Category Archives: hedge funds

breaking companies apart

February 7, 2014 By in activist investing, hedge funds, Portfolio management, securities markets Tags: , , , , , , Leave a comment

corporate activism/raiding

Lots of activist hedge funds–or corporate raiders, as they used to be called–have been taking small stakes in publicly traded companies and then beating the drum for management either to articulate, or to change, corporate strategy.

Why do this?

…to make money for themselves and their backers, of course.  Also, the targets they’re attacking nowadays are very big.  So the prior tactic of taking control of the company through a takeover and forcing change isn’t possible.

How will change create value?

There are two main ways:

–a company may consist of several parts that have virtually no connection with each other.  A firm might, say, own office buildings and an airline, or make medical devices and lease airplanes.

Many times, these are family controlled firms that following the whims of the patriarch/matriarch.  They can also be small divisions whose growth had skyrocketed (think:  ESPN in Disney).  Or the firms might be holdovers from the 1960s, when, unlike today, the world believed there “pure” management skills could be applied to any field–and that, therefore, the best corporate form was the conglomerate.

People don’t think that way anymore.  We believe that the best companies are ones run by top management deeply skilled in one particular area.  Also, today’s professional stock market investors want to create a portfolio of stocks themselves.  They don’t like or want a corporate management that will create a portfolio of subsidiaries and offer it as a take-it-or-leave-it package.  The result:  a heavy discount applied in today’s world to conglomerates.

Put in a different way–n theory, and in practice, there are investors with differing investment styles and different investment objectives who will pay a higher price for some of the corporate components, provided they don’t also have to take the ones they don’t particularly want.  So breaking the package up creates value.

In the case of the airline/office building company I mentioned above (Swire Pacific of Hong Kong), announcement of plans for a separate listing for Cathay Pacific shot the stock price up by 40%.

–Sometimes companies are dysfunctional.  Internal political fiefdoms get created, preventing cash flows generated by operations from being reinvested sensibly.  Sometimes, companies are clueless about where their profits come from, so that some parts run horribly sub-optimally in order to make other parts look good.  This was the concept behind the activist interest in J C Penney–that the retail operations were being propped up by the property division, which was collecting below-market rents to the department stores.  The idea was to fix the retail and then break up the company into retail and real estate parts.

I once studied a publicly traded, family owned department store in Hong Kong.  I found the stores I visited to be completely unappealing, with dated merchandise at high prices–and stronger competitors a short walk away.  Yet the company, which owned all the property where its stores were located,  made a hefty profit each year.  How could that be?  When I began to work out how much rent the locations would command from third parties, I realized that profits would easily be 50% higher if the firm shuttered its stores and simply rented the properties to other.  But that would have meant that all of the relatives  who “worked” in retail would be out of jobs.  So the idea was a non-starter.

In most instances, management is unlikely to disturb the status quo without being educated/forced by outside parties.  That’s where the activists come in.

Sometimes activism doesn’t work, however.  That topic on Monday.

(not so) “Happy Meal” convertible bond offerings

October 20, 2013 By in Convertibles, Current Market Thoughts, hedge funds, Investment firms, the Happy Meal Tags: , , , , , , 2 Comments

Pinky, the more astute of the two eponymous stars of the long-running documentary on genetically engineered mice, once opined that “if they called them Sad Meals, no one would buy them.”  So true.

Wall Street “Happy Meals”

Recently, the Wall Street Journal has been writing about a convertible bond offering technique, known as the Happy Meal, which has come under SEC scrutiny.   It shows what a colorful, inventive but cold-blooded place Wall Street is.

The Happy Meal is/was an offering of convertible bonds, in which the issuer arranged at the same time to lend large amounts of company stock to buyers so that they could sell the stock short.

Got that?  …probably not.

So let’s pull the pieces apart.

1.  A company issues convertible bonds.

Convertibles are bonds with a provision that allows them be exchanged for a specified number of shares of the issuer’s common stock under certain circumstances.  Until they are converted, the buyer collects interest income.

Generally speaking, a company would rather issue common stock or straight bonds, or borrow from a bank.  The fact that the firm is issuing a convertible almost always means these other, more attractive, avenues aren’t open to it.

2.  In the case of the Happy Meal companies, the convertible form wasn’t inducement enough.

Conventional long-only buyers turned thumbs down.  Who would these buyers usually be?  …specialized convertible securities funds, or bond funds looking to boost their returns by holding equities.  They avoid violating the letter of their investment mandates by buying stocks wrapped up in a bond package.

3.  That left hedge funds willing to do convertible arbitrage.

That is  to say, the hedge funds would simultaneously buy the convertibles and sell the stock short.  Exactly what a given hedge fund would do varies.  One technique would be to sell short enough stock to eliminate entirely any effect of stock movements (up or down) on the position–leaving the hedge fund to collect a stream of interest payments.  But a fund could also shade its holding to the positive or negative side.

4.  There’s more.

To sell stock short, you typically borrow the stock from a third party who owns it, using a brokerage firm as a middleman.  In the Happy Meal case, that wasn’t possible–either because there weren’t enough holders of the stock or because holders were reluctant to lend.  So the issuing company itself lent the stock that hedge funds dumped out into the market right after the offering.

What a mess!  A company would have to be really starved for cash, in my view, to contemplate serving up a Happy Meal.

not so appetizing any more

Companies have begun to turn sour on Happy Meals.  Two reasons:

–enough Happy Meal issuers have suffered significant stock price declines after their offerings that simply announcing a Happy Meal issue is now enough to make the common stock swoon, and

–according to the WSJ, a retired investment banker has turned whistleblower and reported the Happy Meal to the SEC.

His claim? …that issuers and their brokers are negligent by failing to disclose in the offering documents  how aggressive post-issue short selling is likely to be.

A concerned citizen, yes.  But one who also stands to collect a bounty under the Dodd Frank Act if the SEC investigation leads to significant fines.  In other words, a vintage Wall Streeter.

Ray Dirks, Kevin Chang and other stuff

October 7, 2013 By in Getting financial advice, hedge funds, How your broker gets paid, insider trading, sell-side analysts, Trading Tags: , , , , , , 1 Comment

a $30 million fine

According to the Wall Street Journal, Citi technology analyst Kevin Chang was fired last month.  Citi was fined $30 million by state regulators in Massachusetts for his leaking the contents of a research report to influential clients the day before it was published.  Other investigations are ongoing.

What happened?

The Journal, whose account appears to be taken from the Massachusetts consent order, says Mr. Chang found out from an Apple component supplier, Hon Hai Precision, that Apple had cut back orders–meaning, presumably, that sales of iPhones were running considerably below expectations. Chang wrote up his findings in a report that he submitted to Citi’s compliance/legal departments for review.

While his report was being processed, Chang was contacted by at least one hedge fund, SAC, which was looking for corroboration of similar conclusions drawn in an already released research report by Australian broker Macquarie.  Chang promptly emailed the guts of his report to four clients, SAC, T Rowe Price, Citadel and GLG.

The legal issue?   …selective disclosure of the research conclusions.

not the first time:  the Ray Dirks/Equity Funding case

Mr. Dirks was a famous sell-side insurance analyst back in the early 1970s.  In researching Equity Funding, a then-high flying stock, he discovered that the company’s apparently stellar growth was a fiction.  The firm had a bunch of employees whose job was to churn out phony insurance applications for made-up people, which EF then processed and showed “profits” for, just as if they were real.

When he found the fraud out, Dirks immediately called all his important clients and told them.  They sold.  Only then did Dirks inform the SEC.

Rather than being grateful for his news, the SEC found Dirks guilty of trading on inside information and barred him from the securities industry–a verdict that was reversed years later by the Supreme Court.

two observations

1.  Why put important clients first, even at the risk of career-ending regulatory action?  After all, many sell-side analysts take home multi-million dollar paychecks.

Their actions show who the analysts perceive their real employers are.  Ultimately, they collect the big bucks because powerful clients continue to send large amounts of trading commissions to pay for access to their research.  If that commission flow begins to shrink, so too does the size of the analyst’s pay.

Also, an analyst’s ability to move to another firm rests in large measure on whether these same clients will vouch for him–and will increase their commission business with the new employer.

2.  What happens to people like Dirks and Chang?

Dirks was eventually exonerated.  While he was appealing the SEC judgment, his thoughts on insurance companies continued to be circulated in the investment community.  Only they appeared under the byline of a rookie apprentice to Dirks–Jim Chanos.

Dirks eventually established his own research firm.  Interestingly, when I Googled him this morning, I found that the top search results were all basically rehashes of the favorable information put out by Ray Dirks Research itself.  No one remembers the real story.

Chang?  I don’t know.  He lives in Taiwan, where I suspect he will catch on with a local brokerage firm or investment manager.  As far as Americans are concerned, disgraced analysts or portfolio managers tend to end up in the media.  For example, Henry Blodget, who wrote all those laudatory “research” reports for Merrill touting internet stocks he actually believed were clunkers, now works for Yahoo Finance.  You can watch similar characters every day on finance TV.  Crooked, maybe.  But they’re articulate and look presentable.  And that’s all that matters.

 

 

J C Penney (JCP) issues stock

September 27, 2013 By in Current Market Thoughts, hedge funds, Stock ideas Tags: , , , , , , , , 2 Comments

the JCP offering

JCP filed a preliminary prospectus with the SEC indicating it is selling 84 million shares of common stock to the public at $9.52 a share through Goldman Sachs.  (In a typical provision of any offering called the “overallotment,” Goldman has permission to sell another 12.8 million shares if it can.)

Let’s say Goldman gets a commission of $.22 a share.  That would mean proceeds to JCP of $781 million – $900 million.

business stabilizing

Just in advance of the red herring, JCP filed an 8-K in which it said it expected comparable store sales to be positive during both 3Q13 and 4Q13.  The reason?  …merchandise that JCP customers want to buy is now in stock, and in the sizes that JCP customers fit.

three aspects of the offering

I hadn’t intended to write so much about JCP, but I think there are three interesting aspects to the offering.

1.  the size

This is a big offering, amounting to over a third of the shares already outstanding.

2.  why a stock offering?

For companies like JCP that want to raise a lot of capital, their first thought is to borrow.  It’s easier to do.  Transaction costs are lower.  Also, Americans firmly believe that debt is a lower-cost form of capital than debt, so borrowing is more beneficial for shareholders.

There comes a point, however, when lenders perceive the capital structure of a firm has become too lopsided.  When that happens, they will refuse to lend any more until the firm demonstrates Wall Street’s confidence in it by raising equity capital.

I assume we’re at that point for JCP.

why not six weeks ago?

After all, the sales projections JCP made in the 8-K are better, I think, than Wall Street had been assuming.  So it’s unlikely that JCP’s need for cash is greater now than it was a few weeks ago.

It’s also hard to think that a big company like JCP would not do continuous financial forecasting of its future cash flows that would indicate when it would need fresh funds, and in what amounts.

I don’t know the answer.

One obvious difference between now and the end of August, however, is that in the meantime two insiders, Pershing Square and Vornado, have unloaded their entire stakes, 52 million shares (!!), at a reported price of about $13 each.  That’s 36% higher than JCP itself is getting today.

I guess you might argue that everyone knew the two activists would be selling, and that this overhang would be enough to scupper a potential offering by JCP.  Seems pretty lame, though.

Me, I’m nonplussed (the first time I’ve used that word in my life).  If I were a JCP shareholder, I’d be stunned.  Maybe we just chalk this up as one of the perils of riding the coattails of latter-day robber barons.  But if I were a shareholder, I’d want to know how the board allowed this to happen.

On September 20th, JCP’s controller left the company.  Is this connected?

two lessons for analysts from JCP

September 26, 2013 By in Current Market Thoughts, hedge funds, Retail, Stock ideas Tags: , , , , , Leave a comment

JCP  in the press again over the past two days.

I’ve only seen the headlines, which assert that:

–JCP is trying to sever the 10-year $200 million agreement the previous CEO, Ron Johnson arranged with Martha Stewart.  Why?   …the MS merchandise isn’t selling

–JCP is looking to raise new funds

–a Goldman analyst has used the “B” word (bankruptcy) in warning clients to avoid JCP stock.

I want to make two relatively narrow points:

1.  Analysts are extremely reluctant to speculate on a possible corporate bankruptcy in writing.  They may mention the possibility on the phone or in meetings, but not in print.

A boss of mine years ago at Value Line did this once.  He wrote about a small-cap magazine company that if weak advertising trends continued for the following twelve months, there was a risk the firm would have to close its doors.  Advertising dried up almost immediately on publication of the report.  The company was out of business in three months.

Raising the prospect of bankruptcy is like shouting “Fire!!” in a crowded theater.  It has consequences.

Also, if the firm survives it will never forgive the analyst who made the call.  The Goldman analyst who wrote the report must either be very young or extremely confident that the prediction won’t come back to haunt him/her.

 

2.  In graduate school I spent a year at the university in Tübingen in southwest Germany.  For a while I lived with a family where we all went mushroom hunting on weekends.  What we found made up at least one or two meals the following week.  That’s where I learned about the deaths head mushroom.  Eating it is most often fatal; symptoms only emerge after it’s too late to get treatment.

The obvious course of action–learn what the deaths head looks like, and don’t eat it.

There’s an analogy here.

In the case of JCP, the symptoms we’re seeing now are the direct result of corporate decisions made two or more years ago by ex-CEO Ron Johnson and defended for a long time by Bill Ackman.  Oddly, both seem to have been thinking–contrary to all experience–that falling sales could be remedied by applying a double does of what was causing them.  What’s equally surprising is the the JCP board let the situation go unaddressed until it had reached crisis proportions.

 

My second point:  many times corporate strategies, once put in motion, are difficult or impossible to reverse.  So we, as investors, have to be constantly scanning the horizon for indications of possible weakness. Normally, the early signs of deterioration are found on the balance sheet (rising receivables and inventories) and the cash flow statement.

For JCP, though, there was nothing subtle about its difficulties.  Sales fell apart almost as soon as Ron Johnson took the controls.  Another reason it”s so hard to understand why the board let the situation get so out of control.