works in the US.

In contrast, hedge funds haven’t typically had these safeguards.  In fact, it may well be that the chief PM is also the head trader–or sits on the trading desk right next to the head trader.  So there’s the opportunity for all sorts of under-the-table activity that would be impossible in a traditional money management firm.

PM as researcher

Scratch a successful equity portfolio manager in the US and you’ll uncover an exceptionally good securities analyst, who may have spent a decade or more polishing his craft.

In my view, the last thing a good analyst wants is inside information.  If you’re in a meeting where a company executive accidentally blurts out some piece of confidential information that you’ve already figured out for yourself, you’re stuck.  The information is suddenly transformed from the product of your creative mind to a company secret revealed.  It’s now forbidden fruit; you trade on it at your regulatory peril.

Though some hedge funds are headed by experienced analysts, others are run by professional traders or marketers.  The latter have their own strengths, but in my experience they don’t have the nerdy turn of mind a true analyst needs.  Yet they’re under tremendous pressure to come up with novel ideas to justify their high fees.  I’d imagine that this creates a big temptation to either accept–or even solicit–inside information.

compliance

Over the past twenty years or so, traditional money managers have all built sophisticated departments to supervise regulatory compliance.  Compliance rules visible every day.  Periodic training sessions are mandatory.  In my experience, emphasis is on avoiding any action that could possibly be (mis)interpreted as being intended to violate the laws.  Better safe than the subject of an SEC inquiry.

Pluck a couple of proprietary traders or a sell-side analyst out of their brokerage firms and set them up as hedge funds, and there isn’t the same awareness.  They may not know what the laws are.  They may not even see the necessity of setting up safeguards.  So the whole corporate culture may evolve into one where principals are encouraged to push the legal envelope in seeking proprietary information from third-parties about potential investments, rather than to safeguard the firm against the negative consequences of using inside information.

dealing with hedge funds: …industry analysts

March 6, 2012 By in Industry Analysis, Investment firms Tags: , , , , , , , , 1 Comment

calling on customers

Two brokerage areas routinely call on corporations.  They are:

–investment bankers.  They’re somewhat like bank lending officers, in that they visits company to try to sell services.  In the investment banking case, that’s typically the possibility of stock or bond offerings, mergers and acquisitions advice or general consulting.

–securities analysts specializing in the company’s industry.  Analysts are members of the firm’s research department.  For smaller and privately held firms, the analyst will want to gather information that may be useful in his reports on publicly traded companies.  He’ll also want to set the stage for possible investment banking business with his firm as/when the company goes public.  For already publicly traded companies in the analyst’s coverage universe, the visit will be for updates–usually right before the analysts issues one of his periodic reports to clients.

Prior to 2000, securities analysts usually reported to the head of investment banking.  After the Internet Bubble-related scandals, where analysts were seen to have written inaccurate reports solely to stimulate demand for the stocks of companies their firms had brought public, that supervisory relationship has been broken.  I’m not sure there is a general rule about who supervises the research department today.

securities analysts

calling on clients

Securities analysts also spend a lot of time interacting with the firm’s brokerage clients, in the expectation that the client will trade with the firm–thus generating commission/spread profits–in return for the information provided.  This interaction may either be with the client’s own securities analysts, their buy-side counterparts, or with the client’s portfolio managers.  Communication may be by phone or e-mail or in person.

Like any other brokerage service, the appropriate institutional salesman will control/advise the analyst about the quality (phone or in person) and quantity of time he spends with a given client.  This will depend on the importance of the client to the firm, measured by the profitability of the relationship.

spreadsheets

Analysts or their assistants create spreadsheets to forecast company earnings.  They also write research reports that either analyze the company’s operations in detail, or highlight recent developments and their significance.  As well, they make buy, hold and sell recommendations for the company’s stock.

technical background?

In many cases, analysts will have worked in the industry they cover before moving to Wall Street.  They may also have relevant advanced technical degrees, such as in petroleum engineering for oil and gas analysts, or in electrical engineering for analysts covering technology hardware firms. (In my experience, such technical training can be a mild positive.  But it can also be a major hindrance, if the analyst mistakenly thinks this exempts him from having to do actual financial analysis of a company’s profit prospects.)

reliant on companies for information

No matter what their background, however, analysts remain very reliant on the companies they cover for industry and firm-specific information.  They’re also dependent on the continuing attractiveness of their industries to investors, whose commission business with the broker influences the analyst’s compensation.

In my experience, therefore, analysts tend to be a bit like home town sports announcers.  They’re highly reluctant to make negative assessments about their industries.  After all, that puts them out of work.  They also can be subject to considerable pressure from holders of large positions in a stock not to write anything negative about it.  Also, some companies may demand that analysts not only make positive statements but also adhere closely to company-issued earnings guidance.  Non-compliance can mean that the offending analyst is denied access to company management that’s routinely given to others.

Sounds crazy, doesn’t it?  But stuff like this happens.  The case of bank analyst Mike Mayo is perhaps the most famous recent case of this type.

A possible response to this pressure is for an analyst to give a “base case” in print, but to supplement this with a “whisper” number that’s noticeably different.  This will be disseminated to clients orally, with or without attribution to the analyst, but never put down on paper.

To be successful, analysts have to be good either at marketing themselves and their research to clients or at analyzing the companies they follow.  Of course, it would be better to excel at both, but in my experience that’s not necessary.  At one end of the spectrum there are (only a few) analysts who have completely pedestrian information, but are witty and know where a client likes to be taken to lunch.  For the majority who provide analytical insights, they come in several varieties:

–able to forecast earnings very accurately

–able to give a good qualitative appraisal of the industry and where all the companies stand within it

–able to say whether the stocks will go up or down.

These are all separate skills, and each worth paying for, I think.

 

 

dealing with hedge funds: institutional salespeople and industry analysts

March 5, 2012 By in hedge funds, Industry Analysis, institutional salesperson, Investment firms Tags: , , , , Leave a comment

a new SEC move

A little less than two weeks ago, the media heralded the opening of another in a long line of investigations by the SEC of insider trading involving hedge funds.  This time, those reportedly targeted include an institutional salesman from Goldman Sachs and the former head of GS’s research in Taiwan, as well as hedge funds who allegedly traded on inside information passed by the GS pair.

what do these people do for a living?

The press reports made me start to think that I should write on three associated topics:

–what does an institutional salesman do?

–what does a sell-side securities analyst do?

–why the focus on hedge funds?

three posts, starting today

I’ll answer these questions–from my perspective as a former client, never myself having been a hedge fund principal, an institutional salesperson or a sell-side analyst–over the next three days.

Before I start, though, I should say that the brokerage landscape has been changing, with increasing speed, over the past decade, and to the detriment of many institutional salesmen and industry analysts.

Two reasons:

–pension fund clients and mutual fund boards of directors are paying increasing attention to the amounts paid by traditional long-only investment managers to brokers.  This is only natural, since this money comes out of the pockets of the clients, not the managers (more about research commissions in Wednesday’s post), and

–increasingly, successful traders (think: Jon Corzine) have become the heads of major brokerage firms.  They’ve been reshaping the firms in their own image, and shifting emphasis away from areas like research and institutional sales.

what does an institutional salesperson do?

An institutional salesperson is a marketer.   He’s is in charge of the overall relationship between the broker and a specific set of money manager clients.  The job is to ensure that the broker makes a profit on each client relationship.

The institutional salesperson is a gatekeeper, in two senses:

–he regulates access to brokerage services, depending on the level of client payments.  “Access” includes things like: phone calls or private visits from industry analysts; private meetings with companies on road shows hosted by the broker; one-on-one company meetings at broker-hosted industry conferences; favorable allocations of initial public offerings (the salesman is only one of several parties in this discussion, though).

–he also regulates the timing of access.  Does a requested analyst drop everything he’s doing and rush to the client’s offices?  …or does he make a phone call the following day?  Is a company meeting for an hour at 10:00am?  …or twenty minutes at 5:30pm?  …or a conference call, instead of face to face?  …or a canned presentation at a group lunch?  If the salesman makes personal calls to relay information from the broker’s morning meeting (in addition to internet dissemination) about companies he knows the client is interested in, who is the first call and who is the tenth?

relationship:  commercial to emotional…

As is the case with any effort to sell recurring services, part of the job is to try to turn a commercial relationship with the client into a personal one.  To that end, institutional salespeople study and cultivate their clients very carefully.

In my experience, salespeople know much more about the client and what makes him tick than he would ever dream.  If the client likes to be taken to lunch or to sporting events, fine.  If the client likes to gossip about rivals, okay.  If he likes flattery, so be it.  If the client responds better to salespeople who are tall/short, young/old, male/female, slim/portly, sports nut/nerd–even if the client is unaware he does so–assignments will be altered to suit. (I’ve even seen one brokerage house–long since merged away–that wanted to establish a certain image.  It had only salespeople who were young, slim, good-looking and very tall.)

…or maybe not

An intelligent salesperson (and that’s just about every one I’ve come into contact with) also makes judgments about the client’s overall business.  Is it on the rise, or has a former hot hand turned permanently cold?  Adjustments are made, accordingly.  One of my friends used to classify clients explicitly in terms of the BCS matrix.  I never asked where I stood.

information collection

The salesperson also has an information gathering function.  Particularly in the US, money managers take pains to separate research decisions made by portfolio managers and their implementation through the trading desk.  One reason is to disguise their investment strategy from their trading partners (another is to guard against bribery).  However, experienced institutional salespeople can often ferret out information by reading between the lines in their conversations with clients–data which is immediately relayed to the broker’s trading desk.  Salespeople also usually know their clients’ analytic strengths and weaknesses very well.  If they believe a key client is buying a stock in an area where he’s an expert, the salesperson may give other clients an extra nudge–after alerting the trading desk, of course.

In a good year, an experienced institutional salesperson in the US can make millions of dollars.  And a strong working relationship with a client who becomes a super-star manager can make an institutional salesperson’s career.  On the other hand, high compensation also makes someone like this an obvious target for downsizing during a period of brokerage retrenchment like the one we’ve been going through over the past few years.

Back to the media reports on the SEC investigation:  can an institutional salesperson develop inside information on his own?  Maybe, but that would be very unusual, in my view.  I think a more likely accusation would be that a salesman either traded on inside information himself or passed it on to a client who did.

Tomorrow:  the sell-side securities analyst.