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.

 

 

reading financial newspapers

When I began working as a securities analyst, I noticed that my more experienced colleagues–and especially the most accomplished–had a peculiar reading habit.  They might glance over the front-page headlines and skim the articles.  But they spent most of their time in the back half of the paper, studying smaller pieces about more obscure economic developments or about small-cap companies.

Why do so?

reading back to front

Their idea, which I quickly adopted, was that the headlines dealt with well-known topics, whose importance was most likely already fully factored into stock prices.  The most important thing for an analyst, on the other hand, is to uncover information that is not yet discounted.  That means, of course, going beyond newspaper coverage.  But as far as the newspaper as a source of new ideas is concerned, it means reading the back half much more carefully than the front.

I, too, soon began reading the paper from back to front.

curation

In the online world, that’s hard to do, for two reasons:

–during the day, stories are constantly being rearranged, with the most-read (arguably the least valuable for us as investors) being pushed forward to the beginning pages and the least read gradually fading further and further back.  In addition,

–there’s no easy way to jump to the back of the queue, where the potentially financially valuable news should be increasingly piling up.

physical paper vs. online

The easiest way I’ve found to deal with the problem of online curation is to read the physical paper instead.  However, that isn’t always possible.  Luckily, if you hunt around on major newspaper websites, you can find an option that lets you read the news in the form the original editors laid it out for the physical paper, that is, without curation.  To my mind, that’s not as good as jumping directly into the stuff few people are paying attention to.  But it’s better than having to wade through the larger piles of non-investable stuff that the online edition creates as a “service” to us.

 

the demise of soft dollars

This is the first of two posts.  Today’s lays out the issue, tomorrow’s the implications for the investment management industry.

so long, soft dollars

“Soft dollars” is the name the investment industry has given to the practice of investment managers of paying for research services from brokerage houses by allowing higher than normal commissions on trading.

Well understood by institutional, but probably not individual, clients, this practice transfers the cost of buying these services–from detailed security analysis of industries or companies to Bloomberg machines and financial newspapers–from the manager to the client.  In a sense, soft dollars are a semi-hidden charge on top of the management fee.

In the US, soft dollars are reconciled with the regulatory mandate that managers strive for “best price/best execution” in trading by citing industry practice.  This is another way of saying:   whatever Fidelity is doing–which probably means having commissions marked up on no more 15%-20% of trades.

In 2007, Fidelity decided to end the practice and began negotiating with brokers to pay a flat fee for research.  As I recall, media reports at the time said Fidelity had offered $7 million in cash to Lehman for an all-you-can-eat plan.  Brokerage houses resisted, presumably both because they made much more from Fidelity under the existing system and because trading departments were claiming credit for (and collecting bonuses based on) revenue that actually belonged to research.

theWall Street Journal

Yesterday’s Wall Street Journal reports that the EU is preparing to ban soft dollars in Europe for all investment managers, including hedge funds, starting in 2017.

not just the EU, however

Big multinational money management and brokerage firms are planning to implement the new EU rules not just in the EU, but around the world.

Why?

Other jurisdictions are likely to follow the EU’s lead.  Doing so also avoids potential accusations of illegally circumventing EU regulations by shifting trades overseas.

soft dollars in perspective

in the US

Let’s say an investment management firm has $10 billion in US equities under management.  If it charges a 50 basis point management fee, the firm collects $50 million a year.  Out of this it pays salaries of portfolio managers and analysts, as well as for research travel, marketing, offices… (Yes, 12b1 fees charged to mutual fund clients pay for some marketing expenses, but that’s another story.)

If the firm turns over 75% of its portfolio each year, it racks up $7.5 billion in buys and $7.5 billion in sells.  Plucking a figure out of the air, let’s assume that the price of the average share traded is $35.  The $15 billion in transactions amounts to about 425 million shares traded.  If we say that the manager allows the broker to add $.03 to the tab as a soft dollar payment, and does so on 20% of its transactions, the total annual soft dollars paid amount to $2.5 million.

foreign trades

Generally speaking, commissions in foreign markets are much higher than in the US, and soft dollar limitations are    …well, softer.  So the soft dollar issue is much more crucial abroad.

hedge funds

Then there are hedge funds, which are not subject to the best price/best execution regulations.  I have no practical experience here.  I do know that if I were a hedge fund manager I would care (almost) infinitely more about getting access to high quality research in a timely way (meaning ahead of most everyone else) than I would about whether I paid a trading fee of $.05, $.10 (or more) a share.

We know that hedge funds are brokers’ best customers.  Arguably, banning the use of soft dollars–enforcing the best price/best execution mandate–with hedge funds would be devastating both to them and to brokerage trading desks.

translating soft dollars to hard

When I was working, the accepted ratio was that $1.75 soft = $1.00 hard.  I presume it’s still the same.  In other words, if I wanted a broker to supply me with a Bloomberg machine that cost $40,000 a year to rent, I would have to allow it to tack on 1.75 * $40,000  =  $70,000 to (the clients’) commission tab.

 

Tomorrow, implications of eliminating soft dollars

 

 

 

 

 

 

securities analysis in the 21st century: fifty years of changes

Fifty years ago, the financial services industry in the US was a backwater, somewhere people went to work if they couldn’t find a job elsewhere.  But powerful changes were on the cards.  Americans were becoming wealthy, at least in part because the country’s industrial base was the only one in advanced economies left standing after World War II.  And they were developing an appetite for stocks.

reasons for rapid growth of financial services during 1970-90

–the maturing of the Baby Boom

–1974 ERISA legislation, which more or less compelled companies to hire competent third parties to manage their employees’ pension assets

–ERISA also established IRAs

–1978 tax legislation established 401ks

–the rise of discount brokers and no-load funds (even in the 1980s, load funds charged purchase fees of up to 8%) that made investing cheaper and easy

–the crash of 1987, which, I think, caused a fundamental shift by individual investors away from traditional brokers and individual stocks, to mutual funds

–a shift in the 1990s, motivated by wanting to reduce their legal liability, by traditional brokerage houses to convert brokers from “stock jockeys” into salesmen of packaged products like mutual funds

The result of all this was the spectacular rise of the money management industry during the second half of the last century.

seeds of decline

–downward pressure on commission rates

ERISA requires that when money managers transact, they obtain the best execution (buying/selling price) as well as the lowest transaction cost.  As technology developed, this meant that trading rooms had a legal obligation to use electronic crossing networks (“dark pools”) instead of routing orders through traditional brokers. Fidelity was a leader in this.

The move also had the positive side effect of denying brokers to opportunity to use client trading information for their own benefit–either by trading on it themselves or by blabbing about it to other money managers.

–questioning of “soft dollars”

money managers routinely buy information from research organizations, including brokers, by allowing them to charge commissions that are 50%-100% higher than normal (called “research commissions”).  Fidelity, the industry standard of best practice, has been working for years to restrict the amount of shareholder money that is being spent this way.  Yes, this is good for Fidelity–by being bad for smaller rivals.  And its efforts have been very effective in cutting the diameter of the firehose spraying commission dollars at research sources.

in recent years, there’s been a small but growing trend for big clients of money managers to demand that a portion of their soft dollar allotment be earmarked for buying services for the client, not the money manager

–the move to index funds, and ultimately to ETFs, which don’t require active management

–massive redemption of equity mutual funds during the Great Recession, reducing further the assets in the hands of active managers.  Since managers are paid a percentage of the assets they oversee as their fee, fewer assets means less money to pay employees like securities analysts and portfolio managers

–large-scale firings of experienced securities analysts by brokerage firms during the Great Recession.  Over the course of my career on Wall Street, brokerage companies have been gradually changing themselves into trading firms–because, rightly or wrongly, they regard trading as much more profitable.  They’ve been laying off experienced analysts for over a decade,  disgorging even the most deeply entrenched during 2008-9.

The net result:  the big brokerage research departments of the 1980s-90s are gone.  There may be bodies occupying seats today, but they generally lack training, supervision and experience.

Active managers, who had cut back their (mostly ineffective) research staffs in the 1980s,  in favor of buying information from brokers with soft dollars instead, have few internal assets to rely on.  They also have lower fee income.  Are they going to rebuild their own research?  If so, whose current pay gets cut?  Will new research be any better than the sub-par operations they ran last time around?

for individual investors, like you and me…

THIS IS GREAT!!!

Yes, less well-informed institutions means that day-to-day volatility may be higher.  But it also means that we have a much better chance than we did a decade ago to discover valuable information that Wall Street doesn’t know yet.

Tomorrow, what companies are doing–with an aside on AAPL.