Category Archives: Investment firms

a new Morningstar study: expense ratios a better performance indicator than stars?

August 11, 2010 By in Constructing a Portfolio, Getting financial advice, Industry Analysis, Investment firms, Portfolio management Tags: , , , , , , , , , Leave a comment

Morningstar, the mutual funds research service famous for its star ratings of funds, apparently issued a press release over the weekend that details a study of its star ratings vs. other fund selection criteria.  I say “apparently” because both the Wall Street Journal and the Associated Press carried the story, but I’ve been unable to locate either the press release or the research document on the Morningstar website.

Two aspects of the WSJ account of the study struck me as interesting.

It’s not the study itself.  From what the press accounts indicate, Morningstar compared the performance of 1-star funds with that of 5-star funds over the five-year period from 2005-March 2010.  The conclusion?–in a majority of cases, an investor who chose funds that charged the lowest fees would have done better than one who used the Morningstar stars.

Although Morningstar has skillfully build a business that generates about $500 million in annual revenue from its star ratings, that fact that they may not have predictive value should come as no surprise. The company itself is careful not to claim that they do.  And there have been academic studies from time to time that have raised the same issue.  Nevertheless, it’s a powerful psychological fact that when faced with highly complex decisions, people are invariably drawn to mechanisms that seem to distill the decision down to a small number of easily understood choices–like “Do I want one star or five?”

What did I find striking?

–the WSJ story notes that 1-star international equity funds outperformed 5-star funds over the study period.  Despite this, just about half of the 1-star funds were closed down during the half decade.  Not only that, but the best performing funds appear to have been the ones that shut their doors.  According the WSJ, the performance situation is reversed when considering funds that survived the entire time period.  5-star survivors outdistanced 1-star survivors.

Why would a fund company shut down a fund that’s outperforming?  Because it can’t get anyone to buy shares.  Why would that be?  My bet is that good performance is not enough to overcome the stigma of a low star rating.  To me this illustrates how powerful Morningstar has become in individual investor behavior.

–as presented in the WSJ, this is a pretty weird study.  Morningstar has over 25 years of data on mutual funds.  Why choose a five-year-and-three-month period?  It should be very simple to see if the same patterns hold over longer time frames.  Did Morningstar look? If so, what did it find?  How did the 2- 3- and 4-star funds, which represent the large bulk of the funds rated, fare?  Did the lowest-cost 5-star funds outperform the highest-cost funds?

Anyway, there are lots of questions the WSJ could have asked that could have provided analysis and insight.  The fact that it didn’t shows what the WSJ has become over the last few years.

Hudson Mezzanine Funding: more trouble for Goldman?

June 10, 2010 By in Current Market Thoughts, hedge funds, Industry Analysis, Investment firms, Recent Market Action Tags: , , , , , , Leave a comment

Hudson Mezzanine Funding

According to numerous press reports (suggesting that in Spitzer-like fashion, the government wants to get this story into the public eye in advance of any possible charges), the SEC is investigating Goldman Sachs for its sale of a collaterized debt obligation linked to sub-prime mortgages called Hudson Mezzanine Funding.

This action follows the indict ment of Goldman on civil fraud charges in April based on another mortgage derivative transaction called Abacus.

As I’ve written before, from what has been made public about Abacus so far, the case against Goldman seems weak to me (remember, I’m an investor, not a lawyer, however).  The accusations appear to rest on the SEC belief that in the Abacus transaction Goldman had an obligation to act as a financial advisor to the participants, not simply as a broker.  The facts, on the other hand, seem to me to show that Goldman functioned merely as a go-between for a deal that the two parties negotiated with each other.

From the leaked information appearing in today’s newspapers, Hudson seems to be a more serious complaint, assuming the press reports are correct, in that:

–Goldman selected the securities for the Hudson deal from its own inventory,

–Goldman asserted in marketing materials that its interests were “aligned” with buyers, since it would own equity in the issue, but failed to disclose that it was taking a much larger short bet against it

–in an internal email, a Goldman salesman describes Hudson as “junk” that his better clients were “too savvy to buy.”

I presume the SEC contention will be that Goldman was in a position to know the contents of Hudson well since it owned them, and made positive public statements about the deal while privately holding a negative opinion and intending to short the security once it came out.

why lead with Abacus and not Hudson?

One possibility, raised right away by the Wall Street Journal, is that the SEC fundamentally misunderstood the nature of the Abacus transaction. 

 Another is that the agency was under political pressure to do something while a financial reform bill was being debated in Congress. 

It may also be that the SEC was only tipped to the existence of Hudson after it went public about Abacus.

why Goldman and not Morgan Stanley or Citigroup?

This morning’s Financial Times, in addition to having a report on Hudson on page 1, contains a very interesting article called “A tricky pick,” in which it discusses the collateralized debt obligation market.  Although the banner on page 1 touts the article as being about “Goldman and the Credit Boom,” the real eye-opener of the story is that it portrays organizations like Morgan Stanley, UBS, Bank of America and Citigroup as engaging in what appears to me to be much more highly unethical and destructive behavior than anything that Goldman has been accused of by the SEC.

My guess is that it’s because Goldman is that compared with a commercial bank, Goldman is relatively simple to understand.  Its activities are more focused and the lines of responsibility for any action are clearer.   Given that the sub-prime derivative business is inherently difficult for non-specialists to get their arms around, why make the task even harder by adding the issue of having to explain a complex  organizational structure?

Also, Goldman has little retail presence.  It does no image advertising.  So few people have strong positive associations with Goldman as “my” bank.  It has also  created resentment, rightly or wrongly,  from seeming to have profited from the financial crisis.  In addition, the company has been described as being “tone-deaf” to public opinion.  Perhaps describing what they do as being “God’s work” isn’t typical of its public relations efforts, but even one gaffe like that can do a lot of damage.

I think the one safe conclusion to draw from all this is that (justifiable) public anger at the financial meltdown isn’t going away.  That implies that neither will the efforts of the SEC to prosecute.  Whether the agancy has the right villain is still open to question, though.

MSFT is issuing an unusual convertible

June 9, 2010 By in Convertibles, Current Market Thoughts, Industry Analysis, Investment firms, Recent Market Action, Stock ideas, Technology Tags: , , , , , , , 2 Comments

the issue

Yesterday, MSFT announced it was selling, in a private (not registered with the SEC) offering, $1.15 billion in senior convertible notes, due (at a time not specified in the press release) in 2013.  The offering has the following terms:

–the notes are being sold at face value

–MSFT will pay no interest

—the notes are convertible into MSFT stock at a price of $33.40 per share, a 33% premium to yesterday’s close

–under normal circumstances, the conversion feature can’t be used until March 15, 2013.

why do this?

a MSFT perspective

MSFT, a company I owned for more than a decade and have followed for over 20 years, is admittedly a quirky company.  But I can’t imagine that the idea for this deal originated with the firm.

As of the most recent 10-Q, MSFT has almost $40 billion in cash on the balance sheet.  It’s generating over $15 billion annually in free cash flow.

Yes, MSFT did try to buy YHOO for about $40 billion a few years ago, but thought better of it when YHOO was subsequently offered to it on a platter at about half that price.  MSFT seems to me much more careful with its money these days, so I don’t think a big acquisition is in the cards.  But even if it were, $1.15 billion–what the company earns every three weeks–would be just a drop in the bucket.  If motivated by the idea of a large purchase, the offer should have been a lot bigger.

I think MSFT sees the deal as free money, the equivalent of picking up a $100 bill you see on the sidewalk.

the buyer

My guess is that the buyer, whose name has not yet been disclosed–and who may remain anonymous–approached MSFT.  In all likelihood, it’s a professional investor who has contracts with some clients that require it hold only  fixed income instruments for them.  The holder forgoes a relatively small amount of interest income in return for the chance at a large capital gain if MSFT stock goes up more than 10% annually for the next three years.

To state the obvious, the buyer must:

–be very bullish about MSFT’s prospects, and/or

–think stocks will do relatively well and MSFT is a comfortable proxy for the S&P as a whole, and/or

–think making money from bonds will be hard over the next few years.

For its part, MSFT continues to buy back its own stock.  It will also try to offset potential dilution from the note offering through options.

oddity or harbinger?

It’s too soon to tell.  But I think it’s something to keep an eye on, as a potential source of support for stocks in general, and for bond-like stocks in the MSFT mold in particular.

AAPL vs. GOOG: battle of the titans (II)

May 23, 2010 By in Current Market Thoughts, Industry Analysis, Investment firms, Stock ideas, Technology, Wireless Tags: , , , , , , , , 2 Comments

Judging by their stock charts, Wall Street has pretty much conceded the battle to AAPL.  In fact, there isn’t much doubt at all.  Since the ipo of GOOG in 2004, AAPL is up about 12x.  GOOG is up 4x–and that includes a big jump after an unusual, and less than successful, ipo in which GOOG tried to market itself directly to investors, cutting out Wall Street investment banks.

Yes, the S&P is just about flat over that span, so both are big winners.  And, yes, AAPL is starting from a low base in 2004, a point when some questioned its survival.  But the big separation between the two names has come between the beginning of 2007 and now, a time period when AAPL tripled and GOOG has been flat.

AAPL has also pulled significantly ahead in simple balance sheet metrics like working capital or accumulated cash holdings.  The balance sheet number read as follows:

————————–12/06—————–12/09———–change

GOOG

cash                  $8.0 bill.                           $15.8 bill.                  $7.8 bill.

wc                      $8.3 bill.                           $17.9 bill.                  $9.6 bill.

AAPL

cash                  $11.9 bill.                          $24.8 bill.                $12.9 bill.

wc                     $9.4 bill.                            $20.2 bill.                 $10.8 bill.

At first glance, it looks like AAPL is pulling away from GOOG, but not opening up an insurmountable gap.  But AAPL has recently begun to divide its marketable securities into those with a life of a year or less and those with more.  The latter, $15 billion at 12/09, although cash-like, are listed as non-current assets.  Adjusting the figures, AAPL’s cash is up by $27.9 billion over the past three years, or 3.5x the cash generation of GOOG.  The main driver of this surge is the phenomenal success of the iPhone.

In addition, AAPL has set up a business, iAd, to sell iPhone ads through the apps downloaded from its store, a move calculated to fence GOOG out of the mobile ad business.  Ironically, however, the FTC has citied iAd plus AOL’s purchase of mobile ad specialist Quattro Wireless as reasons of giving the anti-trust green light to GOOG’s proposed purchase of AdMob, a Quattro rival.

The are are other signs as well, that the contest may not be so one-sided from now on.  According to the Financial Times, sales of smartphones using GOOG’s Android operating system were higher than those of the iPhone in the US market for the first three months of 2010, taking 26.6% of the market vs. 22.1% for AAPL.  Android phones were about 10% of the worldwide market over the March quarter vs. 1.6% during the year-ago period.  The gains come 40% from MSFT, the rest from everyone else.

Since the start of the year, GOOG has released version 2.1 of Android (Eclair), which increases the speed of phone apps significantly.  This week it announced version 2.2 (Froyo), which gives the operating system another big overhaul.  The following upgrade, Gingerbread, has a name and a potential release date of late this year, but no version number and few details.

Chrome os netbooks, at  one time scheduled for release during the second half of this year, appear to have dropped off the radar screen.  After the surprisingly strong sales of the iPad, they seem to have been replaced by a bevy of android-based tablets that are claimed to be hitting the market in time for the year-end holidays.

Suppose, then, that the next year or two show a reversal of trend, in which GOOG products gain market share over their AAPL counterparts?

Will this mean a significant increase in the growth rate of GOOG’s profits vs. what it is presently showing?  Only time will tell, but my guess is that it won’t.  Success of Android phones and Android tablets will allow GOOG to take its business into the mobile arena, but I think this will only erosion of revenue and profit expansion that Wall Street seems to now sense in the company.  That’s probably worth a few points of price earnings multiple expansion, however.

On the other hand, GOOG success would also have the potential to stop the momentum of the AAPL earnings freight train that is currently barreling down the tracks at an extraordinarily rapid clip.  As is the case with any growth stock, a slowing in growth from the pace the market expects has two negative effects on the stock.  It lowers the stock price by the extent to which earnings fall short of Wall Street expectations.  And it causes the price earnings multiple to contract.  This happens both as investors project forward a new, lower rate of profit advance, and as the open-ended “dream” that the stock will always surprise on the upside becomes tarnished.

For me, this means that, as stocks, AAPL has much more to lose than GOOG has to gain from Android success.

Tis is a situation to monitor closely.

Auction Rate Securities (ARS)–in the news again

May 20, 2010 By in Auction-rate Securities, Investment firms, Vocabulary Tags: , , , , Leave a comment

what they are

Auction-rate securities are a type of variable rate financing invented by Lehman, popularized by Goldman and used mostly by charities and governments.  The idea was to sell long-term bonds, but pay interest on them at (much lower) short-term rates.

Periodic auctions, of the type the US Treasury uses to set the coupon on its bonds, but conducted by the brokers who sponsored the offerings were the means for performing this magic trick.  Auction periods varied, but would typically be either weekly or monthly.

The issuer would sell uncollateralized bonds with a long term–even 20 or 30 year–to an initial set of investors at a fixed interest rate.  At each auction, the holder would in theory either decide to keep the bond until the following auction, and collect the interest determined in the auction, or sell it to someone else, who would take his place.   Because the presumed ARS holding period was either a week or a month, ARS interest rates would arguably not be much higher than money market or commercial paper rates.

The marketing pitch to issuers was that they got 20-year money but would pay a very low rate.  Buyers were told that, although these were in fact long-term bonds, one should look at them as pretty much like cash but with a higher-then-cash yield.

ARSs differed from the Variable Rate Demand Obligations that this kind of issuer might otherwise use, in two main ways:

–ARSs have no put feature, that is, no way to return them to the issuer for payment at par (the auctions were supposed to provide all the liquidity holders would need);

–ARSs were cheaper to issue, with most of the fees going to the broker running the auctions, rather than to a bank, as was the case with VRDOs, for a letter of credit to make sure the put feature could be exercised.

Most ARSs were rated AAA, not necessarily because the underlying credits were this strong, but because the issue purchased insurance from one of the large monoline municipal insurers.

what happened

In early 2008, auctions started to fail, that is, not enough buyers showed up to absorb the bonds that existing holders wished to sell.  In hindsight, it’s not clear how much third-party demand there was at the auctions versus how much of the activity was done by the sponsoring brokers.

This had several (bad) consequences:

–the interest rates the issuers had to pay for the ARSs skyrocketed;

–holders began to realize that these instruments had become highly illiquid;  the bond prices also fell.  So much for “just like cash”;

–everyone sued.

why are ARSs in the news again?

It may be just a coincidence, but two revealing stories about the ARS fiasco have just popped up.

1.  Thomas Weisel Partners, the last of the line of Silicon Valley technology boutique investment banks, is being accused of securities fraud in connection with ARSs, according to the Financial Times.  (Actually, I was originally going to use Weisel as a jumping off point for talking about the fleeting phenomenon of the San Francisco area tech boutiques, but thought that ARSs, as a crazy bull market kind of security that made no sense but everyone bought into, was more interesting.)

Weisel reportedly was advising clients to sell ARSs early in 2008 over fears market liquidity would soon disappear.  At the same time, in order to raise money for executive bonuses, it allegedly removed $15.7 million from three clients’ accounts without their knowledge or consent and replaced the money with ARSs it had tried–and failed–to sell on the open market.  Weisel asked the clients to okay the transactions after the fact, but were refused.

2.  Gretchen Morgenson (a name that makes CEOs shudder) detailed yesterday in the New York Times instances where Goldman Sachs has acted in an ethically dubious fashion–like helping Washington Mutual resell packages of sub-prime mortgages while simultaneously shorting the company’s stock.

In the same article, she recounts the experience of the University of Pittsburgh Medical Center, a non-profit, with ARSs that Goldman helped it issue.  In mid-January 2008, UPMC became worried about ARSs and asked Goldman whether it should withdraw from the market.  Goldman told UPMC to “stay the course.”  But a few weeks later, Goldman itself fled the ARS market.

Because interest rates on the UPMC ARSs rose sharply, UPMC decided to redeem the securities.  Of the three ARS sponsors UPMC employed, only Goldman refused to allow the redemption to occur.   And Goldman continued to collect fees even though it was no longer sponsoring the auctions that the fees were supposed to be payment for.

So, take out your pencil and add ARSs to the list of zany bull market securities that sounded good while the champagne was flowing but had little investment merit.  Maybe between hybrid bonds and contingent convertibles would be a good place.