Category Archives: Securities regulation

11th Annual Bain Luxury Goods Worldwide Market Study, October 2012 (iii): market structure

November 21, 2012 By in Bain luxury goods study, Industry Analysis, Luxury goods, Retail, Securities regulation, Strategy Tags: , , , , , , , Leave a comment

Yesterday I wrote about long-term trends in the personal luxury goods industry, as seen by the Bain Luxury Goods study.  The prior day, Monday, the topic was short-term revenue growth prospects.

Today’s post will deal with the responses by luxury goods firms to the development of the global market for their products.  I’ll close with Bain’s estimates of the size of the personal luxury goods market in the context of the market for all luxury goods.

continuing slow vertical integration

The traditional model for luxury goods companies has been to design and manufacture their products and sell them at wholesale to third-party retailers, like department stores or multi-brand specialty retailers (think, e.g.: jewelry stores).

The virtues of this way of doing business are:

–it’s simple and

–the time that company cash is tied up in inventory is, under most circumstances, the shortest.  So its financing needs are the least.

Over the past decade or so, however, luxury goods firms have been entering retail themselves by opening free-standing stores of their own or company-owned boutiques in department stores.  Where necessary to do so, they’ve also been buying back territorial distribution rights they had previously granted to third parties.

The rate of change toward vertical integration is slow, but steady, at the rate of about a 1% increase in market share per year.  Currently, luxury goods’ distribution is still predominantly wholesale, with 30% through company-owned retail channels.

Why the shift?

After all, going all the way to the retail customer requires a much more complex company organization and a lot more capital to meet the heavy extra expense of building and keeping up a store network.  At the same time, a firm’s existing wholesale customers can scarcely be thrilled to see the luxury goods company entering into direct competition with them.

Several reasons:

–the price markup from wholesale to retail for luxury goods is immense

–the company has much better, and more current, information about customers, sales trends and inventories if it has a retail operation

–it has much better control over the brand message and the customer experience

–the company has the opportunity to make the customer its client, rather than the department store’s, thereby increasing the size and frequency of purchases.

single brand vs. conglomerate, private vs. public ownership

the rise of luxury conglomerates

In 1995, according to Bain, a majority (55%) of personal luxury goods sales were of products made by a single-brand company.  The rest came from multi-brand groups.

Today, in contrast, sales by multi-brand groups are double the size of those of their single-brand counterparts, which account for only a bit more than a third of industry revenues.

…and publicly owned firms

In 1995 companies that had raised expansion capital in the stock market represented only 30% of luxury goods revenues.  The vast majority of sales were by privately held firms, mostly family owned.

Today, those proportions are reversed.  Only 30% of industry sales come from traditional privately held companies.  Firms representing 65% of total revenues are publicly traded.  Private equity and sovereign wealth funds hold the other 5%.

The reasons behind this transformation are a bit more complex.  They include:

–the massive rise in world GDP over the past few decades that has made the luxury goods market accessible to many more consumers.  According to Bain, the personal luxury goods market has almost tripled in size since 1995

–the development of supply chain software, which makes the management control task more manageable

–revival of once moribund businesses through modern management techniques–Gucci, Tiffany, Coach are names that immediately come to mind, which has attracted capital to the industry

–often a diffuse group of second- and third-generation owners of a private firm would prefer to cash out rather than remain involved in the family business.

where the personal luxury goods industry stands in overall luxury spending

According to Bain, global luxury spending breaks out as follows:

luxury cars    €290 billion, up 4% from 2011

personal luxury goods     €212 billion, up 10%

luxury hospitality     €127 billion, up 18%

luxury wines/spirits     €52 billion, up 12%    (no beer?)

luxury food     €38 billion, up 8%

design furniture     €18 billion, up 3%

luxury yachts     €7 billion, up 2%

Total     ~ €750 billion

Note:  in the food and beverage category, Bain detects a trend toward in-home consumption rather than in restaurants.  Apparently even the wealthy need to economize somewhere.

China in 2013

October 23, 2012 By in Asian economic development, China, Current Market Thoughts, economics, Hong Kong, Japanese development, Portfolio management, Securities regulation, Strategy Tags: , , , , , , Leave a comment

leadership change

China is currently in the process of its once a decade change in the top leadership of the Communist Party.  Official nominees for the highest posts will be officially announced in about two weeks.  They’ll be ratified in a pro forma vote next March.

New leaders often mean new policy directions.  While the old leaders are on the way out and the new ones are waiting to be anointed, the most prudent stance for lower-level Party functionaries (read: basically everyone) is to do as little as possible that could conceivably be second-guessed later on.

During the six- or nine-month transition period, the Chinese economy slows.  It reaccelerates as new leaders clarify what their priorities are.

I expect the same will happen this time around.  But as I try to imagine what I would do if I were running China, I’m beginning to think that the character of China’s growth from this point on may differ substantially from what it has been to date.

How so?

is the developing country growth model broken?

The standard developing country growth model that helped the EU and Japan recover after WWII and which has been duplicated by every successful emerging economy since, is broken.

The model, which I’ve written about extensively, has two parts:

1.  gear your economy toward exporting to the huge, healthy, fast-growing US, and to a lesser extent the EU, and

2. peg your currency to the US$ so foreign exchange movements won’t erode your labor cost advantage.

The breakdown has come in both areas:

1.  aging of the Baby Boom is reducing the long-term growth rate of the US to around 2%.  The need to repay immense government debt suggests to me that 2% will be a ceiling over the next few years, not a floor.  And the EU, China’s largest export market, probably won’t show much life for the next half-decade.

2.  keeping the currency peg means more or less mirroring US monetary policy, which is now calibrated for an economy in intensive care, not one in full bloom.  Keeping the local currency in sync implies maintaining domestic monetary policy that’s much too loose.

In addition to this, there are signs in China that, at least on the more heavily industrialized east coast, it is running out of the cheap labor needed to fuel the export-oriented development model.

reorienting growth

For all these reasons, I think the new Chinese leadership is going to make a substantial effort to re-orient growth away from exports to the US and EU (where there’s little growth to be had).   Exports will continue to go to other developing nations.

The two other areas for development are the domestic service economy and higher value-added manufacturing.  In free-market economies, forces of the status quo (labor-intensive exports) typically use their substantial political clout to stifle progress here.  And there are certain to be similar efforts made in China.  But Party control of the Chinese economy suggests the status quo will be less successful.

investment implications

If this shift in priorities is underway, and is successful, the biggest winners will be suppliers of products and service for average Chinese consumers. Luxury goods will continue to do well, I think, but mass-market products will do better.  The trick will be finding ways to play them.

On the other hand, suppliers of export-oriented industrial machinery–to some degree domestic, principally overseas-based–to Chinese firms seem to me to potentially be the biggest losers.  (We may already be seeing this phenomenon in 3Q12 earnings results and in management guidance.

AAPL: problems of size

October 9, 2012 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Position sizes, Securities regulation, Stock ideas Tags: , , , , , , Leave a comment

the behemoth

APPL shares now make up about 5% of the capitalization of the S&P 500.  A single share of AAPL sells for over $600.  Both characteristics present headwinds for AAPL’s performance, in my view.  The latter is a minor one, the former somewhat more serious.

Let’s start with the stock price.

the round lot syndrome

Individual investors in the US prefer to buy shares in round lots, normally 100 shares.  A generation ago, when the commission on odd lots (anything less than a round lot) was higher than for round lots, this made a modicum of sense.  Not so now, when flat $7 or $8 commissions are the norm for any number of shares bought or sold through discount brokers.

Professional investors, who think in terms of dollar amount rather than share count, don’t have this hangup.

Nevertheless, the psychological allure to individuals of buying 100 shares remains, as well as the stigma attached to purchasing 8 or 27 or some other “strange” amount.  And the reality is that AAPL has to a large extent been driven by individuals.  For investors unwilling to commit $60,000+ to one stock, then, AAPL shares are priced out of their reach.

a stock split?

There’s a simple, practical solution to this issue.  AAPL could have a stock split, something it did in 1987, 2000 and 2005.

My guess is that a 2:1 or 3:1 (or 10:1) split would add 10% to the stock price.

Why?  The shares would be more affordable to individuals with the round lot mentality.  In addition, the company would be signaling that it cares about its shareholders.

Why is AAPL hesitating?  Who knows.  My take is that management wants to be seen as obsessively focused on creating new products, not on catering to the whims of Wall Street.

professional investors’ position sizes

Growth investors in the US typically hold 50 or so stocks in their portfolios.  Their value counterparts usually have at least 100.  This means that for a professional growth investor, holding a S&P 500 index weighting in APPL requires making the position 2.5x the size he’s accustomed do.  For a value investor, a market weight for AAPL in the portfolio is a whopping 5x his average position size.

To be sure, all professionals have overweights–positions whose portfolio size exceeds the benchmark index weighting.  But these are usually a 3% or 4% position for growth investors, and 1.5% or 2% positions for value investors.

For almost everyone a 5% position is off-the-charts risky.  It’s conceptually very easy to underweight the name, but very hard to overweight it.

not a problem outside the US

Investors in non-US markets don’t have this psychological/operational problem.  Most other markets have at least one giant corporation whose weight can easily be 10% of the index.  Many times, it’s higher.

In most cases, the very large company is also very mature and slow-growing.   A typical strategy is to “neutralize” or equal-weight the stock in the portfolio (so that nothing the stock does will either harm of benefit the portfolio vs. the index) and attempt to make money elsewhere.

I suspect this is the tack US professionals are increasingly taking toward AAPL–equal-weight and forget.

the 5% rule

The 5% rule is an SEC-mandated diversification requirement for equity mutual funds.  It has two provisions:

1.  A manager can’t make a purchase of a stock that would cause the position size to exceed 5% of the fund assets.  This is only about buying.  There’s no need to reduce the position if it goes up a lot or if other positions shrink (which could happen either all by themselves or from the manager selling).  You just can’t add to a 5% position.

2. 25% of the portfolio is exempted from this requirement.  This exception is big enough to drive an 18-wheeler through.  The manager can basically do anything he wants in one-quarter of the portfolio, but is bound by the 5% rule for the rest.

Psychological issues aside, this should leave lots of room for mutual fund managers to hold a ton of AAPL. While that’s true, the other side of the coin is that the SEC has in effect linked prudent investing with having positions that are 5% of assets or smaller.  Bigger is bad.  Plus, the actual 5% rule sounds weird and is hard to explain.

The result has been that the idea of having no positions bigger than 5% has leaked into fund operating and monitoring procedures.  It’s also become part of the descriptions of investment process given to potential investors.  And it’s also in contracts with institutional investors (I don’t know how widely, though).  So the manager may be buying a lot of headaches if he continues to grow his AAPL position.

to sum up

AAPL can fix the round lot issue.

On the position size score, old habits die hard.  The 5% size is institutionalized as a maximum.  No one wants to rewrite contracts, primarily for fear the client will also want to rewrite the fee structure downward.

I don’t think any of this means AAPL will necessarily be a bad stock, either.  But I do think we’re at the point where the tailwind of professional investors having to build AAPL positions or else underperform is changing into a headwind caused by the stock’s large size.

There’s stuff AAPL can do to address this issue, too, but let’s see a stock split before taking up that topic.

GRPN, ZNGA, FB: what were the underwriters thinking?

October 4, 2012 By in Current Market Thoughts, Greater Fool theory, Securities regulation, Strategy Tags: , , , , , , Leave a comment

I’ve been writing over the past couple of days about Groupon and Zynga, stocks I consider prime examples of the Greater Fool theory in action.  GF answers the question of why any investors, particularly professionals, would buy shares of either  offering, given the obvious flaws in their operating models.

Let’s take the other side of the coin today.

Why would anyone want to put his firm’s name on the red herring as a sponsor/seller of merchandise like this?

More than that, in both the GRPN and FB cases, the companies submitted initial S-1 registration statements to the SEC that the regulator rejected.  GRPN tried to define a new kind of operating “profit” that excluded major cost elements.  FB didn’t mention that its high-earning US and European businesses were being hurt dramatically by users’ shift from access by computer to smartphones.  Why would underwriters take the reputational damage that comes with encouraging/condoning such behavior?

The reason not to push these names, or to try to paper over problems, is obvious:

the stocks in question were arguably overpriced, with nowhere to go but down.  Money management clients would lose money by buying them.  This would make them unhappy, endanger their careers and generally weaken the bonds of trust that tie them to the underwriters.  The flow of commission money to the underwriters would decline.

Also, in my (long) experience, such anti-money manager behavior is highly unusual.  In fact, the only parallel I can come up with is the waning days of the 1980s junk bond market, when very weak offerings were the order of the day.  (To be clear, I don’t believe that anything like the unhealthy and unethically close relationship between Drexel and key junk bond fund managers exists today.)

So, why?

I have three thoughts:

1.  The underwriters–both the firms and the individual investment bankers–spent a lot of time and effort courting the companies.  Especially for the individual investment bankers, a payoff on this investment was much more important than maintaining good relations with money management clients.

2.  Their unusually anti-money manager behavior implies to be that creating successful (read: very high-priced) debuts for GRPN and ZNGA were do-or-die events for the fortunes of the tech bankers involved.  They apparently saw no percentage at all in considering how money managers–or individual investors–would be hurt by subscribing for the issues.  It was okay for the issues to crash and burn.  Therefore, no new social media IPOs are on the horizon.

3.  The bankers think the negative fallout on their business from these dud issues will be minimal.  Yes, some managers may lose their jobs.  So what,the bankers think  (read Liar’s Poker if you think this is too harsh).  The new guys won’t know what happened in late 2011.  Less starry-eyed portfolio managers will have short memories.  They won’t hold a grudge and will evaluate future issues on their merits, not on the present bad behavior.

 

Of these conclusions, I think the most interesting is the suggestion that social media IPOs are over for the foreseeable future.  But the series of dud offerings may also be harbingers of a more adversarial and confrontational attitude in the future between bankers and portfolio managers.

 

European money market funds–charging to hold your money?

September 6, 2012 By in Banks, Industry Analysis, Investment firms, Portfolio management, Recent Market Action, Securities regulation, Strategy Tags: , , , , , , , , , 1 Comment

That’s what the Financial Times suggests is about to happen, based on what the largest European money market fund managers have told them.

money market funds

Money market funds are a kind of mutual fund that specializes in holding very short-term government and corporate debt.  They became popular as a much higher-yielding, but safe alternative to bank deposits well over a quarter-century ago.  Although not insured by governments in the way bank deposits are, their investing operations are designed to preserve net asset value at a constant level.  That’s usually $1 or €1.  Interest is paid in new shares.

defending net asset value

Over their entire lifespan, there have been only a small number of incidents, involving a small minority of funds, where investors have received less than their initial purchase price when redeeming shares.  There have been cases–only a few–where funds have made imprudent investments stretching for yield.  But the financial conglomerates sponsoring the wayward managers have invariably made investors whole, typically by buying the dud paper at the initial purchase price.

today’s situation in the EU

Why is today any different in Europe?  Two reasons:

–the European Central Bank has recently reduced the interest rate it pays on overnight deposits from 0.25% to plain old zero.  And it says it might reduce rates further, meaning it will begin to charge banks for holding their money.

–the long-running EU debt crisis has created a two-tier structure of sovereign borrowers, haves and have nots.  Interest rates on short-term French and German notes are already negative (meaning you lend €1 to either country and get €0.995 or so back when the note comes due).  Yes, a money market fund can get a positive yield by lending to Spain or Greece, but only by taking on extra risk.  Also, once your clients learn what you’re doing, they’ll probably move their funds elsewhere.

A manager can, of course, think about buying longer-dated securities that do pay interest.  But he takes on interest rate risk by doing so.  Just as important, the fund’s charter will doubtless bar, or at least limit, such investments.

To sum the situation up, money market funds promise safety + a better yield than bank deposits.  In today’s EU, they can’t deliver both.

plans being considered

According to the FT, some fund sponsors are toying with the idea of keeping the net asset value constant, but charging the negative interest rate to accounts by decreasing the number of shares an investor holds.  Others appear to be considering levying charges in some form, but outside the fund, so that neither the asset value nor the number of fund shares will be affected.

bank accounts must be in the same situation

Given that money market fund managers are usually much more efficient than their bank counterparts, the banks themselves are likely beginning to lose money on savings accounts.  So it’s possible that in the stronger EU nations, banks will begin to charge customers a monthly fee to safeguard their money.

more than an oddity

I think the most important information to take from this discussion is that the money market fund sponsors don’t expect the situation to change any time soon.  If they thought that negative returns on government notes were a three- to six-month aberration, they might quietly suffer through the losses.

But they’re not.  They’re planning on the current situation being around for a long time.