Warren Buffett and Dow Chemical (DOW)

Today’s Wall Street Journal contains a front page article that will be widely viewed on Wall Street, I think, as a bit of comic relief.

In times of financial stress, cash-short companies have tended to go to Berkshire Hathaway for financial assistance.  If successful, they receive both money and the implicit endorsement of Warren Buffet.

In 2009, it was DOW’s turn.  It wanted to acquire Rohm and Haas, another chemical company.   The best deal it could find for a needed $3 billion was in Omaha, where Berkshire took a private placement of $3 billion in DOW preferred stock, with an annual dividend yield of 8.5%.  The preferred has been convertible for some time now into DOW common (yielding 3.4%), at DOW’s option, provided DOW has traded above $53.72 for a period of at least 20 trading days out of 30.

DOW shares were trading below $20 each when the deal was struck seven years ago.

On July 26th, the shares breached the $53.72 barrier and traded above it for five consecutive days–the final two on extremely heavy volume–before falling back.  At the same time, according to the WSJ, short interest in the stock has risen sharply.  In other words, someone has been a heavy seller, using stock borrowed from others.

Who could that be?

Although nothing is stated outright, the strong implication of the article is that the shortseller is Berkshire, which stands to lose $150 million+ a year in dividend income on conversion.

Part of the Wall Street humor in the situation is that the playing field isn’t level.  It’s perfectly legal for Berkshire to sell DOW short, although it does seem to cut against the homespun image Mr. Buffett has been at pains to cultivate for years.  On the other hand, however, DOW would run the risk of being accused of trying to pump up its stock price (and the value of management stock options) if it went out of its way to absorb any unusual selling.

 

Einhorn stops Apple (APPL) shareholder vote on preferred stock

background

Hedge fund manager David Einhorn has been urging AAPL for some time to adopt his pet idea of issuing preferred stock that would basically be backed by the company’s gigantic accumulated cash position.

APPL isn’t interested.

In the Steve Jobs days, I think the AAPL CEO would have told Mr. Einhorn, either directly or through the press, that his answer was “No!!,” and that Einhorn should stop trying to interfere with the running of AAPL’s business.  This probably would have been the end of the matter.

The current AAPL management didn’t do that.  Instead, it put on the agenda at the company’s annual meeting this week a shareholder vote to change the company’s charter in a way that would forbid the kind of perpetual preferred Einhorn is championing (see my analysis of the preferred idea).

Not only that, but AAPL wrapped this proposal in a package of others and asked for a single vote on the whole bundle.

last week

Mr. Einhorn sued, saying in effect that the bundling violates both common sense and SEC rules.  On Friday, a federal judge agreed–and barred a vote on “Proposal #2” at this annual meeting.

According to the Financial Timesby the time of the court ruling AAPL had received ballots representing 40% of the outstanding shares.  Of them, 97.5% had voted for the company and, by implication, against Mr. Einhorn.

the voting results are no surprise

In my experience, individual shareholders vote with management no matter whether it’s in their economic interest or not.  Hard for me to understand, but easy to predict.

For almost two decades, the SEC has been pushing the compliance departments of professional money managers on proxy voting.  The regulator wants them to take seriously their fiduciary obligation to vote the shares under their stewardship in the best interests of their customers–or else.  This pressure has resulted in the rise of third-party firms like ISS and Glass Lewis, which have set themselves up as independent experts in proxy analysis and making shareholder-friendly voting recommendations.  The path of least resistance for institutional investors seems to me to be to subscribe to  one of these firms’ services and vote accordingly.

Both ISS and GL recommended voting for AAPL in this matter.

In other words, all the individuals and all the traditional institutions were going to vote against Einhorn.

why a vote at all?   …and why this vote?

Mr. Einhorn points out on the Greenlight Capital website that because no one has tried his preferred suggestion, that doesn’t mean it’s a bad idea.  Of course, it doesn’t mean it’s a good one either  …or a good one for AAPL.

What’s clear, however, is that AAPL doesn’t want to discuss the idea publicly–even to say that it’s a thought, but one that won’t work for AAPL.  I think this is a mistake.

I think I understand why AAPL set up the vote as a bundle, though, rather than a straight yes-or-no on the preferred issue alone.  From my common sense viewpoint, as well as from an SEC perspective, grouping a bunch of disparate proposals together just doesn’t seem fair.  (In addition, for what it’s worth, I don’t see how narrowing the scope of possible future preferred issues serves shareholders interests.  It just makes Mr. Einhorn go away.)

Why bundle?  AAPL must know that institutions pretty much vote whatever way ISS tells them.  I think AAPL presented the preferred proposal to the advisory service in a package that it simply couldn’t recommend voting against.  It thereby also avoided the risk that if the preferred ban were offered separately ISS would recommend a “no” vote, which a ton of institutional holders would then cast.

AAPL management hasn’t done itself any favors, 

…in my view.

The company’s unwillingness to lay out reasons–like that the preferreds might constrain needed US-sourced cash flow–for opposing the Einhorn proposal make management look weak.

The bundling makes the company look like it has something to hide.

AAPL’s odd behavior suggests there’s considerably more to this story than meets the eye.

the Knight Capital Group (KCG) end game: effective change of control

a recap

Last Wednesday morning, KCG started up a new software trading link, whose total purpose still isn’t clear, to the NYSE computers.

The new software went berserk, buying everything in sight–and without regard to price–as soon as it was turned on.  As subsequent media comment has made apparent, stuff like this happens every so often in today’s financial world.  Usually, though, the defective program is shut down within a minute or two.  Not so in the KCG case.  It took–for reasons also not clear–the better part of an hour for KCG to pull the plug.

The company subsequently announced it had lost $440 million due to the malfunction.

big problems

KCG faced a number of related problems because of this.  Specifically,

1.  If the average loss was 10% of the purchase price, KCG had bought $4.4 billion worth of stock that it would have to pay for three days later.   If the loss was 5%, KCG would have to come up with $8.8 billion.  In any event, KCG only had about $400 million in cash on hand.

2.  The software glitch was like a gigantic fireworks display.  Every trader on Wall Street knew KCG was in trouble–and might have difficulty settling (i.e., paying for) the trades it had made.  So selling out of the positions it had accidentally accumulated, without offering substantial discounts, would have been very difficult.  In some cases (see my previous post on KCG), KCG held far too much to be sold quickly.

KCG appealed to the NYSE to cancel the accidental trades, but was mostly refused.  After a similar incident last year, Wall Street drew up a set of rules for when such trades might be broken.  Only six of the 150-odd stocks Knight bought qualified.

KCG solved this issue–apparently on Wednesday–by selling the bulk of the erroneous position to Goldman.

3.  As a market maker, KCG makes money by collecting a fee for matching buyers and sellers of stock.  It’s a little like a bank.  Customers only deal with it if they believe it is financially sound.  And, regulators require that it put aside a little capital to back each trade it brokers during the three-day settlement period.  But the rogue software program had tied up all of KCG’s capital. The loss it generated had also wiped out all its cash.

So KCG couldn’t accept any new trading orders.  And long-time customers wouldn’t place any, for fear of potential problems (too geeky a topic, even for PSI) if KCG went out of business before trades could settle.

the solution

One part was the sale of stock to Goldman, which got KCG out from under the need to come up with the money to pay for the erroneous trades.

The second, reported in an 8-K filing with the SEC on Monday, is the sale of $400 million in convertible preferred stock in KCG to a group of the company’s long-time business partners.

There are two classes of convertible, one with limited voting rights.  Both earn interest at a 2% annual rate.  Each $1000 preferred can be exchanged for 666.667 shares of common, meaning an effective purchase price of $1.50 per KCG share.

According to the 8-K, conversion would leave the preferred holders owning 73% of KCG.

tidying up may still need to be done

The complicated structure of the preferred issue–two classes, each with different voting rights–seems to me to imply that some of KCG’s rescuers aren’t allowed to own a market maker, either because of conflict of interest considerations or market share concerns.

change of ownership has happened, though

…although in a deferred way (which, of course, is what convertibles are all about).  The directors of KCG have agreed to turn over almost three-quarters of the company to their rescuers in exchange for the bailout.

an attractive stock?

I’m not an expert at financials, so I don’t have a professional opinion.

The one think that strikes me is that, pre-crisis, the stock was trading at about $10 a share (down from the 52-week high of $14+ achieved last October).  If we assume that the $400 million injection from the preferreds offsets exactly the loss from the renegade trading software, then the only factor that’s really changed over the past week is that there are 4x as many shares outstanding.  That would imply the equivalent share price today would be $2.50.  But the stock is currently trading at well over $3.   Strange.   Very strange.

a turning point for bond funds? …stocks, too?

I’ve been noticing commercials on financial TV and radio–why I turn on the functional equivalent of the WWE, I don’t completely understand–for gold.  They tend to go like this:  NOW is the time to buy gold!!!  Why?  …because it’s 4x the price it was ten years ago.

In other words, buy because prices are very high.  That’s crazy.

Bond funds have had a similar pitch over the past few years.  Faced with near-zero, emergency low, interest rates, which imply sky-high bond prices, bond fund managers invented a marketing pitch that became known as the “new normal.”  The thrust is that we are in a post-apocalyptic world, where the earth’s economy has been scorched and will be incapable of growth anywhere on its surface for, say, a decade.  Therefore, buy bonds, avoid stocks.

Interestingly, bond funds haven’t had much trouble popularizing this view.  Bonds, like gold, have performed much better than stocks for a long time.  So bond funds have collected lots of assets and are big advertisers in the media.  And, of itself, the fact that rich and successful people would be predicting a global “lost decade” is a newsworthy story.

As I’ve noted a number of times, one characteristic of this point of view is that it’s very self-serving for bond people.  It’s the only scenario I can think o of where it doesn’t make sense to rebalance your portfolio–to take money out of the strong-performing, high-priced asset, bonds, and put it into the weaker-performing, lower-priced asset, stocks.

Cynics would say that bond managers just told investors a story that would keep them from taking money out of bonds, thus reducing the managers’ income.  They’d probably also point out the quiet diversification of Pimco, the largest bond manager, into stock funds about a year ago.  But, however implausible the idea might have been, it’s possible that bond managers actually believed it.  After all, there’s a powerful psychological tendency, that professional investors have to constantly fight, to screen out facts that call into question the way your portfolio is set up.  And after twenty-five years of almost non-stop success, it must be very hard even to conceive that things might not go your way.

Four factors are beginning to call into question the new normal/by bonds thesis:

1.  Economic growth, which has been very strong in the emerging markets (40%+ of the world), is beginning to pick up in a meaningful way in the US as well.

2.  Stocks are starting to outperfrom bonds in a meaningful way.  According to Barrons, over the past year, actively managed bond funds are up 6%+and their US stock counterparts are up 18%+ (compared with the S&P 500 being up 12%+).

3.  Individual investors have stopped putting new money into bond funds.  For some time, they have been selling municipal bond funds on concerns about credit risk.  But the most recent data suggest withdrawals are spreading to taxable bond funds as well.

It’s not clear what people are doing.  Some data sources show funds beginning to flow into equities.  Others indicate most is being parked in money market funds.

4.  Last week, the Pimco Total Return Fund, perhaps the most famous bond fund in the world (as well as the home of the “new normal”), has announced it will change its investment guidelines so it can put 10% of its money into equity-linked securities, like convertibles.  According to Bloomberg, many other bond funds have been investing in equities for a while and ar leaving Pimco behind in the dust.

my thoughts

I think these developments are bullish for stocks.

In the counterintuitive way that Wall Street thinks, it’s a little worrisome to have the last great equity bear, Pimco, capitulate.  Still, stocks appear cheap, the US is growing again, and the flow of funds data don’t yet show a great deal of investor enthusiasm for equities. It’s not to soon to start to worry that the best may be behind us for this equity cycle (after all, we are about to enter year three of bull market), but it’s way too soon to act.

On a technical note:

If history is any guide, the current active manager outperformance of the S&P 500 can’t continue.  It would explain, however, why professional equity investors appear to have closed up shop for the year a couple of weeks earlier than usual.

I haven’t looked to see what kinds of equity-linked securities bond funds are buying.  But S&P companies typically don’t issue convertibles.  So the risk exposure the funds are taking on may be somewhat different (probably higher) than what one might expect.

Exotic turns in the quest for yield

bond yields are paltry

The yield on the ten-year US Treasury bond is 2.74%.  The yield on the thirty-year Treasury is 3.9%.  The two-year note yields 0.46%.  In shorter-term instruments, your capital is safeguarded but you receive basically no income.

We know that income-oriented investors, both individuals and institutions, have been forced to search for yield elsewhere.  Year to date, the dollar value of new junk bond issues in the US has already surpassed the total for all of 2009–which itself was a record year for issuance.  High yield bond prices have already returned to the levels of mid-2007, before the financial crisis began to take its toll on valuations.  True, yield spread over Treasuries is more than 300 basis points wider today than then, but the two-year note was yielding about 4.9% during the summer three years ago (how quickly we forget!).

New issuance appears to be accelerating.

exotic alternatives

Two new, more exotic types of issue have begun to make the news recently.  I don’t pretend to be an expert on bonds, but in the stock market these would be signs that the market is topping.  They are:

the hundred-year bond Norfolk Southern recently issued, at a price of about 101, $250 million in 6% unsecured notes due in 2015.  Yes, they’re redeemable, but at the company’s option, not the holders.  No, they’re not secured by the company’s physical assets.  Yes, they’re very sensitive to changes in interest rates.  No, trading them won’t be easy.

the mandatory convertible General Motors is planning to issue one along with common stock in its IPO.  Details of the GM mandatory haven’t been announced, but the idea is that it will initially be a preferred stock yielding, say, 5%.  After some specified period of time (two years?) the security will automatically convert into being common equity according to a formula that will give holders some protection against a decline in the new GM shares, and the company some relief it its stock is very strong.

One notable feature of this mandatory is the pik (pay-in-kind) option.  That is, GM can choose to pay the dividend in shares of GM stock rather than in cash.

Put another way, GM will be giving you a 10% discount for agreeing now to buy common stock around the then prevailing market price two years from now.  GM wins if the stock is 10% higher then than now.  And you win vs. buying the common now, if …?

bullish for stocks

To me, this all means that silly season for bond investors is in full swing.  This development is ultimately bullish for stocks, I think.  If investors are willing to buy these exotic instruments, can the purchase of stocks–even regarded as a funny type of bond–be far behind?

Hybrid bonds and contingent convertibles

Investment banking “practical jokes”

Every upcycle, clever investment bankers devise exotic securities that they sell to gullible portfolio managers, who come to regret their purchase decision almost immediately.  They continue to rue their bull-market impulsiveness for the many months it takes them to find (if they can) some even more gullible person to sell them to.

One of my favorite issues of this type was a wildly oversubscribed issue made by Hong Kong property company New World Development in 1993, at the height of an emerging markets mania.  It was a zero-coupon bond, convertible into shares of a China subsidiary of New World that did not yet exist, except as a name on a certificate of incorporation.

The hybrid bond

This time around, a leading candidate for purchase blunder of the cycle is the hybrid bond, a type of security issued notably by financial institutions.

What made these securities hybrid?  They had terms of 40-60 years, or sometimes were perpetual, that is, principal was never returned–just like stocks.  Also, the interest payment could be reduced or eliminated without causing a default.

What made them bonds?  A good question. That’s what they were called on the front page of the prospectuses.  This naming made them eligible to be purchased by bond fund managers.  The inducement to purchase was a relatively high yield.  The instruments ranked below all other bonds, just above equities, in the pecking order in case of bankruptcy.

If bonds were food, I think the Food and Drug Administration would have been alerted to hybrids, just like it was when Aunt Jemima was selling “blueberry waffles” that had no blueberries in them.  In fact, some tax authorities or industry regulators do classify the hybrids as equity. But a couple of years ago, this was regarded as another beauty of the hybrids, because having regulators count them as equity bolstered the issuers’ capital ratios.

Fast-forward to the present

Lloyds Banking Group  of the UK has a bunch of these hybrids on its balance sheet.  It wants to swap them for a new type of securities, which it is calling contingent convertible bonds.

The idea is that under normal circumstances the securities will be bonds, paying interest and having a bond’s liquidation preference over equity.  But if Lloyds gets into trouble (again), the securities would convert automatically into equity, losing their bankruptcy advantage and presumably their income payment as well.  The trigger for conversion would be Lloyds’ tier 1 capital ratio falling below 5%.

Yes, this is kind of like having medical insurance that terminates if you get sick.  No, it’s not a joke.  On second thought, though, this could be a little more investment banking humor. Sometimes, it’s hard to tell.

I can’t imagine contingent convertibles finding any takers in an original issue, other than at the tippy-top of the business cycle.  But Lloyds and the EU are playing hardball with the conversion offer.   Unswapped hybrids are set to cease making interest payments after the swap period ends.

The offer situation isn’t as bad as it looks at first blush, however–it’s worse. Not taking it may be very difficult to do.  Depending on their current carrying value in portfolios, post-exchange, post-interest-elimination hybrids may have to be considered as further impaired and written down.   Also, it seems to me that any remaining hybrids have got to be much less liquid than they are now.  So they may be impossible to dispose of, thereby having to remain on the lists of holdings sent to clients for some time to come.

Moral to the story?

I’m not sure there is one.  If we consider hybrids and contingent converts as two parts to one story, the combo probably rockets to the top of my list of bull market follies.  My only other thought is that this is Liar’s Poker all over again.

An update from Nov. 22nd

Here’s the link.

Preferred Stock

What it is…

Preferred stock, sometimes called preference stock, is a type of equity (ownership interest) in a company.  Holders of preferred stock have at least one extra feature, sometimes called a “preference,” that holders of common stock don’t have.  As a practical matter, however, unless the preferreds are convertible into common, US investors regard preferred stock as fixed income (debt), not equity.  (This ignores the fact that preferreds are perpetual securities (they have no ending date), unlike virtually all fixed income, where the borrower is required to return the principal to the lender after a specified period of time.) Continue reading