the death of research commissions?

Investors in actively managed funds pay a management fee, usually something between 0.5% – 1.0% of the assets under management yearly, to the investment management company.  This is disclosed in advance.  It is supposed to cover all costs, which are principally salaries and expenses for portfolio managers, securities analysts, traders and support staff.

What is not disclosed, however, is the fact that around the world in their buying and selling securities through brokerage houses, regulators have allowed managers to pay substantially higher commissions for a certain percentage of their transactions.  The “extra” amount in these commissions, termed soft dollars or research commissions, is used to pay for services the broker provides, either directly or by paying the bills to third parties.  Typical services can include written research from brokerage house analysts or arranging private meetings with officials of publicly traded companies.  But they can also include paying for third-party news devices like Bloomberg machines–or even daily financial newspapers.

Over the last twenty years, management companies have realized that instead of supplementing their in-house research with brokerage input, they could also “save” money by substituting brokerage analysts for their own.  So they began to fire in-house researchers and depend on the third-party analysis provided to them by brokers   …and funded by soft dollars rather than their management fee.

For large organizations, these extra commissions can reach into millions of dollars.  Yes, the investment management firm keeps track of these amounts.  But they are simply deducted from client returns without comment.

 

This practice is now being banned in Europe.  About time, in my view.  Strictly speaking, management companies may still use soft dollars, but they are being required to fully disclose these extra charges to clients.  Knowing that clients would be shocked and angered if they understood what has been going on, the result is that European investment managers are abandon soft dollars and starting to rebuild their in-house research departments.

What’s particularly interesting about this for Americans is that multinational investment managers with centralized management control computer systems–which means everyone except boutiques–are finding that the easiest way to proceed is to make this change for all their clients, not just European ones.

The bottom line: smaller profits for investment managers and their brokers; much greater scrutiny of soft dollar services (meaning negotiating lower prices or outright cancelling); and higher returns for investors.

the French election?

French elections

As I mentioned yesterday, there’s at least some chance that control of the French government will fall in the Spring to a party that vows to:

–leave the euro,

–engineer a depreciation of the newly-resurrected French franc and

–repudiate euro-denominated French national debt.

This is not just like Brexit, since Brexit didn’t involve government refusal to repay previously incurred financial obligations.  It’s way worse.  This is more like Argentina or Cuba.

Sounds crazy, but so did Brexit and so did Trump.

What to do?

…particularly since it’s hard for me to figure the chances of any of this happening, and I no longer know that much about French stocks.

Two lines of thought:

–avoiding being hurt, and

–trying to make money.

Both will be brief, since I don’t know enough to say any more.

avoiding being hurt

Currency depreciation would have effects much like what’s happened in Japan during the Abe administration.  National wealth and the standard of living of ordinary citizens could take a substantial beating.  Export-oriented industries would thrive.

It’s likely that French companies would have a more difficult time raising money in global capital markets, if France refuses to honor its existing euro-denominated debt.  Companys’ repayment of debt not denominated in francs would become more costly.

Knock-on effects:  my guess is that Italy wouldn’t be far behind France in leaving the euro.  The currency union would likely end up being Germany plus bells and whistles.

The way bond investors are now taking defensive measures is by selling their French government-issued euro bonds for German issues, giving up 0.4% in annual yield to avoid a potential currency loss.

We, as equity investors, can do something similar now, by avoiding non-French multinationals with large exposure to the French economy.  If we want to/need to have some French exposure, it should be in companies that will benefit from possible devaluation–that is, firms with costs in France but revenues elsewhere.  Here the performance of Japanese stocks should be a good guide, except that I’d avoid French companies with a lot of foreign debt.

trying to make money

I consider betting on future political developments to be a dubious enterprise.  If Marine Le Pen makes an unusually good showing in the first round (of two) in French voting in April, and if the French market sells off sharply on that result, I’d be tempted to look for beaten down French multinationals, on the thought that Le Pen would lose in the second round.  I’m not sure I’d actually do anything, but I’d be willing to think about it.  This would imply beginning to study potential purchase candidates, or a suitable ETF, now.

 

 

 

a French sovereign debt default?!?

First there was the surprise Brexit vote in the UK, after which sterling plunged.

Then there was the improbable victory of Donald Trump in the US presidential election, which sent the dollar soaring.

Now there’s France, where the odds of a far-right presidential victory by the Front National have improved.  A competing right-of-center candidate, former frontrunner François Fillion, has been hurt by allegations that his wife and children did little/no work in government jobs he arranged for them (with aggregate pay totaling about €1 million).

If Marine Le Pen, the FN leader and standard bearer, were to win election in May (oddsmakers now give this about a 1 in 12 chance), her victory might conceivably snowball into a similar sea change in the National Assmebly election in June.  Were the FN to win control of the legislature too, the party says it will leave the euro and re-institute the franc as the national currency.  In addition, it intends to, in effect, default on €1.7 trillion in French government bonds by repaying the debt in new francs, at an exchange rate of 1 Ffr = 1 €.

Improved prospects for Ms. Le Pen–plus, I think, President Trump demonstrating he means to do his best to keep all his campaign promises–have induced a mini-panic in the market for French-issued eurobonds.  Trading at a 40 basis point premium to similar bonds issued by Germany as 2017 opened and +50 bp in late January, they spiked to close to an 80 bp premium last week.

my take

At this point, the conditions that would trigger a French exit from the euro and its refusal to honor its euro debt instruments seem high unlikely.  Still, the possibility is worth thinking through, since the financial markets consequences of Frexit would likely be much more severe than those of Brexit.

More tomorrow.

 

 

 

 

 

 

 

Disney (DIS): the valuation issue

Long-time readers may recall that I became interested in DIS in late 2009, the company acquired Marvel Entertainment, a stock I held, for stock and cash.

corporate structure

I hadn’t looked at DIS for years before that.  I quickly learned that DIS was a conglomerate, that is, a type of company where the most useful analysis comes taking the sum of its constituent parts.

I knew the company’s movie business had been struggling for some time and the theme parks were being hit hard by recession.  Still, I was more than mildly surprised that ESPN (plus other media that we can safely ignore) made up somewhere between 2/3 and 3/4 of DIS’s operating earnings.  Why did they still call it Disney?

multiples

Given that the parks are a highly cyclical business and movies moderately so–meaning the PE applied to those earnings should be relatively low–and that ESPN was showing all the characteristics of a secular growth business–meaning high PE–I thought that ESPN represented at least 80% of the market capitalization of DIS.  (That’s despite the fact that the market would apply a higher than normal multiple to cyclically depressed results).

So DIS was basically ESPN with bells and whistles.

ESPN’s turning point

In 2012, ESPN made a major effort to enter the UK sports entertainment market.  To my mind, this wasn’t a particularly good sign, since it implied ESPN believed the domestic market was maturing.  Worse, ESPN lost the bidding, closing out its path to growth through geographic expansion.

It seemed to me that DIS management, which I regard as excellent, understood clearly what was happening.  It began to redirect corporate cash flow away from ESPN and toward the movie and theme park business, which had better growth prospects, and where it has since had unusually good success.

2014-16 results

Over the past two fiscal years (DIS’s accounting year ends in September), the company’s line of business results look like this:

ESPN +        revenues up by +11.9%, operating earnings by +6%

parks           revenues up by +12%, op earnings  +24%

movies        revenues up by +30%, op earnings +74%

merchandise   revenues up by +4.6%, op earnings +33%.

the valuation issue

ESPN has gone ex growth.  This implies these earnings no longer deserve a premium PE multiple.  To me, the fact that ESPN now treats WWE as a sport (!!) just underlines its troubles.

The other businesses are booming.  But they’re also cyclical.  So while improving efficiency implies multiple expansion, earnings approaching a cyclical high note implies at least some multiple contraction.

Because the two businesses are so different, I think Wall Street is making a mistake in treating earnings from the two as more or less equal.

calculating…

DIS will most likely earn $6 a share or so this fiscal year.  That will be something like $3 from ESPN and $3 from the rest.

Take the parks… first.  Let’s say I’d be willing to pay 18x earnings for their earnings.  If that’s the right number, then these businesses make up $54 a share in DIS value.

Now ESPN.  If we assume that the worst is over for ESPN in terms of subscriber and revenue-per-subscriber losses, we can argue that the future earnings stream looks like a bond’s.  If we think that ESPN should yield, say, 5% (a 20x earnings multiple), that would mean ESPN is worth $60 of DIS’s market cap.  If we’d still on the downslope, that figure could be a lot too high.

$54 + $60 = $114.  Current stock price:  $109.

my bottom line

My back of the envelope calculation for the parks… segment may be a bit too low.  I could also be persuaded that my figure for ESPN is too rich, but it would take a lot to make me want to move the needle higher for it.

Yes, most of DIS’s earnings are US-sourced, so the company could be a big winner from domestic income tax reform.

But if I were to be holding a fully valued stock on the idea of a tax reform boost, I’d prefer one with more solid underpinnings.  At $90, maybe the stock is interesting.  But I think ESPN–the multiple as much as the future earnings–remains a significant risk.

 

 

 

 

should the US dollar be strong or weak?

This is the question President Trump purportedly called his adviser, Michael Flynn, to ask at 3am one recent morning.  Flynn, to his credit, said he didn’t know.

Perhaps the genesis of the inquiry is the odd position Mr. Trump has put himself in of criticizing Germany (and by implication the EU as a whole) for damaging the US by having a currency that’s too strong while berating China for damaging us by doing the opposite.

It may also be economists’ comments that the Republican Congressional proposal to introduce a value added tax on imports could trigger a sharp appreciation in the dollar, thereby making exports from the US that much less attractive.

What is the best strategy for the US?

First of all, we should recognize that there’s no generally accepted economic framework that deals with currency.  There are lots of theories for particular aspects of currency relationships, but no one go-to theory.

Also, the US is in the unusual position of being the only universally accepted reserve currency, making the US is in effect the banker to the world.  So rules that apply rigorously to others may not, for good or ill, hold so firmly for us.

 

In 30+ years of dealing with foreign currencies as an equity investor, I think the issue can be summed up in practical terms to the question:  “If this country were a person, would I feel comfortable lending money to him?”

The factors that have meant the most to me are:  political stability, the rule of law, growth-oriented government policies, no excessive government debt, prudent government spending, and no restrictions on being able to repatriate my funds.  All other things being equal, mild appreciation of the foreign currency would be nice.  But I would trade that away in a nanosecond for assurance I wouldn’t have a currency loss.

All this implies that the value of a country’s currency isn’t determined by a deliberate currency policy.  Instead, it’s the result of overall conditions for doing business in that place, and of the effectiveness of government in providing a backdrop conducive for corporations to locate there.

One instructive recent example of what not to do:  massive government-engineered currency depreciation has been the cornerstone of Abenomics in Japan.  The main results so far have been to revive the fortunes of near-obsolete manufacturers, while retarding innovation and inducing an epic fall in the standard of living of ordinary citizens.

My advice for Mr. Trump?   Press forward on tax reform and infrastructure spending.  Establish meaningful vocational training to replace the VA-like stuff we have now.  Don’t try to weaken the dollar; that’s a recipe for disaster.

 

Tesla (TSLA) at $260: what it means

Yesterday, TSLA shares touched $260 early in the day.  That’s the latest high for a stock that has gained 30% since mid-December, a period during which the S&P advanced by 1.8%.

What does this mean?

–On a personal note, it means I don’t own any more TSLA.  Regular readers might reall that one of my sons and I have been trading TSLA between $180-$200 and $250-$260 for the past couple of years.  I had sold some at $250 this time around and placed a limit order for the remainder at $260 about a week ago.  Yesterday, the stock touched $260.00 for a brief period before falling back to close at $257.48.  (An aside:  I find it strange that the stock peaked at such a round number.  I presume this means there’s a lot of stock on traders’ books waiting to be sold in mechanical fashion–meaning with no attempt to entice buyers higher–at $260.)

–The main message, though, is that there’s a lot more going on in the US stock market than the post-election Trump rally–which seems to me to have already exhausted itself anyway.

I’m driving a Kia Sorrento these days, after my Hyundai Veracruz gave up the ghost late last year.  I can imagine my next car being a Tesla.  Nevertheless, TSLA is to my mind the ultimate concept stock.   Yes, the merger with SolarCity is behind it and the death of a driver using the Tesla self-driving feature seems to have been operator error rather than a flaw in the car.  Those are plusses.  On the other hand, the company is still struggling with cash flow breakeven.  And the Wall Street consensus, for what that’s worth, is that it will lose $1 a share in 2017.  So finances continue to be a serious risk.  To my mind, the rally is all about the hoped-for success of the Gigafactory, Musk’s reimagining the car manufacturing process, and the triumph of software over hardware and batteries over fossil fuel.  TSLA’s gains are a testimony to the rude health of the stock market, with or without a Trump tailwind.

–Areas of interest other than aspirational tech or hoped-for tax reform and infrastructure spending?   What about Millennials worldwide?  economic strength in the EU?  regular old tech?  Mexico??  (I haven’t held Mexican stocks for over twenty years, although I’ve had exposure from time to time to that economy through multinationals.  I think it’s too early to make a major commitment, but not too soon to be fact-finding.)