The Ponderings of Woodrow

The Bank of Wal-Mart? Be careful what you wish for...

As the equity markets raced to new lows today, Wal-Mart [WMT] finished up on the day thanks to much better-than-expected same store sales and an increased dividend. Wal-Mart was the top performing S&P 500 component in 2008 [one of only a handful of constituents that provided gains], and although it gave up some ground YTD, the stock has climbed off its lows as the market continues to plummet.

As I look at Wal-Mart and its relative strength, and juxtapose that against what's happening with GE and the fears over its finance unit, I'm reminded of just how easily things could have gone a different way.

It wasn't long ago that Wal-Mart, arguably the most efficient retailer in history, wanted to extend its dominance into the banking arena.

In 2005, Wal-Mart applied to the FDIC for an industrial loan bank license that would be located in Utah and allow the company to forgo the fees it pays to other banks to process credit and debit card charges. Wal-Mart contended, at the time, it had no intentions of expanding into customer-facing banking operations, yet many regional banks vehemently protested the plan; believing that Wal-Mart would eventually move into other facets of banking.

Bankers Oppose Wal-Mart as Rival [NY Times]

A coalition has formed to keep Wal-Mart out of banking and includes the Independent Community Bankers of America (which provided a sample letter for its members to send to the F.D.I.C.), the National Grocers Association, the National Association of Convenience Stores and the United Food and Commercial Workers union, which is trying unionize Wal-Mart workers. A coalition of community groups called Wal-Mart Watch has sent a petition to the F.D.I.C. with 11,000 signatures opposing Wal-Mart's application.

The debate has even reached Capitol Hill, where Representatives Paul Gillmor of Ohio and Barney Frank of Massachusetts, both members of the House Financial Services Committee, have asked the F.D.I.C. to hold hearings. "This is a very controversial application filed by the company that is the largest retailer in the world," they wrote.

This wasn't the first time Wal-Mart tried to work its way into financial services. In the late 90s the Waltons tried to expand the State Bank & Trust Company [which they also owned] by opening branches in Wal-Mart stores. That move was shut down due to the Gramm-Leach-Bailey Act. Three years later, Wal-Mart tried buying Franklin Bank of California but that too was stopped by legislative action.

Fast forward to 2009 and consider what might have been. Had Wal-Mart been successful in its bid for an industrial bank, would it have expanded into customer facing operations as feared? If so, is there any question Wal-Mart could've carved out an important role in the banking system by now? And had that happened, how might the world look at the company differently? One could argue [and I would], that Wal-Mart's lack of exposure to a large financial arm is a big part of why it remains on [relatively] solid footing among investors. Had Wal-Mart gotten what it wanted, we might be seeing the same kind of fear mongering and lack of confidence that plagues seemingly any institution with financial exposure these days.

For even the largest, most dominant businesses, sometimes its better to be lucky than smart.

Disclaimer: At the time of writing, the author or firms affiliated with the author maintained a long position in WMT, but did not maintain a position [long or short] in GE or any related instrument. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Inexperienced Denizens of a Brave New World

The economic picture continues to darken and most investment asset classes continue to flounder in lockstep. To say it's been a trying time as an investor would be akin to saying you might get wet in a monsoon. These last few weeks the bulls and many of the bears have been trying to find reasons why the market should stop going down, but the technical, fundamental and sentiment indicators remain burdensome.

I'm not an economist and am not going to pretend to know just how bad things will ultimately get, or how long they'll last that way. But I do trust my instincts and have the good sense to listen to people smarter than me who deign to share their views when asked. Times are tough. Times will get tougher. And, as I said several times over the last few months, be wary of thinking bad news is priced in, or that valuation is, in and of itself, a catalyst to move markets.

We're no longer debating the issue of recession, but rather the magnitude of said recession. We have a tendency to find false comfort in prior comparison. When something has "happened before", it's easier for us to wrap our minds around the eventualities and potentialities. That's been a huge part of this market correction. For most of us, the velocity, breadth and severity of this economic downturn is unprecedented. As a result, we have no safety net with which to react.

It would be one thing if investors were the only ones wading into uncharted waters; as an industry we've proven quite adept at adjusting to the paradigm du jour. But here's the rub...this is a generational problem that permeates every rung of our society.

Let's focus our attention on an industry near and dear to me, the information technology sector. Let's say, for argument sake, this recession is going to resemble the early 70s recession in magnitude [I think we have to go much further back to any reasonable comparable]. How many publicly traded technology companies even existed 35+ years ago? Those that did, for example IBM and Hewlett Packard, were entirely different constructs back then. And they're the exceptions to the rule. Think of a technology bellwether today and realize that, with near certainty, they haven't had to deal with an economic environment like the one we're currently enduring.

• The internet didn't exist the last time things were this tough
• Online advertising models are untested in a time of global deleveraging
• The cellphone industry has never had to deal with a period when worldwide GDP was as slow as we can reasonably expect in the next 6-12 months
• Semiconductors were a high growth cottage industry in the last slowdown of any magnitude
• Will the video game cycle really survive unscathed in a consumer-driven recession?
• ...and so on and so on

How will companies react? How will their employees handle the new reality? Will executives have the appreciation for history to make the tough decisions? There's a lot of talk about the strong getting stronger, but are they prepared to take truly dramatic measures?

I don't mean to pick on the technology industry, although I think it has unique challenges because of the relative newness and embedded sense of "growth over all else" that's driven the industry for the last few decades. But this systemic inexperience I'm referencing extends far and wide. Precious few management teams have handled this kind of global picture, and fewer still have navigated it successfully, in any industry.

What's the moral of the story? Uncertainty abounds. Logically you can't have any faith in forward estimates right now, particularly those over the next 6-12 months. So my advice? Don't try. Focus on companies that you believe are survivors, those that have a history of doing right by shareholders in good times and bad. Those who are targeting secular trends that will supersede a multiyear recession if you're patient enough. Understand that valuations as most of us have known them are irrelevant now. Right now it's about surviving. Unless you have to catch the bottom, don't try. Roughly 50% of the S&P500 is trading at 10x or less trailing GAAP earnings now, so just because something is "cheap" doesn't mean it's investable. Appreciate dividends and the power of compounding. REALLY appreciate a company's ability to generate cash flow, preferably sustainable FREE CASH FLOW. And recognize that anything you buy today, probably wll be cheaper tomorrow. These are humbling times, and we are all inexperienced denizens of this brave new world.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained a position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions. 

Valuation isn't a catalyst to move markets

I've been hearing a lot of people argue that "stocks are cheap" as we continue to see bourses around the world plummet. As an investor, I'm acutely aware of valuation and its role in investment selection and subsequent performance. But I'm also mindful of how valuation loses significance at times of great velocity.

Link provided by CNNMoney.com

Are stocks cheap? By some measures, they certainly appear to be; at least relative to where they've traded over the last decade. But here's the rub...the de-leveraging we're seeing and the financial crisis we're dealing with is unlike anything this world has seen in generations, much less the last ten years. The daily moves we're seeing are comparable to what we saw in the 20s and 30s folks. So whether our equity markets are cheap compared to the last ten years hardly seems relevant.

But at the end of the day, if you're a fundamental investor [as I and my partners are], you have to remember that valuation doesn't supersede fundamentals. It can be tempting to look at a stock and see that it's trading at valuations we've not seen in our careers, but that can be a painful crutch. It gets back to my assertion last week that stocks aren't as effective at "pricing in" downward estimate revisions as we would like to think.

Remember the Nasdaq Bubble...the inverse can be true, too

At the peak of the Nasdaq bubble, very few investors could make a credible argument that stocks weren't obscenely valued. Blue chips were trading at 10x-20x-30x REVENUES. Triple digit P/Es were the norm. Companies with almost no revenues were coming public and trading at 100x projected sales, or higher. The idea of valuing companies on their future cash flows was resoundingly discredited as "out of date." Sell-side analysts turned to the "relative valuation" game, i.e., "ABC Corp trades at 80x revenue and XYZ is growing faster, so it should trade AT LEAST 80x revenues or more." And buy-siders played the game because you would've been slaughtered on an absolute basis if you didn't.

There were plenty of fund managers waiting for the inevitable crash to happen at the start of this decade. And yet I can tell you that many of them went out of business waiting for that crash to happen. Stocks were expensive, insanely so. And they continued to get more expensive.

The Nasdaq Bubble didn't burst because of valuation. It was only after the fundamental problems became unmistakable that investors began a rampant and unapologetic DE-LEVERAGING of their equity investments. And stocks went from insanely expensive to, in many cases, inordinately inexpensive. How many optical networking stocks went from 80x sales to trading a below net cash? More than you and I care to remember.

So again I'll say...the inverse can be true

Stocks can also become INSANELY cheap. And they can stay that way for years IF the underlying fundamentals that drive the market remain weak. I sure hope that doesn't happen. And I've seen a lot of aggressive action by the world's governments to prevent that from happening. There's a truism that says, "Don't Fight the Fed." Well right now the stock markets are "Fighting the FedS." And we're all not going to magically wake up one day and say, "OK, that's it...stocks are TOO CHEAP and I'm buying." Nope.

Valuations aren't an impediment to a new bull market, and that's a good thing. But for stocks to turn, and sustain an upward trajectory, it's got to come from improvements [or anticipation of said improvements] in the fundamentals. And right now that's as much about watching the TED spread, the Baltic Dry Shipping Index, and what specific investments (and when) TARP will be undertake.

As my friend Howard Lindzon has been saying, this is dangerous market. Guys like Steve Cohen, Israel Englander and John Paulson aren't sitting on billions in cash right now at market lows because they're scared. They are some of the most aggressive, accomplished investors on the planet and yet see too much uncertainty to put the majority of their partners' capital to work. Take note, I certainly am.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions. 

Tech Investing: The Myth of "Priced In"

To those who don't have to be actively involved in the stock market on a day-to-day basis, don't be. Honestly, the volatility and uncertainty in the market right now is making the most astute investors look like rank amateurs. In that kind of environment, unless you're a professional, focus on the task at hand; whatever that may be.

Now for the rest of us who have a fiduciary responsibility to be actively engaged in the market, let's talk about expectations. In an ideal world, a company's stock price would reflect the net present value of all future cash flows [adjusted for what portion of the total ownership of the company said equity represents, of course]. But in a world where companies are revalued on a tick by tick basis, a LOT of other factors can drive stock price movement in the near-, intermediate- and, yes, long-term.

As much as it pains me to look back on the bursting of the Nasdaq Bubble, the experience of being a technology investor in those years has served to steel me (somewhat) from the nastiness that's currently unfolding.

I keep hearing about how "this time it's different." In many ways, that's true:

• Valuations didn't start out at obscene, bubble levels
• The current market hasn't been littered with technology IPOs
• A much larger percentage of IT spending is maintenance related versus discretionary
• The rate of growth for overall IT spending isn't several factors faster than GDP this time out
• Technology, as a sector, isn't far and away the most crowded long trade

Acknowledging that the current environment for technology issues isn't the same as 2001 is comforting in terms of magnitude, but not necessarily in terms of direction.

As sell-side analysts slash and burn their forward estimates and lower their ratings on technology stocks, at a time when the market is already in a free fall, I've begun to hear from a lot of intelligent people that THE BAD NEWS IS PRICED IN.

Sounds great in theory, but falls short of today's reality...

• SAP AG (SAP) was down $5.97 today (13.08%) after issuing disappointing Q3 top-line results and characterizing the September shortfall as "sudden" and "unexpected"
• Double-Take Software (DBTK) was down $1.51 today (17.3%) after the company issued preliminary Q3 results this morning. This was a company that was already trading near its 52-week low and significantly below its 52-week high of $26.54
• RightNow (RNOW) fell $1.43 (12.9%) today after announcing negative CFFO due to extended payment terms and longer collection cycles. This was a company already trading far off its summer high of $17.26

These are just examples from today, to say nothing of the bloodbath we've seen in bellwether names like Research in Motion (RIMM) following an earnings report that didn't meet investor expectations.

The truth is, at some point the bad news will be "priced in" but we're not there yet (in my opinion).

Here are things I'll be looking for in the coming weeks as the earnings season unfolds:

1. Guidance meets reality -- Technology companies need to acknowledge the weakening economic climate and readjust expectations, both internally and in terms of published guidance to the investment community. The truth is, too few technology companies have lowered forward estimates yet, and as long as the velocity of earnings revisions is downward, stocks will struggle to find bottoms regardless of valuation
2. Cost rationalization -- Tech companies, even large, mature ones, have "growth" built into their DNA and often continue hiring aggressively in the face of slowing macro trends. I'm looking for evidence that the industry is slowing hiring and or making appropriate layoffs to right size their businesses
3. Putting money where their mouths are -- While semiconductor companies are capital intensive, many technology issues (software, internet, some hardware) are both cash flow positive and flush with cash on the balance sheets. With the SEC softening corporate buyback rules, and the market selling off demonstrably, there's no better arbiter of a "floor" in the industry than seeing cash-rich companies putting money where their mouths are. In a similar vein, I have a hard time accepting that stocks are bargains when company executives continue to sell their shares indiscriminately
4. Follow buy-side sentiment indicators, not sell-side -- Sell-siders aren't great market timers. And that's being kind. I don't look at a rash of downgrades in a bear market (or upgrades in a bull market) as predictive. But I do look at what my fellow buy-siders are doing in aggregate. If the HF industry is, in aggregate, overweight technology, in a declining market, the bad news isn't "priced in."
5. A stabilizing macro environment -- When the macro environment stabilizes, normalcy will return to tech spending soon enough. Areas where spending is largely non-discretionary (i.e., security, storage) should show the first signs of normalization, if history is any indication.

The market is a humbling mechanism. Yes, stocks aren't trading anywhere near the valuations they were during the Bubble. But let's not forget that many of those same companies ended up trading BELOW NET CASH at the bottom. I'm not suggesting we'll see those kinds of lows again this cycle, but understand that valuation isn't the only thing that matters. When aggregate estimates are going lower, it's VERY difficult for technology stocks to move higher. Impossible? No. But difficult? Indeed.

The key? Own great companies at great prices. Easier said than done? Perhaps; but that gets back to my original advice. To those who don't have to be actively involved in the stock market on a day-to-day basis, don't be.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions. 

Buffett invests in GE...should we smile or frown?

You've got to hand it to him, Warren Buffett knows how to make a splash.

Last week, the world's greatest value investor stepped into the maelstrom and invested $5B in Goldman Sachs. At the time, a lot of us wondered whether Buffett's move would calm the markets -- it hasn't. Tomorrow we'll get another chance to see if the Oracle of Omaha's confidence in bellwether U.S. equities will help stem the tide of investor uncertainty.

That's because today Warren Buffett invested $3B in General Electric. The terms were similar to those he received from Goldman Sachs:

• Berkshire will invest $3B in exchange for perpetual preferred stock that pays a 10% annual dividend
• Berkshire will receive rights to purchase an additional $3B in common stock at $22.25 per share, exercisable for the next 5 years
• GE will raise an additional $12B in common stock through a spot secondary [pricing tonight]
• GE can call in the preferred stock at any time over the next three years for a 10% premium

In discussing the deal, Buffett spoke of the opportunities he's seeing in the equity markets as well as GE's stature as an American institution:

"Frankly these markets are offering opportunities that weren't available six months or a year ago," Buffett said in an interview on CNBC. "So we're putting money to work."

"GE is the symbol of American business to the world. I am confident that GE will continue to be successful in the years to come."

So should investors look at Buffett's actions enthusiastically as a sign that it's safe to get back in the water OR are his investments actually cause for concern and indicative of just how serious the credit crisis has become?

The Bull Case -- Buffett is putting money to work

Buffett has invested $8B in the last week in two respected U.S. domiciled companies. Both are on the SEC's no-short list and both have suffered difficult times and lagging stock prices. Many people have made a career out of following in Buffett's footsteps, and there is unquestionably a symbolic component to seeing him put Berkshire's capital to work at a time when so few investors are willing to commit.

Mike O'Rourke, the Chief Market Strategist for Baypoint Trading (BTIG) summed up the bullish side of Buffett's actions in his nightly newsletter:

Once again, we find the cynicism surrounding another Buffett investment stunning.  For twenty years, market participants clamored to follow Buffett into any transaction, and now that he is finally putting money to work, the common response is that companies are giving him too much. In a capital constrained world, if you can get Buffett’s capital, you are well ahead of the competition.

The Bear Case -- Buffett is naming his terms, and they're not cheap

10% perpetual preferred plus warrants = hardly the same as going out and buying common shares in the open market. Buffett is no altruist, he and his investors expect him to act aggressively when opportunity arises. He's getting extremely attractive terms because GE and Goldman Sachs feel those terms are warranted; and there's the rub. GE is an American institution and carries a AAA credit rating. The fact a AAA-rated firm of GE's caliber would feel compelled to offer a senior perpetual preferred to any investor, even Warren Buffett, is a testament to just how tight liquidity remains throughout the system. To take a page out of my friend Roger's book...companies are paying a premium for option liquidity.

So is Buffett signaling a market bottom? Impossible to say. Buffett doesn't need the equity markets to rally for his investments to pay off. He just needs GE and Goldman Sachs to stay solvent and pay him 10% dividends year in, year out. Furthermore, Buffett is telling anyone who listens just how tenuous a situation the capital markets are in and the necessity of a bail out and then a lot of hard, smart decisions to follow.

One last point...To be a truly great value investor you have to zig while others zag. You have to be willing to put capital to work in an area where most won't. That's why great value investors pounce during periods of extreme sentiment. Buffett has the benefit of hindsight, great instincts and, most importantly, an ability to be patient in a market that, by definition, favors impatience. Stock prices are quoted in the blink of an eye, returns are followed in real time, funds are put to work and redeemed based on what happens over the course of days, weeks and months. To make money the Buffett way, you have to be willing to forgo all of that and treat equity stakes as though they were private investments with long-term horizons. That's MUCH easier said than done. Most public equity investors, particularly those running hedge fund money, are compensated [and rebuked] based on what they do in shorter time intervals. Buffett doesn't need to worry about that; if Berkshire Hathaway's stock were to meander for years, it wouldn't change his functional wealth, his buying power, or his reputation.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Great Google-y Moogly!

If I hear "may we live in interesting times" from one more person...

For investors involved with Google [GOOG], today was indeed memorable. Like many tech bellwethers, Google was slammed in Monday's carnage. Today, in the uber relief rally, Google shares were humming along and regaining much of the losses from Monday. That is, until the closing bell.

Volatility, thy name is Google
One moment Google appears to be trading comfortably above $400 per share, and then, in the final minutes of the day we saw prints as low as $212.63 and as high $483.63; with the closing price as $341.

HUH? Excuse me?
Within seconds of the closing print, my head trader called my office to explain what transpired. He had warned us the day before that with the quarter end, the liquidity crisis and the historic volatility we should expect quite a few odd trades particularly on the opens and closes. While I recall the warning, I certainly didn't expect a 16% swing in a matter of minutes!

Why the closing price matters
Within moments of the closing price, it was clear something was amiss. In after hours trading, Google was trading comfortably above $400 [at $405 or so when I first took a gander]. So that might lead you to ask, so what was the big deal?

Well, as money managers know full well, the closing price matters, PARTICULARLY the closing price at quarter end. Most funds report results in some fashion on a monthly basis, and quarterly filings are required of all registered funds. This was both a month end AND the end of Q3. And this was GOOG, a stock that just about anyone involved in technology investing has at least some exposure to.

Had funds been forced to accept the closing price of $341 today, a number of issues would've been at play:

• Management fees -- Funds that charge management fees [i.e., almost all of them] generally take their fees on the 1st day of every quarter. So if you had a large position in Google, it was possible that the $341 print could've cost your fund a substantial amount of cash flow. For example, let's say you're running a $1B hedge fund that charges a 2% annual management fee. You are long 125,000 shares [roughly a 5% long position]. The difference between the legitimate closing price ($400.52) and the reported closing price ($341) or roughly $60 per share equates to a difference in ending equity of $7.5mm. The quarterly allocation of a 2% management fee (i.e., 0.5%) would be $37,500. Might not seem like much, but $37,500 in lost cash flow is meaningful for any business.
• Reported returns -- Month- and quarter-end returns would've been skewed. In the same example (125,000 share long of GOOG), this would've cost a fund as much as 75 basis points of reported returns. That's a big number, particularly for a volatile month where the majority of funds likely reported losses anyway.
• Skewed basis for capital inflows -- Depending on whether a fund was due for capital inflows at the start of the month, this would serve to unfairly skew the cost bases for existing clients if you initiated a buying program for the new capital at the October 1st stock price.
• Skewed basis for redemptions -- The inverse of the above. Investors taking money out as of September 1st would've had their returns understated. 

Luckily, all of this turned out to be in error. Our trader sent me the following notification after this whole debacle unfolded:

Pursuant to Rule 11890(b) NASDAQ, on its own motion, has determined to cancel all trades in security Google Inc Cl - A "GOOG" at or above $425.29 and at or below $400.52 that were executed in NASDAQ between 15:57:00 and 16:02:00 ET. In addition, NASDAQ will be adjusting the NASDAQ Official Closing Cross (NOCP) and all trades executed in the cross to $400.52. This decision cannot be appealed. MarketWatch has coordinated this decision to break trades with other UTP Exchanges. NASDAQ will be canceling trades on the participant’s behalf.

Interesting times indeed.

Disclaimer: At the time of writing, the author and/or the firms affiliated with the author maintained a long equity position in Google [GOOG]. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

The Necessity of Blame

The search for someone to blame is always successful -- Robert Half

Blame Game for Financial Crisis

Created using http://wordle.net/. Images of Wordles are licensed .

Blame is EASY. Especially in a situation as grave as our nation is facing right now. I say this because I'm overwhelmed by the pervasiveness of blame in the process. Congressional hearings where the only bipartisan action is finding someone, other than Congress, to blame for our financial crisis. Investment banks crying afoul of short-sellers. Homeowners blaming predatory lenders for making it too easy to overextend themselves. People decrying future tax burdens because their neighbors took out huge mortgages with low teaser rates. Debt holders blaming the ratings agencies for rating things AAA when they were Toxic FFF. And so on and so on...

BUT IS THERE A POINT? Is BLAME productive?

When I was in college, I was involved in a car accident. I was in the back seat of my friend's beaten down clunker; and we were driving on the shoulder with our hazards on trying to get off the turnpike and find a hotel for the night since there were no mechanics open at that hour. It was a cloudy, rainy night and unbeknownst to us there was an 18-wheeler coming up behind us. The driver of that 18-wheeler was dozing off. Long story short, the 18-wheeler slammed into the back of the car and I woke up in an ambulance, unsure of what happened. I learned during that process the concept of COMPARATIVE NEGLIGENCE. Essentially the courts try to determine who to blame, and assign a percentage of blame to each participant. I was apparently 10% to blame; for failing to have a seatbelt on [despite it being legal since I was in the back seat]. The truck driver was 60% to blame; apparently falling asleep at the wheel and slamming into another vehicle works that way. And my buddy, the driver, picked up the rest of the blame for being on the road in a broken down car rather than stopping and awaiting emergency service. The courts used the percentages to determine the amount of damages awarded to the injured parties.

While comparative negligence may work for disability tort litigation, it has absolutely no place in stemming the tide of this financial crisis. If we're really on the precipice, as the Treasury Secretary, Fed Chairman and even the Oracle of Omaha believe, isn't assigning blame right now a suboptimal way of spending our time?

Howard Lindzon said, "I am not a fan of witchhunts, but they generally get shit done." His point is well taken, even if I wish it weren't.

Sometimes there are legitimate reasons for assigning blame, for figuring out WHOSE FAULT IT IS. But there will be time for that later. Our country is facing the most severe financial crisis since the Great Depression and there are no easy answers. Paulson and Bernanke haven't done a credible job of articulating the losers in this crisis. Yes, Wall Street stands to lose jobs and a lot of wealth. But Main Street stands to lose much more. The inability for small businesses to stock shelves and make payroll because lines of credit are drying up. The inability to refinance mortgages. Students unable to pay for tuition because student loan programs have evaporated. Retirees unable to pay their bills because their portfolios are pressured. We are already in recession territory, how many of us truly understand what it would mean to be in a Depression? Are we really prepared for double digit unemployment? Unfunded pensions? Municipal bankruptcies? Further devaluation of our currency? Reflation?

If not, we all need to get past our personal biases, our anger, and our desire for a pound of flesh. Can we do it? Or will we worry about making sure those most culpable aren't disproportionately benefited by a bail out effort? You decide.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions. 

Can Buffett do what Paulson and Bernanke couldn't?

It's hard not to appreciate the symmetry of today's events.

Less than a week ago, Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke met with Congressional leaders and painted such a bleak picture of our financial system that they compelled the legislators into action, signaling initial support for a $700 blank check mechanism meant to overpower all the fear, uncertainty and doubt freezing up the liquidity of our capital markets. For good measure, SEC Chairman Cox piled on an ill conceived ban on select short sales.

The impact on the equity markets was short-lived, to say the least, as was the pledge of bipartisan support for getting something done in a timely fashion. As we braced for today's hearings, the equity markets staged a powerful sell off yesterday and many began to question the Paulson plan from seemingly every angle.

Having watched much of the hearings today, I was absolutely stunned at how unconvincing Paulson and Bernanke were in conveying their message of financial Armageddon to the Congressional committee. Let's hearken back to comments made by Senators Dodds and Schumer following last week's late night emergency session:

Congressional Leaders Stunned by Warnings [NY Times]

“When you listened to him describe it you gulped," said Senator Charles E. Schumer, Democrat of New York.

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program “Good Morning America,” the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”

Mr. Schumer added, “History was sort of hanging over it, like this was a moment.”

When Mr. Schumer described the meeting as “somber,” Mr. Dodd cut in. “Somber doesn’t begin to justify the words,” he said. “We have never heard language like this.”

For those of you who listened to the hearings today, you heard those very same Senators (and their fellow committee members) paint a decidedly different picture. Where was the sense of urgency? Where was the "something must be done right now, and it's not about partisan politics" mantra?

More importantly, where was the eloquent, descriptive state of the financial union that so many of us expected to hear from Paulson and Bernanke today?

Today, Bernanke and Paulson HAD to be better than they were. Realistically, these men were asking for a $700 billion bail out package with a broad, sweeping expansion of their powers and had, to date, offered up a 3-page (or 6-page in the revised version) memorandum in defense of the maneuver. They needed to scare the American people with the severity of the realities facing them.

They had to know that the American people had spoken loud and clear to their elected officials in the preceding days. "Main Street" just wasn't seeing how the Paulson Plan helped them. And in an election year, particularly September of said election year, if you can't get "Main Street" to see the validity of the proposal you have ABSOLUTELY NO HOPE of getting Congress to sign on the dotted line. But didn't Bernanke and Paulson know that before sitting down to testify today?

I assumed they did. Which means either they a) simply failed on the grandest of public stages to convey the actual severity of the situation or b) made a calculated bet against coming across as the heavies to the American people; knowing that a significantly reduced version of the bail out plan was a best case scenario to begin with.

The Markets Didn't Seem to Put Much Faith in the Paulson Plan

The U.S. indices finished at the lows of the day today, following a dramatic sell off on Monday; signaling to many that investors simply weren't putting much credence in the state of the Paulson Plan to stem the bleeding in a timely and optimal manner.

Enter the Berkshire Call Option: Buffett Announces Investment in Goldman Sachs

Berkshire Hathaway has agreed to invest in Goldman Sachs, Buffett's first investment in a Wall Street firm since his much ballyhooed involvement with Salomon Brothers in the early 90s. The terms of today's agreement:

• Berkshire will invest $5B in exchange for perpetual preferred stock that pays a 10% annual dividend
• Berkshire will receive rights to purchase an additional $5B in common stock at $115 per share, exercisable for the next 5 years
• Goldman will raise an additional $2.5B in common stock through a secondary [it's first equity issuance since 2000]
• Goldman can call in the preferred stock at any time for a 10% premium

The Perceived Value of Buffett's Endorsement

As I type this, shares of GS are trading at $134.75 [up 7.9% after hours]; signaling the market's enthusiasm for Buffett's investment. Broadly, equity futures are up on this news. There are plenty of rational reasons for the market's enthusiasm tonight:

• Buffett is, without question, one of the best investors walking the Earth
• He's heretofore avoided stepping into the Wall Street malaise; his willingness now will be perceived as a signal of bottoming
• A lot of investors are more than happy to follow Buffett's lead
• This move puts Goldman on sounder financial footing and signals that the government's moves last week to stem the fire sale are working
• We're collectively (and justifiably) more impressed by the actions of a private free market participant than we are by the bazooka of forced socialism

But Let's Not Confuse Buffett's Investment in Goldman with What the Paulson Plan is Trying to Solve

The market is beaten up. Conviction is low. Volatility is (relatively) high. Buffett will make people feel better. Whether it's a temporary tonic or the siphon that gets the investment pump churning again very much remains to be seen. But I remain skeptical of this move as a harbinger of a broader fix for several reasons.

• This is a move to invest in a storied financial entity, Buffett's investment does NOTHING to help set a fair market price for the toxic assets the Treasury is trying to get $700B to acquire
• Buffett is just the latest investor willing to invest in a Wall Street firm under attractive terms; he's not blazing the trail here. For example, it was announced just a day ago that Mitsubishi UFJ is buying 20% of Morgan Stanley
• Buffett is getting extremely attractive terms; Goldman didn't provide Buffett with a $500mm annual dividend in perpetuity plus call options for 7% of the company's equity because it had offers pouring in. Few firms will be able to ask for, and get, those kinds of terms

It's not about this investment, it's about whether Buffett can convince the market of reasonable marks for all the toxic assets in the system. The market is tired and frustrated. A lot of people have been looking for "the sign" of a bottom in the financial sector and whether this helps spark the private sector to put money to work remains to be seen. One would hope that Buffett's willingness to get involved will also signal his willingness to actively vocalize thoughts on the appropriate way to value and dispose of the toxic assets which plague the system. If he can convince private buyers to start taking troubled assets off the banks' balance sheets, he may actually accomplish more with $5B than Paulson and Bernanke can with $700B. A scary thought to be sure, but one that's not out of the realm of possibility.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Hedge Fund fallout just getting started?

Nouriel Roubini, not too long ago considered an alarmist by many, has been so right (while so many were wrong) that his missives are quickly becoming must reads by anyone even tangentially involved in the capital markets.

In today's Financial Times, Roubini discusses what he sees as the "next step" [free registration required] in the global unraveling of the "shadow banking system":

...The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

A Global Process of Deleveraging

Easy money. At the heart of our current financial crisis is a systemic disregard for risk which in turn fueled an asinine bubble in worldwide liquidity. The availability of easy money stemmed every rung of the economic ladder. Consumers got easy car loans, homeowners got easy mortgages, corporations fueled M&A and buybacks with easy debt, MEW was plentiful, historic LBOs, unprecedented money growth in emerging and developed sovereign nations. You name it, the liquidity was there. The notion of "what goes up must come down" is more than a truism in this case. While we're beginning to understand the significance of the mess we've collectively made, anyone that thinks the Paulson Plan magically gets us through the normalization process needs to revisit their statistics textbooks from university.

Felix Zulauf explained the situation succinctly in this week's Barron's [sub required]:

The leveraging-up in this cycle is reversing, and we are now deleveraging. When a huge system -- that is, the global credit system dominated by the investment-bank giants that have been the major creators of credit in the last cycle -- turns down, the fallout is going to be terrible. Deleveraging is a very painful process, and will run longer and deeper than anybody can imagine.

Quantifying Hedge Fund Leverage

The hedge fund industry has grown up during the liquidity bubble. That's no coincidence. I've had a number of people ask me what the "typical" leverage profile is within the industry. A recent study by the ECB puts the average hedge fund leverage at 1.4x-1.5x in its most recent analysis; with the caveat that leverage was declining in the face of tighter credit conditions. Unfortunately, even if this number proved accurate, knowing the Mean for our industry isn't very helpful in estimating the potential fallout that Roubini predicts.

1. Hedge funds are fluid instruments and a snapshot is just that, a snapshot. Industry leverage can change dramatically in a matter of weeks. Quarter to quarter is anyone's guess
2. The mean isn't predictive given the dispersion of styles and risk characteristics within our industry. There are funds that use little to no leverage, and there are firms that use 10-12x leverage [think Bear Stearns Enhanced Leverage Fund]
3. The majority of funds are unregistered and unregulated, creating an opacity of disclosure

But Wait, There's More...

1.5x leverage doesn't seem as bad as you thought, right? Well that only accounts for a component of the unwinding Roubini is hinting at. A good chunk of hedge fund capital comes from fund of funds; which use leverage to generate their returns. Still not enough for you? Then remember that lots of hedge funds used that capital to invest in highly leveraged debt instruments (i.e., CDOs).

Way back in January 2007, Gillian Tett of the Financial Times [sub required] relayed a story from an anonymous emailer who expressed disbelief at the ease by which hedge funds have been able to lever up as much at 50:1 [admittedly an extreme example]:

He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds' money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. "Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors' capital - a 2% price decline in the CDO paper wipes out the capital supporting it.

"The degree of leverage at work . . . is quite frankly frightening," he concludes. "Very few hedge funds I talk to have got a prayer in the next downturn. Even more worryingly, most of them don't even expect one."

Don't Cry for Me Argentina

Right now the "Main Street vs. Wall Street" sentiment is at a fever pitch and, for as little sympathy the average citzen has for the travails of Lehman, AIG, Goldman, Morgan Stanley, et al...you can be sure they have less sympathy for the hedge fund industry. We're big boys (and girls) and the rational among us can't reasonably expect the kind of blank check bail outs being afforded the investment banks, insurers and traditional lenders.

• Unregulated = Unprotected -- The pound of flesh the government is demanding for this monster bail out is HEAVY REGULATION; and as an industry we've fought continuously against oversight. Ironically, if the HF fallout is severe enough, we're probably facing increased regulation when all is said and done anyway.
• Easy Political Targets -- The blame game is already underway. While I personally think it's counter productive to spend cycles figuring out who to blame [especially b/c just about everyone is culpable in a mess of this magnitude], it's an ELECTION YEAR and politicians need someone to rally against. Since they can't blame over-leveraged consumers [they need those votes] and assuredly won't blame themselves [how can they win re-election that way?], hedge funds are an easy target.
• Short-selling criticism is a harbinger -- I've already said my piece on the silliness of the short-selling ban; but that isn't stopping the politicians from beating the "short selling = evil" drum.

Drowning in High Water

Deleveraging and public criticism are just two of the issues at play right now. The proverbial other shoe to drop is the incentive allocation model. For those who aren't familiar with how hedge funds are structured, typically we collect a management fee (based on a percentage of assets under management) and a performance fee (based on a defined percentage of the net profits during a given fiscal period). But what happens when a fund manager fails to generate a positive return? We're subject to a high water mark:

EurekaHedge FAQ:
What is a high water mark?

Where a hedge fund applies a high water mark to an investor's money, this means that the manager will only receive performance fees, on that particular pool of invested money, when its value is greater than its previous greatest value. Should the investment drop in value then the manager must bring it back above the previous greatest value before they can receive performance fees again.

In other words, if a fund loses 10% in Year N, it has to make back that 10% in Year N+1 before it can begin accruing performance fees.

Nine of out Ten Hedge Funds are Under Water

According to a recent survey by EurekaHedge, 97% of the 4,000 funds it surveyed were under their high water mark as of July 31st. That shouldn't be a surprise given where the equity indices currently sit, but it does raise the question of what the resulting impact will be. Barring a major turnaround in the capital markets between now and year end, the majority of the world's hedge funds won't receive performance fees.

Thoughts on the potential fallout:

• Large, multi-strategy mega funds will weather the storm better than most -- The mega funds are diversified and well capitalized to weather a down year or two. Presuming the aggrerate returns aren't significantly below the high water mark, the potential to quickly get back above water in 2009 will be incentive. Furthermore, top performers at smaller funds will likely look upon the relative safety of working for a mega firm in a new light
• Hundreds, if not thousands of funds will shut down, merge or recapitalize -- Some fund managers will simply close their doors and move onto other initiatives; returning capital to LPs and living off their past proceeds. Others will look to "get big quickly." Expect many funds that fall significantly under water to lose top performers who would have otherwise generated performance fees on their own portion of the portfolio
• Capital raising will become more difficult -- This is already happening but capital raising will become more difficult; particularly as fund of funds and large institutions struggle to justify past investments in toxic CDOs and other leveraged, non-performing assets
• Investors will demand more transparency -- This is self explanatory, and inevitable
• Aggregate returns will moderate -- Systemic deleveraging means more muted aggregate returns. For funds that have made their way using little to no leverage [full disclosure: we are one of those entities], this hopefully brings opportunity

Tumultuous times are ahead, for every portion of the financial world. Roubini's prediction that hedge funds have a period of rationalization ahead is both logical and highly likely. There will be pain; much of it necessary. But those who stay focused on the task at hand, execute within their stated investment parameters, and balance the need for absolute returns with the need to service and protect their partners against undue risk will not only survive, but flourish. Changes are inevitable, but I for one don't necessarily think that's a bad thing -- longer term, of course.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Visualization of the "Bail Out"