Posts
Sorry for not updating this. I finally found an investment analyst job in November and as such will not be making anymore posts. Since this is the last post, and because my stock ideas now belong to our clients, I will keep this very high level.
The Irony is Getting Ridiculous! - Although I almost always vote Republican, I am increasingly unhappy with both parties. This rant will focus on the democrats however. Specifically, I am talking about financial reform. Let me back up and start with a premise that I think is accurate. The aggregate level of loans on bank balance sheets two years ago reflected a level of underwriting that we all now consider foolish. To put it another way, bank had made too many loans. The US Congress passed TARP legislation to support the banking sector and prevent a catastrophic collapse. Old news. Jumping to today, the democrats are howling that banks are not lending enough while at the same time basing their drive for financial reform on the premise that the banks are responsible for the Great Recession because they were reckless lenders. And the proof that banks are not lending enough? Their loan balances are shrinking. So just to be clear, banks caused this whole mess by making bad loans, but they are damaging the economy by letting their balance sheets shrink. Getting back to my original premise; if we all agree that underwriting standards were too loose, then it follows that there should be fewer loans outstanding going forward (at least until population growth and economic growth support higher debt levels at better underwriting standards). Unless we want banks to go back to making stupid loans, then we should expect their loan balances to be shrinking. And to add to the irony, the democrats have attacked TARP recipients to the point that the nations largest lenders are desperately trying to repay the money. If we want these banks to be lending, does it really make sense to attack them until they feel forced to return capital? I don't think the democrats can have it both ways.
Even more troublesome (and that is saying a lot) is the amendment to the Wall Street Reform and Consumer Protection Act of 2009 that passed the House on Friday. The specific amendment I am referring to would allow a Congressional watchdog group to audit the Federal Reserve's monetary policy decisions. Lets think about that for just a moment. Do we want politicians to have a say in where interest rates are set? Do we want the Federal Reserve Governors to be making economic decisions based on their ability to defend them to politicians after the fact? I absolutely do not want that! Even more frightening, what about emergencies? Thinking back a year, who would I have wanted calling the shots when SIVs started to have trouble rolling their ABCP, and when auction-rate security auctions failed, and when dealers started raising haircuts on repo financing, and when the OTC derivative market faced the prospect of losing a major couterparty, and when a run started on money market mutual funds? Can you imagine your Congressman or Senator handling that situation better than the Federal Reserve? Politicians make decisions that are good for their constituents and that will get them re-elected (maybe not in that order). The independence of the Federal Reserve should remain firmly in place. The good news is that I am fairly confident that this politically driven amendment will be stripped out of any final bill, but the fact that it passed the House shocked me.
After talking about ironies, this will probably sound ironic. One the one hand, I think the current political environment (rampant spending, hostility toward financial institutions, and attacks on our free market institutions) is frightening and has the potential to spiral out of control. Even though I have not participated, I understand the unease which is driving investors to buy gold and make bets on hyper-inflation etc. While I share many of their fears, I still think this will most likely end well. The economy has a very long history of cyclicality and even the current political environment will have a hard time over-riding that pattern. As such, I think we are at the beginning of an economic recovery. Jobs are about to start returning on a net basis as inventories rebuild on firming consumer spending. Inflation is unlikely to rise given the excess levels of labor and production capacity. Aggregate leverage needs to come down and that will keep this recovery more modest than it otherwise would be, but that is okay. Based on that view, I still want to own stocks, not bonds.
With the jobs number approaching zero, I opened my Prosper.com account and am waiting on a CD to mature so I can fund it. These are risky unsecured consumer loans, but from a macro perspective, I think now is a good time to invest there. Job losses should decline which will lower the odds of default. Additionally, credit card companies are being forced to raise rates on their customers in anticipation of new government regulation that will prevent them from raising rates later. This means there are a lot of credit-worthy borrowers that could benefit from a Prosper.com debt consolidation loan and I intend to participate. I will also be looking to fund small business loans because I know many banks are still short of capital and can't make them. In both cases, I think there is disruption that creates opportunity. Again, these loans are risky, so make up your own mind on how much risk you can accept.
Thanks for reading and I can't tell you how happy I am not to be able to write about individual stocks anymore. This was fun, but having a job is better.
John
Tuesday, December 15, 2009
Saturday, October 3, 2009
Morgan Stanley is worth $40
I just bought some shares of Morgan Stanley on Friday which may surprise you given my comments about Goldman Sachs in prior posts.
But before I get into that, I had been selling some stock and my cash position was up to 15% of my portfolio. I was not unhappy with this position given my view that the market is fairly valued between 1000 and 1050 on the S&P500. The sells reflected some profit taking as well as an admission that I was wrong. For profit taking, I sold some of my Amerigon and Shutterfly shares which were purchased in March. I also sold Greenhill which I have written about before. The stock went up to over $91 and my price target was about $100 by the end of 2010. That only left me with a 7% compounded annual return to my price target, so I decided to sell and look for other ideas. I also sold my shares of Monsanto, which I had owned since last fall. I bought this stock without thinking very carefully about the valuation. The company's value proposition was very attractive to me and I bought some shares. As I re-evaluated the stock recently, I decided that the growth assumptions needed to justify the current price would be very hard for the company to beat. I sold and took a 30% loss as a result of my error.
I continue to be bullish longer term however and have been trying to find stocks that I think will perform well in an anemic recovery, which is the environment I expect to be investing in for the next two years at least. Morgan Stanley is one of the companies that I think can fulfill that role.
But why buy Morgan Stanley and sell Greenhill? Aren't they exposed to the same drivers? The answer is that they are exposed to a lot of the same drivers and I am aware of the possibility that Greenhill might go up much more than I think it should. Morgan Stanley is not the pure-play on the M&A cycle that Greenhill is, so investors are less likely to flock to it when looking to play that specific theme. However, Morgan Stanley is cheap and more diversified. Greenhill has already had a big run based on anticipation.
My valuation work suggests that Morgan Stanley is worth about $40 right now, but it trades under $30. That $40 intrinsic value should rise over time as the economy, M&A market, and broader markets go up. So I think there is 33% upside to intrinsic value and I think this is a company and stock that will have rising value to investors over the next several years.
Morgan Stanley has not come out of the recent crash with the same cache that Goldman and JP Morgan have. As the recovery fully sets in, I expect that sentiment gap between GS/JPM and the rest of the sector to narrow.
Regarding risk, I watched Bear, Lehman and Merrill fail to varying degrees and watched as Morgan Stanley and Goldman teetered on the edge for a few months. I also understand that we were watching a credit market that collapsed, intersecting with business models that had become increasingly leveraged and dependent on the credit markets. The good news is that I doubt we will see either MS or GS in a similar position for a very long time. While GS is expensive and almost universally adored, MS has almost identical drivers but is much cheaper. Right now, the credit market is comfortable supporting GS and MS largely because they are both bank holding companies and have the Fed as a backstop. While I think it is a joke to argue that MS and GS are banks, I also think the Fed will keep the status quo until the credit market is willing to fund them alone. It seems very unlikely that they will risk causing another scare right now given the fragile state of the markets and confidence. Basically, I am investing based on the belief that IF Morgan Stanley fails, it will be during the next crash. Since I think we are just coming off the last crash, I think the stock will outperform the markets for over the next 2-5 years.
But before I get into that, I had been selling some stock and my cash position was up to 15% of my portfolio. I was not unhappy with this position given my view that the market is fairly valued between 1000 and 1050 on the S&P500. The sells reflected some profit taking as well as an admission that I was wrong. For profit taking, I sold some of my Amerigon and Shutterfly shares which were purchased in March. I also sold Greenhill which I have written about before. The stock went up to over $91 and my price target was about $100 by the end of 2010. That only left me with a 7% compounded annual return to my price target, so I decided to sell and look for other ideas. I also sold my shares of Monsanto, which I had owned since last fall. I bought this stock without thinking very carefully about the valuation. The company's value proposition was very attractive to me and I bought some shares. As I re-evaluated the stock recently, I decided that the growth assumptions needed to justify the current price would be very hard for the company to beat. I sold and took a 30% loss as a result of my error.
I continue to be bullish longer term however and have been trying to find stocks that I think will perform well in an anemic recovery, which is the environment I expect to be investing in for the next two years at least. Morgan Stanley is one of the companies that I think can fulfill that role.
But why buy Morgan Stanley and sell Greenhill? Aren't they exposed to the same drivers? The answer is that they are exposed to a lot of the same drivers and I am aware of the possibility that Greenhill might go up much more than I think it should. Morgan Stanley is not the pure-play on the M&A cycle that Greenhill is, so investors are less likely to flock to it when looking to play that specific theme. However, Morgan Stanley is cheap and more diversified. Greenhill has already had a big run based on anticipation.
My valuation work suggests that Morgan Stanley is worth about $40 right now, but it trades under $30. That $40 intrinsic value should rise over time as the economy, M&A market, and broader markets go up. So I think there is 33% upside to intrinsic value and I think this is a company and stock that will have rising value to investors over the next several years.
Morgan Stanley has not come out of the recent crash with the same cache that Goldman and JP Morgan have. As the recovery fully sets in, I expect that sentiment gap between GS/JPM and the rest of the sector to narrow.
Regarding risk, I watched Bear, Lehman and Merrill fail to varying degrees and watched as Morgan Stanley and Goldman teetered on the edge for a few months. I also understand that we were watching a credit market that collapsed, intersecting with business models that had become increasingly leveraged and dependent on the credit markets. The good news is that I doubt we will see either MS or GS in a similar position for a very long time. While GS is expensive and almost universally adored, MS has almost identical drivers but is much cheaper. Right now, the credit market is comfortable supporting GS and MS largely because they are both bank holding companies and have the Fed as a backstop. While I think it is a joke to argue that MS and GS are banks, I also think the Fed will keep the status quo until the credit market is willing to fund them alone. It seems very unlikely that they will risk causing another scare right now given the fragile state of the markets and confidence. Basically, I am investing based on the belief that IF Morgan Stanley fails, it will be during the next crash. Since I think we are just coming off the last crash, I think the stock will outperform the markets for over the next 2-5 years.
Tuesday, September 22, 2009
A123 IPO - Risky but interesting
I have been trying to decide how much I am willing to pay for shares of A123 which is scheduled to issue shares for the first time (IPO) after market close tomorrow. As I noted in my last post, I am pretty excited about the whole battery sector and this has the potential to draw a lot more attention to the sector. Having said that, this is a risky investment case.
First, A123 is a battery company that makes Lithium phosphate batteries for use in consumer products (ex. cordless drills), vehicles (such as the Chevy Volt which they lost) and maybe the electricity grid. I am not a chemist, but my understanding is that Lithium phosphate chemistry has a better safety profile than Lithium Ion, but doesn't pack quite as much punch either.
Let me start with the risks, because they are more significant than I originally thought. First, if you buy this stock, you are expecting that Lithium phosphate chemistry will participate in the industry growth. Early indications were very good, but GM recently picked LG Chem over A123 to provide the batteries for the Chevy Volt car. Granted, this was just one car, but a company that was able to do much better analysis than I can do determined that A123 was not the best choice. I have heard that A123 may not have had the capacity in place to produce enough batteries and that was a big determinant of the outcome. I don't know if that is true. It could be more substantive issues.
Another big risk is that A123 is involved in a couple legal disputes over patents. A123 has an exclusive license from MIT for some nanotechnology used to make the lithium phosphate batteries. Evidently, there are some other patents that are in dispute. It is possible that A123 could be required to license additional patents which would be detrimental to their ability to turn a profit.
The last big risk really incorporates the others as well. A123 is not profitable right now. How much I am willing to pay for this stock depends a great deal on how soon they can break even, and how big future profits will be. These are difficult projections to make. I did end up buying shares of ENS which has an existing business that is profitable and offers some downside protection. A123 does not have that downside protection.
I hope you are reasonably nervous now. Despite those risks, this is also a company that has tremendous upside if it works. It is part of an industry that I think has huge growth ahead of it. To cut to the chase, I am going to try to buy some shares if I can get it under $9.00 per share.
To get that number I have to make some aggressive assumptions so hold on to your hats. First I think revenues will be $100m this year, then $175m in 2010, $350m in 2011, $525m in 2012 and continued high growth thereafter than gradually slows to 10% in ten years. More importantly, I am projecting an operating margin of -93% in 2009, -30% in 2010, break even in 2011, 5% in 2012, and 10% thereafter. I am expecting battery prices to fall by 8% per year.
If those revenue assumption seem crazy, consider this scenario. There are about 70m vehicles with internal combustion engines sold globally every year. If 5% of those have an advanced battery in 2012, A123 has a 2% market share, and they sell the battery for about $8400 each, that would represent revenue of $588 million in 2012. Of course we have almost no way of knowing whether they will miss or exceed those assumptions, but I don't think they are crazy. This does not include any revenue from the power grid or consumer products.
Under those assumptions, I think the company is worth $9.94 per share, assuming a share count of 111 million after the IPO. I think it is likely that there will be a sentiment multiplier on this stock of maybe 1.2 (people will get excited about this stuff). So this stock could easily trade to $12 per share under that scenario. Given the risks, I am not willing to pay a sentiment multiplier and would like to get it at a discount to my estimated intrinsic value. As such I will probably buy a below average position if I can get it below $9, or buy an average size position if I can buy it closer to $8. My guess is that this will be a very successful IPO however, so there is a pretty good chance I won't get a shot below $9. If you buy some, please remember that this is a stock that can go to zero easier than most, so control your risk with position size and be disciplined on what you pay.
First, A123 is a battery company that makes Lithium phosphate batteries for use in consumer products (ex. cordless drills), vehicles (such as the Chevy Volt which they lost) and maybe the electricity grid. I am not a chemist, but my understanding is that Lithium phosphate chemistry has a better safety profile than Lithium Ion, but doesn't pack quite as much punch either.
Let me start with the risks, because they are more significant than I originally thought. First, if you buy this stock, you are expecting that Lithium phosphate chemistry will participate in the industry growth. Early indications were very good, but GM recently picked LG Chem over A123 to provide the batteries for the Chevy Volt car. Granted, this was just one car, but a company that was able to do much better analysis than I can do determined that A123 was not the best choice. I have heard that A123 may not have had the capacity in place to produce enough batteries and that was a big determinant of the outcome. I don't know if that is true. It could be more substantive issues.
Another big risk is that A123 is involved in a couple legal disputes over patents. A123 has an exclusive license from MIT for some nanotechnology used to make the lithium phosphate batteries. Evidently, there are some other patents that are in dispute. It is possible that A123 could be required to license additional patents which would be detrimental to their ability to turn a profit.
The last big risk really incorporates the others as well. A123 is not profitable right now. How much I am willing to pay for this stock depends a great deal on how soon they can break even, and how big future profits will be. These are difficult projections to make. I did end up buying shares of ENS which has an existing business that is profitable and offers some downside protection. A123 does not have that downside protection.
I hope you are reasonably nervous now. Despite those risks, this is also a company that has tremendous upside if it works. It is part of an industry that I think has huge growth ahead of it. To cut to the chase, I am going to try to buy some shares if I can get it under $9.00 per share.
To get that number I have to make some aggressive assumptions so hold on to your hats. First I think revenues will be $100m this year, then $175m in 2010, $350m in 2011, $525m in 2012 and continued high growth thereafter than gradually slows to 10% in ten years. More importantly, I am projecting an operating margin of -93% in 2009, -30% in 2010, break even in 2011, 5% in 2012, and 10% thereafter. I am expecting battery prices to fall by 8% per year.
If those revenue assumption seem crazy, consider this scenario. There are about 70m vehicles with internal combustion engines sold globally every year. If 5% of those have an advanced battery in 2012, A123 has a 2% market share, and they sell the battery for about $8400 each, that would represent revenue of $588 million in 2012. Of course we have almost no way of knowing whether they will miss or exceed those assumptions, but I don't think they are crazy. This does not include any revenue from the power grid or consumer products.
Under those assumptions, I think the company is worth $9.94 per share, assuming a share count of 111 million after the IPO. I think it is likely that there will be a sentiment multiplier on this stock of maybe 1.2 (people will get excited about this stuff). So this stock could easily trade to $12 per share under that scenario. Given the risks, I am not willing to pay a sentiment multiplier and would like to get it at a discount to my estimated intrinsic value. As such I will probably buy a below average position if I can get it below $9, or buy an average size position if I can buy it closer to $8. My guess is that this will be a very successful IPO however, so there is a pretty good chance I won't get a shot below $9. If you buy some, please remember that this is a stock that can go to zero easier than most, so control your risk with position size and be disciplined on what you pay.
Thursday, September 10, 2009
Market Update and Batteries
I apologize for the delay making a post. I have been working through several ideas as well as continuing my job search. But maybe most important for me, I have been refining a valuation methodology that I came up with in grad school, but never really fleshed out. As I have been using it over the last few weeks, I have become increasingly convinced that the overall market is fairly valued between 1000 and 1050 on the S&P500. This is consistent with my prior view that the S&P would be up about 10% this year and another 20% next year. The S&P 500 is currently up about 15% ytd, so a little ahead of what I was expecting. Given that performance and my valuation work, I think the market is most likely to tread water for a quarter or two. The next leg up will need to be driven by real economic data which probably won't happen until well into 2010.
With that view, I think it continues to make sense to be invested in equities since the rally could start sooner than I think, but I think good stock selection or thematic ideas will be key to positive performance over the next few quarters (as opposed to just being in the market).
The theme I have been doing a lot of work on recently is batteries. Not the AA kind, but industrial batteries. There are two trends that are already in play that I think will have a long duration. First, I expect the percentage of vehicles sold around the world that have some level of hybrid capacity will skyrocket. It would not surprise me if hybrid/electric cars represent over 50% of the market within five years. Whether these cars are micro hybrid (use a battery to run functions when car is stopped), mild hybrid (that use a battery to assist the conventional engine), full hybrid (that occasionally use only a battery power to move), or Electric Vehicles (that don't have an internal combustion engine); I think the demand for advanced batteries for vehicles is likely to boom over almost a full decade. The second trend is toward using batteries to stabilize the electricity grid and to integrate alternative power sources into the grid. The existing grid is not good at storing power for peak periods of consumption. Furthermore, my understanding is that peak electricity demand is at about 7pm, but solar output is highest in the early afternoon and wind power is usually highest overnight. Large arrays of industrial batteries are a way to store power during off-peak periods and use it during peak periods. These batteries could be installed at the point of generation (for example, at a wind farm), or potentially in homes across the country (the batteries charge in your basement overnight and then run your AC in the afternoon).
There are a lot of competing technologies as you might expect. Lead acid has been around a long time and is what you use in your car. It is relatively cheap, but the batteries are heavy. There has been a new wave of R&D in this space to see if there can be improvements. If nothing else, it is a proven technology with well established recycling capacity for the lead. Some of that R&D has been toward Lead Carbon batteries, which replace the negative electrode with a carbon based material. This increases the life-cycle of the batteries, reduces their weight, and in some cases improves the speed at which they can be charged. Nickel based batteries are currently the most common in hybrid vehicles. They work pretty well, but there are concerns about the availability of nickel as an input commodity. Finally, lithium ion batteries are the coolest kid on the block. They are much lighter, have higher energy density, but cost a lot more. In addition, there are flow batteries, compressed air batteries, flywheel technology, sodium batteries, all of which are vying for acceptance.
At first, I was trying to determine which technology was likely to be the winner, but I decided that I don't need to. My best guess is that this trend is big enough to accommodate multiple technologies for various applications. The highest performance electric vehicles will probably end up using lithium ion, but mild hybrids can probably use lead carbon as a more economical solution. The power grid probably won't use lithium ion because it will be focused on economics and the cheaper, more established, solutions are more likely to win.
There are three stocks I have decided I like for now. SAFT is a french company (which makes it hard to buy in my brokerage account but maybe not yours) that has a very well established industrial and defense battery business. This offers good downside protection since that business probably won't go away even if my growth thesis doesn't play out. The interesting part is that they have a JV with Johnson Controls to build lithium ion batteries for the auto market. This is not generating a profit yet, but I think the potential is massive. I like this stock under 33 euros. I think SAFT has a great balance of downside protection and a great chance of capitalizing on the lithium ion wave, but I probably won't be buying it unless I switch brokers.
Enersys (ticker ENS) is another established industrial battery company based in the US that is also doing work on lithium ion batteries. Again, their established business provides some downside protection and I think they are especially well positioned to win business from the electricity grid thesis. I like this stock under $25. I currently have a limit order in trying to buy it at $20.10. This is my favorite idea given the low growth assumptions needed to make $25 look attractive.
Finally, Axion Power (ticker AXPW) is a micro cap company that has a lead carbon technology. This one is much more risky because they do not have an established business so you are completely dependent on dramatic growth for their new technology. They lost money in the most recently reported quarter, but they also recently signed some contracts with Exide to provide the carbon electrodes. I just listened to a conference webcast today and it sounded to me that their biggest obstacle is increasing their capacity. Having said that, this one is tricky to value because the range of outcomes is simply massive. I am hoping to buy it closer to $2 per share. For now, I'm watching it and continuing to do more work on it.
With that view, I think it continues to make sense to be invested in equities since the rally could start sooner than I think, but I think good stock selection or thematic ideas will be key to positive performance over the next few quarters (as opposed to just being in the market).
The theme I have been doing a lot of work on recently is batteries. Not the AA kind, but industrial batteries. There are two trends that are already in play that I think will have a long duration. First, I expect the percentage of vehicles sold around the world that have some level of hybrid capacity will skyrocket. It would not surprise me if hybrid/electric cars represent over 50% of the market within five years. Whether these cars are micro hybrid (use a battery to run functions when car is stopped), mild hybrid (that use a battery to assist the conventional engine), full hybrid (that occasionally use only a battery power to move), or Electric Vehicles (that don't have an internal combustion engine); I think the demand for advanced batteries for vehicles is likely to boom over almost a full decade. The second trend is toward using batteries to stabilize the electricity grid and to integrate alternative power sources into the grid. The existing grid is not good at storing power for peak periods of consumption. Furthermore, my understanding is that peak electricity demand is at about 7pm, but solar output is highest in the early afternoon and wind power is usually highest overnight. Large arrays of industrial batteries are a way to store power during off-peak periods and use it during peak periods. These batteries could be installed at the point of generation (for example, at a wind farm), or potentially in homes across the country (the batteries charge in your basement overnight and then run your AC in the afternoon).
There are a lot of competing technologies as you might expect. Lead acid has been around a long time and is what you use in your car. It is relatively cheap, but the batteries are heavy. There has been a new wave of R&D in this space to see if there can be improvements. If nothing else, it is a proven technology with well established recycling capacity for the lead. Some of that R&D has been toward Lead Carbon batteries, which replace the negative electrode with a carbon based material. This increases the life-cycle of the batteries, reduces their weight, and in some cases improves the speed at which they can be charged. Nickel based batteries are currently the most common in hybrid vehicles. They work pretty well, but there are concerns about the availability of nickel as an input commodity. Finally, lithium ion batteries are the coolest kid on the block. They are much lighter, have higher energy density, but cost a lot more. In addition, there are flow batteries, compressed air batteries, flywheel technology, sodium batteries, all of which are vying for acceptance.
At first, I was trying to determine which technology was likely to be the winner, but I decided that I don't need to. My best guess is that this trend is big enough to accommodate multiple technologies for various applications. The highest performance electric vehicles will probably end up using lithium ion, but mild hybrids can probably use lead carbon as a more economical solution. The power grid probably won't use lithium ion because it will be focused on economics and the cheaper, more established, solutions are more likely to win.
There are three stocks I have decided I like for now. SAFT is a french company (which makes it hard to buy in my brokerage account but maybe not yours) that has a very well established industrial and defense battery business. This offers good downside protection since that business probably won't go away even if my growth thesis doesn't play out. The interesting part is that they have a JV with Johnson Controls to build lithium ion batteries for the auto market. This is not generating a profit yet, but I think the potential is massive. I like this stock under 33 euros. I think SAFT has a great balance of downside protection and a great chance of capitalizing on the lithium ion wave, but I probably won't be buying it unless I switch brokers.
Enersys (ticker ENS) is another established industrial battery company based in the US that is also doing work on lithium ion batteries. Again, their established business provides some downside protection and I think they are especially well positioned to win business from the electricity grid thesis. I like this stock under $25. I currently have a limit order in trying to buy it at $20.10. This is my favorite idea given the low growth assumptions needed to make $25 look attractive.
Finally, Axion Power (ticker AXPW) is a micro cap company that has a lead carbon technology. This one is much more risky because they do not have an established business so you are completely dependent on dramatic growth for their new technology. They lost money in the most recently reported quarter, but they also recently signed some contracts with Exide to provide the carbon electrodes. I just listened to a conference webcast today and it sounded to me that their biggest obstacle is increasing their capacity. Having said that, this one is tricky to value because the range of outcomes is simply massive. I am hoping to buy it closer to $2 per share. For now, I'm watching it and continuing to do more work on it.
Wednesday, August 5, 2009
Two sells
I shared some of the stocks I purchased and thought I should share when I was selling them. In the last couple days I sold about 40% of my CLWR shares at $8.96. I had put in a limit order to sell 40% of my shares at a 50% gain and that order executed. Yesterday, I sold about a third of my PFG shares at $25.81, also with a limit order I had in place. This was the second tranche of PFG shares I sold. I bought the shares at the bottom of the market in March and I sold a third when it doubled and another third when it tripled. I actually like this company, so I still have a third of my original shares and need to decide if I want to keep it as a longer term holding, or set another limit order.
I also forgot to mention that I bought some HSBC ADRs (ticker HBC) in late June at $42.13. This was largely a macro purchase. I have been an admirer of the bank for a long time and decided to use some of my idle cash to buy shares. The stock pays a good dividend that I think is more likely to go up than down over the coming years. They are one of the best positioned banks in China and in emerging markets around the world. Because I am generally bullish, I decided a diversified global bank could be a long term holding. I do not have any limit orders in to sell this stock and plan to hold it for a long time. I think of this a core holding that I will probably add to over time. Lastly on HBC, the US is both a black eye and huge opportunity in my opinion. For investors in the stock, HSBC's entry into the US consumer lending business turned out to be ill-timed and a very costly mistake. At this point, I am willing to bet that most of the losses from that portfolio have been taken. Longer term, the US is really an opportunity for HSBC. Despite being one of the largest banks in the world, most Americans have never heard of it. They have a fledgling retail and private banking presence in a few large cities, but it represents a rounding error.
I am also using HBC as a way to improve my skills analyzing non-US companies, so I will make a more detailed post on this stock in the future.
I also forgot to mention that I bought some HSBC ADRs (ticker HBC) in late June at $42.13. This was largely a macro purchase. I have been an admirer of the bank for a long time and decided to use some of my idle cash to buy shares. The stock pays a good dividend that I think is more likely to go up than down over the coming years. They are one of the best positioned banks in China and in emerging markets around the world. Because I am generally bullish, I decided a diversified global bank could be a long term holding. I do not have any limit orders in to sell this stock and plan to hold it for a long time. I think of this a core holding that I will probably add to over time. Lastly on HBC, the US is both a black eye and huge opportunity in my opinion. For investors in the stock, HSBC's entry into the US consumer lending business turned out to be ill-timed and a very costly mistake. At this point, I am willing to bet that most of the losses from that portfolio have been taken. Longer term, the US is really an opportunity for HSBC. Despite being one of the largest banks in the world, most Americans have never heard of it. They have a fledgling retail and private banking presence in a few large cities, but it represents a rounding error.
I am also using HBC as a way to improve my skills analyzing non-US companies, so I will make a more detailed post on this stock in the future.
Tuesday, July 28, 2009
Housing has bottomed, and some market commentary
There have been three data points over the last week that lead me to believe we are at the bottom for housing prices in the US.
Today, Case-Shiller announced the their 20 city home price index rose from April to May 2009, which was the first month to month increase in three years. The data is not seasonally adjusted, but the point is that prices have stabilized enough for seasonality to generate a positive datapoint. For three years, that wasn't the case.
Second, yesterday, new home sales jumped 11% which was the biggest monthly jump in eight years. This one is a little bit ambiguous because we don't really need a lot of new homes being built if we are trying to stabilize housing prices. It does have the potential to be good news if it implies that the builders are either finally clearing out their inventory, or they are seeing real new demand.
And finally, data from the National Association of Realtors indicates that the share of sales coming from foreclosures is dropping. I couldn't find the data on their website directly, but here is a clip from a Bloomberg article. "The share of homes sold as foreclosures or otherwise distressed properties fell to about 31 percent in June, down from 45 percent to 50 percent seen earlier this year, the real- estate agents’ group said last week". This is great news as it means one of the downward levers on prices appears to be coming off a bit.
If I take these three datapoints, and mesh them with the fact that housing peaked in 2006 (we are in 2009 now), and that the housing price index I mentioned earlier is down 32% from that peak, and that there are other indications that the economy is entering a recovery; I come to the conclusion that housing prices have bottomed. This is great news.
This leads me to a second topic: the changing nature of the current bull market. The conventional definition of a bull market is a 20% gain in the market. What I want to talk about though is the change. From the market low on the S&P500 in early March, the market ran from about 670 to over 900 by early May. I consider this run to have been a relief rally. Fundamentals did not improve much at all during that stretch, but the fear of collapse dissipated. Then the S&P500 stagnated from early May through early July. But the markets started to climb again in the back half of July. I think this most recent rally, to about 975, has been more fundamentally driven and that is a very big deal. Technically, it has all been one bull market, but I think the first leg was sentiment driven, and the second leg has had fundamental underpinnings.
Q2 earnings season is not over, but I have been amazed at how many companies are beating estimates and giving positive guidance. I don't have good statistics on this, just my overall impressions from reading the news every day. My guess is that the S&P500 ends 2009 up about 10%, but I think 2010 will be a very good year for the markets (probably 20+%).
Today, Case-Shiller announced the their 20 city home price index rose from April to May 2009, which was the first month to month increase in three years. The data is not seasonally adjusted, but the point is that prices have stabilized enough for seasonality to generate a positive datapoint. For three years, that wasn't the case.
Second, yesterday, new home sales jumped 11% which was the biggest monthly jump in eight years. This one is a little bit ambiguous because we don't really need a lot of new homes being built if we are trying to stabilize housing prices. It does have the potential to be good news if it implies that the builders are either finally clearing out their inventory, or they are seeing real new demand.
And finally, data from the National Association of Realtors indicates that the share of sales coming from foreclosures is dropping. I couldn't find the data on their website directly, but here is a clip from a Bloomberg article. "The share of homes sold as foreclosures or otherwise distressed properties fell to about 31 percent in June, down from 45 percent to 50 percent seen earlier this year, the real- estate agents’ group said last week". This is great news as it means one of the downward levers on prices appears to be coming off a bit.
If I take these three datapoints, and mesh them with the fact that housing peaked in 2006 (we are in 2009 now), and that the housing price index I mentioned earlier is down 32% from that peak, and that there are other indications that the economy is entering a recovery; I come to the conclusion that housing prices have bottomed. This is great news.
This leads me to a second topic: the changing nature of the current bull market. The conventional definition of a bull market is a 20% gain in the market. What I want to talk about though is the change. From the market low on the S&P500 in early March, the market ran from about 670 to over 900 by early May. I consider this run to have been a relief rally. Fundamentals did not improve much at all during that stretch, but the fear of collapse dissipated. Then the S&P500 stagnated from early May through early July. But the markets started to climb again in the back half of July. I think this most recent rally, to about 975, has been more fundamentally driven and that is a very big deal. Technically, it has all been one bull market, but I think the first leg was sentiment driven, and the second leg has had fundamental underpinnings.
Q2 earnings season is not over, but I have been amazed at how many companies are beating estimates and giving positive guidance. I don't have good statistics on this, just my overall impressions from reading the news every day. My guess is that the S&P500 ends 2009 up about 10%, but I think 2010 will be a very good year for the markets (probably 20+%).
My mistake selling CBG
I sold about 60% of my remaining position in CB Richard Ellis yesterday. I had already sold half my shares after the stock doubled from my purchase price. The stock was up 200% from my purchase price yesterday, so I decided to sell some shares.
The question I wrestled with yesterday was whether to sell the whole thing. My investment thesis on CBG was that it was dramatically oversold (as were a lot of stocks). This was a stock I knew pretty well having covered it at my last job. The point is that I didn't buy the stock because I thought the fundamentals of the commercial real estate market were about to get a lot better. Ultimately, this thesis was based on an improvement in sentiment, not intrinsic value. I think sentiment has largely normalized now so that trade is over. For the stock to rise dramatically from here, either sentiment needs to swing to the exuberant side of the spectrum (very unlikely in my opinion) or the fundamentals need to improve enough to raise Intrinsic Value. I have been reading about some renewed interest in commercial real estate from foreign investors, but ultimately, I think fundamentals will come back slowly.
So why didn't I sell the whole position. I think I fell victim to some classic thinking traps. CBG has been my best performing stock and I like owning it as a result. Keeping a small position serves as a trophy of sorts. Second, it is simply hard to sell a stock when it is going up. The fear of missing future gains is powerful and I think I was lured in.
Just wanted to share some of what I'm learning.
The question I wrestled with yesterday was whether to sell the whole thing. My investment thesis on CBG was that it was dramatically oversold (as were a lot of stocks). This was a stock I knew pretty well having covered it at my last job. The point is that I didn't buy the stock because I thought the fundamentals of the commercial real estate market were about to get a lot better. Ultimately, this thesis was based on an improvement in sentiment, not intrinsic value. I think sentiment has largely normalized now so that trade is over. For the stock to rise dramatically from here, either sentiment needs to swing to the exuberant side of the spectrum (very unlikely in my opinion) or the fundamentals need to improve enough to raise Intrinsic Value. I have been reading about some renewed interest in commercial real estate from foreign investors, but ultimately, I think fundamentals will come back slowly.
So why didn't I sell the whole position. I think I fell victim to some classic thinking traps. CBG has been my best performing stock and I like owning it as a result. Keeping a small position serves as a trophy of sorts. Second, it is simply hard to sell a stock when it is going up. The fear of missing future gains is powerful and I think I was lured in.
Just wanted to share some of what I'm learning.
Tuesday, July 14, 2009
Goldman Sachs still king of the mountain
Goldman Sachs reported Q2 earnings this morning that were significantly better than the consensus estimates. As I listened to the conference call, I was reminded again that Goldman's stock really is special and I am angered by the whole situation.
First, why is Goldman special?
Then TARP was rushed through Congress. Ten systemically important banks were basically forced to take equity infusions. Some of those, most notably J.P. Morgan, probably really didn't need or want the capital. Goldman however needed all the help they could get. Their business model had clearly been under attack and confidence was shaken. As the crisis has since receded, Goldman has fought to return the capital and be free of Congress' heavy hand (I can't blame them for that).
I think what bugs me is that Goldman was basically saved by the government, but there is no humility. Despite being a bank holding company, their last quarter made it crystal clear that Goldman has not really changed at all. They have reduced their leverage, but no one reading through their earnings release would be thinking, "Oh, this looks like a bank". But to listen to their conference call, it is as if nothing weird happened in the last year.
Am I just jealous because they are so good and I did not own the stock from $60 to $150? I am jealous that they are so good, but I'm also suspicious. Almost all banks (I would say all, but there is probably an exception I don't know about) report a lot of detail about their balance sheet and business. Goldman is famously light on detail. Someone asked on this morning's call how much of their FICC revenue came from commodities and they wouldn't answer the question. That specific question isn't that important to me, but it underscores yet again, that we know so little about how they make their money.
The blogs have been buzzing about the stolen code from Goldman's proprietary trading business. I read that the FBI was called in because, in the wrong hands, the code could be used to manipulate the markets. I hope Goldman itself isn't the "wrong hands." But with such little disclosure and such high-powered friends, we may never know.
Despite all my annoyance at Goldman, I think it is very hard to short this stock. My guess is that the M&A cycle will start to improve very soon and this is a high beta stock that will most likely do well in the bull market I am expecting. And as I mentioned, it is hard to come up with a catalyst that would dislodge such a loyal and devoted shareholder base.
First, why is Goldman special?
- This is one of the very few stocks in the financial sector where the expectation is for them to beat expectations. Normally, this is a very dicey position to be in for a stock as it creates the possibility of a dramatic drop in sentiment if they miss. I think JP Morgan might be one of the other stocks that is broadly expected to beat expectations.
- Long-only investors "trust" Goldman more than any other financial stock I have seen. One could argue that Goldman has earned this trust by outperforming its peers for quite a few years now and surviving the financial meltdown of 2008. The reason this is important is that it would be hard to convince these investors to sell their Goldman stock, which makes a short thesis problematic. "Goldman will figure out how to make money," is a widely held view and therefore I think sentiment on the stock could survive an earnings miss that would damage almost anyone else. I think even Warren Buffett is a bit too enamored with Goldman.
- Goldman is possibly the most politically connected firm in the US. This is a double-edged sword, but at least so far, it would appear that it has only helped, without much, if any, backlash.
Then TARP was rushed through Congress. Ten systemically important banks were basically forced to take equity infusions. Some of those, most notably J.P. Morgan, probably really didn't need or want the capital. Goldman however needed all the help they could get. Their business model had clearly been under attack and confidence was shaken. As the crisis has since receded, Goldman has fought to return the capital and be free of Congress' heavy hand (I can't blame them for that).
I think what bugs me is that Goldman was basically saved by the government, but there is no humility. Despite being a bank holding company, their last quarter made it crystal clear that Goldman has not really changed at all. They have reduced their leverage, but no one reading through their earnings release would be thinking, "Oh, this looks like a bank". But to listen to their conference call, it is as if nothing weird happened in the last year.
Am I just jealous because they are so good and I did not own the stock from $60 to $150? I am jealous that they are so good, but I'm also suspicious. Almost all banks (I would say all, but there is probably an exception I don't know about) report a lot of detail about their balance sheet and business. Goldman is famously light on detail. Someone asked on this morning's call how much of their FICC revenue came from commodities and they wouldn't answer the question. That specific question isn't that important to me, but it underscores yet again, that we know so little about how they make their money.
The blogs have been buzzing about the stolen code from Goldman's proprietary trading business. I read that the FBI was called in because, in the wrong hands, the code could be used to manipulate the markets. I hope Goldman itself isn't the "wrong hands." But with such little disclosure and such high-powered friends, we may never know.
Despite all my annoyance at Goldman, I think it is very hard to short this stock. My guess is that the M&A cycle will start to improve very soon and this is a high beta stock that will most likely do well in the bull market I am expecting. And as I mentioned, it is hard to come up with a catalyst that would dislodge such a loyal and devoted shareholder base.
Wednesday, July 8, 2009
Jobs number was disappointing
First off, I wrote this on July 3rd but got distracted and forgot to post it. Sorry about the delay.
The US economy shed 467,000 jobs in June, which was worse than I thought it would be. The context for me is that I have been very bullish on the markets and I thought a steady improvement in the jobs number would fuel the markets. I did not think all the news would be good, because the economy is still clearly weak, but I have been expecting the mix of good/bad news to gradually improve.
The economy shed 322,000 jobs in May which, while still a bad number, was a real improvement. So how does this data impact my views? I'm still trying to sort that out in my own mind, but here are my thoughts. I am still bullish. Being in the job market myself, I have noticed a dramatic improvement in tone as I talk to potential employers and my friends in the investment community. Hiring is still very slow, but I am starting to see firms begin real searches and a friend of mine just got hired again. My guess is that if I worked for an auto manufacturer, dealer, or supplier, I would be observing the opposite trend right now. What I'm getting at is that I think there is starting to be improvement in some industries and continued weakness in others. My best guess is that the positive trend will resume in July, but the pace looks like it will be slower than I thought. I think we could see a -300,000 number in July.
Should this change my bullish stance? I don't think so. I am about the most bullish person I know right now and I would have to admit that I was starting to think a recovery was coming quicker than I originally thought. Yesterday's data was cold water on that increased optimism, but it still leaves me optimistic. I still think we are in the early stages of an economic recovery and I expect the markets to do well ahead of that recovery, and concurrent with that recovery. From a broader view, I want to own equities in this environment even with the understanding that there will be hickups along the way. Predicting those hickups with enough accuracy to trade them is very hard and I would rather try to get the bigger trend right.
The savings rate is up, so Americans with jobs are rebuilding their personal balance sheets. This will most likely mean that consumer spending growth will be anemic for quite awhile (maybe years), but it is setting us up for more stable and sustainable growth. I'm all for that.
The pipeline: On the docket for me are some research on Interactive Brokers and MF Global. I think I will have a chance to sell most of my GFIG stock at $8 within the next couple months so I'm looking for a place to put the cash. MF Global is a similar business, but with a higher risk profile because they act as clearing member for their clients and that does expose them to some risk. 95% of the time, I don't think that extra risk really matters, but it showed up about a year ago when a rough trader ran up huge losses on wheat contracts. The markets were already in witch hunt mode at the time and the stock was crushed. MF Global had to eat the loss and it uncovered some risk management decisions that were questionable at best, but also isolated to a very small part of their business. There was a period where I thought the sentiment had gotten so bad that their customers would all leave and the company would go under. That has not happened and risk management has been improved. Those of us that were burned by this stock will have a hard time buying it again, but I think it is time for another look.
Interactive Brokers is on the docket because I find myself considering opening an account there. I am currently a Schwab client and shareholder and am not looking to sell the stock, but Interactive brokers has a compelling value proposition and the stock looks cheap at first blush. More to come on both.
The US economy shed 467,000 jobs in June, which was worse than I thought it would be. The context for me is that I have been very bullish on the markets and I thought a steady improvement in the jobs number would fuel the markets. I did not think all the news would be good, because the economy is still clearly weak, but I have been expecting the mix of good/bad news to gradually improve.
The economy shed 322,000 jobs in May which, while still a bad number, was a real improvement. So how does this data impact my views? I'm still trying to sort that out in my own mind, but here are my thoughts. I am still bullish. Being in the job market myself, I have noticed a dramatic improvement in tone as I talk to potential employers and my friends in the investment community. Hiring is still very slow, but I am starting to see firms begin real searches and a friend of mine just got hired again. My guess is that if I worked for an auto manufacturer, dealer, or supplier, I would be observing the opposite trend right now. What I'm getting at is that I think there is starting to be improvement in some industries and continued weakness in others. My best guess is that the positive trend will resume in July, but the pace looks like it will be slower than I thought. I think we could see a -300,000 number in July.
Should this change my bullish stance? I don't think so. I am about the most bullish person I know right now and I would have to admit that I was starting to think a recovery was coming quicker than I originally thought. Yesterday's data was cold water on that increased optimism, but it still leaves me optimistic. I still think we are in the early stages of an economic recovery and I expect the markets to do well ahead of that recovery, and concurrent with that recovery. From a broader view, I want to own equities in this environment even with the understanding that there will be hickups along the way. Predicting those hickups with enough accuracy to trade them is very hard and I would rather try to get the bigger trend right.
The savings rate is up, so Americans with jobs are rebuilding their personal balance sheets. This will most likely mean that consumer spending growth will be anemic for quite awhile (maybe years), but it is setting us up for more stable and sustainable growth. I'm all for that.
The pipeline: On the docket for me are some research on Interactive Brokers and MF Global. I think I will have a chance to sell most of my GFIG stock at $8 within the next couple months so I'm looking for a place to put the cash. MF Global is a similar business, but with a higher risk profile because they act as clearing member for their clients and that does expose them to some risk. 95% of the time, I don't think that extra risk really matters, but it showed up about a year ago when a rough trader ran up huge losses on wheat contracts. The markets were already in witch hunt mode at the time and the stock was crushed. MF Global had to eat the loss and it uncovered some risk management decisions that were questionable at best, but also isolated to a very small part of their business. There was a period where I thought the sentiment had gotten so bad that their customers would all leave and the company would go under. That has not happened and risk management has been improved. Those of us that were burned by this stock will have a hard time buying it again, but I think it is time for another look.
Interactive Brokers is on the docket because I find myself considering opening an account there. I am currently a Schwab client and shareholder and am not looking to sell the stock, but Interactive brokers has a compelling value proposition and the stock looks cheap at first blush. More to come on both.
Monday, June 22, 2009
Exposure to falling oil prices
It turns out, I don't have the authorizations in place to trade options in my account like I thought I did. Very frustrating, but that is not your problem. I bring it up because I tried to place an options order this morning and thought I should share my reasoning.
I tried to buy puts on USO, which is an Oil ETF. Specifically I was looking at the January expiration Put with a 33 strike price. The pricing was not as favorable as I hoped, but I was still planning on making the trade.
Why? I was trying to give myself exposure to two separate outliers (at least to conventional wisdom). First, if the Iranian protests succeed in bringing about change in Iran, that change could be a more moderate, less belligerent power in the middle east. My point really, is that I see the possibility of a much more stable middle east in the next six months. This is the macro outcome that I wanted some exposure too. I don't have any crystal ball here, but I know there is a catalyst in place right now, which means the potential for real change is there.
Second, almost everyone in the investment community I talk too is very worried about inflation, usually with comments about printing money and debt to GDP ratios attached. I have a contrarian streak so this one-sided consensus has really been getting my attention. The fear of inflation has been driving investors into commodities such as gold and oil. My view is that oil is dramatically overvalued right now considering the weakness of the global economy, but is being pushed up by inflation hedgers. While I do not have much confidence that Obama's long-term spending will cease to be an issue, I do have a lot more confidence in the Fed than many investors. In my view, the Fed will be able to shrink the monetary base to compensate for the eventual increase in velocity of money. Also, I think consumer spending will be anemic for quite awhile, which leads me to be less worried about an overwhelming spike in the velocity of money. And of course, Fed Funds are basically at zero, so they have a lot of room to raise rates when the time comes. (As an aside, I do not think it is time to raise rates yet and am annoyed at investors who are calling for immediate rate increases to calm their own inflation fears)
In light of all that, I thought I would be able to buy some puts at very good prices. Unfortunately, the implied volatility in oil is also very high right now which makes oil options in general more expensive. My base case assumption was a 30% decline in oil by January 2010. Under that scenario I would have made 130%. To break even, oil had to decline 20% which was a lot more than I was expecting. Ultimately I was prepared to make the trade, but pricing made it less attractive than I thought it should be. I could just short the ETF but that gives me unlimited loss exposure and I like the idea of a fixed downside in this case.
Options trading is not for everyone (evidently not for me either according to Schwab) but mostly I wanted to share the thought process. If you make a trade like this, understand that you will lose the entire upfront cost (100% loss) if oil doesn't go down so this needs to be money you can afford to lose. That is probably obvious, so I'm sorry I insulted your intelligence.
I tried to buy puts on USO, which is an Oil ETF. Specifically I was looking at the January expiration Put with a 33 strike price. The pricing was not as favorable as I hoped, but I was still planning on making the trade.
Why? I was trying to give myself exposure to two separate outliers (at least to conventional wisdom). First, if the Iranian protests succeed in bringing about change in Iran, that change could be a more moderate, less belligerent power in the middle east. My point really, is that I see the possibility of a much more stable middle east in the next six months. This is the macro outcome that I wanted some exposure too. I don't have any crystal ball here, but I know there is a catalyst in place right now, which means the potential for real change is there.
Second, almost everyone in the investment community I talk too is very worried about inflation, usually with comments about printing money and debt to GDP ratios attached. I have a contrarian streak so this one-sided consensus has really been getting my attention. The fear of inflation has been driving investors into commodities such as gold and oil. My view is that oil is dramatically overvalued right now considering the weakness of the global economy, but is being pushed up by inflation hedgers. While I do not have much confidence that Obama's long-term spending will cease to be an issue, I do have a lot more confidence in the Fed than many investors. In my view, the Fed will be able to shrink the monetary base to compensate for the eventual increase in velocity of money. Also, I think consumer spending will be anemic for quite awhile, which leads me to be less worried about an overwhelming spike in the velocity of money. And of course, Fed Funds are basically at zero, so they have a lot of room to raise rates when the time comes. (As an aside, I do not think it is time to raise rates yet and am annoyed at investors who are calling for immediate rate increases to calm their own inflation fears)
In light of all that, I thought I would be able to buy some puts at very good prices. Unfortunately, the implied volatility in oil is also very high right now which makes oil options in general more expensive. My base case assumption was a 30% decline in oil by January 2010. Under that scenario I would have made 130%. To break even, oil had to decline 20% which was a lot more than I was expecting. Ultimately I was prepared to make the trade, but pricing made it less attractive than I thought it should be. I could just short the ETF but that gives me unlimited loss exposure and I like the idea of a fixed downside in this case.
Options trading is not for everyone (evidently not for me either according to Schwab) but mostly I wanted to share the thought process. If you make a trade like this, understand that you will lose the entire upfront cost (100% loss) if oil doesn't go down so this needs to be money you can afford to lose. That is probably obvious, so I'm sorry I insulted your intelligence.
Wednesday, June 17, 2009
Taking a Pass on E*Trade
Normally I wouldn't write up a stock I'm passing on, but I've been thinking about it a lot and decided to pass along my thoughts.
E*Trade is a discount retail stock brokerage firm that has had a horrible run. It bought an internet bank in the early part of this decade (I can't remember the year off hand) and somehow the CEO of that internet bank ended up being CEO of the E*Trade. This is important only because E*Trade blew up by making really bad decisions in its banking operations which you would think a former bank CEO would have avoided. They had a good strategy that was poorly executed.
They were able to raise a lot of deposits from their customers, which was a good thing, but could not make enough loans to those customers to put those deposits to work. Their choices were to plow those deposits into a conservative investment portfolio until they could make good loans, or be more aggressive. They were more aggressive. They purchased a large loan portfolio, which means they didn't have anything to do with the underwriting of those loans, and they bought a riskier level of securities. Not only did they purchase mortgages, they purchased home equity lines of credit, which have a bad habit of being worth zero if the borrow stops paying because they are the second or third lien on the underlying property. Their timing was clearly bad in retrospect, as the housing market crashed and non-performing assets skyrocketed.
That is the history, leaving out a lot of detail about Citadel stepping in etc. So why am I interested at all? Because despite my earlier expectations, retail clients don't seem to care that E*trade has imploded financially. I assumed they would start bleeding clients and assets as the news came out. That has not happened. They continue to attract new accounts and assets! Amazing! Couple that with the idea that the sentiment on this stock is very poor, and I thought there might be an opportunity to buy the stock now and wait until normalized earnings power shows up.
The punch line is that I would pass on E*Trade. Under a rosy outlook, not exuberant, I can come up with $0.12 in 2011 EPS after taking dilution into account from the equity and bond exchange being offered today. If the market will pay 15x for that at the end of 2010, then the stock could trade at $1.85. I need at least a 30% cagr to get me interested in this stock which puts me at $1.25 today. The stock is at $1.42 this morning. And I need to repeat that $1.25 is the most I would pay; realistically, I would like to pay $1 so that I don't have to assume a 15x multiple.
Citadel is reported to be planning to convert $600m of their 12% coupon debt into zero coupon convertibles and buy $50-$100m of the equity offering, but I am baking that into my numbers. If E*trade gets very good terms on the equity and convertible swap, I will reconsider.
I really wanted to buy this stock, and you can tell a pretty compelling story about why it makes sense, but I do not think the potential returns are enough to compensate you for the risk in this case.
If nothing else, this has been a very interesting story to follow.
E*Trade is a discount retail stock brokerage firm that has had a horrible run. It bought an internet bank in the early part of this decade (I can't remember the year off hand) and somehow the CEO of that internet bank ended up being CEO of the E*Trade. This is important only because E*Trade blew up by making really bad decisions in its banking operations which you would think a former bank CEO would have avoided. They had a good strategy that was poorly executed.
They were able to raise a lot of deposits from their customers, which was a good thing, but could not make enough loans to those customers to put those deposits to work. Their choices were to plow those deposits into a conservative investment portfolio until they could make good loans, or be more aggressive. They were more aggressive. They purchased a large loan portfolio, which means they didn't have anything to do with the underwriting of those loans, and they bought a riskier level of securities. Not only did they purchase mortgages, they purchased home equity lines of credit, which have a bad habit of being worth zero if the borrow stops paying because they are the second or third lien on the underlying property. Their timing was clearly bad in retrospect, as the housing market crashed and non-performing assets skyrocketed.
That is the history, leaving out a lot of detail about Citadel stepping in etc. So why am I interested at all? Because despite my earlier expectations, retail clients don't seem to care that E*trade has imploded financially. I assumed they would start bleeding clients and assets as the news came out. That has not happened. They continue to attract new accounts and assets! Amazing! Couple that with the idea that the sentiment on this stock is very poor, and I thought there might be an opportunity to buy the stock now and wait until normalized earnings power shows up.
The punch line is that I would pass on E*Trade. Under a rosy outlook, not exuberant, I can come up with $0.12 in 2011 EPS after taking dilution into account from the equity and bond exchange being offered today. If the market will pay 15x for that at the end of 2010, then the stock could trade at $1.85. I need at least a 30% cagr to get me interested in this stock which puts me at $1.25 today. The stock is at $1.42 this morning. And I need to repeat that $1.25 is the most I would pay; realistically, I would like to pay $1 so that I don't have to assume a 15x multiple.
Citadel is reported to be planning to convert $600m of their 12% coupon debt into zero coupon convertibles and buy $50-$100m of the equity offering, but I am baking that into my numbers. If E*trade gets very good terms on the equity and convertible swap, I will reconsider.
I really wanted to buy this stock, and you can tell a pretty compelling story about why it makes sense, but I do not think the potential returns are enough to compensate you for the risk in this case.
If nothing else, this has been a very interesting story to follow.
Friday, May 8, 2009
Fluctuating Conviction
This is just a thought I have been mulling over the last couple days that relates to investing.
I read about a third of "Reminiscences of a Stock Operator" before I lost it, but even what I read had a big impact on me. The young men in the book would be in a flurry of activity and excitement. They would often ask a particular older gentleman if he thought the specific stock they were talking about would go up. His repeated response was "It's a bull market", which really annoyed the younger traders because they didn't think he was answering the question. I'll come back to this in a second.
I played golf with my brother the other day and we were talking about the markets. I mentioned that many of my recent purchases had gone up dramatically and that I was really enjoying being an investor right now. He made that comment that maybe I should just trade for myself rather than keep trying to find a job working for someone else. His suggestion forced me to verbalize something I already knew; We have been experiencing an unusually good time to be an investor and these times don't last. This rally off what I think was the bottom has been violent and very profitable if you were lucky enough to get involved at the right time. Picking doubles and triples will not be as easy once we get into a more normal bull market.
My recollections about "Reminiscences" and my conversation with my brother are the catalyst for this post. I think that as an investor, the level of conviction I have should vary over time as the circumstances of the market change. Having worked as an analyst at an investment firm, I can tell you that there is unspoken pressure to maintain a high level of conviction; all the time. How do you get a portfolio manager to buy your stock recommendation? You "pound the table"! But as the old man in the book pointed out, the back drop really matters. Will XYZ stock go up? If we are in a bull market, then it most likely will. In mid-march, my conviction level was very high that I should buy a basket of beaten-down stocks because I was convinced that those types of stocks had explosive upside potential. I mentioned the stocks I bought in the last post, but my point here is that my success in that case had less to do with the five stocks I picked than with matching my purchases to the environment I thought we were in. I'm sure there are hundreds of other stocks I could have bought that would have matched or outperformed the five I purchased.
What are the current implications? As I have been thinking about this, the key point is that I think the environment is shifting. We were in an environment where the most beaten down stock could really bounce off the bottom. I think we are entering a phase where investors are still looking for pockets of extreme pessimism to play the bounce, but in general the environment will start focusing on longer term growth and earnings power. As such my level of conviction probably needs to be reigned in to match a less extreme environment.
I occasionally catch a show on CNBC called "Fast Money" which is basically a show for traders. One of their favorite lines was "everyone is a trader now". I think they were picking up on the environment we were in. The environment was a traders market, but I really think that is changing as I write.
I have not seen the job numbers yet this morning, but the number of data points that look good continues to build. Things are getting better and money on the sidelines will start pouring back into equities driving a bull market.
Let me be presumptuous and give you my formula for prices (this applies to stocks and the market broadly). P=(IV*S)+T. Price equals the product of intrinsic value and a sentiment multiplier, plus the impact of technicals. Intrinsic value is theoretically what a financial instrument is actually worth if we could all agree on what discount rate, and growth rates to use. As you know, sentiment pushes prices around that intrinsic value. The price of a dot.com stock in 1999 was largely driven by the sentiment multiplier, not calculations of intrinsic value. I am using the term "technicals" to describe unusual imbalances of buyers or sellers, such as if the top share holder starts liquidating their position, or if pension funds in aggregate start reallocating away from US stocks and into international stocks. The distinction between sentiment and technicals can get blurry so don't over-think it. The formula is really just a mental framework, not a calculation tool.
Using that framework, I would argue that intrinsic value has not changed much, but sentiment and technicals have been overwhelmingly negative until mid March. Now that I am convinced both factors will be a tailwind, I want to own equities. "It's a bull market."
I read about a third of "Reminiscences of a Stock Operator" before I lost it, but even what I read had a big impact on me. The young men in the book would be in a flurry of activity and excitement. They would often ask a particular older gentleman if he thought the specific stock they were talking about would go up. His repeated response was "It's a bull market", which really annoyed the younger traders because they didn't think he was answering the question. I'll come back to this in a second.
I played golf with my brother the other day and we were talking about the markets. I mentioned that many of my recent purchases had gone up dramatically and that I was really enjoying being an investor right now. He made that comment that maybe I should just trade for myself rather than keep trying to find a job working for someone else. His suggestion forced me to verbalize something I already knew; We have been experiencing an unusually good time to be an investor and these times don't last. This rally off what I think was the bottom has been violent and very profitable if you were lucky enough to get involved at the right time. Picking doubles and triples will not be as easy once we get into a more normal bull market.
My recollections about "Reminiscences" and my conversation with my brother are the catalyst for this post. I think that as an investor, the level of conviction I have should vary over time as the circumstances of the market change. Having worked as an analyst at an investment firm, I can tell you that there is unspoken pressure to maintain a high level of conviction; all the time. How do you get a portfolio manager to buy your stock recommendation? You "pound the table"! But as the old man in the book pointed out, the back drop really matters. Will XYZ stock go up? If we are in a bull market, then it most likely will. In mid-march, my conviction level was very high that I should buy a basket of beaten-down stocks because I was convinced that those types of stocks had explosive upside potential. I mentioned the stocks I bought in the last post, but my point here is that my success in that case had less to do with the five stocks I picked than with matching my purchases to the environment I thought we were in. I'm sure there are hundreds of other stocks I could have bought that would have matched or outperformed the five I purchased.
What are the current implications? As I have been thinking about this, the key point is that I think the environment is shifting. We were in an environment where the most beaten down stock could really bounce off the bottom. I think we are entering a phase where investors are still looking for pockets of extreme pessimism to play the bounce, but in general the environment will start focusing on longer term growth and earnings power. As such my level of conviction probably needs to be reigned in to match a less extreme environment.
I occasionally catch a show on CNBC called "Fast Money" which is basically a show for traders. One of their favorite lines was "everyone is a trader now". I think they were picking up on the environment we were in. The environment was a traders market, but I really think that is changing as I write.
I have not seen the job numbers yet this morning, but the number of data points that look good continues to build. Things are getting better and money on the sidelines will start pouring back into equities driving a bull market.
Let me be presumptuous and give you my formula for prices (this applies to stocks and the market broadly). P=(IV*S)+T. Price equals the product of intrinsic value and a sentiment multiplier, plus the impact of technicals. Intrinsic value is theoretically what a financial instrument is actually worth if we could all agree on what discount rate, and growth rates to use. As you know, sentiment pushes prices around that intrinsic value. The price of a dot.com stock in 1999 was largely driven by the sentiment multiplier, not calculations of intrinsic value. I am using the term "technicals" to describe unusual imbalances of buyers or sellers, such as if the top share holder starts liquidating their position, or if pension funds in aggregate start reallocating away from US stocks and into international stocks. The distinction between sentiment and technicals can get blurry so don't over-think it. The formula is really just a mental framework, not a calculation tool.
Using that framework, I would argue that intrinsic value has not changed much, but sentiment and technicals have been overwhelmingly negative until mid March. Now that I am convinced both factors will be a tailwind, I want to own equities. "It's a bull market."
Wednesday, May 6, 2009
Some recent buys and sells
In mid-march, I bought a mini-portfolio of beaten-down risky stocks with the thought that any of them could triple or go bust, but were more likely to triple (PFG, IBOC, SKX, SFLY, and ARGN). I should have talked about it in this blog, but I was buying stocks that I considered either very risky or that I didn't know very well, so I chickened out. That is behind us. Now I have some new decisions to make and I decided I should share them. The five stocks in my "beaten-down" portfolio are up between 42% and 172% so I have started to trim these stocks to take some profits. However, I am still bullish overall, and have been trying to decide how to invest that cash.
Basically, I took the view that the markets were dramatically oversold and that the best near-term performers would be the "junk". I think the "junk rally" is in the 6th inning, so I want to start buying some higher quality stocks in addition to more beaten down stocks that I still think have a lot of upside.
Here are the five stocks I have purchased in the last week with an explanation (limited as they may be):
Duckwall-Alco (DUCK): I wanted some consumer exposure, but more importantly, I like this investment thesis. Duckwall is a micro cap with a market cap of only about $50 million which makes it very tough for institutional investors to get in and out. Basically, I bought the stock because I wanted consumer exposure, they brought in a new management team a few years ago to modernize an old business model, they operate in markets with limited competition, and management appears to be doing a good job because they have been showing same-store-sales growth for the last three months. In the middle of horrendous employment trends and a bad recession, they have had positive same-store-sales. If this can continue, the stock is too cheap and as it moves up it could start to attract institutional investors again. My price target is $30-$45 within two years. I'm in at $11.34.
Ryland Group (RYL): This is a homebuilder and falls into the beaten down bucket. The stock has come off its lows like everything else, but I don't think sentiment has really turned for the home builders yet. The thesis here is that we are getting close to a housing bottom. As housing prices bottom, sales will pick up and we will start to burn through our excess housing inventory very quickly. Therefore, when investors decide housing has bottomed, they will naturally start thinking about inventory levels, and that will lead them to start buying the homebuilders in anticipation of renewed building. I don't have a price target on this one, just the thesis that the stocks will do very well over the next two years. I'm in at $20.70.
Partner Re (PRE): Over 40% of my portfolio is in financials because that is what I know best, but I didn't own any insurance and this is one I have wanted to own for awhile now. Of all the reinsurance managements I have met, this one impressed me the most. Their risks are very well diversified all around the world, which I think is critical for a business model that essentially short black swan events (read The Black Swan if you can). I think the recent environment has allowed them to write business that will be very profitable over the next few years as it seasons, and as such I will be able to exit this position at a multiple of 1.5x book (currently about 1.2x). So the thesis is that I expect book value to grow, the multiple to expand, and I get a modest dividend as well. I'm in at $66.34.
UnderArmor (UA): This is a high-flyer and that is the risk. I guess I am starting to believe that this really could be the next Nike. They grew revenue by 27% last quarter in a recession. I know they added running shoes; but we are in a recession! What would that number have been in a normal economy. The stock is expensive and expectations are high, which generally would keep me away. At $24.50, the stock trades at 30x 2009 consensus estimates and the street is building in 21% EPS growth from 2009 to 2010. This is a growth stock and I think the growth can continue which will actually allow the multiple to expand in the early stages of a bull market. The most likely bear case is that they post good growth, but don't really exceed expectations and the stock flatlines as the multiple fades. I'm in at $24.78.
Clearwire (CLWR): According to industry observers, Clearwire owns some of the best spectrum in the US and is trying to roll out WiMax based telecom service. They have powerful backers, like Google, and I guess I just really like the WiMax idea. This stock is dangerous for me, because I don't understand the technical issues that will play a big role in determining whether they succeed or fail. The biggest obstacle appears to be improvements to technology using existing cell-phone spectrum. Realistically, I'm still getting to know this stock and probably wouldn't encourage anyone to follow my lead on this one. I think I'm falling back on the idea that even if they don't succeed, they still have valuable spectrum which should limit my downside as long as they maintain modest leverage. I'm in at $5.90.
I clearly don't know these stocks as well as the financials I cover, but I decided to let you know my thought process before I know whether they were good buys or not. (I may never have told you about my mini-portfolio if it had not worked out and I decided that isn't really what I wanted this blog to be)
As an aside, ADP came out with an employment report today that estimated the US economy lost 491k jobs in April. This would be a big improvement over the last four months, although clearly still a bad number. So far, I have been wrong on employment trends. I thought the improvement would have started sooner and was surprised by how uniformly bad the prior four months were. This data point is very positive in my opinion and I think the market will get really excited if next month can show losses of 300k or better. Remember that employment is a lagging indicator, so the markets will move long before employment really looks good.
Basically, I took the view that the markets were dramatically oversold and that the best near-term performers would be the "junk". I think the "junk rally" is in the 6th inning, so I want to start buying some higher quality stocks in addition to more beaten down stocks that I still think have a lot of upside.
Here are the five stocks I have purchased in the last week with an explanation (limited as they may be):
Duckwall-Alco (DUCK): I wanted some consumer exposure, but more importantly, I like this investment thesis. Duckwall is a micro cap with a market cap of only about $50 million which makes it very tough for institutional investors to get in and out. Basically, I bought the stock because I wanted consumer exposure, they brought in a new management team a few years ago to modernize an old business model, they operate in markets with limited competition, and management appears to be doing a good job because they have been showing same-store-sales growth for the last three months. In the middle of horrendous employment trends and a bad recession, they have had positive same-store-sales. If this can continue, the stock is too cheap and as it moves up it could start to attract institutional investors again. My price target is $30-$45 within two years. I'm in at $11.34.
Ryland Group (RYL): This is a homebuilder and falls into the beaten down bucket. The stock has come off its lows like everything else, but I don't think sentiment has really turned for the home builders yet. The thesis here is that we are getting close to a housing bottom. As housing prices bottom, sales will pick up and we will start to burn through our excess housing inventory very quickly. Therefore, when investors decide housing has bottomed, they will naturally start thinking about inventory levels, and that will lead them to start buying the homebuilders in anticipation of renewed building. I don't have a price target on this one, just the thesis that the stocks will do very well over the next two years. I'm in at $20.70.
Partner Re (PRE): Over 40% of my portfolio is in financials because that is what I know best, but I didn't own any insurance and this is one I have wanted to own for awhile now. Of all the reinsurance managements I have met, this one impressed me the most. Their risks are very well diversified all around the world, which I think is critical for a business model that essentially short black swan events (read The Black Swan if you can). I think the recent environment has allowed them to write business that will be very profitable over the next few years as it seasons, and as such I will be able to exit this position at a multiple of 1.5x book (currently about 1.2x). So the thesis is that I expect book value to grow, the multiple to expand, and I get a modest dividend as well. I'm in at $66.34.
UnderArmor (UA): This is a high-flyer and that is the risk. I guess I am starting to believe that this really could be the next Nike. They grew revenue by 27% last quarter in a recession. I know they added running shoes; but we are in a recession! What would that number have been in a normal economy. The stock is expensive and expectations are high, which generally would keep me away. At $24.50, the stock trades at 30x 2009 consensus estimates and the street is building in 21% EPS growth from 2009 to 2010. This is a growth stock and I think the growth can continue which will actually allow the multiple to expand in the early stages of a bull market. The most likely bear case is that they post good growth, but don't really exceed expectations and the stock flatlines as the multiple fades. I'm in at $24.78.
Clearwire (CLWR): According to industry observers, Clearwire owns some of the best spectrum in the US and is trying to roll out WiMax based telecom service. They have powerful backers, like Google, and I guess I just really like the WiMax idea. This stock is dangerous for me, because I don't understand the technical issues that will play a big role in determining whether they succeed or fail. The biggest obstacle appears to be improvements to technology using existing cell-phone spectrum. Realistically, I'm still getting to know this stock and probably wouldn't encourage anyone to follow my lead on this one. I think I'm falling back on the idea that even if they don't succeed, they still have valuable spectrum which should limit my downside as long as they maintain modest leverage. I'm in at $5.90.
I clearly don't know these stocks as well as the financials I cover, but I decided to let you know my thought process before I know whether they were good buys or not. (I may never have told you about my mini-portfolio if it had not worked out and I decided that isn't really what I wanted this blog to be)
As an aside, ADP came out with an employment report today that estimated the US economy lost 491k jobs in April. This would be a big improvement over the last four months, although clearly still a bad number. So far, I have been wrong on employment trends. I thought the improvement would have started sooner and was surprised by how uniformly bad the prior four months were. This data point is very positive in my opinion and I think the market will get really excited if next month can show losses of 300k or better. Remember that employment is a lagging indicator, so the markets will move long before employment really looks good.
Sunday, April 19, 2009
JP Morgan's Debt Offering, Goldman still makes me nervous
As I have reflected on the last week, one news item really sticks out in my mind. JP Morgan raised $10 billion in debt the day they announced earnings, but they did it without the FDIC backing that is available for large financial institutions right now. I don't follow the debt markets closely enough to know if other firms have raised similar amounts without a government backstop for investors, but I don't remember hearing about it. I think this is yet another very good datapoint. The debt markets are starting to function without the need for government help. The cynics will argue that I shouldn't be excited about the strongest bank in the country being able to raise some debt financing; of course they should be able to. They would say that my excitement only proves how bad things are. My point is simply that I don't expect JPM to be the last bank to be able to do this. The trend is bullish.
There were also a string of better than expected earnings from Wells Fargo, Goldman, JP Morgan and Citigroup. As I have said before, things get less bad before they really get better. Despite my bullishness, I as still a skeptic on Goldman Sachs. Don't misunderstand me, I admire their culture and the caliber of the the people they attract. These are very good things. But as an investor I am staying away. At the end of the day, this is still a highly leveraged company that makes money in a very opaque way. People who buy this stock (I fell into this mindset in the past so this is also a confession) will shrug their shoulders and say "Yes, but these guys are REALLY smart and will figure out how to make money like they always have." That's right; very highly paid investment professionals will use this as their investment thesis.
I have learned quite a few things over the last three years and here is one; if the business model is flawed, whole industries can be wiped out. It wasn't that long ago that mortgage originators were darlings of the investment community. They are simply gone now. The leveraged investment bank industry almost followed suite; we lost Bear and Lehman, Merrill was forced to sell, UBS is still in trouble, Goldman and Morgan had to convert to bank holding companies so the Fed could keep them from the same fate. My point is that Goldman may be full of smart people, but I can't even begin to predict how much money they will make next year and I no longer think the business model is attractive. And yet the stock was at $130 the other day. This is a cult stock and I'm going to find better models to invest my money in. For the sake of the broader market, I hope Goldman does very well but I'm willing to miss that gain.
There were also a string of better than expected earnings from Wells Fargo, Goldman, JP Morgan and Citigroup. As I have said before, things get less bad before they really get better. Despite my bullishness, I as still a skeptic on Goldman Sachs. Don't misunderstand me, I admire their culture and the caliber of the the people they attract. These are very good things. But as an investor I am staying away. At the end of the day, this is still a highly leveraged company that makes money in a very opaque way. People who buy this stock (I fell into this mindset in the past so this is also a confession) will shrug their shoulders and say "Yes, but these guys are REALLY smart and will figure out how to make money like they always have." That's right; very highly paid investment professionals will use this as their investment thesis.
I have learned quite a few things over the last three years and here is one; if the business model is flawed, whole industries can be wiped out. It wasn't that long ago that mortgage originators were darlings of the investment community. They are simply gone now. The leveraged investment bank industry almost followed suite; we lost Bear and Lehman, Merrill was forced to sell, UBS is still in trouble, Goldman and Morgan had to convert to bank holding companies so the Fed could keep them from the same fate. My point is that Goldman may be full of smart people, but I can't even begin to predict how much money they will make next year and I no longer think the business model is attractive. And yet the stock was at $130 the other day. This is a cult stock and I'm going to find better models to invest my money in. For the sake of the broader market, I hope Goldman does very well but I'm willing to miss that gain.
Wednesday, April 15, 2009
Market in Transition and Equity Raises
I have been thinking and realizing over the last week that the market is at a tough spot. For some perspective, I remember hearing a lot of investors say things like the following: "I can't call the bottom so I won't try. I'm willing to miss the first 15-20% of the next bull market so that I have confirmation that it IS a bull market." My conversations with people lead me to believe that these same people are now very uncertain about what to do. They had the 20% rally off a bottom, but they are still hesitant. I have noticed my own tendencies are to want to buy on a pull-back when the markets are going up, but being afraid to buy when the pull-back is actually occurring. If I am bold enough to extrapolate my tendencies on the market, it implies that there are still a lot of potential buyers that are still waiting to buy. All this to say, we just had a rally but I don't think investors are convinced we are in a bull market, despite their comments prior to the rally. And for those who bought on the way up, or are just still holding old positions, it is tempting to lock in some of the recent gains. I still think we are in a new bull market, but these pauses make sense to me.
What I was really excited to see was some equity raises. Everyone saw that Goldman Sachs raised $5 billion yesterday, but unless you cover the financial sector you may easily have missed three other equity raises (First Niagara and Fidelity National yesterday and Chimera today). Seeing four financial sector equity raises in two days was a bit of a surprise; in the pleasant sense. The capital markets are normalizing under our noses. I'm still leery of Goldman's business model, but from a broader perspective, I'm very happy that other investors are willing to give them more capital.
And finally, I little aside. I was thinking about one of my favorite internet ideas again yesterday; Prosper.com. They are currently in a quiet period while they go through a registration process to sell promissory notes, but this is fine because I wouldn't lend money through Prosper.com quite yet. This website allows people to borrow and lend from each other through Prosper.com. As a lender, you are making an unsecured loan to a stranger based on their write up and some standardized data they have to provide. When the US economy loses less than 75k jobs in a month, I think it will be time to put some money to work here, based on the assumption that the most likely reason the loans won't be repaid is loss of income. At about -75k jobs, I expect loan performance going forward to be good, but interest rates still attractive.
What I was really excited to see was some equity raises. Everyone saw that Goldman Sachs raised $5 billion yesterday, but unless you cover the financial sector you may easily have missed three other equity raises (First Niagara and Fidelity National yesterday and Chimera today). Seeing four financial sector equity raises in two days was a bit of a surprise; in the pleasant sense. The capital markets are normalizing under our noses. I'm still leery of Goldman's business model, but from a broader perspective, I'm very happy that other investors are willing to give them more capital.
And finally, I little aside. I was thinking about one of my favorite internet ideas again yesterday; Prosper.com. They are currently in a quiet period while they go through a registration process to sell promissory notes, but this is fine because I wouldn't lend money through Prosper.com quite yet. This website allows people to borrow and lend from each other through Prosper.com. As a lender, you are making an unsecured loan to a stranger based on their write up and some standardized data they have to provide. When the US economy loses less than 75k jobs in a month, I think it will be time to put some money to work here, based on the assumption that the most likely reason the loans won't be repaid is loss of income. At about -75k jobs, I expect loan performance going forward to be good, but interest rates still attractive.
Thursday, March 26, 2009
Greenhill on a roll
Greenhill (Ticker GHL) announced another MD hire today, bringing the YTD number to five. My projections were for them to hire ten in 2009 so they are already half way there. For those that own it, I would start to think of the position as a source of funds if it goes above $85 within the next month or two. The stock can go higher, but I think you can find better risk/rewards in other stocks at that point. I wouldn't initiate a new position at these prices, but I am sticking with my position for now.
Monday, March 23, 2009
Toxic Assets, Expectations and an Anecdote
If you have read my prior posts, you know that I am bullish on stocks and consider this a good time to be allocating into equities. There are four things I want to highlight today to bolster that argument. Namely, the Treasuries Toxic Asset Plan announced this morning, Tiffany reported better than expected results, and a conversation I had last week that startled me.
First the Toxic Asset Plan. Treasury Secretary Geithner announced a plan to partner with private investors to to create investment entities that will bid on pools of toxic assets with financing assistance from the government. There is a factsheet on the Treasury's website so I won't rehash it here. In a prior post I mentioned that I was optimistic because I thought the government was finally trying to address all five of the key issues needed to return to a more normal financial and economic footing. They were to: recapitalize the banks, remove toxic asset overhang, find a bottom in housing prices, slow consumer deleveraging, and try to create jobs. Whether this toxic asset plan will work is still debatable, but we have a concrete plan of action from the government and I think that is a positive step. There is real movement on all five areas now.
Second, Tiffany & Co reported bad Q4 results, but they were better than analyst estimates and the stock was up about 5% at the open. I don't cover consumer stocks very closely, but I feel like I am seeing more headlines where things were not as bad as projected. Before things get better, they get less bad, and I think that is what we are starting to see.
Third, and I think most interesting, I talked to a friend of mine last week who told be that they were still being swamped with requests from wealthy households to sell stocks and buy bonds. I found it shocking that investors that have lost so much in equities would now decide to lock in low interest rates and effectively give up the opportunity for capital gains from here. I asked my friend if he was serious. He said that investors were not thinking about how to regain some of the money they lost, they were just trying to prevent further loss. I knew this reallocation had been happening, but I guess I thought it had mostly run its course. There continues to be selling pressure on equities from this type of activity, yet the market has bounced about 18% off its March 9th low. The fear remains, but I think we are running out of sellers.
First the Toxic Asset Plan. Treasury Secretary Geithner announced a plan to partner with private investors to to create investment entities that will bid on pools of toxic assets with financing assistance from the government. There is a factsheet on the Treasury's website so I won't rehash it here. In a prior post I mentioned that I was optimistic because I thought the government was finally trying to address all five of the key issues needed to return to a more normal financial and economic footing. They were to: recapitalize the banks, remove toxic asset overhang, find a bottom in housing prices, slow consumer deleveraging, and try to create jobs. Whether this toxic asset plan will work is still debatable, but we have a concrete plan of action from the government and I think that is a positive step. There is real movement on all five areas now.
Second, Tiffany & Co reported bad Q4 results, but they were better than analyst estimates and the stock was up about 5% at the open. I don't cover consumer stocks very closely, but I feel like I am seeing more headlines where things were not as bad as projected. Before things get better, they get less bad, and I think that is what we are starting to see.
Third, and I think most interesting, I talked to a friend of mine last week who told be that they were still being swamped with requests from wealthy households to sell stocks and buy bonds. I found it shocking that investors that have lost so much in equities would now decide to lock in low interest rates and effectively give up the opportunity for capital gains from here. I asked my friend if he was serious. He said that investors were not thinking about how to regain some of the money they lost, they were just trying to prevent further loss. I knew this reallocation had been happening, but I guess I thought it had mostly run its course. There continues to be selling pressure on equities from this type of activity, yet the market has bounced about 18% off its March 9th low. The fear remains, but I think we are running out of sellers.
Tuesday, March 17, 2009
Greenhill - a great franchise, buy at $60
Greenhill (Ticker: GHL)
Who they are: Greenhill is a NYC-based investment bank that focuses on Corporate Advisory (both M&A and restructuring), Merchant Banking and a newer Funds Placement business. As of 3/17/2009, they have 52 managing directors around the world.
Investment Thesis:
-M&A is cyclical and will return in the future, at which point investors will pay 20x estimates for this high quality pure-play.
-Unlike bulge bracket rivals, Greenhill has remained a low-capital-intensive business. Advisory has almost no capital requirements, and merchant banking has low capital requirements (which are not levered up).
-Greenhill's boutique business model is in favor and will gain prominence given the tarnished image of the bulge brackets and fewer conflicts of interest when working with Greenhill.
-They are attracting the best and brightest amid the market turmoil.
-They have won some very high profile assignments that bolster their industry standing among corporate chieftains.
-I have tremendous respect for Bob Greenhill and Scott Bok, and think they have built a differentiated culture that will serve clients, employees and shareholders well.
-I like this stock under $60 per share.
Catalysts/Risks:
-Need to hire about 10 top-notch MDs in 2009 or investors will be disappointed.
-Merchant Banking will try to raise GCP III this year and was hoping for $1b; +/- will be noted.
-GCP II is 80% invested since being raised in 2005. While it appears they were more prudent with leverage than the industry, there is mark-to-market risk at a minimum.
-Additional high profile assignments in advisory. Getting the lead role to Roche on its Genentech merger was a big deal. Investors will be looking for signs it wasn't a one-timer.
-Can their culture survive and thrive as they grow? I think so, but this is a risk.
Math/Assumptions:
-I assume that at the end of 2010, investors will pay 20x for a normalized earnings power estimate because the M&A cycle will be re-accelerating and Greenhill is a high quality way to get pure-play exposure to that cycle.
-I assume they will start 2011 with 63 managing directors which can each generate $8 million in revenue, and that on a normalized basis, merchant banking will contribute 15% of total revenue. (I assume no interest income for conservatism sake)
-I assume compensation expense ratio of 46% and a non-comp expense ratio of 15%, for an operating margin of 39%.
-With a 35% tax rate, that gives me $150 million in net income for normalized 2011 ($5 in EPS with a 30m sharecount)
-That implies the market will pay right around $100 per share at the end of 2010 and I want a 30% CAGR to that price. Discounting back to today means I like this stock at about $60 per share.
A note on culture:
Culture is a tricky thing to analyze because it is inherently subjective, but it is often very important. I think Greenhill is an example of a company where they have been very deliberate about their culture and where I think it is a competitive advantage. Most i-banks have cut-throat environments where the MDs bring in the business and operate at a very high level, but leave most of the execution and detail to their subordinates. Compensation is often opaque and there is very little collaboration among MDs.
Greenhill has built a culture of collaboration, execution and meritocracy. MDs at Greenhill routinely help each other find contacts in the course of completing and sourcing deals. As Scott Bok said, if an MD turns out not to be a team player, they will be drummed out of the firm. Additionally, a rival firm might send ten people to a board meeting, each of which is competing for air time to demonstrate their sliver of knowledge on the deal. Greenhill sends a couple people with the MD knowing the whole story because they have been involved in the execution. Greenhill looks for MDs that want to be involved with completing deals, not just golfing with CEOs to source deals. Finally, every MD knows the compensation for every other MD. This creates a culture of meritocracy where the new hires know they can be paid for their performance and the veterans know they have to justify their compensation in the eyes of their peers. Maybe I'm drinking the corporate cool-aid, but I can see why a CEO would prefer to work with Greenhill.
Word of caution:
I think buying GHL at $60 or less will provide a nice return by the end of 2010, but recognize that the fundamentals in the M&A and Merchant Banking business are at the bad part of their cycle right now. It is probable that there will be bad news between now and the end of 2010. I guess I'm trying to warn investors that the fundamentals could be extremely volatile on this stock and therefore the stock price may be extremely volatile as well. When I try to model this company I don't even bother to forecast an EPS number for 2009 or 2010 for the reasons I just mentioned. Just understand the type of investment this is before you buy it.
Who they are: Greenhill is a NYC-based investment bank that focuses on Corporate Advisory (both M&A and restructuring), Merchant Banking and a newer Funds Placement business. As of 3/17/2009, they have 52 managing directors around the world.
Investment Thesis:
-M&A is cyclical and will return in the future, at which point investors will pay 20x estimates for this high quality pure-play.
-Unlike bulge bracket rivals, Greenhill has remained a low-capital-intensive business. Advisory has almost no capital requirements, and merchant banking has low capital requirements (which are not levered up).
-Greenhill's boutique business model is in favor and will gain prominence given the tarnished image of the bulge brackets and fewer conflicts of interest when working with Greenhill.
-They are attracting the best and brightest amid the market turmoil.
-They have won some very high profile assignments that bolster their industry standing among corporate chieftains.
-I have tremendous respect for Bob Greenhill and Scott Bok, and think they have built a differentiated culture that will serve clients, employees and shareholders well.
-I like this stock under $60 per share.
Catalysts/Risks:
-Need to hire about 10 top-notch MDs in 2009 or investors will be disappointed.
-Merchant Banking will try to raise GCP III this year and was hoping for $1b; +/- will be noted.
-GCP II is 80% invested since being raised in 2005. While it appears they were more prudent with leverage than the industry, there is mark-to-market risk at a minimum.
-Additional high profile assignments in advisory. Getting the lead role to Roche on its Genentech merger was a big deal. Investors will be looking for signs it wasn't a one-timer.
-Can their culture survive and thrive as they grow? I think so, but this is a risk.
Math/Assumptions:
-I assume that at the end of 2010, investors will pay 20x for a normalized earnings power estimate because the M&A cycle will be re-accelerating and Greenhill is a high quality way to get pure-play exposure to that cycle.
-I assume they will start 2011 with 63 managing directors which can each generate $8 million in revenue, and that on a normalized basis, merchant banking will contribute 15% of total revenue. (I assume no interest income for conservatism sake)
-I assume compensation expense ratio of 46% and a non-comp expense ratio of 15%, for an operating margin of 39%.
-With a 35% tax rate, that gives me $150 million in net income for normalized 2011 ($5 in EPS with a 30m sharecount)
-That implies the market will pay right around $100 per share at the end of 2010 and I want a 30% CAGR to that price. Discounting back to today means I like this stock at about $60 per share.
A note on culture:
Culture is a tricky thing to analyze because it is inherently subjective, but it is often very important. I think Greenhill is an example of a company where they have been very deliberate about their culture and where I think it is a competitive advantage. Most i-banks have cut-throat environments where the MDs bring in the business and operate at a very high level, but leave most of the execution and detail to their subordinates. Compensation is often opaque and there is very little collaboration among MDs.
Greenhill has built a culture of collaboration, execution and meritocracy. MDs at Greenhill routinely help each other find contacts in the course of completing and sourcing deals. As Scott Bok said, if an MD turns out not to be a team player, they will be drummed out of the firm. Additionally, a rival firm might send ten people to a board meeting, each of which is competing for air time to demonstrate their sliver of knowledge on the deal. Greenhill sends a couple people with the MD knowing the whole story because they have been involved in the execution. Greenhill looks for MDs that want to be involved with completing deals, not just golfing with CEOs to source deals. Finally, every MD knows the compensation for every other MD. This creates a culture of meritocracy where the new hires know they can be paid for their performance and the veterans know they have to justify their compensation in the eyes of their peers. Maybe I'm drinking the corporate cool-aid, but I can see why a CEO would prefer to work with Greenhill.
Word of caution:
I think buying GHL at $60 or less will provide a nice return by the end of 2010, but recognize that the fundamentals in the M&A and Merchant Banking business are at the bad part of their cycle right now. It is probable that there will be bad news between now and the end of 2010. I guess I'm trying to warn investors that the fundamentals could be extremely volatile on this stock and therefore the stock price may be extremely volatile as well. When I try to model this company I don't even bother to forecast an EPS number for 2009 or 2010 for the reasons I just mentioned. Just understand the type of investment this is before you buy it.
Sunday, March 8, 2009
My apologies
My weekend has turned out busier than I planned and I am getting sick and feel horrible. I'll get the GHL write up done as soon as possible, but it won't be this weekend.
Friday, March 6, 2009
Buy Greenhill (Ticker GHL)
I will write this up in more detail over the weekend, but I saw a press release that I have been waiting for and was worried wouldn't happen. Greenhill announced the hiring of two managing directors (one in NYC on one in London) to head its restructuring business. They have indicated they were planning to do this, but it took longer than I thought it would.
In the interest of getting this out before market close; this is an excellent company that will be worth a lot of money when the M&A market returns (and it will return). I like this stock below $60 and it is $56 now. If you already know the story, buy now. Otherwise wait for the better write up this weekend.
In the interest of getting this out before market close; this is an excellent company that will be worth a lot of money when the M&A market returns (and it will return). I like this stock below $60 and it is $56 now. If you already know the story, buy now. Otherwise wait for the better write up this weekend.
Thursday, March 5, 2009
Straying from my focus a bit
I have purposefully kept this blog focused on investments and economics, but I have been watching the socialist tide rising like so many others. I wanted to share one of the more thought-provoking quotes on democracy I'm aware of; just something to mull over again (or for the first time if this quote is new to you).
I first heard this quote in college and it has always struck a chord with me. I am a capitalist at heart, and think the best road to rising standards of living is to incentivize society's best and brightest to create, innovate, and take risk by allowing them to keep the vast majority of the rewards they generate. I'm not against safety nets, but I tend the think they are too generous in this country.
So here is the quote. I did a quick google search and it sounds like the author is unknown although it is usually attributed to Alexander Tytler.
"A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship."
I guess I'm not as fatalistic about our future as this quote suggests I should be, but I do think it is a real tendency and conflicts with my capitalist views expressed above. Of course, if we vote ourselves largesse from the public treasury, that requires higher taxes on the wealthy minority who get outvoted. Surprise, surprise; it is often that wealthy minority who are the innovators, creators, and risk takers in our society.
It occurs to me that the most powerful offsetting force is the desire of most people to have the possibility of becoming very successful and wealthy. A socialist should never allow the lottery because it exposes our willingness to sacrifice current benefits for the chance at great wealth. In the same way, I think many of us prefer less assistance from our government in return for getting to keep more of our gains if we manage to generate great wealth.
Finally, and I hate to even bring this up, but I am not opposed to the estate tax because I think it encourages the successful to use their wealth in their lifetime, which is good for the broader standard of living, and because I do not think a massive inheritance encourages innovation, creativity and risk-taking. I've gone back and forth on this issue over the years, but this is were I stand now.
I first heard this quote in college and it has always struck a chord with me. I am a capitalist at heart, and think the best road to rising standards of living is to incentivize society's best and brightest to create, innovate, and take risk by allowing them to keep the vast majority of the rewards they generate. I'm not against safety nets, but I tend the think they are too generous in this country.
So here is the quote. I did a quick google search and it sounds like the author is unknown although it is usually attributed to Alexander Tytler.
"A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship."
I guess I'm not as fatalistic about our future as this quote suggests I should be, but I do think it is a real tendency and conflicts with my capitalist views expressed above. Of course, if we vote ourselves largesse from the public treasury, that requires higher taxes on the wealthy minority who get outvoted. Surprise, surprise; it is often that wealthy minority who are the innovators, creators, and risk takers in our society.
It occurs to me that the most powerful offsetting force is the desire of most people to have the possibility of becoming very successful and wealthy. A socialist should never allow the lottery because it exposes our willingness to sacrifice current benefits for the chance at great wealth. In the same way, I think many of us prefer less assistance from our government in return for getting to keep more of our gains if we manage to generate great wealth.
Finally, and I hate to even bring this up, but I am not opposed to the estate tax because I think it encourages the successful to use their wealth in their lifetime, which is good for the broader standard of living, and because I do not think a massive inheritance encourages innovation, creativity and risk-taking. I've gone back and forth on this issue over the years, but this is were I stand now.
Thursday, February 26, 2009
Highlights from an Economist lecture
I attended an alumni event on Tuesday evening at which an economist from the Chicago Fed was the speaker. I assume that as a Federal Reserve economist, he considers it his duty to promote a sense of optimism and confidence, so I took his forecasts less seriously than some of the data he used. This post is simply some of the data and commentary that I found most interesting.
- A $.01 drop in the price of gasoline at the pump adds about $1 billion in aggregate to US consumer pockets. I had heard that before. His follow on point was that normally a price change would simply be viewed as a transference between parties in the US economy, but because we import so much of our oil, the price reduction is incrementally adding dollars to the US.
- I wish he would have provided more detail, but he said their models indicated that companies have been laying people off more aggressively than the economic conditions would dictate. Or, the unemployment spike has been bigger and sooner than it maybe should have been. He seemed to think that laid the groundwork for a material improvement in the monthly job loss numbers as we move forward. (I think I agree with this)
- Comparisons to the Great Depression are not realistic. This is the worst downturn most of us have experienced so we naturally compare it to the worst that we are aware of, but he argued the differences outweigh the similarities. One key similarity that may also explain the constant comparison is that both downturns were associated with a financial crisis, unlike most intervening downturns.
- The critical difference between the Great Depression and today is that in the 1930, the government held the philosophical view that it should balance its budget like a normal household would. As such, the response to the severe downturn was to raise taxes and cut government spending which simply compounded the downturn. (Even liberal Obama seems to understand that raising taxes right now is a bad idea and no one will accuse the current government of reducing spending)
- Speaking of other downturns, the inventory cycle has often been associated with milder downturns. He presented some data that although light auto sales have plunged, production has plunged with it an that auto inventories are not really in very bad shape. (As I think about this, the better synchronization of production and consumption may also explain why layoffs have been earlier and more aggressive than in prior cycles)
- In 1980, about 75% of cars sold in the US were made by the Big Three; the rest were imported. Today, the Big Three only account for about 45% of domestic production, but total domestic production is still around 75% because many "foreign nameplate" cars are built in the US.
- Foreclosures - The national average foreclosure rate in 2008 was 1.8%. New Jersey has the tenth highest foreclosure rate at 1.8%. So 40 of 50 states have average or below average foreclosure rates. The top ten highest states represent 40% of the population and foreclosures have been highly concentrated in four states (NV, FL, AZ, CA).
- New Housing supply - Roughly 1.4-1.6 million new households are formed every year which we can think of as the natural new demand for housing units. In response the the glut of inventory, housing starts have fallen to a rate of about 500k per year which is a record low since WWII. He estimated that about 300k homes are simply replacement stock for homes that either burn down or are torn down, so we are only adding about 200k net new housing units right now. (My view: this is clearly a critical component for finding a new base for housing prices)
- Housing affordability is at its highest level since 1990. The combination of low rates and lower prices has pushed this index up dramatically. (I think this index is valuable, but has to be used carefully. It doesn't capture the "artificial affordability" that was offered via exotic mortgages and loose underwriting during the boom, so beware of the caveats)
- He found it very interesting that both the deflation camp and the inflation camp seem equally worried and vocal about the dangers ahead. Usually one side or the other dominates the collective worry.
Finally, I'll include the Feds forecasts but take it all with a grain of salt and consider their motivations.
GDP Q1 2009 -4.8%, Q2 2009 -1.5%, Q3 2009 .9%, Q4 2009 2%, Q1 2010 2.3%, Q2 2010 2.9%, Q3 2010 3.1%, Q4 2010 3.1%.
Peak unemployment of 8.8%.
Friday, February 20, 2009
GFI Group Reports tough quarter
GFIG reported non-GAAP EPS of $.09 for the fourth quarter of 2008, versus analyst expectations of $.13. While the poor showing does not impact my reasons for owning the stock, I was hoping for a more resilient quarter despite the terrible environment. Brokerage revenue declined 19% from a year ago and can be broken out by segment: +3% in equities, -21% in credit, -37% in financial, and -30% in commodities. In constant currencies brokerage revenue was actually up $5 million, but FX was a very big drag this quarter.
Margins were under pressure as revenue declined meaningfully. Compensation was only down 9% in the face of the 19% decline in brokerage revenue. This was disappointing because I thought this line item would show more variability with revenue. The only hints from the earnings call were that they continue to amortized sign-on bonuses from the rebuild of their NYC credit desk and there has been a 10% mix shift away from electronic platforms (in Europe) which would effectively increase the pay-out ratio. I am inclined to agree with management that the mix shift is a product of the extreme volatility and disruption, not a longer term phenomenon. Non-comp expenses were down 3%. These expenses are harder to adjust, especially short-term, so I am less concerned here.
GFIG increased cash on their balance sheet by $100 million and announced their normal cash dividend for shareholders of record on March 17th.
In addition to the color on FX, the most significant part of the earnings call was their outlook for 2009. Micky Gooch described what he considers to be a "worst case" scenario - although I think he was using this term loosely - as $700 million in revenue at a 7-9% pretax margin. If you play that through you get about $.30 of EPS for a stock now trading at about $3 per share.
I still believe in this story. While I was hoping for a better quarter, they made money in a horrendous environment, have a solid balance sheet without the credit risk of most financials, and I think they are very well positioned to benefit from the normalization I expect in the credit markets. As I write this, I see my limit order just filled as I bought a few more shares at $2.94.
One last tidbit from the call. Mickey was asked if they would be expanding their client base given the weakness of the dealer community. I asked him the same question in September of 2008 and he didn't think so because he didn't want to risk antagonizing the dealers. Today, he said "Yes". No details, but I have thought they should do this for awhile now and it looks like management thinks so too now.
Margins were under pressure as revenue declined meaningfully. Compensation was only down 9% in the face of the 19% decline in brokerage revenue. This was disappointing because I thought this line item would show more variability with revenue. The only hints from the earnings call were that they continue to amortized sign-on bonuses from the rebuild of their NYC credit desk and there has been a 10% mix shift away from electronic platforms (in Europe) which would effectively increase the pay-out ratio. I am inclined to agree with management that the mix shift is a product of the extreme volatility and disruption, not a longer term phenomenon. Non-comp expenses were down 3%. These expenses are harder to adjust, especially short-term, so I am less concerned here.
GFIG increased cash on their balance sheet by $100 million and announced their normal cash dividend for shareholders of record on March 17th.
In addition to the color on FX, the most significant part of the earnings call was their outlook for 2009. Micky Gooch described what he considers to be a "worst case" scenario - although I think he was using this term loosely - as $700 million in revenue at a 7-9% pretax margin. If you play that through you get about $.30 of EPS for a stock now trading at about $3 per share.
I still believe in this story. While I was hoping for a better quarter, they made money in a horrendous environment, have a solid balance sheet without the credit risk of most financials, and I think they are very well positioned to benefit from the normalization I expect in the credit markets. As I write this, I see my limit order just filled as I bought a few more shares at $2.94.
One last tidbit from the call. Mickey was asked if they would be expanding their client base given the weakness of the dealer community. I asked him the same question in September of 2008 and he didn't think so because he didn't want to risk antagonizing the dealers. Today, he said "Yes". No details, but I have thought they should do this for awhile now and it looks like management thinks so too now.
Thursday, February 19, 2009
Two Big Speeches
Yesterday, President Obama laid out his housing plan in more detail and Fed Chairman Bernanke gave a speech and answered questions at a Press Club luncheon. Both speeches were significant.
First; Housing. I read through the factsheet on the Treasuries website as well and I think the plan has promise. From what I can tell there are two prongs. The government will use Fannie Mae and Freddie Mac (which they already control through conservatorship) to allow a wave of refinancing into lower monthly payments. They will get rid of the provision that these agencies can only guarantee a mortgage with at least 20% equity. Scrapping that provision will allow the agencies to refinance an estimated 4-5 million mortgages that were ineligible given the decline in home prices. This should prevent some homes from being foreclosed on, and it is likely to reduce monthly mortgage payments by a couple hundred dollars in many cases. Notably, speculators (who don't live in the home) and jumbo loans (referred to as "millionaire loans" in the Treasury factsheet) will not be eligible.
The second prong is a partnership with the banking industry to modify mortgage terms before a borrower goes into default. The government will lay-out a standardized set of criteria that banks must use if they want to participate in the TARP program. It sounded to me like this was really targeted at the subprime mortgage market since those loans were largely originated away from Fannie and Freddie, but it has the potential to impact the Alt-A mortgage market as well. This prong is estimated to impact another 3-4 million mortgages. You can read the specifics on the Treasuries website, but in summary the government will share the cost of lowering the interest rate on loans to bring them down to 31% of gross income. http://www.treas.gov/news/index2.html
Key point: We are all focused on whether this can stabilize housing prices, but I think the benefit to consumers' monthly cash flow is equally significant here. My rule of thumb is that a 1% reduction in the mortgage rate will reduce the monthly payment by 11%. The government is effectively lowering America's aggregate mortgage payment every month by allowing Fannie and Freddie to refinance loans they normally wouldn't and strong-arming the banking industry to do the same. The government will inject an additional $200 billion into preferred stock at the agencies to help absorb the potential losses and allow them to increase the size of their respective portfolios by another $50 billion, to $900 billion each.
Bernanke also spoke yesterday and addressed the issues of credit risk on the Fed's balance sheet and the question of whether the increase in the monetary base will necessarily lead to future inflation. I thought these comments were very timely and I was surprised the market didn't react more favorably.
As a quick background, the Federal Reserve has more than doubled the size of it's balance sheet to over $2 trillion dollars in the last year by adding a wide variety of new lending programs and asset guarantees. Bernanke pointed out that in addition to holding more collateral than they lend, they also have recourse to the institutions that borrow. So if the borrower can't repay the loan, the Fed has collateral and will have a claim against the institution as well if the collateral is not enough to cover the loan. The dollar swaps they have engaged in are with other central banks and here again, they received an equivalent amount of foreign currency at the time of the swap, so these are not uncollaterallized. Bernanke allowed that the transactions with AIG and Bear Stearns are riskier but they only represent 5% of the Fed's balance sheet and they felt the cost of allowing failures would have been higher.
The concern has been that the collateral the Fed accepts is much lower quality that they would normally have accepted. This is true of course and was deliberate as an attempt to help banks get short-term funding in a broken credit market. Bernanke's point is that if collectively we can save the banking sector, then the Fed will eventually be repaid even if the collateral has dropped in value because the claim. At the end of the day, if you think disaster and collapse are coming, then Bernanke's comments do not ease your concerns.
On the money supply: I know this is a topic of concern because I have heard the question come up many times over the last six months. Investors seem to understand that the Fed needs to increase the monetary base right now to offset the decline in leverage across the financial system, but will they be able to reduce it when the time comes or are we locked into a future of high inflation?
Bernanke had a few interesting things to say. The vast majority of Fed lending has a short maturity, so once the credit markets normalize they can simply let the loans run-off. He also said, and I thought this was especially helpful, that the terms of the loans are specifically written to be attractive now in a time of crisis, but unattractive in a normal credit environment. Or put another way, once things normalize, the banks themselves will not want to roll the loans because they will be able to get funding from the credit market at more favorable terms. And finally, he pointed out that several of the programs were instituted under 13(3) which requires that conditions in financial markets are "unusual and exigent". By law, these programs will have to be fazed out when the financial markets are functioning normally. I realize that these terms are subjective, but the point is that some of these programs are designed to be temporary and Congress could force them to be discontinued at some point.
For anyone wanting a great synopsis of what the Fed is doing, I highly recommend that you read the transcript to Bernanke's speech. http://www.federalreserve.gov/newsevents/speech/bernanke20090218a.htm
One other great reminder from Bernanke's speech. The press has been fixated on whether the banks have been lending more or less since they received capital infusions, but Bernanke pointed out that the real reduction in lending has happened as a result of the securitization markets shutting down. The banks are effectively treading water trying to stay alive, but the securitization market has virtually dried up and it was a very large source of consumer lending. So while the press has distracted most of us (myself included), the Fed has been working hard on the TALF program to stimulate renewed securitization of consumer loans.
To beat a dead horse, make sure you think about all of this together: the Fed's aggressive actions to keep the system functioning, the Treasury recapitalizing the banking system and trying to remove the overhang of bad assets, and the Congress trying to stimulate the economy with tax breaks and job creation.
First; Housing. I read through the factsheet on the Treasuries website as well and I think the plan has promise. From what I can tell there are two prongs. The government will use Fannie Mae and Freddie Mac (which they already control through conservatorship) to allow a wave of refinancing into lower monthly payments. They will get rid of the provision that these agencies can only guarantee a mortgage with at least 20% equity. Scrapping that provision will allow the agencies to refinance an estimated 4-5 million mortgages that were ineligible given the decline in home prices. This should prevent some homes from being foreclosed on, and it is likely to reduce monthly mortgage payments by a couple hundred dollars in many cases. Notably, speculators (who don't live in the home) and jumbo loans (referred to as "millionaire loans" in the Treasury factsheet) will not be eligible.
The second prong is a partnership with the banking industry to modify mortgage terms before a borrower goes into default. The government will lay-out a standardized set of criteria that banks must use if they want to participate in the TARP program. It sounded to me like this was really targeted at the subprime mortgage market since those loans were largely originated away from Fannie and Freddie, but it has the potential to impact the Alt-A mortgage market as well. This prong is estimated to impact another 3-4 million mortgages. You can read the specifics on the Treasuries website, but in summary the government will share the cost of lowering the interest rate on loans to bring them down to 31% of gross income. http://www.treas.gov/news/index2.html
Key point: We are all focused on whether this can stabilize housing prices, but I think the benefit to consumers' monthly cash flow is equally significant here. My rule of thumb is that a 1% reduction in the mortgage rate will reduce the monthly payment by 11%. The government is effectively lowering America's aggregate mortgage payment every month by allowing Fannie and Freddie to refinance loans they normally wouldn't and strong-arming the banking industry to do the same. The government will inject an additional $200 billion into preferred stock at the agencies to help absorb the potential losses and allow them to increase the size of their respective portfolios by another $50 billion, to $900 billion each.
Bernanke also spoke yesterday and addressed the issues of credit risk on the Fed's balance sheet and the question of whether the increase in the monetary base will necessarily lead to future inflation. I thought these comments were very timely and I was surprised the market didn't react more favorably.
As a quick background, the Federal Reserve has more than doubled the size of it's balance sheet to over $2 trillion dollars in the last year by adding a wide variety of new lending programs and asset guarantees. Bernanke pointed out that in addition to holding more collateral than they lend, they also have recourse to the institutions that borrow. So if the borrower can't repay the loan, the Fed has collateral and will have a claim against the institution as well if the collateral is not enough to cover the loan. The dollar swaps they have engaged in are with other central banks and here again, they received an equivalent amount of foreign currency at the time of the swap, so these are not uncollaterallized. Bernanke allowed that the transactions with AIG and Bear Stearns are riskier but they only represent 5% of the Fed's balance sheet and they felt the cost of allowing failures would have been higher.
The concern has been that the collateral the Fed accepts is much lower quality that they would normally have accepted. This is true of course and was deliberate as an attempt to help banks get short-term funding in a broken credit market. Bernanke's point is that if collectively we can save the banking sector, then the Fed will eventually be repaid even if the collateral has dropped in value because the claim. At the end of the day, if you think disaster and collapse are coming, then Bernanke's comments do not ease your concerns.
On the money supply: I know this is a topic of concern because I have heard the question come up many times over the last six months. Investors seem to understand that the Fed needs to increase the monetary base right now to offset the decline in leverage across the financial system, but will they be able to reduce it when the time comes or are we locked into a future of high inflation?
Bernanke had a few interesting things to say. The vast majority of Fed lending has a short maturity, so once the credit markets normalize they can simply let the loans run-off. He also said, and I thought this was especially helpful, that the terms of the loans are specifically written to be attractive now in a time of crisis, but unattractive in a normal credit environment. Or put another way, once things normalize, the banks themselves will not want to roll the loans because they will be able to get funding from the credit market at more favorable terms. And finally, he pointed out that several of the programs were instituted under 13(3) which requires that conditions in financial markets are "unusual and exigent". By law, these programs will have to be fazed out when the financial markets are functioning normally. I realize that these terms are subjective, but the point is that some of these programs are designed to be temporary and Congress could force them to be discontinued at some point.
For anyone wanting a great synopsis of what the Fed is doing, I highly recommend that you read the transcript to Bernanke's speech. http://www.federalreserve.gov/newsevents/speech/bernanke20090218a.htm
One other great reminder from Bernanke's speech. The press has been fixated on whether the banks have been lending more or less since they received capital infusions, but Bernanke pointed out that the real reduction in lending has happened as a result of the securitization markets shutting down. The banks are effectively treading water trying to stay alive, but the securitization market has virtually dried up and it was a very large source of consumer lending. So while the press has distracted most of us (myself included), the Fed has been working hard on the TALF program to stimulate renewed securitization of consumer loans.
To beat a dead horse, make sure you think about all of this together: the Fed's aggressive actions to keep the system functioning, the Treasury recapitalizing the banking system and trying to remove the overhang of bad assets, and the Congress trying to stimulate the economy with tax breaks and job creation.
Thursday, February 12, 2009
The Sky is not Falling
I watched Geithner's speech a couple days ago and had a very similar reaction to the market. Namely, I still can't believe how little detail was provided. As a quick aside, it reminded me of Lehman Brothers before they declared bankruptcy. Dick Fuld announced a conference call in which he would lay out their plan for getting through the crisis. Almost the entire investment community dialed in. Mr. Fuld proceeded to tell us about the steps they were thinking about taking. The market was shocked. They expected to hear something concrete and got a roadmap. It was uncomfortable watching the Geithner speech because I had the same sensation as during the Lehman call. As much as most investors cringe at all the government intervention, they generally want to believe that the government can successfully reverse the downward economic spiral. Most of us also think the government is terribly inefficient and so slow that most of their stimulus will kick in once the economy is already recovering. Sadly, Geithner did nothing to counter that belief.
Despite my own frustration with government intervention and the ugly political posturing, here is my argument for why I am optimistic that the government plan is finally on the right track and will prevent a doomsday outcome.
In a nutshell, we are finally attacking all the key problems. We are recapitalizing the banks AND trying to remove the overhang from bad assets AND trying to stop home price depreciation AND trying to slow consumer deleveraging AND trying to create jobs. It is easy to criticize the government in retrospect for not tackling all these issues from day one, but realistically, the cost of doing so is enormous and is only worth the risk now that we know how bad things are. Would you really have wanted your government committing trillions of dollars to a problem that might develop?
Banks: I understand that mainstreet hates the idea of bailing out the same institutions that contributed to the current mess, but I think it is silly to single out one group when so many are guilty (Banks, non-bank originators, Wall-street securitization engines, rating agencies, greedy borrowers, stupid investors, regulators, polititians, basically everyone) Even if you are still fixated on the banks, you have to come to terms with the reality that a modern economy requires an operating financial system that converts savings into credit. That means we need a functioning and healthy banking system and capital market.
I remember having a somewhat heated debate with a colleague when the TARP was first announced. My argument at the time was that we needed to help remove the overhang of the bad real-estate assets because banks need to know they are well capitalized before they can really start lending again. If we simply infused equity, the banks would still not know if they would be well-capitalized next quarter because the assets continued to deteriorate, so they wouldn't lend. My argument was that the government could help fix the bad asset problem, which would allow the banks to know how big the final losses were, which would quantify how much additional capital they needed to raise from the private sector. Ironically, Paulson reversed course and infused equity without solving the bad asset problem. The key point remains the same; the banking system needs to be recapitalized AND have the bad asset overhang removed. I would prefer that the the private sector provide the capital, but at least both issues are being addressed.
I don't know enough about the private/public bad bank proposal yet to have a guess about whether it will work, but that is not the only possible solution. The governement could guarantee assets after a first loss peice as they have already done with a few specific banks. The key is to stop separating the asset question from the equity question and recognize that they are intertwined.
Housing and Deleveraging: Geithner and Congress are also focused on stabilizing the housing market. Every foreclosure puts another home on the market (increasing supply and pushing prices down) and generates another loss for a bank or MBS investor. Every time housing prices go down, another stretched mortgage borrower owes more than they could sell for, which makes it almost impossible to refinance or sell. Addressing foreclosures attacks the supply side of the housing market. The government is also trying to generate new purchases on the demand side of the equation. I've said this before, but I think the government is essentially trying to artificially loosen mortgage underwriting standards to prevent a quick consumer deleveraging. We all know that consumers are making less money and spending less money. Part of the money we spend is from income and part is from borrowing. The fact that getting a mortgage is so difficult is in and of itself hurting spending and pushing up the "savings rate". We need households to be able to take out new mortgages (especially first time buyers) in order to slow the pace of aggregate deleveraging.
Jobs: And finally, the government stimulus package is designed to create jobs, which give households money to spend, which is good for business, which allows them to hire more people... This one is pretty obvious in my mind so I won't spend more time on it.
Fly in the ointment: One of the most common concerns I hear is that the government will be dramatically increasing its debt level; which seems manageable now given the rush to safety and the resulting ultra-low treasury rates. What if treasury investors get spooked and push rates up? For what it is worth, I am worried about this too but am struggling to think through all the dynamics and offsets. This line of thought very quickly becomes geo-political (will China keep buying treasuries etc.) in addition to financial and economic. I think what is missing from this debate is the likelihood that total US debt (including business and consumer debt) will continue to decline while government debt specifically goes up. In order to be really worried about this, I think you have to assume that demand for debt instruments will fall, in aggregate, faster than the supply of debt. If I want some of my money in a fixed income investment, I can choose between a government bond, a corporate bond, a consumer loan-based bond or other asset-backed instruments. Corporations and consumers have recently seen the damage that can come from too much leverage, so I find it hard to believe that those categories will be growing for several years. Unfortunately, I also think demand for debt instruments will decline in aggregate as risk appetites are re-discovered. I think predicting the relative magnitude of these trends is almost impossible, but I think it is a risk. Do I think Treasury yeilds are artificially low and are likely to go higher? Yes. Do think that they will go up so much that it forces a default or currency devaluation? Probably not, but this question is too hard for me right now.
Conclusion: Despite the lousy speech, Congress is set to pass the stimulus bill and the Treasury and Federal Reserve are focused on the right things. As an investor, my thesis is that we avert doomsday and start gradually pulling out of this recession.
Despite my own frustration with government intervention and the ugly political posturing, here is my argument for why I am optimistic that the government plan is finally on the right track and will prevent a doomsday outcome.
In a nutshell, we are finally attacking all the key problems. We are recapitalizing the banks AND trying to remove the overhang from bad assets AND trying to stop home price depreciation AND trying to slow consumer deleveraging AND trying to create jobs. It is easy to criticize the government in retrospect for not tackling all these issues from day one, but realistically, the cost of doing so is enormous and is only worth the risk now that we know how bad things are. Would you really have wanted your government committing trillions of dollars to a problem that might develop?
Banks: I understand that mainstreet hates the idea of bailing out the same institutions that contributed to the current mess, but I think it is silly to single out one group when so many are guilty (Banks, non-bank originators, Wall-street securitization engines, rating agencies, greedy borrowers, stupid investors, regulators, polititians, basically everyone) Even if you are still fixated on the banks, you have to come to terms with the reality that a modern economy requires an operating financial system that converts savings into credit. That means we need a functioning and healthy banking system and capital market.
I remember having a somewhat heated debate with a colleague when the TARP was first announced. My argument at the time was that we needed to help remove the overhang of the bad real-estate assets because banks need to know they are well capitalized before they can really start lending again. If we simply infused equity, the banks would still not know if they would be well-capitalized next quarter because the assets continued to deteriorate, so they wouldn't lend. My argument was that the government could help fix the bad asset problem, which would allow the banks to know how big the final losses were, which would quantify how much additional capital they needed to raise from the private sector. Ironically, Paulson reversed course and infused equity without solving the bad asset problem. The key point remains the same; the banking system needs to be recapitalized AND have the bad asset overhang removed. I would prefer that the the private sector provide the capital, but at least both issues are being addressed.
I don't know enough about the private/public bad bank proposal yet to have a guess about whether it will work, but that is not the only possible solution. The governement could guarantee assets after a first loss peice as they have already done with a few specific banks. The key is to stop separating the asset question from the equity question and recognize that they are intertwined.
Housing and Deleveraging: Geithner and Congress are also focused on stabilizing the housing market. Every foreclosure puts another home on the market (increasing supply and pushing prices down) and generates another loss for a bank or MBS investor. Every time housing prices go down, another stretched mortgage borrower owes more than they could sell for, which makes it almost impossible to refinance or sell. Addressing foreclosures attacks the supply side of the housing market. The government is also trying to generate new purchases on the demand side of the equation. I've said this before, but I think the government is essentially trying to artificially loosen mortgage underwriting standards to prevent a quick consumer deleveraging. We all know that consumers are making less money and spending less money. Part of the money we spend is from income and part is from borrowing. The fact that getting a mortgage is so difficult is in and of itself hurting spending and pushing up the "savings rate". We need households to be able to take out new mortgages (especially first time buyers) in order to slow the pace of aggregate deleveraging.
Jobs: And finally, the government stimulus package is designed to create jobs, which give households money to spend, which is good for business, which allows them to hire more people... This one is pretty obvious in my mind so I won't spend more time on it.
Fly in the ointment: One of the most common concerns I hear is that the government will be dramatically increasing its debt level; which seems manageable now given the rush to safety and the resulting ultra-low treasury rates. What if treasury investors get spooked and push rates up? For what it is worth, I am worried about this too but am struggling to think through all the dynamics and offsets. This line of thought very quickly becomes geo-political (will China keep buying treasuries etc.) in addition to financial and economic. I think what is missing from this debate is the likelihood that total US debt (including business and consumer debt) will continue to decline while government debt specifically goes up. In order to be really worried about this, I think you have to assume that demand for debt instruments will fall, in aggregate, faster than the supply of debt. If I want some of my money in a fixed income investment, I can choose between a government bond, a corporate bond, a consumer loan-based bond or other asset-backed instruments. Corporations and consumers have recently seen the damage that can come from too much leverage, so I find it hard to believe that those categories will be growing for several years. Unfortunately, I also think demand for debt instruments will decline in aggregate as risk appetites are re-discovered. I think predicting the relative magnitude of these trends is almost impossible, but I think it is a risk. Do I think Treasury yeilds are artificially low and are likely to go higher? Yes. Do think that they will go up so much that it forces a default or currency devaluation? Probably not, but this question is too hard for me right now.
Conclusion: Despite the lousy speech, Congress is set to pass the stimulus bill and the Treasury and Federal Reserve are focused on the right things. As an investor, my thesis is that we avert doomsday and start gradually pulling out of this recession.
Friday, February 6, 2009
Maybe China should control US banks...
I keep hearing people say things like, "if the government is giving the banks money then the government should be able to tell them what to do", and "this is taxpayer money going to bail out the banks so..." fill in the blank. Skipping to my conclusion, I do not think the government should be telling a business whether they can buy a corporate jet, or how much they are allowed to pay their people. Those are decision for the majority of common shareholders.
Two points.
First, the government has invested in preferred shares of these banks. The government is not a common share holder. If I invest a minority stake in the preferred shares of a company, I do not get to tell the CEO how to run his company. If the company goes into bankruptcy, then I have preference over the common shareholder as it relates to the bankruptcy outcome and a share of whatever is left. If the company is not in bankruptcy, then the common shareholders own the business and I just get my dividend. The government does not have a right to control these banks simply because it has become a preferred investor. If they want to exert control, they should exercise their warrants for common stock. If that gives them a majority then they are in control; if not they need to convince some other big shareholders to go along with their proposals or buy up enough additional shares to become the majority shareholder. If an incremental investor wants to exert control, they can tell the company that their capital infusion is contingent on specific actions. For example, if a company desperately needs capital and only one investor will step up, that investor might say "I will invest the $100 million you need as soon as you fire the current CEO because I don't think he is any good." But if that same investor put in the money a year ago, they cannot wake up one day and have the CEO fired. My bank does not have the right to force me to fix my roof unless I default on my mortgage.
Second, and I'm being facetious and playing out the logic I keep hearing, if the incremental investor in a US bank gets to control the bank, then the incremental investor that allows the US government to invest in the bank should control the US government. Guess what, the government already spent taxpayer money. The incremental spending they are making will be funded by borrowing. Since China is one of the biggest investors in US treasuries, maybe we should make the argument that they should get to control the entity they are invested in.
So returning to reality, I do not think China should get to tell the US government what to do simply because they have chosen to invest in Treasury bonds, and I do not think the US government should get to tell business what to do simply because they have chosen to invest in some preferred stock with un-exercised warrants.
The motivation for investing in the preferred stock should not be to allow government to take over business, it should be because the banking system needed to be recapitalized and the capital markets were in complete disarray. If the government wants to step in to a crisis and try to prevent a failure of the financial system, then the government is trying to fulfill its role of protecting and serving its citizens. It can end there. The government does not need get an acceptable return on its investment or gain incremental control of private enterprise.
Two points.
First, the government has invested in preferred shares of these banks. The government is not a common share holder. If I invest a minority stake in the preferred shares of a company, I do not get to tell the CEO how to run his company. If the company goes into bankruptcy, then I have preference over the common shareholder as it relates to the bankruptcy outcome and a share of whatever is left. If the company is not in bankruptcy, then the common shareholders own the business and I just get my dividend. The government does not have a right to control these banks simply because it has become a preferred investor. If they want to exert control, they should exercise their warrants for common stock. If that gives them a majority then they are in control; if not they need to convince some other big shareholders to go along with their proposals or buy up enough additional shares to become the majority shareholder. If an incremental investor wants to exert control, they can tell the company that their capital infusion is contingent on specific actions. For example, if a company desperately needs capital and only one investor will step up, that investor might say "I will invest the $100 million you need as soon as you fire the current CEO because I don't think he is any good." But if that same investor put in the money a year ago, they cannot wake up one day and have the CEO fired. My bank does not have the right to force me to fix my roof unless I default on my mortgage.
Second, and I'm being facetious and playing out the logic I keep hearing, if the incremental investor in a US bank gets to control the bank, then the incremental investor that allows the US government to invest in the bank should control the US government. Guess what, the government already spent taxpayer money. The incremental spending they are making will be funded by borrowing. Since China is one of the biggest investors in US treasuries, maybe we should make the argument that they should get to control the entity they are invested in.
So returning to reality, I do not think China should get to tell the US government what to do simply because they have chosen to invest in Treasury bonds, and I do not think the US government should get to tell business what to do simply because they have chosen to invest in some preferred stock with un-exercised warrants.
The motivation for investing in the preferred stock should not be to allow government to take over business, it should be because the banking system needed to be recapitalized and the capital markets were in complete disarray. If the government wants to step in to a crisis and try to prevent a failure of the financial system, then the government is trying to fulfill its role of protecting and serving its citizens. It can end there. The government does not need get an acceptable return on its investment or gain incremental control of private enterprise.
Thursday, January 29, 2009
Affiliated Managers Group (AMG) Q4 results
Affiliated Managers Group reported Q4 earnings yesterday that were not as disastrous as feared. Unfortunately, the most appropriate word for this quarters result is "messy". On a GAAP basis, AMG lost $1.73 per share, but made $1.24 in pro-forma cash earnings. The delta was mostly driven by a non-cash impairment charge on two affiliates (but mostly on Value Act). There was also a net non-cash gain of $.06 from the repurchase of some trust preferreds at $.35 on the dollar, offset by the accelerated amortization of options expense due to management forfeiting them (strange accounting rules if you ask me). Even worse, management announced some changes to what they add back to get their cash earnings number. That was the noise.
Just to get this off my chest, I'm really surprised they decided to add another add-back item to get Cash Earnings. The reality is that the AMG story is already complicated and it hurts valuation. Increasing the complexity level seems like a bad idea to me. The only thing I can come up with is that management thinks they are already being penalized for the complexity, so they are making a change now that will increase cash earnings in the future, and there will come a time when investors do not shun complexity like they do now. When that happens, the stock will get an undiscounted multiple on a higher earnings number. I don't know if that was the rational, but either way, I don't like it. I still like this stock, but I disagree with the change to pro-forma presentation.
Fundamentally, times were tough. Net new flows at their affiliates was a negative $3.3 billion. This is actually a meaningful improvement from very recent quarters but is still negative. The markets were down significantly as we all know which hurts revenue at the affiliates and subsequently for AMG shareholders. The holding company still has $200m in cash as well as access to another $120 via a forward equity sale they entered last year (they can sell about 1.2 million shares for about $95 per share).
The assumptions going into the 2009 guidance were modified, which was probably an attempt to distract investors from the fact that AMG will earn a lot less than we thought they would even six months ago. Having said that, the guidance is very conservative in order to give management a very good chance of beating (if you lower the bar enough…). The 2009 guidance was $3.75 - $4.30. Both ends of the range assume no market appreciation from yesterday, but the upper end does assume some modest performance fees and some modest organic growth. For the sake of easy math, I’ll use $4 as the midpoint. Consider that AMG’s revenue grows for three main reasons: market appreciation of AUM, net new inflows (or subtract outflows), and accretion from new acquisitions. A $4 estimate for 2009 assumes that two of the three drivers will be non-existent and that the third (organic growth) will be very modest. So in my mind $4 will end up being too low. I think this business model should trade at 15x bear market earnings, so I get $60 even if two and a half of three drivers are turned off. Bottom line, I think this stock continues to have meaningful upside.
Last thing: I was reminded again this quarter that management is very astute at capital management. When the market cooperated, they raised convertible debt that had very low after-tax interest expense. Before the market really dropped, they sold equity forward which looks brilliant now. Most recently, as market participants are scared and afraid of complexity, they bought back some of that convertible debt at $.35 on the dollar. These are smart guys running the show.
Just to get this off my chest, I'm really surprised they decided to add another add-back item to get Cash Earnings. The reality is that the AMG story is already complicated and it hurts valuation. Increasing the complexity level seems like a bad idea to me. The only thing I can come up with is that management thinks they are already being penalized for the complexity, so they are making a change now that will increase cash earnings in the future, and there will come a time when investors do not shun complexity like they do now. When that happens, the stock will get an undiscounted multiple on a higher earnings number. I don't know if that was the rational, but either way, I don't like it. I still like this stock, but I disagree with the change to pro-forma presentation.
Fundamentally, times were tough. Net new flows at their affiliates was a negative $3.3 billion. This is actually a meaningful improvement from very recent quarters but is still negative. The markets were down significantly as we all know which hurts revenue at the affiliates and subsequently for AMG shareholders. The holding company still has $200m in cash as well as access to another $120 via a forward equity sale they entered last year (they can sell about 1.2 million shares for about $95 per share).
The assumptions going into the 2009 guidance were modified, which was probably an attempt to distract investors from the fact that AMG will earn a lot less than we thought they would even six months ago. Having said that, the guidance is very conservative in order to give management a very good chance of beating (if you lower the bar enough…). The 2009 guidance was $3.75 - $4.30. Both ends of the range assume no market appreciation from yesterday, but the upper end does assume some modest performance fees and some modest organic growth. For the sake of easy math, I’ll use $4 as the midpoint. Consider that AMG’s revenue grows for three main reasons: market appreciation of AUM, net new inflows (or subtract outflows), and accretion from new acquisitions. A $4 estimate for 2009 assumes that two of the three drivers will be non-existent and that the third (organic growth) will be very modest. So in my mind $4 will end up being too low. I think this business model should trade at 15x bear market earnings, so I get $60 even if two and a half of three drivers are turned off. Bottom line, I think this stock continues to have meaningful upside.
Last thing: I was reminded again this quarter that management is very astute at capital management. When the market cooperated, they raised convertible debt that had very low after-tax interest expense. Before the market really dropped, they sold equity forward which looks brilliant now. Most recently, as market participants are scared and afraid of complexity, they bought back some of that convertible debt at $.35 on the dollar. These are smart guys running the show.
Subscribe to:
Posts (Atom)