Yearly Archives: 2013

accredited investors and the JOBS Act

November 19, 2013 By in accredited investors, Getting financial advice, Investment firms, Securities regulation, the SEC Tags: , , , , , , 1 Comment

“accredited” investors

When you open a brokerage account in the US, you fill out a form that requests information about your income, risk tolerances and investment knowledge.  From what I can see, it gets only superficial scrutiny.  But saying that you have some money and understand the risks of investing in various types of publicly traded securities does two things.  It gets you a seat at the table and it protects your broker from customer lawsuits claiming they lost money because they didn’t understand what they were getting into.  In a sense, passing this vetting process makes you accredited–but that’s not what the term “accredited” usually means.

Instead, it refers to the same kind of vetting process, but for private placements–purchases of securities not registered with the SEC and not sold through the traditional (expensive and time-consuming) IPO process carried out by the big brokerage houses.

For individuals, “accredited” means you have $1 million in assets, not including your principal residence, or you earn at least $200,000 a year.  (There’s a different criterion for institutional investors who want to trade in non-registered–usually foreign–securities.  To be accredited in that sense means having $100 million in investable funds under management.)

The bottom line:  “accredited” means either you’re in the top 1% or pretty close.

not good enough for the 21st century

In the pre-internet, pre-JOBS Act, pre-Mary Jo White world, that was ok.  Private placements were restricted to a very small number of individuals, whose main characteristic is that they can afford losses they might incur in buying risky securities.  The wealth criterion also effectively preserved the near-monopoly on public issuance of securities of the big brokerage houses on Wall Street.

That’s all changing.

the new order

There are already special rules to allow crowdfunding sales of securities.

For the JOBS Act (which allows smaller, early stage companies to raise funds with only limited disclosure) to be truly effective as a  capital raising vehicle for business startups, the pool of investors has got to be larger than just the usual “accredited” suspects.

Interestingly, at the same time as the newly active SEC is saying it sees some merit in things like bitcoin, the agency is also preparing to overhaul the definition of what an accredited investor is.

The new emphasis appears to be on accrediting people who have knowledge, training or experience that gives them insight into the risks and rewards of investing in a startup rather than just being able to take their lumps if an investment goes south.

I don’t know whether this is a good thing or not.

But Washington passed the JOBS Act last year to make it much easier for startups to raise money.  And, contrary to Mary Shapiro’s foot dragging, Mary Jo White is certainly going to set rules of procedure to allow the Act to function.  And that means opening this class of investments to more potential buyers.

I do think, however, that this will turn out to be another instance of a new internet-based business model undermining an older higher-cost pre-internet one.  It will be interesting to see how–and if traditional brokerage/investment banking firms will adapt.  I suspect that this change will have far greater ripple effects than anyone now expects–maybe even momentous ones.

.

the EU and negative nominal interest rates

November 18, 2013 By in economics, Strategy Tags: , , , , , , , Leave a comment

Over the past year or two, the European Central Bank has periodically talked about the possibility of engineering negative nominal interest rates in the EU.  What it is talking about?

There are two possibilities:

1.  In overly simple terms, money policy is stimulative if the real (that is, after subtracting inflation) interest rate is less than zero.  For example, if inflation is 3% and the nominal interest rate is 1%, the real interest rate is -2%.  So cash is a loser, giving a sharp economic incentive to individuals and corporations a sharp incentive to borrow money and to invest their cash balances in projects that will cause economic growth.

Suppose there’s no inflation, though, or that prices are falling by, say, 2% per year.  If the best that money policy can do is bring nominal interest rates down to zero, the real interest rate is still +2% from holding cash.  So cash is a big winner.

In this deflationary scenario, the only way to achieve a positive real interest rate is to get nominal interest rates down to, say, -4%.  How to do so?  …tax bank deposits.

That’s not enough, though.   …and here’s where things get a little wacky.

If I’m going to lose 4% a year by keeping my cash in the bank, I’m going to buy a safe, withdraw my money and keep bills and coins in my house.  Scrooge McDuck writ small!!

Government can’t accept this.  So it puts “use by” dates on currency, so money expires at the rate of 4% a year if it isn’t spent (I said this wad going to be wacky).

But wait…  Citizens won’t accept this move, either.  They run to currency dealers (or gold merchants) and convert their money into non-imploding stuff.

Government responds by imposing controls on purchases of metals, foreign currency and maybe other commodities, too.

…and so on.

Anyway, this recipe for political and economic chaos can’t be what the ECB is talking about.

2.  As evidence has been mounting that the EU economy has passed its cyclical bottom and has begun to perk up a bit, the euro has been strengthening.  From early July until late last month, for instance, the currency had risen by about 8% against the US$.  A bit of that is fallout from the government shutdown in the US, but most is because investors are beginning to reallocate funds away from other parts of the world and toward the EU, where they sense surprising positive economic momentun.  Trade is starting to increase, as well.  Both developments increase demand for the €.

Once an uptrend like this starts, it also attracts speculative inflows of cash from large banks, hedge funds–sometimes gigantic inflows–who want to bet that the uptrend will continue.

What’s wrong with this?

It’s that a rise in a currency acts very much like a rise in interest rates–it slows down economic growth.  Not exactly what the ECB wants.

So it’s jawboning.  It’s threatening to tax large inflows of speculative cash, most likely by at least enough to offset any anticipated currency gain.  It’s hoping to fend off speculators by announcing the actions it will take to drive them away.

So far, the ECB has been successful.  It wouldn’t be entirely out of the realm of possibility, however, to see taxes placed on large bank deposits (after all, big speculators are going to deal in electronic money, not bills and coins) at some point to drive speculators away.   The main point to remember is that this won’t be some loony scheme to create overall negative nominal interest rates, just losses for currency speculators.

The main effect on investors will be to lessen the attractiveness of pure domestic EU plays and to retain some allure for EU-based multinationals.

pining for inflation to return

November 15, 2013 By in Constructing a Portfolio, Current Market Thoughts, Dividend Discount Model, growth vs value, inflation vs deflation Tags: , , , , , , , , Leave a comment

background

Every macroeconomics student quickly learns the lesson of the Great Depression–that deflation (an environment where prices in general are falling) is the gravest ill that can befall a country.  Why?   …for companies, deflation means continuously declining revenues.  At some point, the firm can no longer meet its payroll.  Eventually, it can no longer service, much less repay, any borrowings it may have.  As the 1930s showed, deflation breeds widespread unemployment and corporate bankruptcies.

Second place on the list of bad things that can happen goes to runaway inflation (accelerating rises in prices in general), a malady common in emerging economies–and one the US experienced in the 1970s.  The issue here is that no one knows what interest rates in the future will be–only that they’ll be crazy high.  So no one, neither individuals nor companies, invests in long-term projects–because they can’t figure out whether they’re money-makers or not.  Instead, everyone starts to shun financial assets in favor of buying and hoarding tangibles like gold or real estate, sometimes in a completely loony way, on the idea that they will rise at lest in line with the soaring price level.

When the US began to fight its incipient runaway inflation under Paul Volcker in the early 1980s, the question arose among  academic economists as to what was the “right” level of inflation.  The consensus answer:  2%.  Not so close to zero as to say “deflation,” but low enough not to suggest “runaway.”

So 2% inflation became the holy grail of US, and global, monetary policy.  It took the US twenty years to hit this target.

the present

Over the past several months, I’ve been reading and nearing comments from lots of different sources that suggest that 2% may be the wrong answer.   Not the academic world, of course.  Two reasons:

1.  The Fed has been perplexed at its inability to keep inflation at 2%. The number seems to want to gravitate toward zero, instead.  This raises the specter of deflation, the sure-fire investment killer.  So this tendency is bad.

2.  For small businesses, which have been the biggest engine of economic growth in the US in recent decades, a 2% rise in prices + at best 2% real growth = a 4% increase in annual revenues.  The first objective for most family-owned firms is to make sure that this year’s profits won’t fall short of last year’s.  That’s because any shortfall is money out of their pockets, not simply a theoretical loss.  Apparently, +4% in revenues isn’t far enough away from zero to create enthusiasm for taking the risk of investing to expand the business.  Therefore, no capital projects, no new hires.

significance?

Two reasons are most often cited for the current slow growth in the US:  hangover from the Great Recession and dysfunction in Washington that prevents growth-promoting fiscal policy from being enacted.

I think a consensus is beginning to form that there may be a third culprit–an inflation target that has been set too low and which has inadvertently mired us in a kind of Bermuda Triangle monetary situation that  the Fed can’t extract us from by itself.

This implies fiscal policy may be the only cure for sub-par growth.  Therefore, ineptitude in Washington, even if that has been the norm forever, is no loner as tolerable as it has been in the past.

If this is so, growth stocks will continue to outperform value names in a slow-growth economy–unless/until fiscal policy gives a helping hand.

goodwill: a quirky concept

November 14, 2013 By in Accounting, goodwill Tags: , , , , , Leave a comment

goodwill

My daughter, who’s in an MBA program, called up the other night to register her thoughts (read: complaints) on how bogus the concept of goodwill is.

She’s right…the concept of goodwill is a patchwork fix of a problem that arises with an accounting system like GAAP (Generally Accepted Accounting Principles, used for financial accounting)  whose ground-level assumption is that value resides in the net worth (after depreciation) of tangible assets.

On the other hand, past attempts to alter GAAP to account for intangibles have ended in disaster.  So, GAAP may be the least of the possible evils.

where GAAP goes wrong

1.  For tangible assets like buildings or equipment, GAAP assumes that they decline in value through use.  Depreciation/depletion reduces their balance sheet carrying value according to a regular schedule to account for this.

But the parking lot that was on the outskirts of town fifty years ago may be in the center of downtown today–and worth a fortune, even though its current balance sheet value is close to zero.  This kind of thing has been the idea behind the recent wave of takeovers of retail companies like JCP–that their properties are worth way more (sometimes in alternate use) than the balance sheet shows.

2.  For intangible assets, like patents, software, brand names, the ability to make extra-good, extra-dependable products that consumers love, distribution networks…, they usually don’t appear on the balance sheet anywhere.  In fact, the money spent creating these company attributes–like advertising, R&D, and training–appear only as expenses on the income statement.  These expenditures reduce income, and, therefore, shareholders’ equity.  GAAP treats them as a net minus!

how goodwill arises

Suppose Company A buys Company B.  Company B has book value of $1,000,000, but Company A pays $2,000,000 to obtain it.

Overbidding?   …maybe not.  Maybe Company B has a lot of undervalued property.  In that case, Company A is allowed to revalue Company B’s tangible assets upward to reflect current market values.  Say that adds $200,000 to asset value.

What about the other $800,000?

Maybe Company A has indeed overpaid.  If so, it has to immediately write the $800,000 off as a loss.  But maybe Company A wants Company B because it has valuable patents or a great brand name or a powerful sales force–all intangibles.  In Company A’s view, these factors alone justify the entire purchase price.  If it can make its case convincingly to its auditors, Company A can add the value of the patents, etc. to the balance sheet at a value of $800,000 as goodwill.  That way it avoids a gigantic writedown on the acquisition–something that wouldn’t thrill Wall Street, and might ding its credit rating.

What’s bogus about the concept is that Company B can’t do this for intangibles it developed itself while independent.

Why not?

a history of abuse

1.  At one time, GAAP allowed tech companies to put their R&D expenditures on the balance sheet as an asset.  But after widespread abuse–companies claimed tons of loss-making activity was “R&D”–led to the bankruptcy of a bunch of companies with apparently pristine income statements, the practice was prohibited.

2.  In the early 1980s, the SEC required companies to calculate and disclose their own shareholders equity using “current cost” accounting, a method of dealing with the effects of then-rampant inflation.  The idea was that companies would know the true value of their assets better than anyone else.  They could, in effect, write up their assets for increases in value of their tangibles, as well as give a value to intangibles.

Firms did know their true value, all right.  But the way I read the resulting numbers, company managements fell in to two categories.  Those afraid that disclosing their true value would make them takeover targets lied by making their book value figure extraordinarily low.  Those that wanted to be taken over made their book values laughably high.  Despite the fact that the SEC was asking, few companies told the truth, in my view.  The project was abandoned.

 

But I think the lesson was learned.  Management political agendas are too powerful to allow companies to do their own asset valuations.  GAAP is as good as we’re going to get.

four reasons retailers are antsy about the upcoming holiday season

November 13, 2013 By in Industry Analysis, Retail Tags: , , , , , Leave a comment

The first two are obvious:

1.  Retailers make a disproportionately large shares of their profits during the final quarter of the year.  For some highly seasonal businesses (toys, coats, ski equipment…), they aspire to simply break even during the first nine months of the year and cash in during the last three.

2.  The continuing erosion of bricks-and-mortar market share to online merchants.  Highly seasonal firms are particularly susceptible to online competition, but they have also been battered for decades by general merchants like WMT or TGT, which expand and contract various departments as the seasons change.

The third is very simple, but often overlooked by Wall Streeters:

3.  The holiday selling season runs from Thanksgiving to Christmas.  But the number of selling days can vary considerably from year to year.

Thanksgiving is the fourth Thursday in November.  If November begins on a Thursday, as it did last year, Thanksgiving is on the 22nd.  So the holiday selling season consists of 8 days in November and 24 in December = 32 days.  That’s the longest.

If November begins on Friday, as it does this year, Thanksgiving is on the 28th.  That means the selling season is 26 days long.  That’s the shortest.

Historically, people shop until December 24th–and spend more when the selling season is longer.  So revenue and earnings comparisons are the toughest possible this year.

4.  In the post-Great Recession world, retailers hold another belief as firmly as they hold #3.  It’s that consumers have firmer budgets than they previously have had.  Therefore, if a retailer isn’t the first place a consumer goes to, it runs the risk that the potential customer will have run through his budget already–and (contrary to pre-Great Recession behavior) won’t purchase, no matter how attractive the merchandise is.

So this year there’s immense pressure both to get off to a good start and to move the starting line forward, to Thanksgiving Day or even earlier, if at all possible.

my take

My guess is that the holiday season will be more successful for retailers in general than Wall Street currently expects–despite the shortest possible selling season.  Why?   …strengthening employment and lower gasoline prices.

The more interesting question, to my mind, is who the relative winners and losers will be.  In particular, will AMZN’s agreement to collect state sales tax on its online transactions affect its business negatively?  My guess is that it will.  I think the beneficiaries won’t be the bricks-and-mortar stores that lobbied heavily for this, but instead smaller online merchants who still sell tax-free–including (maybe especially) the ones AMZN displays on its site but only fulfills for.

Also, will BBY’s decision to match online prices in its stores and to rent out space to third parties like Samsung and MSFT have a positive impact on sales?  I say yes.  What about profits?  I think they have to be lower.  But my instinct is also to say they’ll be better than the consensus expects.  I’m not about to bet the farm that this will be so, however.