Tag Archives: money

speculative stocks: the gold mine paradigm

March 26, 2012 By in Gold, Industry Analysis, Portfolio management, Speculative stocks Tags: , , , , , , Leave a comment

speculative stock behavior

Speculative stocks of all stripes are often compared with gold mining stocks–not just any gold stocks but young companies with a potentially important strike but no history of profitable production.  Here’s why:

like gold mines

fraud?

In one sense, it’s because gold mining stocks have been fertile areas for fraud, in financial centers from Perth to Denver to Vancouver.  There was even a case in the US many years ago–a major scandal–where a mutual fund took large positions in junior Canadian miners that had fabulous financials indicating deep undervaluation.  When the portfolio manager went to visit the mining operations, however, he discovered they existed only in the imaginations of promoters who were happily churning out fake financial statements.

stock trajectory

Putting such cases to the side, the stocks of legitimate start-up companies often follow the same trajectory as gold miners as they approach the day when their first major development finally comes into production.

–the new strike is announced.  There’s limited exploratory drilling and little other information other than that the find is good enough to be commercially viable.  The stock goes up.

The lack of information itself opens the door to all sorts of speculation.  Analysts, who are always working from imperfect information in any event, may arrive at their preliminary estimates from an average of the productive capability of other mines in the area, or from the past experience of the geologists or the professionals associated with the project.

Even at this stage, analysts begin to jockey for position with each other by offering, in turn, increasingly more optimistic assessments of the find.  The stock goes up some more.

–financing is lined up.  Further drilling has been done to delineate the find and to justify a bank loan that will fund construction of productive facilities.  Getting a loan means a third party has examined, and signaled its validation of, the geological data and production plan.  This sets off another round of more positive speculative assessment of the find.  The stock goes up again.

–the mine and associated processing facilities are constructed.  As analysts can see the scope of the project, even more bullish reports are issued.  The stock goes up once more.

–the mine opens; production commences.  For most stocks this means reality intrudes on–and shatters–the reverie of stock market speculation.  Dream shifts into reality.  Analysts can no longer imagine extraordinarily high ore grade being processed at a world-record rate.  They have to deal with the facts of, say, ordinary grade ore being processed at pedestrian rates.  The stock plummets.

Almost always, the day that the mine opens is also the day that the stock price peaks.  

Greg Smith’s resignation letter from GS

March 16, 2012 By in Industry Analysis, institutional salesperson, Investment firms, Trading Tags: , , , , , , , Leave a comment

the letter

On Wednesday, the New York Times published the resignation letter of Greg Smith, a (former) derivatives salesman at Goldman Sachs.  Smith, a 12-year employee, says he’s leaving because the GS work environment has become “toxic and destructive.”

My first reaction:  plus ça change…

In 1989, Michael Lewis, of later Moneyball fame, wrote Liar’s Poker, an expose of the culture of cutthroat competition and macho banality of Salomon Brothers while he was a bond salesman there.  Salomon, you may recall, had to be rescued by Warren Buffett after top executives colluded to illegally manipulate prices in the US government bond market.  What’s left of the firm now resides inside Citigroup.

Yes, Moneyball shows that Lewis is sometimes reluctant to let facts stand in the way of a good read.  Nevertheless, I think Liar’s Poker is an important book.  In fact, I’ve asked all the securities analysts and portfolio managers I’ve trained since its publication to read it.

Three points from the Lewis account still stand out to me:

–the strong internal pressure for salesmen to get unattractive, illiquid bonds off the company’s books by persuading some gullible customer to buy them

–a sketch of the growing dismay of a certain client as the realization dawns that he has been sold a toxic security that he can’t resell and which will get him fired when his bosses figure out what he’s done (why they don’t already know is beyond me)

–the feverish rush to unload dud bonds on a client the brokerage community figures is so unskilled that he’ll soon be fired.  Like blood in the water to sharks.

Welcome to Wall Street.

an adversarial relationship

What the Michael Lewis book and the Greg Smith letter bring out most strongly, to my mind, is the simple truth that the relationship between broker and client is a commercial one where the interests of the two sides are not aligned.

Two senses:

–Every time you trade, you think you know more than the other party.  You think any security you buy is undervalued and that the other side of the trade will give up future profits by selling it to you at today’s price.  You expect anyone you sell to to lose money by taking your offer.  You also expect the broker to act as the counterparty if he can;t find someone else.  It’s like baseball.  You take the field expecting to beat the other side.  You’ll win; they’ll lose.

–Investment managers earn higher fees by having superior performance, which helps attract new assets; brokers get paid in direct relationship with the amount of trading the client does.  Experience shows, however, that for most managers superior performance and the amount of trading are inversely related.  So, what’s good for the manager isn’t particularly good for the broker, and vice versa.

 

In addition, each side markets itself to the other.  That is, each tries to replace the cold commercial structure of the relationship with a warmer “like me, trust me” one.  That’s partly because we’re all decent people.  It’s partly so the other side will continue to do business with you after you’ve traded them into the dust.  And it’s also partly because it’s a way of gaining a competitive advantage, of tilting the ratio of compensation to services in your favor.  In my experience, brokers are much more successful in getting clients to deliver excess compensation than clients are in getting excess services without payment.

the business has changed

A generation ago, the principal business of investment banks was providing comprehensive financial services and advice to companies of all sizes–everything from working capital finance to strategy to mergers and acquisitions.  For small- and medium-sized firms, its investment banker may well have held a seat on the board of directors.

Not any more.  In today’s world, however, most firms have an in-house staff of financial professionals who do most of this.

At the same time as businesses based on building long-term relationships of trust have eroded, the trading business, which focuses on rapid-fire, reflex-action, individual transactions, has exploded in size and scope.

As the composition of company profits for brokers has changed, so too has the character of those who rise to positions of control.  The traditional investment bankers, whose temperament is to focus on long-term relationships, are out.  High skilled traders, who focus on short-term profits, are in.

playing hardball vs. cheating

Where to from here?

The huge profits that trading businesses have generated during the past decade are already spurring changes.  Institutions are already shifting to electronic crossing networks, where fees are much smaller and where the activity won’t be seen by a broker’s proprietary trading desk.  Retail investors are doing more business with discount brokers.  They’re increasingly shifting, I think, to passive products like ETFs as well.

Institutions have long memories.  In cases where they believe a broker has crossed the line between aggressively competing and cheating, they simply won’t do business with them anymore.

there’s something about Europe, too

Did it really take Greg Smith 12 years to figure out what brokers do for a living?   …or was it his final year, in Europe, that changed his mind?  Why is it that the losing end in all the toxic credit default swaps was a European bank?

 

 

business has changed away from long term repationships—now cos do for selves, change of control toward traders in brokerage firms

you may own more AAPL stock than you think

March 15, 2012 By in Dividends, Industry Analysis, Investment firms, Portfolio management Tags: , , , , , , , , Leave a comment

Yesterday’s Wall Street Journal has an article in which it looks at the investment vehicles that hold AAPL shares.  A third of equity mutual funds sold in the US hold AAPL; 20% of hedge funds claim it as one of their top ten long positions (given the sketchy nature of hedge fund disclosure, I wouldn’t bet the farm that this is figure is entirely accurate, though).

what Apple is

Just to be clear,

–Apple is a US-based company.

–It’s incorporated in California, where its headquarters is located.

–Primary trading is on NASDAQ.

–AAPL doesn’t pay a dividend.

–AAPL isn’t just a large-cap stock.  It’s a MEGA-cap stock.

The median market cap for members of the S&P 500, the large-cap index, is a touch under $12 billion.  AAPL, in contrast, has a market cap of close to $550 billion, or 45x the median.  The company has no debt and over $100 billion in cash on its balance sheet.

what funds hold AAPL shares

Despite this description, according to the WSJ the following kinds of funds hold AAPL shares:

–40 funds that focus on dividends in selecting stocks

–50 funds that specialize in small- or mid-cap stocks

–3 Fidelity funds that specialize in Europe

—international funds, including the Ivy International Growth and the Waddell & Reed Advisors International Growth

–the BlackRock High Yield Bond Fund, a $5.9 billion junk bond fund that held $8.3 million in AAPL shares at 12/31/11.

how can these funds do this?

In one sense, it’s crazy.  How can you trust a manager who says he’s going to buy small, fast-growing stocks with market caps below the S&P 500 median for you, after you see his outperformance is coming from a half-trillion dollar stock?  In this regard, the BlackRock High Yield position that the Journal reports is extremely hard for me to understand.  Ignore the fact that it’s a bond fund owning stocks.  The AAPL position size is so small, at 0.14% of assets, that it’s immaterial to fund performance.  There has to be more to that story.  One guess is that the position is much larger today.

In another, narrowly technical, sense–even though the fund name, and presumably its marketing materials, don’t give the slightest hint that this may be going on–fund rules doubtless permit the purchases.

If you read the prospectus carefully, it will surely say something like the fund will achieve its objective (of buying small-cap, or foreign stocks…) by having at least, say, 65% of the fund assets invested in the specified kind of securities.  It will go on to state that the fund reserves the right to invest the rest of the fund in other stuff.  (By the way, the prospectus may also say that for temporary defensive purposes, the fund has the right to redeploy its assets entirely to cash or to Treasury bonds, or some other presumably safer form.)

why do they do this?

I think the obvious answer is the correct one.  The portfolios in question want to achieve a performance advantage, either over the other funds in the same category or against their benchmark index, by buying securities that are outside their normal investment universe.

Is this illegal?  No, because of the prospectus disclosure.

Is it unethical?  In my view, yes.  An international manager might try to argue that because APPL manufactures and sell products abroad, it’s actually a foreign stock.  Someone might buy that explanation.  It certainly wouldn’t fly in the institutional pension management world, however.  And small-cap managers, who typically charge higher fees to compensate for the extra work involved in small-cap, don’t have an ethical leg to stand on.

what to do

Figure out how much AAPL you actually own and ask yourself if you’re comfortable.

Remember that any S&P 500 index vehicle you hold is about 4.5% AAPL.  AAPL may also be 20+% of any tech fund you own.  And, as the WSJ article suggests to me, it might be wise to take a quick look at all your mutual funds or ETFs to see how much AAPL is in them.  You can get the information from the management company website, the SEC Edgar site, or to the latest report you’ve gotten from the fund itself.

a price war among ETFs?: implications

March 13, 2012 By in ETFs Vs. Mutual Funds, Industry Analysis, Investment firms, Portfolio management, securities markets, Strategy Tags: , , , , , , , , 2 Comments

the ETF phenomenon

To my mind, the ETF phenomenon is not just a story about price advantage.  I think the popularity of ETFs is an indicator of a fundamental sea change in sentiment on the part of individual investors.  For me,ETFs mark the end of the almost twenty-year love affair of individuals with actively managed mutual funds–and maybe with mutual funds, period–that began after the stock market crash in 1987.

Just as individuals shifted from relying on retail brokers to puting their faith in mutual fund portfolio managers after Black Monday, the trigger for the change in direction has been the Great Recession.  Its cause is the continuing failure of even the most highly publicized active managers to beat their benchmark indices-or, even if they did, to preserve during the downturn of 2007-2009 what their clients thought of as enough of their wealth.

The new trend is for individuals to take responsibility for themselves and to allocate their portfolios by sector through narrowly focused passive vehicles, that is, ETFs.

price war?  yes and no

Exchange traded funds, which now control over $1trillion in assets in the US, appear to be entering a new phase of competition, one marked by sharp reductions in their management fees.  The media are calling this a “price war.”

It’s not a price war in the most dramatic sense–where firms with excess production capacity slash selling prices in a desperate bid to keep their heads above water, or to generate cash flow needed to repay debt.  But it still is one, in the sense of a widespread fall in fee levels.

What do the fee reductions mean? 

Two aspects:

a maturing industry

1.  At one time, ETFs were competing for investor dollars primarily against their cousins, index mutual funds.

During this period, simply having an expense ratio lower that that of an index fund was all an ETF needed to succeed.  Today, despite the fact that their per share expenses are already far below those of index funds, ETF companies are beginning to slash their fees further.

(An aside:  to some extent, the ETF fee advantage is offset by the commission charges that ETF transactions bring with them.  More important, buyers pay more than net asset value at the time of purchase, sellers collect a bit less.  There isn’t enough data available for third parties to determine what this bid-asked spread typically amounts to.  Comparisons of ETFs vs. index funds usually deal with this issue by ignoring it, making ETFs look somewhat more attractive on a cost basis that then actually are.)

That’s because competition between ETFs and index funds is over.  Index funds have been defeated.  The new contest for customers is between one ETF and another.

closing the door to newcomers

2.  Investment products like mutual funds and ETFs have substantial up-front fixed costs, mostly computers and professionals to manage the money and safeguard it.  So they initially run at a loss.  Once a fund gets to the point where fees cover these costs, however, new assets bring almost pure profit.  Margins expand fast.

At some point high margins become a negative, not a positive.  They act as a lure for new competition.  And they allow new entrants to become profitable quickly.

Therefore, lowering fees has a second purpose.  It lengthens, possibly by an enormous amount, the time a potential new entrant must operate at a loss–and increases proportionally the amount of assets he must gather in order to reach profitability.  Naturally, this decreases the attractiveness of the industry to newcomers.  So, as counter-intuitive as it may seem, the fee reductions also serve to preserve the long-term profit profile of at least today’s very largest players.  It makes no economic sense for anyone else to enter the fray.

It’s interesting to note that of the three largest sellers of ETFs in the US, BlackRock, Vanguard and State Street, only Vanguard has a significant actively managed mutual fund complex.  All the other last-generation investment companies have had their heads in the sand.  Internal forces of the status quo have preferred to let assets leave rather than create an ETF divisions that might be headed by a political rival.

collective action clauses: Greece’s deus ex machina

March 8, 2012 By in Banks, Derivative instruments, Industry Analysis, Trading Tags: , , , , , , , , , 1 Comment

Greek sovereign debt restructuring under way

Greece is in the final stages of restructuring €270 billion in government debt.  Its deadline for holders to “voluntarily” exchange their bonds for new debt that’s worth only a little more, on a present value basis, than a quarter of what creditors were originally promised, is today at 8pm London time.

For the past few months, EU governments have been engaged in high stakes behind the scenes duel with their major commercial banks, which hold a majority of the Greek securities, over whether the financial institutions would agree to the Greek offer.  During the past couple of days, the banks have all been falling in line and saying they’ll take the Greek deal.  I don’t think the banks ever seriously considered doing anything else.  The discussion has all been, I think, about what quid pro quo they would receive in return.

That leaves private holders  …who don’t stay up at nights worrying that the bank examiners will be unusually thorough this year or that their applications to open new branches might be denied.  So both the threat of future bureaucratic ill will and the call to make a patriotic sacrifice of their (own and their clients’) capital fall on deaf ears. That’s where collective action clauses come in.

collective action clauses

A collective action clause is a stipulation in a bond indenture saying that if holders of a certain majority percentage of the issue agree to a given proposal by the issuer, then the rest can be forced to go along with the decision of the majority.

About one outstanding Greek government bond in seven was issued under English law and have had collective action clauses in the indentures from the outset.

The rest were issued under Greek law.  Being subject only to local law isn’t the norm for emerging markets debt, but I guess buyers weren’t concerned because Greece is part of the Eurozone.  Until a few days ago, those bonds had no collective action clauses.  Then the Greek parliament passed a new law to retroactively include them in its government bond indentures.

Not only that, but the lawmakers conveniently set a low threshold of around 60% acceptance (usually, it’s 75%) as the point at which the clauses can be invoked.  EU banks who have been arm-twisted into agreeing to the restructuring will doubtless lift Greece past that mark.  So, like it or not, private holders will be forced to accept the huge haircut Greece is proposing.  The maneuver is all perfectly legal.  The move isn’t a surprise to the bond market, no matter what you hear in the news.  It has been anticipated by bond pundits for at least a couple of years.

the English-law bonds

The case of the English-law bonds is more interesting.  From what I’ve read, their collective action clauses are set at 75% acceptance.  Early betting is that Greece won’t come close to that amount.

But Greece has already announced that if holders don’t tender in lat least large enough amounts to allow it to exercise the collective action clauses, it simply won’t pay anything.  The holders can see Greece in court.  Tomorrow we’ll see how much of this is bluff–and how successful the tactic has been.

rating agencies have already declared a Greek default

Major credit rating agencies have already declared that Greece has defaulted on its bonds.  So far, the body that decides whether credit default swaps (effectively, insurance policies against default) must be paid off is saying that no default has yet occurred.  That’s because the language of the swap agreements that describes what a default is contains an accidental loophole.  The government-inspired “voluntary” restructuring doesn’t qualify, even though holders are losing almost three-quarters of their money.   If Greece invokes collective action clauses and forces bondholders to take the new securities, however, that may change.

not many Greek CDSs?

Reports I’ve read say that Greek CDSs amount to a relatively small €3+ billion.  If that figure is correct, it’s hard to see why the EU has put so much effort into arranging a “voluntary” restructuring that avoids triggering them.  Maybe bank issuance of CDSs on Spanish and Italian debt is immense and contagion is the worry  …or the official figures may substantially understate bank exposure.

This time tomorrow we’ ll have more answers.