Category Archives: Vocabulary

insider trading, hedge funds, expert networks and skilled securities analysis (ll)

November 24, 2010 By in Current Market Thoughts, hedge funds, insider trading, soft dollars Tags: , , , , Leave a comment

In yesterday’s post, I wrote about what insider trading and expert networks are.

Why have expert networks flowered over the past decade and been especially favored by hedge funds?

hedge funds

When I started working in the stock market in 1978, it was common for both brokerage houses and large institutional investors in the US to have extensive staffs of analysts.

As the sell side continued to rebuild itself and improve its analytic capabilities after the 1973-74 recession, buy side firms worked out that they could save money by shrinking their own staffs and rely on brokerage house research instead.  Better still, from their point of view, they could pay for access to the brokers’ analysts through commission dollars (“soft dollars”), a tab picked up by money management clients, rather than paying analysts’ salaries out of the management fees clients paid them.

Control of brokerage firms gradually passed into the hands of traders, who regard research as a cost center that produces no profits.  They did what seemed the obvious thing to do and began to lay off analysts.  During the Great Recession of 2008-2009 the steady trickle of layoffs became a torrent–and gutted the major brokers’ analysis capabilities, particularly in equities.

The professional disease of analysts is that they analyze everything, including their own jobs.  Senior people have long known that they’re vulnerable in a downturn, especially since they all are compelled to have assistants who earn a small fraction of what they do–and who can sub for them in a pinch.  Their response?  –in many cases, the senior people hire assistants who look good in business attire and can present well to clients, but who have limited analytic abilities.  As far as I can see, this defense mechanism protected no one during the fierce downturn recently ended.  It may be harsh to say, but “place holder” assistants may be all that’s left in some research departments.

If the cupboard is pretty bare in brokerage house research departments, do hedge funds build their own?

Some have.  But–and this could be nothing by my own bias–a lot of hedge funds are run by former brokerage house bond traders.   Traders and analysts are like the athletes and the nerds in high school.  Very different mindsets.  So hedge funds that are run by traders, and that have a trading orientation, don’t have the temperament or the skills, in my opinion, to build research functions of their own.  They also want information that’s focused strongly on the very short term.  (Is it a coincidence that the subjects of the recent FBi raids are all run by former bond traders?)

They can’t get it from brokers.  They can get it from independent boutique analysts.  But were better to get information about, say, the upcoming quarter for Cisco than from a Cisco employee visiting as part of an expert network.

securities analysis

I wrote yesterday about the immense amount of information publicly available to a securities analyst.  In the US, companies are required to make extensive SEC filings, in which they report on the competitive environment, the course of their own business and the state of their finances.  Some firms hold annual analysts’ and reporters’ meetings–sometimes lasting several days–in which they try to explain their firms in greater detail.  There are trade shows, brokerage house conferences on various industries and–in many cases–specialized blogs that discuss industries and firms.  Publicly traded suppliers, customers and the firms themselves hold quarterly conference calls, in which they discuss their industries and their results.  The internet allows you to reach competitor firms around the world.

Companies also have investor relations and media departments that provide even more information for those who care to call.  Many times these departments also organize periodic trips to major investment centers to meet with large shareholders and/or with large institutional investors.  The talking points for these trips are scripted in advance.   My experience is that the company representatives attempt to create the impression that questioners in the audience have penetrating insights and are forcing the company to answer tough, and unusual, questions.  And people on my side of the table are usually more than happy to believe that this is true.  But in reality the companies tell basically the same things to everyone.

Still, the idea that anyone who obtains inside information is “infected” by it and becomes a temporary or constructive insider as a result has made profound changes, I think, in the way companies and analysts interact.

Let me offer two examples:

1.  In my early years, I ended up covering a lot of smaller, semi-broken companies that senior analysts didn’t want.  It’t actually a great way to learn.  Anyway, I had been talking regularly for about a year with the CEO of a tiny consumer firm that was flirting with bankruptcy.  This CEO was understandably downbeat and our talks were rather depressing.

Then rumors began to circulate that a Japanese firm was interested in buying the firm at a high price (in reality, anything greater than zero would have been a high price).  I called the CEO a couple of days later to prepare for my next report.  He was very cheerful, didn’t have a care in the world, actually joked his way through my questions.  I didn’t need to ask about the potential takeover.  His whole demeanor told me that the rumors were true.

Did I have inside information?  Twenty years ago, the answer would have been no.  I was just a skilled interviewer drawing inferences from the conversation.  Today, I don’t  know.  I suspect the answer is yes.

2.  I’m in a breakout session with the CFO of a company which has just presented at a brokerage house conference and is answering follow-up questions from analysts in a smaller room.  Someone raises his hand and says that for a number of reasons he thinks this quarter the firm will miss the earnings number it has guided analysts to.  He requests a comment.  Most people know the questioner–or at least can read his name badge.  He comes from a hedge fund that is rumored to be short the company’s stock.

The CFO clears his throat, takes a sip of water and says there’s no reason to think the firm won’t easily make its guidance.

I’ve known the CFO for a few years.  He only clears his throat and sips when he’s getting ready to say something that’s technically true, but is misleading  –in other words, a lie.

Do I have inside information.  Again, years ago the answer would have been no.  Today, I’m not sure.  If this were a private meeting with the CFO, I think it’s likely that I’ve got inside information.  But is a breakout session public disclosure?  Does it make a difference if the session is televised, so everyone can see what the CFO is doing?

My uncertainty changes my behavior.  How?

I probably no longer want a private meeting with top management of a company.  I probably don’t want the company to comment on my earnings estimates, or to give any indication that a non-consensus estimate I may have could be right.

I have to rely more on my independent judgment.  I want to be wary of any interaction with company management.  I don’t want any “help” with my estimates (not that I need any).

This is actually good news for individual investors, because the playing field between them and professional analysts has been leveled significantly.


measuring equity performance using style indices: growth vs. value

November 15, 2010 By in Basic Concepts, growth vs value, Portfolio management, style indices Tags: , , , Leave a comment

value vs. growth

It’s been my strong impression that in the US market growth stocks have outperformed value stocks this year.  I get that impression, among other things, from looking at my own portfolio (remember, I’m a growth investor).  This wouldn’t be surprising, since in a typical business cycle recovery value stocks outperform strongly in the first year.  But as pent-up demand is gradually satisfied and the economy slows a bit, growth stocks typically take over market leadership.

IWD vs. IWF

But I know I look mostly at growth stocks.  So I thought I’d check the IWD and IWF ETFs.  These are securities that track the Russell large-cap value and growth stock indices, respectively.  They show a neck-and-neck battle until the past couple of months, when the growth index pulls out in front.

Indices like these are the best we have.  And from a practical money management perspective, if a client were to hire me as a money manager and specify the Russell 1000 Growth Index as my benchmark, it would be simple enough to construct a portfolio whose under- and overweights would be geared to that index.

how good are style indices?

But are such indices really good representations of the relative performance of growth and value stocks?   Not so much.  The reason has to do with the academic tilt to their construction.  To be honest, I don’t have a better solution.  And as you’ll see in a moment, the way the growth index is composed may give a manager benchmarked against that index a slight performance advantage.  So I’m sure these style indices are here to stay.  You just have to remember that the growth index in particular has some drawbacks.

Here’s what I mean.

The idea of style indices has its genesis in the reasonable question, posed by academics, as to whether either a value discipline or a growth investing discipline has an inherent advantage over the other.  Their method was to divide a stock index with broad market coverage, like the S&P 500 or the Russell 1000 into value and growth components and then study the relative performance of the two.

constructing a style index

They proceeded as follows:

1.  They defined value stocks, reasonably, as those with some combination of low price to book (or net asset value), low price to cash flow, and low price to earnings.

2.  Using various weightings of these three factors, or other similar ones, they constructed a ranking of index constituents that ordered them from being the most value-like (scoring the best on the value stock variables) to the least.

3.  Using this list, they (usually) took the half exhibiting the best value characteristics and called it the Value sub-index.  They called the other half of the list the Growth sub-index.

4.  They compared the performance of the two sub-indices.

Looking at the relative performance of the sub-indices over time is itself interesting:  until the Nineties, relative outperformance of either style is short-lived.  Starting in the recovery of 1992, however, Growth and Value each have multi-year periods of significant outperformance.

The overall academic conclusion, supported by the sub-indices, is that Value trumps Growth over long periods of time.

the error in logic

The academics make two assumptions that have no factual, or logical for that matter, support.

–They assume that every stock can be characterized either as growth or value.  This allows them to define growth as being what’s left over when value stocks are separated out.  hey don’t consider that there may be a set of “clunkers,” or stocks no one in his right mind would touch (even though there’s research showing that bad-performing stocks persist in underperformance far longer than good stocks in their outperformance).  They all get tossed into the growth pile.

–They assume that the growth stock universe and the value stock universe are mutually exclusive–that growth investors somehow refuse to buy fast-growing companies unless their price-earnings multiples were already high.  That would be crazy.  At the beginning of this year, for example, AAPL–a classic growth stock–was trading at 10x earnings, with no debt and cash making up a quarter of its market value.  Has AAPL been a growth stock for the past five years?  Yes.  Has it been a value stock, too?  Yes, again.  But which sub-index is it in?  Depending on how a particular style index is constructed, it could be either.

Of these two errors, I think the first is the more serious.  My suspicion is that the supposed underperformance of a Growth sub-index is because of the presence of clunkers.

Why don’t growth investors make more of a fuss over their investing style being maligned?  I think it’s the same reason why professional investors don’t make a fuss about many of the other crazy, erroneous things taught about investing in business schools.  Why invite more competition?

 

 

 

 

Basel III and trade finance

November 10, 2010 By in Asian economic development, Banks, China, economics, emerging markets, Hong Kong, Industry Analysis, trade finance Tags: , , , , , , , Leave a comment

A heated lobbying effort is underway to change the way that the new comprehensive banking regulations, known as Basel II, propose to deal with trade finance.  It’s being led by Asia-centric banks like Standard Chartered and HSBC, for whom this sort of relatively low-risk lending has been a staple for a long time.

Under present rules, banks have to provide reserves against trade credit advanced to customers that are equal to 20% of the outstanding amount.  Basel III proposes to up that to 100%.

This is an important issue.  Globalization and the resulting growth in trade have been main pillars of the increase in worldwide prosperity of the past several decades.  Standard Chartered says the new rules, if implemented in their present form, would depress world trade by 2%, and clip a half-percent from global GDP.  Presumably things would be considerably worse for HSBC and Standard Chartered.

how trade credit works

Let’s say Very Big Department Store of San Francisco orders 50,000 pairs of blue jeans at $5 each from Great Wall Blue Jeans of Shanghai.

When the contract is signed, Great Wall asks Very Big to have VB’s bank send a letter of credit to GW’s bank, the Hong Kong branch of the Bank of China.  VB goes to its bank, Bank of America, to have BA issue the letter.

The letter is normally irrevocable.  In it, BA tells the Bank of China to pay GW $250,000 when GW presents proof specified in the letter–usually a bill of lading from the shipping company handling transport of the order–that the order is complete and the goods are under way.  BA also promises to reimburse GW immediately.

Based on the signed contract or on the letter of credit, Bank of China will most likely be willing to make a working capital loan to Great Wall, if needed, to finance the manufacture of the jeans.

So, BA and BC both collect fees associated with the letter of credit.  Both may also make working capital loans to their customers, to finance, respectively, the purchasing and the making of the jeans.  The banks’ risk exposure is of short duration.  Assuming that both Great Wall and Very Big are well-known customers, the chance of anything going wrong with the transaction is remote.  This is plain vanilla, everyday low-risk business (other than at times of historically high stress, like the recent financial crisis, when this business completely dried up).  But it’s also very profitable.

my thoughts

It seems to me that the Basel III rules have to change.  But it’s something to keep an eye on.  The obvious losers were the proposed rules to stay as they are now are the trade finance-oriented banks.  But I don’t think this is the main issue.  If China or Brazil go from 8% growth to 7.5%, no one will really notice.  But neither the US nor (especially) the EU are likely to have enough extra economic energy that they can shrug off the loss of .5% in expansion.

bondholders’ responsibility for banks: contingent convertibles and Anglo Irish Bank

October 29, 2010 By in Banks, hybrid bonds/contingent convertibles, Industry Analysis, Securities regulation Tags: , , , , , Leave a comment

Europe seems to want to change the culture of their banks and bondholders from one of “gentlemen’s understandings” that governments and equity holders will suffer all the pain in the case of bank failure to one where legal and covenant obligations will be enforced–meaning bondholders, too, will participate financially in bank restructuring.

One vehicle being pushed in the contingent convertible, an instrument that I’ve regarded as a top-of-the-market gimmick that looks good on paper but has the potential to end in tragedy.  European governments appear to be pushing it as a concept, however, because COCOs spell out explicitly what the bondholders’ obligations are in case the issuer has difficulties.  There’s no room for negotiation, no ability for a politically connected holder to put pressure on the bank regulator to take a soft stance on a certain tranche of bonds.

Europe appears to me to be taking this new attitude a giant step farther in the case of debentures of the failed Anglo Irish Bank, a property-oriented institution that proved to be a monument to opacity in lending.

The Irish government is offering to issue new, Dublin-guaranteed, bonds to holders of about €3 billion of various tranches of AIB debentures.  The rate of exchange would be: 1€ of the new issue for every 5€ of the old debt.  Holders of the affected AIB bonds, many of whom will, I think, prove to be hedge funds that bought in the secondary market after AIB failed, have squawked.  Their expectation apparently was to receive new bonds at something more favorable than a 4/1 rate.

Voting on the Dublin/AIB proposal will take place in December.

None of this is too surprising.  The rest of the government’s plan is, however.

According to the Financial Times, Dublin also wants accepting bondholders to agree to change the bonds’ covenants to provide that any holders who do not accept the offer will be forcibly redeemed at .001% of par–basically nothing.

Again, according to the FT, a result in favor of the exchange at the initial meeting requires that holders of two-thirds of the bonds vote and the 75% or more of the votes say yes.  If less than the required two-thirds attend the initial meeting, a second can be called at a lower quorum level.

Bloomberg says that investment bank Houlihan Lokey, representing a large enough proportion of the affected bondholders to defeat the proposal, intends to vote no.  The Irish legislature has also chimed in, suggesting it will pass a law allowing the exchange to occur without regard to the vote results, should bondholders reject the offer.  Houlihan Lokey apparently wants to negotiate with AIB, but the bank has refused.

This should be interesting.  Stay tuned.

liquidity trap: what is it? are we in one?

October 18, 2010 By in Current Market Thoughts, economics, liquidity trap, Recent Market Action, Strategy, Vocabulary Tags: , , , , , , Leave a comment

liquidity trap

Over the weekend, Charles Evans, president of the Federal Reserve Bank of Chicago, said at a Fed conference in Boston that he thought the US is in a “bona fide liquidity trap.”  His prescription to cue this situation:  a second round of quantitative easing (basically, the Fed trying directly to push down longer-term interest rates) plus inflation-level targeting (promising to continue loose money policy until inflation reaches 2%).  The purpose of the second is to try to assuage fears of deflation by money market participants.

What does all this mean?

what it is

When the Fed, or any central bank, lowers short-term interest rates, the move has a whole series of effects:

–the initial move signals that the short-term direction of policy is reversing;  the money authority wants to encourage faster economic growth, not slow down inflation

–lower returns on savings instruments tied to short-term rates encourages people to spend money rather than to leave it in the bank

–lower rates on lending money tend to encourage consumers to borrow to finance consumption;  to the extent that younger people tend to be borrowers and senior citizens savers, economic power undergoes a demographic shift that puts money in the hands of those more likely to consume

–arbitrage extends the lowering of rates to longer-maturity debt instruments; lower long-term rates make company investment projects more economically attractive and thus encourage spending on capacity expansion and new hiring.

You can, in theory–and, looking at Japan over the past twenty years, in practice–envision circumstances where this process of lowering interest rates to stimulate economic activity won’t work.  That’s a liquidity trap.  The money authority lowers rates but gets no economic response.

Economists have, not always clearly, distinguished between two types of liquidity trap:

1.  deflationary, sometimes called the “zero bound” case.  The goal of accommodative money policy is to lower nominal rates until they are negative in real terms.  The idea is that once the saver realizes he is no longer even preserving his purchasing power by holding short-term deposits, he will boost his consumption and look for (riskier) investments where he can earn a positive real return.

But nominal rates can in practice only be reduced to zero.  If prices are falling (which is what deflation is), real rates stay high despite the best efforts of the money authority.  If prices are dropping by 3% a year, for example, a zero nominal rate is a 3% real rate.  As a result, savers don’t budge.

There have been instances of negative nominal interest rates–like in Hong Kong in the late 1990s, when the government there announced plans to charge a recurring fee to foreigners for holding bank deposits.  But they’re a practical impossibility.

2.  a “true” liquidity trap, or “pushing on a string.”  The idea is that a point might be reached where central bank action in pumping ever larger amounts of money into the economy would have no further positive effect.  The economy would, in a sense, be saturated with money.  The original thought was that interest rates would remain above zero but would not decline further, despite the efforts of the central bank to push them down.  But the idea can easily be expanded to include other cases where money polity is ineffective:  the transmission mechanism may break down if economic entities are frightened and want to hold precautionary balances even though they earn no economic return; or there may be enough regulatory or government policy uncertainty that it’s hard to identify viable projects to invest in.

where we are now

In the US, inflation has been running at about 1% over the past year or so.  The sharp decline in the dollar over the past several months suggests that, if anything, inflation will rise a bit as we head into 2011.  So, although policy makers and economists may fear deflation, we’re not in that situation today.  That means type #1 above doesn’t apply to us.

There’s a lot of liquidity sloshing around in the US–in the whole world, for that matter.  Several private companies have been able to borrow money at a fixed rate for fifty years or more.  Mexico, despite its history of economic meltdowns and its internal political difficulties, has recently successfully issued a hundred year fixed-rate bond.

This leaves us with breakdown in the transmission mechanism as the reason why money policy has become ineffective.

Mr. Evans of the Chicago Fed seems to think that fear of deflation is the main problem, or at least that’s what his remedy of in effect having the Fed promise to create 2% inflation suggests.  Other economists lack of enthusiastic support suggests his is a lone voice.

This leaves the possibility that attractive investment projects are hard to find.  In a recent speech, the head of the Minnesota Fed, Narayana Kocherlakota, suggested that the gating factor may be lack of skilled workers.  The sound bite the press picked up was his observation that the Fed has no ability to turn construction workers into machinery workers.  He also pointed out that Bureau of Labor Statistics data indicate the economy has about 800,000 more unfilled jobs now than it did in March 2009.

It’s also at least a logical possibility that uncertainty about medical care costs or about future taxes is at the root of companies’ reluctance to invest domestically.  Given that the Fed members are political appointees, though, I think there’s a pragmatic limit to what they’re willing to say in print.  To me, however, it’s clear the Fed thinks a dysfunctional congress and an ineffective president are the reasons the current liquidity trap persists.

I think adjustment to the new economic circumstances is already taking place.  Lack of effective regulation and supportive legislation will just mean the transition process is a longer one.