I’ve just updated my Current Market Tactics page, writing about the more favorable stock market environment that has emerged in the US.
Monthly Archives: March 2016
currency effects on US companies’ 1Q16 earnings
Over the past year or more, the international portion of the earnings results of US publicly traded companies has suffered from the strength of the US dollar.
Data dump:
-By and large, US products sold in foreign countries are priced in local currency. When the dollar rises, the dollar value of foreign sales falls. Speaking in the most general terms, firms can raise prices without damaging sales volumes only at the rate of local inflation, meaning that it can take quite a while for a US company to recoup a currency-driven loss through price increases.
-The rise in the dollar has come from two sources:
–the collapse of the currencies of emerging countries with unsound government finances and radically dependent on exports of natural resources like oil and base metals, and
–the greater strength of the US economy vs. trading partners like the EU and Japan.
-What appears on the income statement as a currency gain or loss is the result of a complex process with two components: cash flows; and an adjustment of balance sheet asset values. There’s no easy way to figure out what the exact number will be.
-We do know, however, the very important fact that the dollar has been weakening against the euro and the yen for the past several months. If the quarter were to end today, the euro would be 3.2% stronger vs. the dollar than at the end of 1Q15. The yen is now 5% stronger than it was at the end of last March. The Chinese renminbi is 5% weaker against the dollar than this time a year ago, but there’s much greater scope to raise prices in China.
My conclusion: US companies with mainly and EU or Japanese assets/earnings will likely post modest foreign exchange gains during 1Q16 vs. large losses in 1Q15.
Hedging? Many international firms try, more or less successfully, to smooth their foreign earnings by hedging. This activity is crucial for an exporter with long lead times, cosmetic for everyone else. The key point, however, is that in my experience when hedging results in a gain, this is recognized in operating profit and companies say nothing. When the hedging makes a loss, companies disclose the figure and argue that this is a non-recurring item. For whatever reason, Wall Street usually ignores a loss of this type.
So, ex emerging markets, currency can be a significant positive surprise for internationally-oriented firms this quarter, instead of the earnings drag it has been in recent quarters. My guess is that Wall Street hasn’t factored this likelihood into prices yet.
is “tenure voting” the answer?
tenure voting
The weapon institutions are currently discussing to combat the potentially negative influence of activists on company management plans is called “tenure voting.”
Under a tenure voting scheme, a shareholder accrues more voting power the longer he holds a given stock. On day one, for example, the shareholder might have one vote to cast on proposals at a shareholder meeting. This might rise to three votes after three years of continuous ownership and peak, say, at five after five years.
This heavier voting power given to long-term shareholders would, in theory at least, make it much more difficult for an activist investor with a hit-and-run strategy to coerce favorable action from a timid CEO.
the arithmetic of influence
An activist can have leverage over company management at present by buying, say, 3% of the outstanding shares to obtain 3% voting power. If the typical institutional holder bought his core position five years ago and if institutions overall hold 60% of the outstanding stock, then with tenure voting in place the activist wouldn’t achieve the same amount of clout until he had accumulated at least 10% of the target firm’s stock. Of course, the activist could also wait for a half-decade for his stake to achieve maximum voting power, but none strike me as having that much patience.
an effective deterrent
So tenure voting would likely insulate many of the large firms potentially under activist attack from such predation.
But…
–there’s a practical issue of implementation. Instituting tenure voting at a firm would presumably require rewriting corporate bylaws.
–it doesn’t stop activist action. It just changes the game. Activists would have to adopt a two-step strategy, the first of which would be to court one or more big long-term institutional holders of a target firm’s stock. Of course, this is arguably the intent of proponents of tenure voting–the presumption being that professional portfolio investors would rebuff the activists. Maybe so. But maybe not. However, the obvious place to start would be index funds. It’s not really clear what unintended consequences this might produce.
–tenure voting has been a traditional practice in places in Continental Europe like France. In my view, it has been a disaster there, cementing in place an elitist old boy network of corporate managements that have had little regard for ordinary shareholders. More than that, the French government’s move last year to make tenure voting mandatory for all publicly traded firms met with violent opposition from investors who know this system the best.
All in all, although I’m not necessarily a fan of activists, I think in this case the cure is worse than the disease.
institutional investors vs. “activists”
As I see it, today’s activist investors are the successors to the corporate raiders/ “greenmailers” of the 1980s. In some cases–Carl Icahn is an example–they’re the same person.
Greenmailers (a takeoff on blackmailers) would typically attack small cash-rich companies by buying a 5% – 10% equity position and threatening to launch a hostile bid to take over the firm unless they were bought out at a high price. That price would typically be all the cash in the corporate treasury.
The tactic often worked. A CEO who had spent thirty years clawing to the top of the heap so that he could exercise power and reap large cash/stock rewards during a five-year tenure as chief executive, knew he would be out the door if a change of control took place. So he might be all for acquiescing to the greenmailer. Sometimes, too, a company might have questionable accounting or other dirty secrets that could scarcely stand to see the light of day.
The issue for other shareholders: while the greenmailer would make a financial killing, he would leave behind a firm drained of cash and typically worth considerably less than before the greenmailer showed up at the door.
Activists play a slightly different game. They attack large companies (perhaps because smaller prey has long since been devoured). They typically invest millions of dollars in buying a company’s shares, but because of the size of the target, may only hold 1% – 3% of the outstanding equity. Activists typically demand seats on the board of directors and offer “advice,” which may be sound (or may not), and which usually consists in actions like dividend increases, stock buybacks and/or spinoffs of business lines. These are all levers designed to get the stock price up quickly–so the activist can sell and be on his way.
The threat is the same: the sitting CEO has run a grueling thirty-year corporate marathon only to see the prize snatched away as he’s crossing the finish line if the activist decides that he’s part of the problem.
The issue for other shareholders: none of the actions activists recommend may be good for the long-term health of the company (look at what happened to J C Penney). And unlike the greenmail case, where the attacker’s threat is to take over the firm–meaning a profit for other holders and resolution to the issue–the activist may well tie up management time and energy with proxy fights or other distractions that go on for years.
Tomorrow: what to do.
Active Share (ii)
As I wrote yesterday, Active Share (AS) is a way to measure the portion of a portfolio that deviates from its benchmark index. It’s arrived at by adding up all a portfolio’s underweights and overweights, dividing by two and expressing the result as a percentage of assets. AS can range from 0%, which means the portfolio exactly replicates its benchmark index (i.e., is an index fund), to 100%, meaning the portfolio holds nothing that’s in its benchmark.
what’s good about AS
I’ve always used it as a measure of the riskiness of my portfolio.
If I had four potential outperforming stocks that I thought would carry my portfolio for the current year or more, and the same number of underweights that I had similar conviction in
and if I established, say, a 1.5% difference from the index with each of the eight positions,
and if I thought that my good stocks could outperform the index by 20%, and the bad ones underperform by the same amount,
then I could earn outperformance of 20 percentage points on the 12% of the portfolio that differed from the benchmark. That’s the same as outperformance of 2.4% for the portfolio as a whole, assuming that everything went according to plan. (That rarely happens, of course. Things are either a lot better–or a lot worse.)
+/- symmetry
If we assume the world is symmetrical and that I would lose 20% on any position that went against me (this is a wildly arbitrary assumption), then the worst that could happen (I’m shuddering as I type this) is that the portfolio would underperform by 2.4%.
performance vs. expectations
Okay, I now know something about the risk character of my portfolio. As a money manager, I also have to ask how this corresponds with the needs and expectations of my clients.
During the mid-1980s, I worked for a couple of years for TIAA, managing money in Pacific Basin stock markets. In the international area, our performance bonuses maxed out with outperformance of 1% above our benchmarks. We would receive a small payment for keeping pace with the benchmark. Even that disappeared entirely, however, if yearly performance fell more than 0.25% below the index.
This is an example, in my mind, of severe risk aversion. The bonus guidelines told me: nice if you can get some outperformance, but never, ever, fall below the index. Arguably, this is closet indexing.
In contrast, I subsequently worked at a firm that for a (mercifully, short) time had a compensation schedule that set the risk bar at +/- 60o basis points vs. the benchmark. To my mind, this encouraged managers to take crazy high, risk-the-franchise levels of risk. More below.
what’s bad about AS
summarizing the good
AS gives a vocabulary for discussing how much a portfolio deviates from its index. It implictly introduces the idea that portfolio risk consists in such deviation, which I think is correct.
We can also say that there’s something wrong with a $10 billion fund that collects $100 million in management fees yearly for active management, while maintaining an AS that’s at or close to 0.
the bad
On the other hand, there’s a temptation to think that because an AS of 0 for an active manager is bad, that, while an AS of 10% might be good, one of 50% must be even better.
I think that’s wrong, in two ways:
–to get an AS above, say, 30%, a manager has to have deep knowledge and conviction about at least 15 or 20 things. (One could, in theory, get to that level by making one gigantic stock bet, but regulations and contracts most likely rule out that option.) I know I could never have been the smart money on so many topics. I’ve never encountered anyone who could.
Better to be a yard wide and a mile deep than the opposite.
In other words, at some point, I would think, high AS becomes a warning sign that a manager has lost control of his portfolio. That’s not a positive.
–if an AS of 2% is a Fourth of July sparkler, an AS of 30% is a ton of nitroglycerine. If all the bets go wrong, the result will be a loss of, say, 12% vs. the index in a year. No matter what they say up front, this is not what clients expect. They’ll leave in droves.