Sunday, November 29, 2009

The Good and the Bad about “Black Friday”

Several members of this blog’s audience asked me about revisiting the topic of last year’s blog on the weekend after Thanksgiving Day. (Note that I am referring to “members” rather than “readers,” as there are now enough regular visitors to this site to cause me to believe that we now have something of a viral community.) Similar to last year, my intention was to visit both the nearby glitzy high-end mall and the local downtown on Friday following our favorite holiday. There were two interventions however, which prevented me from completing my mission on Friday.

The first intervention began late Wednesday, when I was happily notified that there was going to be an earlier-than-anticipated, sizeable contribution to the money we manage for a long-term client. One’s initial reaction to cash flow into an account, after expressing gratitude, is to apply the new money in the exact proportion in the existing allocations. However, my rule is that any addition or subtraction to an account is an opportunity to reexamine the entire structure of the account to optimize the potential net reward. (The term net reward includes risk reduction as well as looking to the upside.) In this particular case, a number of the mutual funds which this account holds are “hard closed” to new money. A few other funds are in limbo or have portfolio managers whose actions are a bit disturbing, thus I am not comfortable adding new money. In one case the inflow was large enough that it could fund a number of new positions without causing too great diversification. Much time was devoted on Friday to examine whether the new fund candidates had sufficiently different portfolios from one another that we weren’t double counting our exposure. Further, we reviewed all the funds’ total expense ratios to watch that we were not inadvertently raising the costs to the client’s beneficiaries. (This work will continue next week.)

The second intervention, which may be much more important to investors around the globe, was the announcement on Thanksgiving Day that Dubai World was asking the holders of its $ 60 billion debt to extend maturities by six months. In view of the near-term memory of the credit crisis that became a liquidity crisis coming out of sub prime mortgage defaults, the markets reacted violently. Dubai World’s real estate subsidiary, Nakheel, has a bond issue that is due for repayment on December 14th. Prior to the announcement, I am told that the bond was trading at 109 and on Friday was quoted in the 40's. In response, European and Asian banks led their markets down. In the US, significant, initial lenders to Dubai were weak. (The reason I stress initial lenders is that we have learned from the residential mortgage decline, that often the initial lenders sell out all or almost all of their positions.) Both Goldman Sachs and NASDAQ OMX fell in sympathy with their Dubai customers’ problems. As with the residential mortgage problems around the world, there were signs of trouble prior to the headlines. I know one respected investment manager, who upon returning from Dubai, stated that Dubai was out of cash to complete its various projects or to start new ones. As this brewing crisis had too great a potential to be really disruptive to our existing investments (let alone any new investments), I was glued to my computer and television screens on Friday. Thus, I did not go out except briefly for a late lunch after the NYSE early close for the day. (I expect some calming news will come out before the Tokyo market opens Sunday evening.)

Having delivered my excuses for working on Black Friday, I will now briefly describe my positive and negative reflections to my abbreviated visits to both the mall and our suburban downtown, along with a number of insightful conversations. Perhaps, the single biggest clue to how the shopping season was going is that both the mall and downtown had ample parking spaces available. In fact, I found better parking than on a normal Saturday. Walking around, we did not encounter crowds. In a number of stores the slimmed down sales staff outnumbered the purported customers. Some stores did have customers, but were not overflowing. My wife Ruth, who had a Black Belt in shopping when we married 23 years ago, noted that there were no customers at numerous cash register positions and one store had only four shoppers waiting to pay for their selected merchandise. Casual conversations with various sales clerks revealed no interest in contacting supervisors to get a more favorable price on a high-priced item. A major department store was advertising a short fur jacket rather than their normal full length fur, in their way lowering price points.

Focusing on prices was revealing. Several stores had significantly lower-than-normal priced merchandise in their display windows. Not lower prices on their normal products, but lower value, lower priced goods. Perhaps, the most revealing input we got was how the mall’s management reacted. Prior to the season there were a number of empty store-fronts. Most of these are now filled with “pop-up” stores that can quickly open with easily moveable fixtures, signage, and support equipment. These “pop-ups” are usually for seasonal items or marketing tests. Often these stores do not occupy the full store bay of the prior tenant, adding short space stores to the category of short-sale real estate transactions. The mall management is vigorously protecting its base. According to local real estate gossip, the mall gave significant rent concessions to a brand name merchant to prevent them from moving out of the mall and into the town, (reversing the normal pattern). I suspect there must have been a major concession, as the downtown now has 19 vacant stores. (We saw a similar pattern when we visited Birmingham, Michigan recently; another wealthy suburban community that has had a vigorous downtown retail district.)

An additional cause of concern to me is that it now appears appropriate to call this the “Shopping Season.” In our politically correct world there is little mention of Christmas or Chanukah. Religion and religious events seem not to be discussed in polite society. This approach has supposedly been taken so as not to offend anyone. As a Marine, I find this a defensive, or worse, a passive stance. We should stand for care and concern for others, which can even include our families and friends, but most importantly to those who are less fortunate. The muzzling of religious and spiritual thoughts is an attack on another pillar of our society. Institutions are important to our way of life, and incidentally important to how and in what we invest. Without strong, viable institutions in which we believe, we will be lost in a morass of meaningless politeness.

The job of a good analyst is to see things that others don’t. In the aforementioned “glitzy” mall, there are a number of higher-end jewelry stores. In these times one would expect to find at least one of these stores to be in the bankruptcy process. I found it encouraging that, in an auction of one store’s assets, the winning bid was by a respected professional liquidator. To my mind, the existing competitors were more logical buyers, as they already have sales outlets to sell the acquired merchandise, and wouldn’t have to employ the failed store’s people. That a professional would put up cash to buy merchandise from a failed firm in order to sell it out of existing locations, is a very positive sign. I hope they make a lot of money on this bet. Their past history would indicate that the odds are good.

One of the reasons that the US has been traditionally successful is that we adapt to calamities well. We rise to the occasion. Taking a leaf out of the liquidator’s book, adding the “pop-up’ stores, lowering price points but maintaining price discipline, are all signs of adapting to the current economic problems. Unlike a number of other recessions which impacted lower wage people primarily, the current one is a trickle-down recession with the problems hitting the wealthy either before, or at the same time, as the general population. Thus the adaptability at the high end is a good sign that unless materially higher taxes don’t prevent it, the high end will lead us out of the recession.

Therefore I expect we are coming out of our recession if we haven’t already done so. While we may take a little bit of time in making new equity fund commitments with new money, we think we will look back from the future and see that today’s prices will look as opportunities.

Please share your thoughts and reactions.

Sunday, November 22, 2009

Changes to Risk Compensation
and “Best Practices”

Are They Barn Door Closers?

Many in the popular press and a few politicians believe that current compensation practices do not sufficiently penalize risk taking. Thus, they rail against incentive compensation both for “Wall Street,” (read financial institutions), and for industry in general. As we all have suffered from the collapse of the financial markets in 2008, there is a deep psychological need to assess blame and punish those that created this pain. We need to accept the reality that everyone of us bears some responsibility for over-extending ourselves and our society beyond a level of wise prudence. To come to grips with this issue there are two realizations which with we need to fathom. The first is that risk is not usefully measured as a number, but rather its impact. For me, risk is the penalty for being wrong to such a degree that it forces changes in one’s life’s plans. If one’s financial assets are ten thousand dollars or less, a loss of one thousand dollars may cause a change of plans for college, rent or purchase of a car. The same loss by a millionaire is an annoyance, but not a life changer. The second realization is that while in truth we are at risk every single day from some catastrophe, we don’t feel at risk. We believe almost everything we purchase was bought at an appropriate price, without fear that some subsequent event will cause our purchase to be worth much less. Both the mortgagee and the mortgagor believed at the time the sub-prime mortgage was struck, that neither the buyer nor the seller was at substantial risk. The same could be said of the domestic or foreign institution that bought a tranche in a structured financial package of subprime mortgages as well as those who sold the paper to them. There was little in the way of history which would alert all those who, in actual fact, were taking substantial risks. The size of the extra incentive compensation would not have been worth the large losses which were sustained. In many cases the participants’ jobs, careers, and their own capital in their firms were sacrificed by being wrong. I seriously doubt that any change to the risk/reward matrix would have changed many people’s behavior.

We are not blameless for the mistakes that caused us, our clients and our society to pay the risk penalty. We are guilty of not looking for the unexpected, or if you will the “Black Swan.” Under the pressure to meet human needs for housing on the one side and income generation on the other side, we failed. I am not suggesting that there weren’t liars and others driven by greed, but for the most part the mistakes that were made were made by relatively honest, upstanding people who had no knowledge or experience to guide them through their next set of troubles. Even many of the traders, with their own and their firms’ capital, were unaware of the risks about to fall on them. At the end of the day, the fault was poor, one-sided research, not the compensation arrangement.

In our natural desire to avoid future penalties, we look at what went wrong in a mechanical sense and wish to institute changes to prevent what happened from happening again. I guess this comes under the headline of avoiding a second lightening strike. The theory holds that if one attacks the motivation of the guilty, (compensation), they will become reformed and won’t stray again. I believe that this type of change is unlikely.

To avoid future problems there is a tendency of the great and the good, (to use a British expression), to codify a new and more stringent Code of Conduct. Some of the popular headlines would require more transparency, more capital, and less leverage. These lists of “Best Practices” attempt to correct the past in a systemic approach. Perhaps, they should look at the lack of complete success at past lists of Best Practices. I believe they will find two obstacles in designing effective risk penalties. First, we live in a dynamic world that is always re-inventing or perhaps more accurately, re-packaging financial instruments. In this most creative community, good and bad people will find ways around the current rules. The second drawback to believing that Best Practices or regulations will prevent future problems, is that problems are caused by people, not procedures.

People are human, so they can and will make some mistakes. People have friends and family that they will treat differently than total strangers at times (and in some cases, very subtly different ways). People also have unfulfilled desires which can override their natural caution. I suggest that most problems will be avoided by those groups or families where the supervision knows their fellow workers/members, and can anticipate many of the human problems that drive people to take risks.

Changing financial compensation procedures without changing the psychic benefits gained from various forms of risk taking is like closing the barn door after the animals have fled. Better results will be had by leading people to the benefits of avoiding unwarranted risks rather than by promulgating Best Practices or by additional regulation.

We look for fund managers who lead their organizations effectively, they manage risk well.

Sunday, November 15, 2009

Post Mortem 2007-8 and Pre Mortem 201X

In last week’s blog, I promised to devote this week’s musings to the causes of the recent declines in the economy and markets. You will find my focus is more of a systemic approach than singling out specific instruments, organizations, regulations or people.

The history of the rise and fall of markets and related economies goes back to the beginnings of recorded time. This history can be described graphically as undulating waves following a cyclical pattern. As these waves began long before the creation of hedge funds and credit default swaps, there must be something more basic in human nature. I believe the drive that causes these cycles is the four letter word that a well known labor union leader enunciated more than a century ago when asked what his laborers wanted; the reply was “More.” It is each person’s desire for more of what is in short supply that drives the demand side of the economic equation. The supply side is provided by those who produce or possess “more” than what they can consume. In periods of population growth and net immigration, there is normally more demand being generated than supply coming onto the market. Spurred on by the dynamite of rising expectations driven by all forms of media, the demands for higher priced goods and services drove demand. There is hardly a human alive today who does not want more of something, including ‘peace of mind,” which itself can be costly. (Think of various forms of physical, medical and financial protection.) In this sense, we are all the sinners of driving for “More.”

There is a two letter word that we do not want to hear from our government or employer. That word is “No.” Thus, governments rarely say no to a demand for more services. The normal solution is reliance on inflation, as governments can repay their enlarged debts with currency that is worth less due to inflation. Employers also want to avoid saying no to increased wage demands if they can avoid it. Employers count on both increased productivity and higher selling prices to meet wage demands.

The growing demands for more goods and services could not be satisfied in their entirety through growth of the market. Most developed economies, including the US, have been growing more slowly than the escalation in demands. The solution to this problem was to borrow money in ever- increasing amounts. In effect, borrowing new money to repay old debts. In the corporate world, debt grew faster than equity, so any shortfall in the ability to issue new debt for old debt would have a dramatic impact on a proportionately smaller equity base. (Leverage has this annoying characteristic of working both ways to magnify gains and shortfalls.)

As an equity analyst and portfolio manager I did not pay much attention to fixed income securities. Neither did most individual investors. I should have been more conscious that segments of the fixed income markets were showing signs of distress by requiring higher yields to clear transactions. These particular securities were housing-related, and mostly the hot new Wall Street product called structured finance securities (which were large packaged and sliced residential mortgages). Their rising prices at the same time that more of the financial community’s capital base was being devoted to this trade, should have been the proverbial chirping of the “canary in the mine.” Like most others, I missed these early warning signs. Along with the regulators, I further failed to understand the implications of counterparty risks on a global basis. I missed the fact that overseas participants had taken on much more leverage. One could borrow more money, at better terms, in London than in New York. The poorly identified mortgage products were sold around the world to satisfy local needs for income to meet “more” demands.

Space and time do not permit for a more inclusive analysis of what went wrong and how we missed spotting the problems. What I want to focus on now is the possible “Pre-Mortem” for a future decline, which history tells us will surely come at some point. (Let us hope years in the future!)

Many people fear two possible causes for the next major decline that I do not. The first is a dramatically worse real estate market. Could residential market prices drop further, causing more defaults? Yes, but in terms of magnitude unlikely to be major. (Remember, I missed spotting the first decline when I knew local prices were unsustainable.) Many have identified commercial real estate as the next big problem. I think these problems have been largely identified. Vacant properties are a problem but I believe the order of magnitude is much smaller than the residential real estate hit we sustained, and the market is prepared for defaults.

The second popular worry at the moment is the relative decline of the US dollar. In the last couple of weeks, I have commented on the decline compared to other currencies, not commodities.

My true concerns however, are for two other problems that I perceive on the horizon. Either one could cause major instability in our markets.

The first concern is the increasing level of speculative foreign exchange trading. Corporations, financial institutions (including hedge funds), and increasingly individuals, have discovered these markets whose daily volume is larger than the traded securities markets on many days and nights. (Currencies are traded around the clock, around the world.) The advertised leverage potential for the retail participant is 500 to 1. (Many of the frauds in the financial markets have been caused by attempting to regain undisclosed losses by the rapid trading of highly leveraged products.) Foreign exchange that goes through banks has some regulatory oversight, but not heavy. Those trades executed outside the bank channel have little or no oversight. Either a suspected (or actual) fraud, or a surprise devaluation/revaluation by a government could cause a significant amount of margin calls. Many organizations and individuals could not immediately meet the repayment obligations on their loans from such margin calls, possibly leading to some bankruptcies. Nevertheless, a foreign exchange collapse is analogous to other kinds of margin calls, with enough case law in place that we should quickly seal off the problem.

My second concern is pure conjecture. Assume, whether, we like it or not, some healthcare legislation is passed. Initially the first victims of this price- control legislation will be the profit margins of doctors, hospitals, pharmaceutical companies, medical equipment providers, as well service companies. Most important of all, individuals will find their costs will rise; particularly the elderly and the formerly wealthy. Many different approaches will be attempted to restore their past financial relationships. Almost guaranteed, more debt will be found on hospital balance sheets,* doctors’ practices, as well as many other organizations. I suspect some individuals either by happenstance or by conscious decision will find it necessary to borrow money against some future financial stream. As many of these groups are inexperienced in shopping for, and managing external debt, they will fall behind in their repayments. My fear is that we will see medically-induced bankruptcies with enormous emotional pains, and very little easily convertible collateral. As a society, we are not prepared for this contingency. Pity the judges who will have to deal with these issues.

*I sit on the Financial Oversight Committee and chair the Investment Committee for an important not-for-profit hospital group that currently holds a very good credit rating.

Sunday, November 8, 2009

Winning Calls

Life rarely presents us with celebratory events sponsored by others for us. Thus, occasionally we need to create our own in the fashion of Lewis Carroll’s wonderful invention of the “Unbirthday.” With this as a premise, I am indulgently going to celebrate the recent successful calls in our blog. If I don’t, who will?

The first correct call was the recognition that the month of October, 2009, had specific characteristics; which this year resulted in a negative bias to equity performance for the month. I also pointed out that mutual funds end their tax reporting year in October. While most funds have accumulated large realized losses created in ’08 and ’09, it would be possible (and perhaps prudent) to recognize some gains. The gains would not trigger a tax payment because the gains would offset the losses. Since there are no “wash sales” rules on gains, the smart thing to do is sell some of this year’s winners and either repurchase the same stocks, or perhaps to use Sir John Templeton’s phrase, search for “better bargains.” As the SEC no longer requires funds to disclose transactions on a quarterly basis, we no longer see a list of transactions made by the funds, thus I do not know what happened.* However, during the last three weeks of October, a significant number of the best performing stocks for the year were met with selling. On an overall basis, the month of October was down. My supposition is, that with the removal of the incremental mutual fund selling, the short term performance (at least in early November) would be up. This actually happened. I call it a win.

The second call was on the relative value of the dollar, which I felt was bottoming. This appears to be happening. Please note that I phrased my comment in relative terms. I agree with many of the views of the dollar’s detractors, that the buck should be worth less due to the present deficit, the almost certainty of a larger deficit, and the strong odds of a pick-up in inflation, probably induced. Why then should the dollar stop falling? World trade currencies are priced relative to other currencies. From a managed trade point of view, the decline in the US dollar is an increase in the value of the counter currencies. In many countries exporters are politically important. They see a rising price of their own money as an inhibitor to their export sales. Thus, I believe that other countries will buy some dollars to prevent their own money from being priced out of the world market. I have great respect for George Soros and his investment accomplishments over the years, even though I rarely am in agreement with his political views and actions. When he was recently asked about the worth of the US dollar, he replied that it was over-valued, except in comparison with other currencies. Today, I do not see a better value in other paper currencies, even though personally I own some other currencies to support my foreign equity investments.

From the standpoint of those who are focused on the absolute value of the dollar, that is to spend rather than trade, the price of gold (and to a lesser extent prices of some other commodities) is instructive. The nominal price of gold is at record levels, about $1100 a troy ounce. However when translated into today’s dollars, the old record price of over $800** an ounce in 1980 would be at least a thousand dollars higher. One reason for the recent strength in the gold price is that several central banks have made it known that they will not be carrying out their previous plans to sell gold. In addition, both India and China are buyers. I will claim this call as a winner in light that the other side is not winning.

On a tactical side, my recent calls for long term investing for growth, and particularly technology-driven innovation, appears to be winning relative to bets on value, and to some degree on industrials. I will claim these as short term winners, even though they were meant for long term investment.

Emotionally, the final two words in last week’s blog, “Go Yankees,” (written by the ‘born in Manhattan boy’ in me) proved to be the week’s biggest win. Please remember that there are legions of New York haters who resent the swagger generated by this culture of winning. Thus while I am very pleased, after eight long years of lack of fulfillment, my guard is up to defend against those who wish to punish New York. New York is a state of mind and not just a place. The biggest threat we face is a repeat event as severe to our economy and the financial markets as we experienced last year. We will retain our “license” to be central to the progress of the world only if we have learned something and we change our thinking.

I believe that we must change our thinking, thus next week’s blog will be devoted to my attempts to become more aware of the shape of future problems before they overwhelm us.

Any contributions from readers will be appreciated.

* Years ago, the SEC required mutual funds to report their transactions quarterly, allowing a deeper dimension to the analysis of funds than is now available. The SEC caved-in to the funds in abolishing this report, reasoning that the SEC and its staff could get the specific information anytime they needed it. Fund owners and their analysts no longer have access to that insight.

** A very valued former associate of mine, the late Alling Woodruff, of Greenwich, CT, did sell his physical gold position above $800. He was an independent director of what was then the largest US gold fund and was going to South Africa to visit some mines, thus out of touch with the market for a couple of weeks.

Sunday, November 1, 2009

Random Thoughts on November 1st

One of the pleasures and pains of writing a weekly financial blog is determining what to say. This weekend I have a number of incomplete thoughts from various stimuli I received over the weekend. Any of these ideas could be developed into blog in and of itself. However, by focusing on a single subject, one would not see a number of the cross-currents that are washing over my mental boat in rough seas. In no particular order, my thoughts include the following ideas:

  1. Peggy Noonan writes in The Wall Street Journal that many people either believe our various structural problems will not get better and we have to live with the current imbalances, or that they have a sense of optimism without any focus on innovation. I believe that both views are wrong. Some of the structural imbalances are cyclical, made worse by government intervention which prolongs the period of healing. Other imbalances will get worse, such as structural unemployment; we have produced a labor force that does not know how to labor in today’s world. I am afraid this is a multi- generational problem of education in the home. On the optimistic side, I believe that technology will create new products and services that will make much of our existing ones obsolete to a point that we will replace the old with the new, even before the old wears out. My optimism, particularly in technology, leads me to favor funds that have significant technology holdings, often found under healthcare and energy classifications, as well as those that have a separate technology classification.

  2. Alan Abelson in Barron’s quoted John Williams of Shadow Government Statistics, stating that 92% of the 3.5% gain announced for the 3rd quarter 2009 GDP was essentially contributed by “one-off” items, i.e. “Cash for Clunkers,” and expiring first-time home owner mortgage credits. Abelson’s comments reinforce my concern on the reliance on government numbers. One might add to the list, the President’s claim of 1 million jobs created or saved by the stimulus. As primarily equity investors, our focus should be on the revenue production of companies and the bottlenecks they are discovering in their sales and delivery processes. Commodity prices and transportation data are much more reliable indicators.

  3. Little mention is being made in the financial press, and none in the stock market comments of the general press, about the fact that Mutual Funds operate on an October tax year. Most of the equity funds have large realized losses created in 2007 and 2008, as well as earlier this year. I suspect that in October, a number of portfolio managers sold some of their positions that had gains, without incurring any additional tax liability for their shareholders. They may share my point of view that it is unlikely that any significant news will break in the next thirty days, suggesting at best, a flat market for a month. This hiatus in the market recovery will allow them to reallocate their portfolios or return to their prior positions, (we will never know for sure, as the funds that report on a calendar quarterly or semiannually do not have to report on intra-quarter activity). In my mind, I believe this factor is a possible additional explanation why the month of October was flat. If I am correct, the stock price weakness shown in the last week is not a canary in the mine giving us a signal to get out of the stock market.

  4. Another market phenomenon is that in the last week Berkshire Hathaway disposed of another major portion of their holdings in Moody’s, at current prices. The credit rating company is regularly under attack in the press, the regulators and some well known short sellers. What I find significant is that the stock absorbed this selling without further declines. As the company is not currently buying back its shares, the other side of the trades may represent one or more substantial buyers, as the public does not appear to have any interest in this stock. Often I find when a stock does not decline much in the face of a strong, well-known seller, there is a “story” in the unidentified buyer. Perhaps these thoughts are wishful thinking in that Moody’s is a long-standing position in our Financial Services Hedge Fund.

  5. Now for a non-market thought: Saturday night’s, or more accurately Sunday morning’s, victory by the New York Yankees in the third game of the 2009 World Series is something of a cultural identity. People have a visceral reaction to the New York Yankees; they either like them or hate them. Friends of mine from all over believe that everyone who currently works or lives in New York, or ever did, is a Yankee fan. Never mind that many of these people are not baseball fans, and like me, have difficulty in naming the starting team, but the Yankees represent something. I would suggest they represent a culture of winning. (The image is greater than the statistical history. Nevertheless they have won more pennants and World Series than any other team, although in any many years they are not the best team). To many others, the Yankees represent a swagger or arrogance. This is one of the deep root causes for the current Administration’s and Congress’ desire to “reform,” or some may say punish, Wall Street. During the rain-delayed game I saw the Vice President of the United States in the front box seats. As a kid growing up in Pennsylvania, and a long-time Senator from the neighboring state of Delaware, one can easily understand his affection for the Philadelphia Phillies. Parenthetically, I find it interesting that his brother and son are involved with a hedge fund.

We should not expect any solace from the vice president, his administration or Congress for New York. One of the critical issues recognized by the current CEO of the New York Stock Exchange is that its future is dependent upon on what Washington pitches at New York. In the long-run, those of us who are spiritual New Yorkers have to find ways to become more loveable to the rest of the country. This tension is not new, as Alexander Hamilton and Thomas Jefferson, as well as Theodore Roosevelt and JP Morgan somewhat successfully worked on creating conditions from which all benefited. That is our job today. Go Yankees. .