paying for brokerage research

As part of an EU overhaul of the financial industry, the UK has recently concluded an inquiry into pricing practices for mutual fund and other products offered to individual investors.  Press commentary is that the good luck for an industry with a bewildering array of prices (much higher than in the US) and little link between cost and value is not having been referred to the law enforcement authorities for criminal prosecution.

One big issue has been “soft dollars,” that is, paying brokers higher than usual commissions in return for their research, or for trading machines, or even newspapers–items that customers generally believe (and rightly suppose, in my view) they are paying for through management fees.   …but no!

Asset managers have been proclaiming that this is a weighty and complex issue, that the don’t know how to proceed.  They’ve generally been gnashing their teeth.

To me, this is all somewhat comical.  For decades, firms that do business in the US have been following an SEC mandate to keep meticulous records of the amount of their soft dollar expenses and what is being paid for.   The general rule was that if you stayed in line with industry practice, meaning doing whatever Fidelity did, you’d be ok legally.  They know exactly what they’ve been doing.  Also, the EU inquiry (see the link above) has been going on for three years.

There are two real issues:

–there’s a lot of money at stake, and

–handling the potential outcry from customers when they realize they’ve been paying twice (management fee + soft dollars) for research expenses.

An example:

A mutual fund has $50 billion in assets.  It turns those assets over at the industry average of 50% per year.  That means $50 billion in buys and $50 billion in sells.

Let’s say: the average stock trades for $40; the soft-dollar markup is $.02 per share; and the markup is taken on 20% of all shares traded (maybe slightly high, but the math is easier).

So, the fund “service” includes giving up $10 million a year of customer money on brokerage commissions in order to get the management company free goods and services.  That’s even though they’re collecting something like $250 million in management fees from the same customers.

disclosure vs. restructuring

Internally, I think disclosure is the lesser of the two issues.  The more difficult one is that industry revenues are stagnant or falling and by far the largest expense of any investment manager is salaries.  So, whose pocket does the lost soft dollar revenue come out of?

Vanguard, this decade’s Fidelity

Just prior to the 2007 financial crisis, Fidelity decided to turn up the competitive heat on fund management rivals by declaring it was unilaterally going to stop using soft dollars.  This time around, it’s silent so far.

Last week, Vanguard made a similar announcement.


the French election, round 1: market reaction

As I’m writing this just after 8am est, the French stock market is up by about 5%, large-cap European issues are up 4%, the euro is up by 1%+ against the US$, and stock index futures show US stocks opening up about 1%.

This is all because yesterday’s first round of the French presidential election ended up pretty much as the polls had predicted.  Candidates with 5%+ of the vote, in their order of finish, are:

Macron          23.9%

Le Pen          21.4%

Fillon          19.9%

Mélenchon          19.6%

Hamon          6.3%.

Fillon, an experienced politician and candidate of the center-left, had been the early favorite, but was undone by a scandal involving no-show government jobs for family members that paid, in total, more than €1 million.   Fillon’s subsequent refusal to withdraw directly undermined the prospects for Macron, the centrist candidate, and gave life as well to Mélenchon, of the far left.

The market fear had been that, with the center/left vote split three ways, Marine Le Pen, the far right choice, might end up doing surprisingly well.  That worry was intensified by the Brexit vote, the Trump victory and a terrorist incident in France last week.

The stakes in this election are very high.  Le Pen’s key economic platform: leave the euro and repudiate French euro-denominated debt.  The euro would be replaced by a new franc, which would be rapidly devalued–à la Abenomics in Japan–in order to give the economy a short-term boost.  Repaying euro-denominated French government debt with francs would “solve” the problem of French national debt, but at the cost of destroying the country’s ability to borrow internationally in the future (think: Argentina).  Were the Le Pen agenda to be implemented, it’s not clear to me how the EU could survive.

The consensus view now is that the Fillon and Mélenchon votes will gravitate to Macron, giving him a large victory in the second round of the election, between Macron and Le Pen, on May 7th (and earlier version of this post had the incorrect date).  Let’s hope so.

We now have whole week until the potential US government shutdown over funding for the Trump-envisioned border wall with Mexico.







tallying up the cost of Brexit

How good is the UK, the part of the EU most American investors know best, as a way to participate in potential economic strength in Europe over the coming 12 months?

Probably not good at all.  Here’s why:

–since the Brexit vote last June, sterling has depreciated by 13+% against the US dollar and 8+% against the euro.  While the loss of national wealth in Japan through depreciation dwarfs what has happened in the UK, the blow to holders of sterling-based assets is still immense.

Depreciation lowers the UK standard of living and reduces the purchasing power of residents by raising the cost of imported goods.  While one might argue that the fall in sterling is in the past–and while the consumer will be in trouble benefits to export-oriented firms through lower costs are still to come–this may not be the case here.  More in point #3.

–there’s some evidence that UK residents, realizing last June that prices would soon begin to rise, did a lot of extra consuming before/while firms were marking up their wares.  If so, the UK economy could be in for a significant slowdown over the coming months, both because consumers are now poorer and because they’ve already used up a chunk of their budgets through anticipatory buying.

–much of the appeal of the UK as a destination for export-oriented manufacturing comes from its position as the large foreigner-friendly country in the EU, from which multinationals could reach into the rest of the union.  That’s no longer the case.  An article from yesterday’s Financial Times is titled ” Brussels starts to freeze Britain out of EU contracts.”  Its basis is an EU government memo, which, as the FT reads it, advises staff to:

–avoid considering the UK for any new business dealings where contracts may extend beyond the two year deadline for Brexit

–cancel existing contracts with UK parties that extend beyond the Brexit deadline

–urge UK-based companies to relocate to continental Europe, presumably if they want favorable consideration for new business.

It seems to me that the EU leaked this memo to the FT to get the widest possible dissemination of its new not-so-friendly-to-the-UK policies.  It implies that the post-Brexit business slowdown in the UK will start immediately, not in two years.

One set of potential winners:  UK-based multinationals that do little or no business with the EU.  These, like ARM Holdings, are also potential takeover targets–although it’s questionable if the UK will permit further acquisitions by foreigners.


Chinese economic growth

China, the largest economy in the world (by Purchasing Power Parity measurement), reported 1Q17 economic growth of 6.9% earlier today.  The best analysis of what’s going on that I’ve read appears in the New York Times.

The bottom line, though, is that this is a slight uptick from previous quarters–and good news for the rest of the world, since one of the big factors that is driving growth is exports.

Traditionally, the first question with Chinese statistics has been whether they attempt to represent what is happening in the economy or whether they’re the rose-colored view that central planning bosses insist must be shown, whatever the underlying reality may be.

I think this is a much less worrisome issue now than, say, ten years ago.  But in addition to greater faith in statisticians, we also have other useful indicators about the state of China’s health.  They’re all positive:

–As I wrote about a short while ago, demand for oil in China is rising.

–Last week, port operators reported an activity pickup, led by exports.

–And Macau casino patronage, which bottomed last summer, is showing surprising increases–with middle class customers, not wealthy VIPs, in the vanguard.

While I think that consumer spending in the US is probably better than recent flattish indicators would suggest (on the view that statistics are catching all of the pain of establishment losers but much less of the joy of new retail entrants), my guess is that increasing export demand for Chinese goods is coming from Continental Europe.

More tomorrow.

the EU today: structural adjustment needed

Let’s assume that my description of the EU ex the UK is correct–that beneficiaries of the traditional order (the elites) are, and will continue to be, successful at thwarting structural change that would rock tradition but produce higher economic growth.

How should an equity investor proceed?

There are two schools of thought, not necessarily mutually incompatible:

–the first is that in an area where there is little growth, companies with strong fundamentals will stand out even more from the crowd.  This lucky few will therefore gain much of the local investor interest, plus the vast majority of foreign investor attention.  If so, in places like continental Europe or Japan one should look for fast-growing mid-cap companies with global sales potential for their products and services.  These will almost certainly outperform the market.

The more important question for an equity investor is whether they will do as well as similar companies domiciled and traded elsewhere.

–my personal observation is that the general malaise that affects stock markets in low-growth areas like Japan or the EU infects the fast growers as well.  The result is that they don’t do as well as similar companies elsewhere.  I haven’t tried to quantify the difference, but it’s what I’ve observed over the years.

It may be that the local market is offended by brash upstarts.  It may be that local portfolio managers deal only in book value and dividend yield as metrics.  It may simply be the fact that local laws prevent owners from eventually selling to the highest bidder, thereby damping down the ultimate upside for the stock.  One other effect of a situation like this is, of course, that entrepreneurs leave and set their companies up elsewhere.


The bottom line for a growth investor like me is that these areas become markets for the occasional special situation, not places where I want to be fully invested most of the time.  Because of this, and because of Brexit, the UK assumes greater importance for me.  So, too, Hong Kong, as an avenue into mainland China.  And to the degree I want to have direct international exposure–which means I want to avoid the US for whatever reason–emerging markets also come into play.


A final thought:  one could argue that the lack of investment appeal I perceive in Japan and continental Europe has nothing to do with political or cultural choices.  Both areas have relatively old populations.  If it’s simply demographics, signs of similar trouble should be appearing in the US within a decade.  I don’t think this is correct, but as investors we should all be attentive to possible signs.


internal/external adjustment and the EU

Yesterday I wrote about the tools a country has available if it faces a combination of sluggish GDP growth, excessive borrowing/weak banks and non-competitive industry (processes are outmoded and costs are too high).  Greece is the poster child among EU countries   …but Italy is the major EU economy that this description calls to mind.  France is riding a compartment or two away.

What can an EU country whose economy is structurally out of balance do?

Well, external adjustment–meaning currency depreciation–is out, since it’s part of the euro.

That leaves internal adjustment, which can take three forms:

–tariff or other regulatory barriers.  Yes, the EU can, and does, erect barriers to protect local industries against imports.  But most EU countries trade more with each other than the outside world.  So, say, Italy can’t bar imports from super-competitive Germany or lower-cost eastern Europe.

–slowing the borrowing, which is intended to maintain the current (unsustainable) lifestyle, by raising interest rates in a way that will cause a recession.  This is the German “austerity” solution, which few, if any, other countries (nor any politicians concerned about being reelected) will willingly adopt.  The EU experience after the 2008-09 recession shows austerity doesn’t work particularly well, either.

–that leaves structural reform.

This gets me to why I started writing about this.  Paul Krugman recently reviewed a book I haven’t read, The End of Alchemy, by  the former head of the Bank of England, Mervyn King. In the review, found in the New York Review of Books, Krugman says of King:

“He argues that Europe’s imbalances in production costs and hence in trade are too large to be resolved without either abandoning the euro or moving to full political union, and that given the lack of will for the latter, the former it must eventually be.”

What grabbed me is the “imbalances in production costs” part.   In other words, despite almost two decades of having the euro, plus all the time before its debut when companies knew it was coming, inefficient EU countries have done very little to bring their production costs down.  In addition, the reason Mr. King gives for this is “the lack of will.”  In other words, the forces of the status quo, aimed at preserving local fiefdoms (both political and industrial), are so strong that no progress can–or will–be made.

Sounds a lot like Japan, with a twenty-year lag.

Tomorrow:  investment consequences, if the King/Krugman analysis is correct.



Brexit looming

Voting takes place a week from today in the UK on the question of whether the country should remain in the EU or leave.

If the vote is in favor of Brexit, the government will presumably inform Brussels of its intention to depart, which will start the clock on a two-year waiting period before Britain can officially withdraw.

Recent polls have begun to show for the first time that a majority of citizens favor severing ties with the EU.  This is the reason for recent weakness in London stocks.

My thoughts:

–polls on issues like this are notoriously unreliable.  Some are either tacitly or overtly political, with question design (on the order of “You do favor leaving the EU, don’t you?”) slanted to one side or the other.  As far as internet surveys go, it’s impossible to know whether the respondents are a representative sample of likely voters.  During in-person, and especially during phone, interviews, respondents often tend to be less than truthful, giving instead what they perceive to be expected responses

–Pro voters, who seem to think that exiting the EU will return Britain to its eighteenth-century glory, are delusional

–the two-year waiting period gives both sides time to renegotiate trade agreements (almost half of Britain’s exports are to the rest of the EU).  It’s reasonable, I think, to assume that new agreements will be less favorable than the current ones.  But it’s hard to know whether they’ll make a significant practical difference

–non-EU multinationals who have located operating divisions and general headquarters in the UK because of its being inside the EU will presumably begin to shift operations elsewhere (Ireland?)

–as far as portfolio investors like us are concerned, the main direct economic effect of Britain leaving the union will likely be the weakening of the currency that’s happening now.  So far there has been no counterbalancing positive movement by stocks where the costs incurred by the underlying companies are primarily in sterling but where revenues are in euros or dollars.  Such firms, however, should be star performers if the vote is for Brexit and as the currency stabilizes.


My conclusion:  prepare to buy multinationals traded in London on a further selloff that will likely occur if the vote next week is for Brexit.