more trouble for active managers

When I started in the investment business in the late 1970s, fees of all types were, by today’s standards, almost incomprehensibly high.  Upfront sales charges for mutual funds, for example, were as high as 8.5% of the money placed in them.  And commissions paid even by institutional investors for trades could exceed 1% of the principal.

Competition from discount brokers like Fidelity offering no-load funds addressed the first issue.  The tripling of stocks in the 1980s fixed the second.  Managers reasoned that the brokers they were dealing with were neither providing better information nor handling trades with more finesse in 1989 than in 1980, yet the absolute amount of money paid to them for trading had tripled.  So buy-side institutions stopped paying a percentage and instead put caps on the absolute amount they would pay for a trade or for access to brokerage research.

All the while, however, management fees as a percentage of assets remained untouched.

 

That appears about to change, however.  The impetus comes from Europe, where fees are unusually high and where active management results have been, as I read them, unusually poor.

The argument is the same one active managers used in the 1980s in the US.  Stock markets have tripled from their 2009 lows and are up by 50% from their 2007 highs.  All this while investors have been getting the same weak relative performance, only now they’re paying 1.5x- 3x what they used to–simply because the markets have risen.

So let’s pay managers a fixed amount for the dubious services they provide rather than rewarding them for the fact that over time GDP has a tendency to rise, taking corporate profits–and thereby markets–with it.

The European proposal to decouple manager pay from asset size comes on the heels of one to force managers to make public the amount of customer money they use to purchase third-party research by allowing higher-than-normal trading commissions.  Most likely, customer outrage will put an end to this widespread practice.

Both changes will doubtless quickly migrate to the US, once they’re adopted elsewhere.

 

 

 

what a good analysis of Tesla (TSLA) would contain

A basic report on TSLA by a competent securities analyst would contain the following:

–an idea of how the market for electric cars will develop and the most important factors that could make progress faster or slower.  My guess is that batteries–costs, power/density increases, driving range, charging speed–would end up being key.  Conclusions would likely not be as firm as one might like.

–TSLA’s position in this market, including competitive strengths/weaknesses.  I suspect one main conclusion will be that combustion engine competitors will be hurt by the internal politics of defending their legacy business vs. advancing their electric car position.  The ways in which things might go wrong for TSLA will be relatively easy to come up with; things that could go right will likely be harder to imagine.

–a detailed income statement projection.  The easy part would be to project (i.e., more or less make up) future unit volume and selling price.  The harder part would be the detail work of breaking down unit costs into variable (meaning costs specific to that unit, like labor and materials, with a breakout of the most important materials (i.e., batteries)) and fixed (meaning each unit’s share of the cost of operating the factory).  An important conclusion will be the extent of operating leverage, that is, the degree to which fixed costs influence that total today + the possibility of very rapid profit growth once the company exceeds breakeven.

There are also the costs of corporate overhead, marketing and interest expense.  But these are relatively straightforward.

The income statement projection is almost always a tedious, trial-and-error endeavor.  Companies almost never reveal enough information, so the analyst has to make initial assumptions about costs and revise them with each quarterly report until the model begins to work.

–a projection of future sources and uses of cash.  Here the two keys will be capital spending requirements and debt service (meaning interest payments + any required repayments of principal).  Of particular interest in the TSLA case will be if/when the company will need to raise new capital.

 

 

Tesla (TSLA), me and momentum investing

Why should a company fundamentals-driven investor have a problem with momentum investing?

Two reasons:

–momentum investing is a reactive strategy, and

–one that focuses on the past price movement of the little pieces of paper (or electronic impulses) that trade in the secondary market.

In contrast, fundamental investing is a predictive strategy based on the idea that the price of the paper/bits will ultimately be determined by the value of the underlying company.  Among fundamental investors, value investors believe that the key is the worth of the company as presently constituted (but perhaps running more smoothly than it in fact is).  Growth investors think the key is in early recognition of novel and unexpected profit positives that will fully emerge only in the future.

 

What kind of a thing, reactive or predictive, is my formula for TSLA of:   buy at $180 and sell at $250?  In a sense, I’ve got some fundamental underpinning.  My back-of-the-envelope figuring suggests nothing is likely to happen inside the company Tesla over the next couple of years that could possibly justify more than a $250 price.  And I’m willing to sell at that price even though the stock is still exhibiting positive price momentum.

But how did I get the $180?

What I’ve really done is to take a chart of the stock and draw a line that runs through the lows of the past four years or so and to conclude that this line forms the bottom of a channel (with something like $250 as the top) that TSLA has been navigating itself through since late 2013.  Yes, at $180 I have better potential for upside than I do at $250.  But that’s more a fact about arithmetic than a deep insight into corporate operations at Tesla.

In sum, then, the fundamental underpinning of at least the buying are pretty lame.

So I guess I have to say that there’s a healthier dose of momentum in my fooling around with TSLA than I might like to admit.  On another non-fundamental note, though, this ensures that my California son and I stay in regular contact.

Snap (SNAP): non-voting shares (ii)

Two potentially important issues arise with non-voting shares.  The underwriters and prospective investors in SNAP are clearly not worried about them.  Granted, they’re unlikely to emerge as actual issues in the near future, but here they are:

–value investors often buy shares in companies they believe are undervalued by virtue of  having bad management.  Their rationale is that management will change in one of several ways:  existing managers will learn from past mistakes and improve;  the board of directors will replace existing managers with better ones; shareholders will vote out current directors and replace them with better ones; the company will be taken over by a third party, which will toss out the incumbents and replace all of them with more competent individuals.

In the case of SNAP, management, the board and the voting shareholders are basically one and the same.  The likelihood of them firing themselves is pretty small.  And the chances of a hostile takeover are zero.  So the value investor argument for eventually buying SNAP shares that there’s a level below which they can’t go without triggering change of control doesn’t apply here.  So if things turn south with SNAP, the chances of rescue are small.

The results of this situation are plain to see in the Japanese stock market, where disenfranchised shareholders have had to watch their investment in family-owned company shares lie dormant for decades.

–change of control can happen voluntarily.  But does an acquirer have to buy non-voting shares in order to take the reins?  I don’t know.  But I don’t think the answer is clearly “Yes.”  Say Amazon decided to bid for the voting shares of SNAP at double the price of the publicly traded, non-voting ones.  AMZN could presumably then replace management and the board of directors and guide the company in any direction it chose–without buying a single non-voting share.  If this were to happen, my guess is that non-voting shares would plunge in value.  Years of expensive legal wrangling  would decide the issue one way or the other.

A third musing:   Can SNAP declare dividends for voting shares but not for non-voting?  The answer should be in the prospectus, which I haven’t read carefully enough to have found out.  But then I’m not interested in taking part in the IPO.

the issue of Snap’s non-voting shares

A time-honored strategy for entrepreneurial individuals or families to maintain control over their enterprises is to issue two classes of stock.  One will be held by the entrepreneurs, the other by the investing public.  Shares of the former type will typically have a high multiple, say 10x, the voting power of the latter.  If the number is 10x, the entrepreneurs will still control a majority of the votes even if they hold only 10% of the outstanding shares.

Hershey shares are like this.  So, too, the New York Times, News Corp, Facebook and Google.

A variant on this idea, often used outside the US, is to list and issue to the public only preferred stock, not common.  Preferreds vary.  They derive their name from the fact they have some “preference” or other over common (which are also sometimes called ordinary). It may be a higher dividend.  Most usually in the US, preferreds simply have a place in line in the case of bankruptcy in back of all creditors but just ahead of common stockholders–which, to my mind, is as small a preference as you can get.

Snap (ticker: SNAP), the parent of Snapchat, is taking this idea one step farther.  It currently has two classes of stock:  Class C which has 10 votes per share and which the company’s founders hold; and Class B that has one vote per share and which is held by key employees and venture capital investors.  Snap intends to go public by issuing Class A shares that have no voting power at all.  Third party investors will have to accept the fact from Day 1 that they will never be able to wrest control of Snap from its insiders.

Questions:

–Will investors stand for this?

–Are the A shares really stock?   …or are they a funny kind of option?

–What does this say about value investing in the 21st century?

The answer to the first question is apparently “Yes!!!”

 

More tomorrow.

 

 

 

Warren Buffett selling Wal-Mart (WMT)

Investment companies are required to file lists of their holdings with the SEC at the end of each quarter.  The latest such 13-F form for Berkshire Hathaway shows a buildup in Apple and airlines   …and the sale of virtually all of Buffett’s long-term holding in WMT.

WMT as icon

A powerhouse in the 1970s and 1980s, WMT has been a bad stock for a long time.  It had a moment in the sun during the market meltdown from mid-2007 through early 2009, when it rose by about 1% while the S&P 500 was almost cut in half.  Since the bottom, however, WMT has gained 40% while the S&P is up by 219%.

Wal-Mart isn’t an obviously badly run company.  It isn’t, say, Sears, or the Ackman-run J C Penney.  But it does have a number of impediments to achieving significant growth in earnings.  One is its already gigantic size.  A second is its focus on less affluent rural customers who were disproportionately hard-hit by recession and who have in many instances yet to recover.  There’s increased competition from the dollar stores.   And there’s Amazon, whose competitive threat WMT itself admits it played down for far too long.

My reaction:

old habits die hard.  Mr. Buffett built his career from the 1950s onward on the observation, novel at that time, that traditional Graham/Dodd portfolio investing techniques glossed over the considerable value of investment in intangible assets–brand names, distribution networks, superior business practices.  However, by the time I entered the business in the late 1970s, other people–me included–were beginning to adopt his methods.  So thinking about intangibles became part of the toolkit, rather than something special.  Then, of course, the internet began to erode the power of intangibles to stop newcomers from entering a business.  Mr. Buffett, like any successful incumbent (including WMT), has been slow to adapt.

WMT as metaphor for today.  WMT could become more profitable quickly if its heartland lower-income customer base could earn more money.  One way to do that would be to bar imported goods from the country, with an eye to creating manufacturing jobs in the US.  Of course, that would also destroy the WMT value proposition in the process.  So rolling the clock back to 1950 isn’t the answer, either for the health of WMT or for its customers.

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.