Monday, December 31, 2007

S&P500 Index's Best 2007 Total Return Performance: National Varco

I'm pleased to note that, as of today's market open, the best total return performer of 2007 in the S&P500, according to CNBC's Squawkbox program, is National Oil Varco.


Varco is in my current equity portfolio, with a return, since July, of over 34%. For the full year, it looks to have returned in excess of 100%.
This isn't the first time my equity portfolio has held the #1-performing S&P equity for a given year. The portfolio often holds at least one of the top ten performers, by total return, for the S&P in a calendar year.
It's a testament to how important a company's consistently superior performance is to its total return performance. And to how well our selection process works.
Still, Varco isn't our best-performing equity holding this half-year. It doesn't even have the heaviest weight among holdings in my portfolio. Apple is both our best performer of the second half of the year, with a total return of nearly 50%, and the heaviest weight level in the portfolio. MEM Electronic Materials has had a total return of roughly 43% this half-year, with a weighting similar to that of Varco.
It's reassuring to know that our equity portfolio selections and, by extension, our options selections, continue to feature top performers among the S&P500 membership for yet another year.

MBIA & AMBAC: Bond Insurers Went Astray

Among the casualties this year in the fixed income-related financial sector have been two bond insurers, MBIA & AMBAC. Both have become unstable and caused doubt as to their ability to stand behind their obligations due to mortgage-instrument related losses.


As the nearby Yahoo-sourced, six-month price chart of AMBAC, MBIA, and MGIC versus the S&P500 Index shows, all of these bond insurers have seen their stock prices plummet since July of this year. Why have the three firms suddenly lost so much value?

Mortgage Guaranty Insurance Corporation, MGIC for short, obviously came under pressure for its obligations to payoff on bad mortgage loans and related instruments.

But what about MBIA and AMBAC? I guessed that these firms were not originally in the mortgage-related instrument insurance business. Here's what I found when Googling both firms.


MBIA's history, which reads, in part,

1973
Municipal Bond Insurance Association (MBIA) forms. Managed by MISC, MBIA is formed by four major insurance companies: The Aetna Casualty and Surety Company, St. Paul Fire and Marine Insurance Company, Aetna Insurance Company (then part of Connecticut General and now part of CIGNA), and United States Fire Insurance Company, a Crum & Forster Company.


1971
Municipal Issuers Service Corp. (MISC) forms. It becomes the managing agency of the Municipal Bond Insurance Association, which was created in 1973.



AMBAC's site tells us,

1971
American Municipal Bond Assurance Corporation (Ambac) is founded in Milwaukee, Wisconsin as a subsidiary of MGIC Investment Corp. Ambac begins with $6 million in initial capital and receives a AA rating from Standard & Poor's (S&P). Ambac insures its first issue, a $650,000 general obligation bond for The Greater Juneau Borough (Alaska) Medical Arts Building Company. The issue funds construction of a medical arts building and a sewage treatment facility adjacent to the local hospital.

1974
Ambac's first competitor, Municipal Bond Insurance Association (MBIA), formed as a consortium of four major insurance companies, receives a AAA rating from Standard & Poor's.


As I surmised, both were originally municipal bond insurers. Now, as it turns out, a friend's daughter has the opportunity to interview for a municipal finance-related internship, among other choices, at a large investment bank. In order to help her choose from the options available to her, I gave her a description of what actually occurs in the process of financing a municipality's capital requirements.
Doing so reminded me of a key difference between municipal and mortgage bond insurance. Municipalities have a great degree of authority over the generation of income to pay interest on and, ultimately retire their obligations. True, the occasional situation arises, such as Cleveland, New York City, or Orange County, where mismanagement of the city causes solvency issues.

But mortgage insurance is far riskier. Compared to a municipality's ability to tax and raise fees, a mortgage is typically repaid from the borrower's far more risky and volatile personal income stream.

One has to wonder at the wisdom of AMBAC and MBIA jumping into the mushrooming world of mortgage-backed instrument guarantees. I'd be willing to bet that, compared with the sleepier, slower-growing world of municipal obligations, the burgeoning volumes of CDOs with mortgages underpinning them became too tempting for the two municipal bond insurance firms.

It probably seemed relatively simple to them to hire some experienced mortgage bond analysts, leverage their existing operations into the new sector, and watch the new income invigorate their stock prices.

Instead, both AMBAC and MBIA are ending the year down more than 60%.

It seems that financial excess wasn't limited to just the borrowers and lenders. Even the insurers got into the act. No wonder Warren Buffett has chosen this opportune time to enter the municipal bond insurance business- while the two major competitors are reeling from losses in unrelated market segments.

Sunday, December 30, 2007

Financial Innovation in VC-Land

This is probably the last post of 2007 you'll read on my blog. I may write a post tomorrow morning, but whether anyone will be in the office reading it is debatable.


For this post, I want to comment on a WSJ article in yesterday's weekend edition on smaller-scale venture capital operators. Peter Thiel, a former CEO of PayPal, runs Founders Fund, a small VC group. For a half million dollar investment in Facebook, he earned a 50 multiple return. According to the article,


"Mr. Thiel, the former CEO of online-payment company PayPal, is making waves in Silicon Valley with an investment strategy that differs significantly from the traditional approach. His company invests only modest amounts of money, sometimes just a few hundred thousand dollars, and focuses on entrepreneurs Mr. Thiel and his partners often know personally. He also takes an uncharacteristically hands-off approach to company management.

Already, the gambit has yielded several potential winners like Facebook."


Could larger, more stolid VC outfits be seeing the end of their days?

The Journal piece further notes,

"The venture-capital world "definitely needs to be shaken up," says the 40-year-old Mr. Thiel, an avowed libertarian who helped bankroll the movie "Thank You for Smoking," a satire about improving the reputation of cigarettes.

His company also reflects how a new type of venture capitalist is emerging, as start-up costs for Internet companies decline sharply. Many start-ups now need a bankroll of no more than a few hundred thousand dollars to get rolling, compared with the millions of dollars required a few years ago."

This sort of development seems to me to demonstrate new product development and evolution in the largely-unchanged VC world of the past few decades. Someone has developed a way to make good returns on VC investments, but leave the companies in the hands, and control, of the founders. Which doubtless is very attractive to the latter, as they seek funding.

As the Journal article reminds us,

"Most traditional VC companies want to invest larger sums, several million dollars, say, for large stakes in start-ups and then exert control over the companies' operations. Some demand "liquidation preferences," or guaranteed returns if companies are sold.

Venture capitalists often can be too quick to fire start-up founders and replace them with professional managers, Mr. Thiel says. He blames a cultural divide: Many VCs "have these very cushy jobs, they get paid a lot," and often can't relate to founders, he says.

With so much money chasing deals in Silicon Valley these days, start-ups can afford to be choosy in picking their financial backers. They are increasingly turning to companies like his that offer less of a "command and control" model, he says.

Mr. Thiel, who based Founders Fund in San Francisco rather than the traditional VC hotspot of Sand Hill Road in suburban Menlo Park, Calif., is structuring deals differently from how traditional venture capitalists do. Significantly, the fund often buys only a 5% or 10% stake in a company and sets up a special class of stock that start-up founders can sell while they are building their companies -- and before venture-capital investors see profits. That way, the thinking goes, the company founders can reap some financial reward and stay motivated to build the company before an IPO or company sale, which can take years."

It sounds like Thiel had found an edge over his longer-lived competitors. By identifying with his target market, he and his colleagues seem to have discovered a non-price competitive advantage. According to the article, other firms are beginning to follow Thiel's lead, albeit slowly.

On the negative side, though, the article reports,

"Mr. Thiel acknowledges his company faced resistance from blue-chip investors when it set out to raise money for its latest, $220 million venture-capital fund. One large institutional investor, who declined to be named, said he was put off by Founders Fund's anti-establishment pitch. Others wonder whether Founders Fund could soon tap out its close-knit network of entrepreneurs and run out of companies to fund."

Still, what matters most is whether Thiel's approach begins to turn a generation of startups in his direction, and simply take them off of the table for larger, more conventional VC groups.

Then, the 'large institutional investors' may not have the luxury of refusing to play ball with Thiel.

With Larry Ellison's dutch auction IPO last week, and Peter Thiel's novel VC approaches, there are signs that even the clubby worlds of investment banking and venture capital might, over time, be shaken up...and down to their core.

Friday, December 28, 2007

The New Financial Excesses & The Old

Last Thursday's Wall Street Journal contained a wonderful article entitled "Wall Street Wizardry Amplified Credit Crisis."

I wasn't going to write about it, until I happened to be riding an exercise bicycle Thursday night, viewing a rerun of that old, rather misleading cinematic faux classic, Oliver Stone's "Wall Street."

Like much of his other semi-historical films, such as Platoon and JFK, Wall Street mixes some truth with a lot of untruths and improbabilities, delivering it with a straight face that causes the uneducated to believe it as whole cloth truth.

In the movie, as you may recall, Charlie Sheen plays the protagonist, Bud Fox, a young, struggling, newly-minted retail stock broker. Michael Douglas is cast as an Ivan Boesky-like arbitrage trader, Gordon Gecko.

In real life, people like Boesky didn't have anything to do with retail brokers. Instead, they focused on using information sources, sometimes illegally, including underwriters or printers, plus a network of others to help pump interest in positions Boesky and his ilk already had built, such as business media, institutional investors and institutional brokers.

Thus, the artificial pairing of Fox and Gecko made for a lusty, action-packed financial thriller which, in reality, never occurred. Boesky did ultimately go to jail for using insider information and manipulating securities prices by 'parking' stock with, I believe, Jeffries & Co.

What got me thinking about this post was how unreal and seemingly needlessly phony Stone's move was. In characterizing the go-go, 'me decade' financial scandals of the '80s, he simplified the stock price manipulations of the arbs in order to make it salable as cinema.

My, though, how truth can be stranger than fiction.

When I finished the Journal's superb post mortem of "Norma," a CDO facilitated by Merrill Lynch, I was totally incredulous that this sort of thing had actually transpired.

Mind you, I believe it. But it makes for incredible reading. Must reading, if you will.

For quite some time, I thought that the CDO and credit crises were largely the result of simple, bad credit risk practices, pumped by ballooning manufacture of the synthetic securities and distribution of them directly to institutional investors.

Not so, according to the Journal account of Norma.

Rather, according to the article, here is an illustrative example of 'worst practices' a la the late '00s.

Merrill recruited 'managers,' such as Corey Ribotsky, a former penny stock brokerage, to buy, assemble and distribute CDOs from Merrill-originated mortgages and derivatives. Norma is one such CDO which the article traces through its life to date.

By reading this article, I lost quite a few false beliefs in the process which has brought Merrill low.

Merrill didn't merely manufacture CDOs full of mortgages directly to bona fide institutional investors. Instead, they found and orchestrated the 'management' of CDOs full of their mortgages, and associated credit derivatives, by intermediary firms. These firms, such as Mr. Ribotsky's N.I.R., then held the resulting CDO, assembled with help from Merrill. Merrill then found buyers for NIR's CDO.

While NIR was not an SIV in the classic sense, it functioned like one. That is, while funded by buyers of Norma's debt, i.e., the ultimate investors, and wholly off Merrill's balance sheet, it was, nonetheless, wholly a creation of Merrill Lynch.

Norma, the CDO, didn't just contain mortgages. Instead, for reasons best left to readers of the Journal article to learn, it also contained credit derivatives, a sort of insurance policy/bet on mortgage defaults.

Then, later CDOs would use some of the more risky, or toxic, tranches of earlier CDOs. And so on.

What is particularly informative in the piece, and was news to me, is that, by virtue of the use of credit derivatives, CDOs became abundant due to the inclusion of many 'bets' on mortgage rates and defaults.

In essence, then, this allows us to now realize, clearly, why the financial mess of complex credit instrument valuations is quite distinct from the simple, underlying issue of basic home mortgage defaults. The volume of CDOs is far in excess of the value of underlying mortgage loans.

Way back in the 1980s, when my boss, Chase Manhattan Bank SVP Gerry Weiss, sent me to a CMO conference filled with S&L executives, I gleaned a related insight. Upon my return, I debriefed Gerry on what I had learned. The concept of securitizing mortgages to spread risk made sense, I said, so long as the true risk spreading value exceeded the haircut that Morgan Stanley, Salomon, Kidder and Merrill were taking on the business. I speculated that one could endlessly add layers of paper resecuritization to the process, merely massaging risk around, to not greater systemic benefit, but for additional financial fees.

This is, in essence, precisely what has occurred. By mixing in insurance contracts on mortgages, the credit derivatives, securitizers expanded the supply of CDOs far in excess of the underlying mortgage values. It is very much the same as writing naked call options. Anyone can do it, and the outstanding call options on an equity can, at any one time, far exceed the actual shares outstanding.

Thus, when we discuss the basic issues of mortgage defaults, bailouts, and losses thereof, we need to not count any values beyond the basic, first-tier mortgages.

To include CDOs is to begin to double, triple, and perhaps even quadruple count losses. Further, once these CDOs left the simple mortgage content, and became betting instruments, they ceased to really be related to the home ownership issue, and simply became new ways for institutional investors to make market bets on something.

For purposes of regulatory and political involvement in the recent, and ongoing, credit situation, one must, as a result of this piece, distinguish the basic mortgage origination situation from downstream packaging and distribution of securities which contain, but are not limited to, and exist in greater volumes than, the underlying mortgage loans.

To me, from a careful read of the Journal's fine article, one thing remains eminently clear to me- as it has from the beginning of my writing on SIVs and the credit 'crisis.'

Institutional and, if affected, retail investors received what they deserved. Given the incredible complexity, opaqueness, and suspicious provenance of these CDOs, anyone who bought them either: was too naive and inept to be doing so, and/or; thought they were getting 'free' return without commensurate risk.

No amount of regulation or legislation will ever limit the boundlessly creative types on Wall Street from dreaming up new, unregulated ways of packing and selling financial assets and risk to greedy, naive investors.

Thursday, December 27, 2007

Wither Goldman Sachs?

In this recent post, I noted that Goldman Sachs is currently the 'class of the class' among US publicly-held large financial service firms.

Nearby is one of the charts I used in that post. If you were to strip away the other banks, Goldman's consistently superior performance would be more obvious.

From my records, it appears that Goldman first entered our equity portfolios a year ago, in January of 2006. Generally speaking, companies don't appear in our portfolios for more than a few years.

From a Schumpeterian perspective, firms typically fall from consistently superior performance after a rather definable time period.

That said, I don't believe Goldman will continue its enviable streak of consistently superior total return performance for too much longer. Perhaps another 18 months.

What will eventually bring GS back to earth?

Looking back to other great firms which eventually became simply average, such as Microsoft, Home Depot, Kohls, Compaq, Dell and Pulte Homes, one or more of four forces usually do the job.

First, natural market saturation can simply bring a firm's business model to a halt. To some extent, that became true of Home Depot, Pulte and Microsoft.

Closely related to this is competitive action. When a firm is consistently superior for too long, it becomes an easy target for one or more competitors to take advantage of the former's business model and exploit weaknesses, or evolving consumer preferences. Again, Microsoft partially fell victim to this force, as did Dell.

Third, regulatory attention can end a consistently superior streak, too. Wal-Mart has encountered some of this, as well as the other two forces. So has Microsoft.

And, fourth, the market simply accepts the firm's stellar performance, and expects it. This effectively destroys consistently superior performance, by pricing it into the stock, and depressing gains back to the index, or lower. Even sell-side analysts eventually wake up to a firm's consistently superior performance after about a decade.

My guess is that Goldman will face a sort of market saturation/push-back, coupled with some nuanced competitive reactions. And, then, the rising expectations among sell-side analysts that the firm will power through various problems, and maintain its performance. Once this happens, the stock's price will reflect expected continued good performance, and end the run of outperformance.

As I described Goldman's diverse business activities to a friend the other day, she quickly observed how many conflicts the firm has created with its proprietary trading operations and various underwriting and advisory businesses.

Already, it has drawn fire publicly from economist/actor Ben Stein. He wrote a New York Times editorial excoriating the firm's chief economist for having allowed the firm to underwrite so much mortgage securitization earlier this year, while privately forecasting a bear market for the instruments.

But, really, everyone knows this is Goldman's game. Stein, while perhaps technically correct, appeared naive by writing that piece.

It's no accident that Goldman publishes its equity recommendations. How better to make sure the rest of the market piles in and drives up the prices of its holdings?

I think eventually various customers/counterparties of Goldman Sachs will begin to back away from the firm, sensing they are being used and abused. Calling into question Goldman's commitment to doing the best for the customer will, I think, eventually curb its growth.

They seem pretty well-managed with respect to risk. But growth may be a different story, as the firm's profile continues to remain so high. With their CEO, Blankfein, earning north of $50MM two years running, and the firm's relatively unblemished performance, counterparties realize they are paying for these phenomena.

Perhaps one other investment banking firm will eschew so much proprietary trading, in order to earn more market share in underwriting.

Or, given that underwriting is really a commodity business, perhaps enough competitors will attract Goldman alumni that its trading approaches will be cloned, depressing the margins earned by proprietary trading among all competitors.

With John Thain running Merrill now, it could easily become a viable competitor to Goldman in a few years. I had a spirited debate last night with an ex-Merrill friend. I contend that Thain will get rid of the retail brokerage business, while my friend heatedly disagreed. But in Merrill, Thain has the perfect vehicle on which to build a newer version of Goldman, keeping what he liked about his alma mater, and changing what he thinks could be improved.

Between Blackstone, a new Merrill, and customer caution regarding Goldman's self-interested conflicts with so many of its customers, I think the next two years will see Goldman's business growth attenuate.

Add to that analysts' expectations, and Goldman's run as the single consistently superior total return performer among US large financial entities is likely to end within the next two years.

Finance Parable

With Christmas Day past, and just 2 1/2 slow, thinly traded market days left this year, I'm back at posting in my blog. I hope you enjoyed the Christmas holiday, and are looking forward to the new year.

Wednesday's Wall Street Journal carried a piece by their affiliate, breakingviews.com, comparing this year's various financial firm follies to a biblical parable involving 10 virgins.



The gist of the column, by one Hugo Dixon, is that, in contrast to the bible story, in which the foolish virgins paid consequences for their mistakes, in the financial version, Chuck Prince and Stan O'Neal left with their pensions intact. Other firms, Northern Rock and Fannie Mae, were either bailed out or left intact, with the assumption that the latter will, if need be, be rescued by the Federal Government.

Hedge funds which took 20% of many years of lush profits from their customers didn't share in this year's losses.

Dixon's point, in his closing sentence, is



"In this financial version, all 10 virgins are invited. The bridegroom looks around the room and scratches his head. Which are the real fools?"



If you ask me, it wasn't the '5 wise virgins,' who, according to Dixon, managed themselves prudently.

No, it would be the shareholders in the unwise virgins.

Whatever loss of options premium we incurred from one position in Merrill Lynch was more than offset by several profitable Goldman Sachs call options this year.

Our overall returns so dwarf any losses from cheaper money that we really weren't hurt by Fed easing, either.

I can't speak as a shareholder of Citigroup, but, from the outside, I'd be thinking twice about leaving my investment in the hands of that board. Same with Merrill, for that matter.

It's not the CEOs of these firms, as much as their boards, that ultimately have been unwise. Prince and O'Neal were each performing inconsistently, or simply poorly, for some years before 2007, as I've noted in prior posts about each of their erstwhile firms.

It's misleading to blame them, when they just worked the system in which they played. Their boards failed to ask about risk, tolerated mediocrity, and paid too well for failure. Is that Prince's or O'Neal's fault?

You, or I, might not like the fact that the two deposed CEOs walked away with so much money. But that's their board's fault.

The best way to discipline or punish those boards is to not buy, or sell, the shares of those companies. You can't change the boards, per se. But you can certainly find better firms, with better boards, in which to invest.

Meanwhile, both Merrill and Citigroup continue to limp along with ailing stock prices, as depicted in the nearby, one-year price chart comparing the two companies' shares with the S&P500 Index.

You could take a chance on their new CEOs, and hope you are buying at a bottom. Maybe each will claw back some of the 2007 40% loss in the coming year, or later. Maybe not.

It's a pretty big risk to bet enough on just these two damaged firms to make it worth your while if either one recovers. And then there are opportunity costs for those investments.

As I mentioned earlier, I'd skip them, with their inept boards, and look at better-performing companies first.

Monday, December 24, 2007

That's Not Possible

This morning, after playing squash, my business partner and I were discussing recent equity and options markets performances.
My website, linked to this blog, provides weekly performance information on the equity portfolio strategy which I run. A chart of monthly gross returns for this year, to date, appears nearby.
As of last Friday, 21 December, the portfolio has realized a 35% return, versus the S&P500's 4.7%, yielding a performance margin for my portfolio of 30.3 percentage points.
When my partner's son related this to some clients of his in one of Deutsche Bank's trading operations, I am told they simply refused to believe this.
Maybe they viewed the rest of the performance information, including the prior year performances of the portfolio's approach, dating back to 1990. Maybe not.
I'm not totally surprised at their reaction, though. I've heard it so often before.
Those who can't do, evidently, simply deny. Especially when the approach differs so radically from that of the critic.
In contrast to institutional traders, we invest in equities for six-month durations. Our options positions are bought and held up to a six-month duration, with sales occurring at return levels established via proprietary options performance research.
It must be difficult, indeed, for institutional equities and derivatives traders to imagine making our returns on simple, unhedged equity and options positions over such timeframes.
If the equity portfolio performance was unbelievable, imagine how my partner's son's clients would have reacted, had they seen our performance data on our options implementation of the same equity strategy. The nearby table is taken from last Friday's closing performance, covering the six active portfolios.
Prior to these six, our May options portfolio had a 41.5% gross return, and June's was 77.6%.
While there are a variety of methods for weighting and annualizing the various monthly portfolio returns, the overall return for this year, to date, for uniform monthly investments, is in the neighborhood of 70%.
Since call options have downside loss protection, relative to holding equities, and allow for inherent leverage of as much as 20x, they provide much higher returns than the equity approach, while using the same selection process and weightings.
Three of the current options portfolios' daily performance charts are included nearby- December, November and September.
The blue curves represent the performance of the options as purchased, without any management. The red curve depicts the performance of a similarly dated and priced, relative to the money, S&P500 call option. No value exists past November, since Yahoo discontinued free index options tracking near the end of that month. The green curve represents the actual performance of our portfolios resulting from sales of call options at pre-determined points throughout the portfolios' durations.
As good as our equity returns have been this year, our options returns have been even better.
By applying the results of proprietary research into the performance of large-cap equities over time, our portfolios, both equities and options, tend to consistently produce superior returns, relative to the S&P500 and its related options instruments.
Not every month's portfolio achieves the same high returns. But, on balance, already, they've delivered stunningly good performances in one of the most challenging and volatile seven month periods in the equity markets in the last five years.
It's been an above-average year for our equity portfolio in terms of the level of outperformance of the S&P500, though not in the mere occurrence of this outperformance.
Our options portfolios, which have been live since May of this year, have met our expectations, considering market conditions.
Are these levels of performance possible? We believe so, because we have experienced them in live investing, including equity portfolios as far back as 1997.
Originally, I began this blog as a way of expressing opinions and analysis about current business topics from the viewpoint of our equity strategy. My partner felt that having a body of written observations and analysis which reflected my proprietary research findings would make it easier to attract equity investments to our portfolio management efforts.
As such, the success of our equity strategy gives us cause to feel that our perspectives on investing and business management are validated.
Others may not believe our live investment results, because they simply cannot imagine strategies which, while simple, rest on quantitative expressions of powerful insights into equity and options performances. More often than not, I think, criticism stems from envy, lack of comprehension, and lack of creativity on the part of the critics. It's easier to simply dismiss what you can't understand, or didn't think of first, than to accept it.
Fortunately, though, in the institutional investment field, most managers will stick with their own underperforming approaches, rather than accept that another approach yields superior returns. And, since our options approach provides return levels which reduce our need for other customers, we don't need to waste a lot of time convincing people that what we do works.
Instead, we now simply treat it as a proprietary approach for proprietary capital.

The 2007 Financial Debacle- It Could Have Been Much Worse

As bad as the mortgage-related travails of 2997 have been for the financial services sector, particularly the commercial banks, it could have been so much worse.

For instance, as I wrote here, in August, commenting on a Wall Street Journal article tracing one family's mortgage,

"What I saw in this article is an example of people who should have waited until they actually had the money for a reasonable down payment, and then should have been more sanguine about their prospects of affording the mortgage they chose. Additionally, they seem gullible, in that they simply believed a mortgage broker's promise that they could refinance the mortgage. Perhaps they should have planned on affording the one for which they applied?

The broker, of course, hardly did anyone a favor by putting the Monteses into a barely-affordable mortgage. The institution which lent the money for the house didn't seem to have done a very careful job stress testing the Montes' ability to afford the mortgage.Then the loan was likely bundled up into a security. I don't know what the 'seasoning' period is nowadays, but years ago, lenders typically had to hold their mortgage loans for a year, if I'm not mistaken, before other investors would buy them in CMOs.

This story displays a shocking tale of greed and overreaching on everyone's part, including the Monteses. They should never have expected, in their financial position, with other loans to service, to be paying as much as 42% of their income for housing, before taxes and insurance.It's no wonder that this is the last year of the housing expansion. With loans like these, to borrowers like these, it was clearly time for mortgage merry-go-round to stop. I can't honestly express any sympathy for investors who purchased instruments backed by loans like those of the Montes.'

This was a total lending, underwriting and investing system failure. But it's not a banking failure, per se. Those who bought these loans, packaged as whatever, deserve the losses they take, just as if they had made unwise equity or currency investments."

The current structure of the mortgage finance system should have been a signal to institutional investors that times have changed. As I further observed in this October post,

"The passage in Wednesday's Journal article citing the importance of the SIV sector, "at its peak....about 30 funds....$400 billion in assets," causes me to ponder how the three largest commercial banks- Citigroup, Chase, and BofA- and perhaps a few more, would have managed the mortgage assets on their own balance sheets a decade ago.

Back then, the largest banks built or bought large mortgage origination businesses, feeding into the banks' own large lending portfolios. The rise of securitization, with its liquidity and market-based risk pricing, made it economically feasible and sensible for the commercial banks to cede the portfolio lending business to a market of CMOs and, now, CDOs.

If the commercial banks had remained portfolio lenders, would this current SIV sector have reached $400B in assets? Or would the risk management functions of the banks have slowed as the mortgages began to decline in quality, hitting the sub-prime market? For example, one-time high-flying manufactured housing lender Green Tree Financial was rescued by an Indiana-based insurer, not a commercial bank.

As inept and stodgy as commercial banks can be, including their own prior mortgage lending problems which helped lead to the RTC creation to clean up the last housing finance mess, I think they perhaps exercise a bit more focused risk oversight than a widespread free market in CDOs."

My own belief is that we should be thankful that securitization has prevented the largest US commercial banks from taking more losses than they already have. Rather than being in the tens of billions of dollars, I believe we would have seen at least one, and probably two of the largest five US banks collapse.

As it was, the banks' formations of SIVs in which to ostensibly park mortgage-backed securities at arms' length from the commercial banks' own balance sheets should have given pause to the institutional investors who bought the notes backing them.

Portfolio lending, while worse than financial markets at correctly pricing risk, does, on the other hand, tend to exert an attenuating effect on a commercial bank's risk positions. A mortgage lending unit can afford to underwrite riskier loans when it knows they will be securitized and sold to investors.

This is simply common sense. That commercial banks have experienced severe losses from CDO tranches they kept tells you they would have experienced even worse losses, had they kept everything they underwrote.

As I see it, the various players in the financial services sector have all gotten what they deserved from playing a form of 'hot potato' with risky mortgage lending.

Mortgage brokers will probably become heavily regulated. Commercial banks are now exercising the kind of credit judgment that they used to when they held most of their mortgages in portfolio. Investors and traders have sustained losses by failing to recognize the new risks inherent in buying structured mortgage-backed instruments that weren't retained by the firms which underwrote the original loans.

What has become clearer over the past few months, including this Christmas season, is that the losses and effects felt in the US financial sector isn't spreading to the rest of the economy's sectors, as so many pundits have predicted since August. Recent consumer spending data, and continuing job and incomes growth would seem to testify to a healthy economy, outside of the self-inflicted damage of the financial sector.

Yes, I think things could have been much, much worse. If not for securitization, much of the risky mortgage loan volumes, though perhaps less in the aggregate, would have remained on commercial bank balance sheets, causing a few total failures.

Thanks to our sophisticated financial markets, those investors and traders who believed they knew how to assess and price risk have borne most of the losses. As such, the few hundreds of billions of dollars of ultimate losses from these bad mortgage loans will appear as simply more investment losses, rather than economy-crippling contractions in bank credit markets.

Friday, December 21, 2007

Be Not Afraid! Foreign Investment In US Large Financial Firms

Citigroup has taken a capital infusion from the Mideast. Morgan Stanley reported a capital fillip from China. Now Merrill is joining the crowd, reporting a large capital investment from overseas. UBS, the Swiss bank, has joined with these American financial institutions seeks repairs to the multi-billion dollar holes in their balance sheets.


I'm sure I've missed someone in this crowd. Mideastern, Southeast Asian, and Chinese sovereign funds are scooping up equity positions in these firms at apparently bargain basement prices.


Are we selling the sinew and bone of the world's predominant financial system to foreigners due to credit instrument losses and poor risk management among the US financial sector's largest and most prestigious firms?


Actually, I doubt it. Be not afraid! There is, I think, a silver lining or two to this story.


First, it's a global economy. Having foreign investors owning parts of our financial service firms directly puts their interests in line with our own.


Second, buying into, for example, Morgan Stanley, isn't the same as buying into Ford, Oracle or Intel. Service sector firms are different in that their key assets leave the building each night and go home.


These foreign funds aren't buying production lines, raw material reserves, or real estate, per se. They are buying shares of existing, and, frankly, damaged brand franchises, and the temporary employment relationship with traders and underwriters.


Third, to continue on a portion of my second point, it's not clear that these foreign firms are making wise investments.

For example, nearby are Yahoo-sourced charts of Goldman Sachs, Morgan Stanley, Merrill, Bear Stearns, UBS and Citigroup vs. the S&P500 Index over the past two years, and Goldman, Lehman, Morgan Stanley and Bear Stearns vs. the S&P for the past two years.

By using a collection of, first, recently troubled commercial and investment banks, then just investment banks, it's clear that most of these firms are simply damaged goods. Only Goldman has outperformed the index over the past 24 months, with Lehman next best, but still trailing a simple buy of the index.

The same firms over the past five years exhibit similar performances. The collection of badly-performing firms still mostly underperform the index. This time, though, UBS looks better. Goldman is still well above the rest of the pack and the index.

The second chart displays Lehman as being better than the index, implying that its problems have been in the recent two years.

My point is that out of some seven large US financial service firms, only one, Goldman Sachs, has consistently outperformed the S&P over the past five years.

But that's not the firm that has been on sale. Instead, the foreign sovereign funds have been buying into, essentially, the losers. Of course, they believe they are buying on the dip.

Maybe they are. Maybe they're not.

Maybe the past five- and two-year performance displays reveal that most publicly-held US investment banks can't outperform the S&P. Most commercial banks haven't, either, as I've noted here- and not just the worst of them, i.e., Citigroup.

As Wednesday's Wall Street Journal/breakingviews article noted, Goldman now has a commanding lead in average compensation on Wall Street. Its recent performance has allowed it to retain current valued staff, and probably recruit the best from its ailing competitors.

In the final analysis, financial service franchises are only as good as their recent performances. Some of the best investments aren't public. Or only recently so, and, now, not so well-performing, like Blackstone Group.

But as most of Wall Street went public over the past few decades, there has been a corresponding regrouping of talent back in privately-held hedge funds and investment banks. And they don't seem to be seeking bailouts or emergency capital infusions.

The very best US financial firms aren't even available for investment. Perhaps the foreign investors are buying into yesteryear's stories, and will be holding a very expensive bag a few years from now.

Wouldn't these funds have been more prudent by just buying S&P Index funds, if they sought exposure to, and equity stakes in the US economy? As the charts in this post demonstrate, only one large US financial services firm, Goldman Sachs, has been a consistently solid investment. Even buying Goldman at market prices would have been a better bet than buying stakes in any of the other firms.

Now, you might argue that these foreign investors are getting off-market, special sale prices. But they're getting those prices on ailing firms with poor risk management and, in many cases, completely new management teams. Who's to say the future will be any better for these firms, after a one-year pop in their price?

If the sovereign funds are just making a timing play on distressed US financial firms, then there's no long term worry, is there? But some of the announced convertible deals suggest longer time frames.

Personally, I think these foreign investors are making a common mistake- buying damaged firms at the bottom, and hoping they will turn around. Were they to have a basket of such bets, that might be a good, risk-adjusted bet.

Somehow, though, I suspect that they are taking outsized, non-diversified bets that won't do as well, on a risk-adjusted basis, as alternatives such as US index funds or buying shares in Goldman or Lehman. Or, over the next few years, perhaps even Blackstone.

Thursday, December 20, 2007

Vikram Pandit- Citigroup's New "Can't Lose" CEO

Something dawned on me yesterday, as I read and heard debates on whether or not Citigroup will continue its dividend amidst pressures on its balance sheet.

Vikram Pandit, the company's newly-appointed CEO, is in a very enviable position. In fact, by my count, he joins just two other CEOs who have enjoyed his "can't lose" situation- Lou Gerstner, erstwhile CEO of IBM, and Art Ryan, the soon-to-retire CEO (and chairman and president) of Prudential since joining the firm in 1994.


Gerstner had enjoyed great success running RJRNabisco prior to joining IBM in 1993. Originally a McKinsey consultant, than an American Express executive, he demonstrated an unusual gift for running consumer-oriented businesses. At the time of his departure from Nabisco, to run IBM, he was paid foregone deferred compensation, by the latter. If memory serves, I believe the amount was something like a then-unheard-of $24MM. Relatively modest by today's standards but, in its day, the payment was considered huge.



Thus, upon arriving at the loss-plagued IBM, Gerstner could not lose, financially. And IBM was in such bad shape that nobody would find fault with Lou if he had failed to reverse the ailing computer giant's fortunes.

But Gerstner succeeded beyond anyone's wildest expectations. As the nearby, Yahoo-sourced chart indicates, IBM's stock price began an upward climb, outpacing the S&P, just after Gerstner took over as CEO. While the S&P slipped in the early 2000s, Gerstner's IBM see-sawed through the tech bubble deflation.

As a result, tracking from 1963, Gerstner took over after the firm had fallen below the S&P500 Index's price line (in 1987) and drove it back to parity when he left in 2002.

Then we have Art Ryan of Prudential.

By way of full disclosure, I should mention that I had interactions with Ryan earlier in my career. As a senior strategist working directly for the SVP of Corporate Planning & Development, I had several occasions to meet with, present to, and discuss business and corporate strategy and operating performance issues with Ryan when he was EVP of Consumer Banking. He later rose to President and COO of Chase Manhattan Bank.

In contrast to Lou Gerstner, who had distinguished himself earlier in his career as a consultant and senior executive at American Express, Ryan's major claim to fame at Chase was having been a member of the winning cabal earlier in the bank's history.

Back before I joined Chase, in 1983, from the dissolving AT&T, Chase Manhattan Bank had seen a veritable brawl between the two major internal groups, each of whom sought to see their leader replace the esteemed and much-beloved, retiring David Rockefeller. Barry F. Sullivan's "Irish mafia" lost out, and he decamped to head up First Chicago Bank. For some years, Sullivan's compensation was set so that, whatever Chase chairman Bill Butcher's was, Sullivan's was set a few thousand dollars more. Out of spite.

Art Ryan had been a mathematician cum systems and, then, operations executive at Chase, and, as such, sided with the operations group behind Tom Labrecque, who was Butcher's lieutenant. The operating systems executives wielded much power at Chase, which, no doubt, partially accounted for the bank's continuing dismal performances in the 1980s and '90s. Ryan climbed the leadership ladder as an operations executive, eventually replacing veteran banker and keen quantitative guru Fred Hammer as consumer banking chief.

When Labrecque engineered Butcher's fall from grace, and assumed the CEO title, he elevated his trusted operations guy, Ryan, to President and COO. I recall Tom once telling me, in a corporate planning briefing that my then-partner, Deb Smith, and I gave for our SVP, Gerry Weiss, that, contrary to the suspiciously optimistic performance numbers Ryan's consumer group had submitted,

'I trust Art. If he says he'll meet those numbers, I can count on it.'

Of course, Art's group didn't meet the targets. At all. Labrecque and his financial management team simply reset the goalposts, once again, that year, and declared budget victory, while the bank's actual performance remained lackluster.

The best that could be said of Ryan at Chase was that he was ineffective in running the consumer bank, and part of the management team whose inept performance eventually led to its takeover by Chemical Bank.

However, by the mid-1990s, Ryan was COO, and chafing under a similarly-aged Labrecque. Becoming CEO of Chase looked unlikely, when Prudential came calling on him.

The insurance giant was, as I recall, mired in one of its seemingly recurring regulatory messes. Between the policy-holder/ownership form, a struggling Pru-Bache unit, and various legal problems, the company looked unsalvageable.

Ryan, too, like Gerstner, couldn't lose. He was paid handsomely to forfeit various Chase deferred compensation, and signed on to head the Newark insurance titan.

Going public in the early 2000s, Prudential under Ryan is difficult to assess, because his first six years there didn't have a total return by which to gauge his performance.

However, in the years since Pru went public, Ryan's record is decidedly mixed. While, according to Forbes, being paid in the neighborhood of $25MM in 2005, the company has actually only enjoyed periodic outperformance vis a vis the S&P500. The nearby Yahoo-sourced performance comparison of the two since 2002 shows Pru to have bettered the index. But on closer examination, the only years in which it clearly trumped the index were 2004-2005.

As the next chart shows, the past two years have been problematic for the insurance firm. It's market performance has see-sawed with the S&P, crossing paths three times, and now largely tracking the index's performance.

Has Ryan been worth $25MM/year to Prudential's shareholders during this time? It doesn't look like it. But, since Pru is still around and independent, I think most people would judge Ryan to have not failed in his job. He'll retire next month having probably evaded termination at Chase Manhattan after the Chemical takeover.

Without a clear, public stock price and total return record of Prudential for Ryan's entire 13 year career there, it's impossible to determine how effective he was for shareholders. But he certainly did well for Art Ryan.

Now we have Vikram Pandit as the third in my little pantheon of "can't lose" CEOs.

No matter what happens next at Citigroup, Pandit will probably come out untarnished. Unless he actually contributes to even further boneheaded trading and investment banking losses, requiring the bank to be taken over to preserve the integrity of the US banking system, Pandit will likely be either credited with a turnaround, or judged to have inherited an impossible mess from Weill and Prince.

Either way, Pandit banked his share of the Old Lane purchase premium before he even joined Citigroup. Then enjoyed two promotions since receiving that windfall.

By agreeing to become CEO of a basket case, Pandit, perhaps unwittingly, joins a very select club of CEOs who, by virtue of successful or long service at another firm, have been prepaid a modest fortune to try their hand at rescuing a large American business icon.

Wednesday, December 19, 2007

Saudi Oil For Industry & Western Energy Needs

My younger daughter asked me the other day if I thought that technology would still be radically changing our lives in the future.

Though only 11, she is aware of how different the world is now versus even a decade ago. With text messaging on cell phones, laptop computers and online gaming, she can't imagine how much more advanced technology will get as she becomes an adult.

After considerable thought, I replied that as long as there are problems to solve, technology will probably continue to change things radically, although, as in the past, in ways we have yet to fully comprehend or expect.

As I reflected on a Wall Street Journal article in last Wednesday's (week ago) edition concerning Saudi oil usage, it occurred to me that perhaps it portended the source of the changes I mentioned to my daughter.

In a week in which I saw John McCain refer to the recent Democratic Congress' energy bill as containing "no new energy (sources)," it dawned on me that our Federal legislators now have the mistaken impression that, by enacting laws, they can somehow 'create' energy sources.

Truly, King Canute had nothing on them.

As if by raising CAFE standards, more energy will suddenly materialize on our shores. In fact, as Holman Jenkins wrote in an October WSJ editorial, on which I commented here, nothing could be further from the truth.

All of which brings me to this post's main topic- innovation and Saudi oil consumption.

The intriguing Journal piece of last week stated,

"So Saudi Arabia is on a building binge. In the works are new seaports, an extended railroad system, a series of new industrial cities and a score of refineries, power stations and smelters. Over the next dozen years, such Saudi investments are expected to consume $600 billion.

But they'll also consume something else: large quantities of Saudi oil -- oil that otherwise could help slake other countries' growing thirst.

The problem is that with output slumping in places like the North Sea and Mexico, the world is counting on increased oil supplies from the Middle East, and above all from Saudi Arabia. Global oil demand, now just over 85 million barrels a day, is expected to exceed 100 million barrels a day within 10 years. So the question arises: Can the kingdom continue to satisfy the world's growing oil needs at the same time as its own economic engine demands ever more crude?

Within Saudi Arabia, there's heated debate over the wisdom of staking development on industries that use so much energy. A big aluminum smelter being built on the Persian Gulf coast, for instance, will consume upwards of 60,000 barrels of oil a day -- because the Saudis are turning to crude oil to make electricity. Yet the smelter will create fewer than 10,000 jobs.
Some boosters want to build 10 smelters. They'd devour nearly 7% of the Saudis' current oil production.


Abdallah Dabbagh is a proponent of the industrialization push, as head of Saudi Arabian Mining Co., which is building the east coast smelter. Yet even he says, "I think the Saudi government will have to stop and think at some point if this is the best utilization of Saudi's crude."

Suppose you had a diet that consisted mainly of corn. But you didn't have a farm. If your neighbor, who owned large corn fields, began using his corn for fuel, instead of letting you buy it as your food, what would that mean?

Probably that, long term, you had better find something else to eat. You could ask your neighbor not to be so wasteful as to burn food for fuel, but in the final analysis, it's his property. He can do what he likes.

Bottom line? You'd better get busy finding alternative food sources.

So, what's more important, an energy 'policy,' or economic reactions to the economic actions of others with respect to resource usage?


Rather than global warming or clean air, I think the Journal piece reveals what's really going to drive new energy technologies in the West. Here's more from that article,

"The result is that 22 barrels of every 100 the Saudis produce stay at home, compared with under 16 of 100 seven years ago. Forecasts from the U.S. Energy Department and the International Energy Agency say that by 2020, Saudi Arabia will be consuming more than a third of its own oil -- leaving a lesser share for American cars, Indian airliners and Chinese factories.

Many of these extra barrels will never leave the Middle East. A Lehman Brothers report predicts that oil needs in Saudi Arabia, Kuwait, the UAE, Qatar and Bahrain will jump by almost 200,000 barrels a day next year alone.

Saudi leaders had a different model in mind when they launched their bid to remake their economy a decade ago. The plan was to fuel the industrial boom -- from new power stations to petrochemical plants -- with fresh stocks of natural gas. Saudi Arabia is thought to sit on the world's fourth-largest gas reserves, after Russia, Iran and Qatar. Geologists spent years in the mid-1990s identifying deep pockets of gas below giant oil fields.

But Aramco has been slow in bringing this gas on line. Saudi Arabia broke with longstanding practice starting in 2003 by signing deals with foreign oil companies to prospect for gas in the Empty Quarter. Despite more than $1 billion spent, the companies haven't found commercial quantities of gas.

So the Saudis switched course. Last year, King Abdullah mandated that crude oil be used to fire nearly all of the kingdom's soaring electricity needs. Natural gas, the government said, would be reserved increasingly for the booming petrochemical sector.

Even oil-rich countries normally scramble to avoid burning oil in their power plants, because oil is so easily sold and transported on the international market, while gas isn't. But Mr. Barrak estimates that by 2012, petroleum will fire nearly 60% of Saudi's mounting electricity needs."

Pretty scary stuff, isn't it? In the US, we began to wean ourselves off of burning oil, which is uniquely suited as a transportation fuel, just to make electricity. Now, the guy who owns the oil is reversing all of our carefully-planned and implemented substitution of oil in utilities with natural gas and coal. Or, in the future, probably gassified coal.

As I told my daughter, I think cars of the future will use other fuel sources than petroleum, because of the long term consequences of the world's major oil supplier electing to consume its own commodity for rather uneconomic purposes.

And, by the way, when the Saudis burn oil to make electricity, they are doing the equivalent of a Dutch tulip 'investor' buying a bulb in order to destroy it, and make his own worth that much more. The more oil the Saudis foolishly waste, the more valuable their remaining below-ground reserves.

In a world like this, American innovators have historically stepped in with creative solutions. In fact, this situation is virtually identical to our invention of synthetic rubber (the Buna process) before WWII, when the Japanese seized the Southeast Asian natural rubber plantations.

More than any other single driver of a change in how we fuel US autos, trains, planes and ships, this looming demand increase by the Saudis for their own commodity will, I think, cause a radical change in fuel technologies in this country over the next twenty years.

As I explained to my daughter, the car I drive does not differ all that much, functionally, from the one my grandfather drove. Sure, it's safer, probably quieter, and has some added creature comforts. But fundamentally, a gas tank and carburetor feed gasoline into a metal engine block where the gasoline is exploded to physically drive a cam shaft that powers a drive train which turns the wheels.

My daughter's children will probably drive cars with a very different power technology. CAFE standards will likely be laughably outdated and moot for that new technology.

Rather than governmental standards, I told my daughter, you can usually count on some creative, hungry American inventor to develop a technological solution to the problem of ever more scarce and expensive gasoline to power our cars.

Imagine, a decade from now, Dupont, GM and ExxonMobil collaborating to power, build and fuel new technology cars. Or perhaps not Dupont, but some venture-capital funded new fuel technology startup. With the assurance of the production of the fuel, GM will build vehicles using it, and ExxonMobil will use its existing fuel distribution system, if relevant, to provide the new fuel's ubiquitous availability.

But the Saudi developments don't just stop at oil and transportation fuel. The Journal article concludes with this passage,

"Aluminum Corp. of China Ltd. has signed a $3 billion deal with a Saudi consortium to build one of the region's largest aluminum smelters at the Jazan economic city. The smelter's proposed $2 billion power plant, by one estimate, could require more than 70,000 barrels a day of crude oil.

The country's mining giant, called Ma'aden, recently plunged into a vast mining enterprise deep in the northern interior. Ma'aden's Mr. Dabbagh, standing in front of a big map of the kingdom in his Riyadh office, traces how a new railroad line under construction will bring tons of bauxite, phosphates and magnesite from the mine to the Persian Gulf city of Ras az Zwar. "Here," he says, jabbing the map, "we are going to have the largest sulfuric-acid plant in the world, the largest phosphoric plant and the largest ammonium plant." The factories, he says, "will make Saudi Arabia a major player in fertilizer in the same way we are already a major player in energy."

The coup de grĂ¢ce is the $7.6 billion aluminum smelter, which Ma'aden is building in partnership with Rio Tinto Alcan, a unit of Rio Tinto Group. The smelter will mark Saudi Arabia's first plunge into one of the most energy-intensive industries, with others sure to follow. And similar smelting projects are in the works for the UAE, Qatar and Oman.

"Eventually," Mr. Dabbagh says, "everybody is going to come to the Gulf to make aluminum because this is where the energy is."

Meaning, of course, goodbye to even more primary industry jobs and infrastructure base in America. When the owner of much of the world's oil decides not only to consume its own resources, rather than sell them on the open market, but, explicitly subsidizes others to create new chemical and metals production in their country, a lot of basic materials industry will move to the Mideast.

The implication for America is to further cast ourselves as the global knowledge and innovation capital. Not only won't we own so many raw materials anymore, but we won't even be producing basics like aluminum or chemicals onshore, either. No amount of Congressional legislation will change this.

So the one thing that will continue to drive US jobs, incomes and wealth growth will be our reliance on an educated populace to use our relatively free-market economic system to out-innovate and create the rest of the world. And, in the process, earn more intellectual property-based income and create ever more value-added through ownership of design and implementation of advanced products and services.

With the world's owners of basic commodities gravitating toward consuming those resources themselves, and using them to climb up the supply chain by adding basic materials production, the US has to sustain its lead in the creation of value through innovation. Or face a long slide into nationwide poverty, and loss of control over our own future.

Tuesday, December 18, 2007

"Tomorrow's Paper Today"

I heard a really great quote from the only guy on 'Fast Money' who I can actually stand to hear. Not that I've ever voluntarily watched it for more than about 5 minutes. But occasionally, I am subjected to it in a locker room for longer than that.

John Najarian (?) is an options guru. He has a recurring spot as guest options analyst on CNBC's morning program, Squawkbox. He is eminently sensible, modest, and funny. I believe he also appears on Fast Money after the market closes.

This morning, he appeared to discuss the probably-illegal uptick in 5-day duration December call options in Trane, which was involved in merger activity yesterday. He and Jacob Frenkel, a one-time securities cop, opined on how the pattern of options trading last Tuesday through Thursday almost certainly will lead to charges of insider trading.

Ironically, though, if one were simply observing that options volume, and deduced that someone else knew something, then one could legally buy Trane equity or call options and benefit from any subsequent activity which sent the stock higher, per the options behavior implications.

Thus, Najarian's quote. When Joe Kernen asked about the unusual activity, John replied that it looked like someone thought they had

"tomorrow's paper today."

In essence, my own equity portfolio strategy behaves as if I have a paper dated six months from now. That's the beauty of focusing on consistently superior company performance. By using that quality of a company's performance, it is its own reward. And, truly, in a portfolio sense, lets one effectively read a six-month future paper today.

By contrast, Legg Mason's vaunted Bill Miller's equity portfolio was at -6% , as reported in this morning's Wall Street Journal. He's the guy whose S&P500-beating streak ended last December, after something like 14 consecutive years. This morning, live, my equity portfolio has a 28.5% return, gross, for the year. The S&P is at roughly 1.5%.

Early this year, my partner and I still were working on the premise that we would raise funding for my equity portfolio strategy by establishing it as superior when pitted against someone held in high regard, like Miller. In addition to this, he had me writing chapters for a book we would publish via Google, online, describing some of the research and theories which underpin my approach to equity portfolio investing.

However, with my partner's realization that call options might be a more efficient and effective manner in which to use my equity selection approach, all that became moot, for now. Since we have moved to long-dated call options portfolios, with commensurately much higher, unleveraged returns, comparisons with Miller's equity results are no longer valid, nor necessary. The corresponding fall in required investment capital meant that we no longer have to actively seek many investors in order to profit sufficiently from my applied equity research.

My partner's July options portfolio, alone, has returned 31% to date. Given the half-year duration of the portfolio, and, thus, its use of the capital twice, a conservative estimate of that capital's full year return would be approximately 69%, or the July-to-date return, plus the current average of outstanding portfolios, 37.5%, on a capital-day-weighted-average basis.

Coming on the heels of the post about sell-side analysts, I have to say that, even with the prior six weeks of rocky market and portfolio performances, I'm quite pleased with the past, and evolving, long term performance of our equity and options portfolio strategies.

They very much seem to be allowing us to read future editions of papers like the Wall Street Journals today.

On Wall Street Analysts' Forecasting

Yesterday's post on Bob Doll's CNBC equivocation performance pushed this post back to today. Appearing in the 'Ahead of the Tape' column in the Wall Street Journal's Money & Investing section was a piece entitled "Analysts Botch Profit Forecasts On Home Turf."

In this piece, Journal staffer Scott Patterson observes that Wall Street's analyst corps seemed particularly blind to their own sector's weakness this year. He begins with noting that in July, analysts forecast an average third-quarter earnings gain of 9% for the sector, when, in reality, it came in at -27%. At that same time, these analysts projected the sector's fourth-quarter earnings as increasing 10%. Now, those same analysts expect a -45% earnings change for the year-ending period.

Patterson spotlights Merrill's Guy Moszkowski as retaining a buy rating on various large brokers/investment banks, including Bear Stearns, through late August.

Mike Mayo, now at Deutsche Bank, recommended selling various second-tier banks, but got Merrill wrong and maintained a buy rating through early November.

Finally, longtime commercial bank analyst and Citigroup apologist Dick Bove is regarded by Patterson as "better than most." But while he

"started getting bearish on banks and brokerages in late 2006, though he waited until July to downgrade the broader sector. He is the only analyst with a "sell" rating on Bear Stearns, Morgan Stanley and Lehman, according to Zacks Investment Research."

Bove is a frequent guest analyst on CNBC, and happens to have been a personal friend of my business partner when Bove still lived up north, near New York City. Bove has, in an odd omission by Patterson, been steadfastly bullish on Citigroup throughout the year. Back in the spring, he held forth on how Citigroup would be forging ahead with earnings growth. Even now, Bove won't throw in the towel.

If this is 'better than most,' it's a sad commentary, indeed, on sell side analysts rating their own sector's members, isn't it?

Patterson observes that Besty Graseck of Morgan Stanley broke ranks to make Citigroup her top short stock recommendation for 2008.

Of course, it's worth considering this in light of the recent year's performance of Citigroup stock. Even with its dividend added back, the stock's price is down around 40% this year, while the S&P is just barely positive.
So you have to ask yourself, can Citigroup's stock price really fall, again, in 2008, more than any other large cap?
Don't you think most of the surprise is gone now? I mean, a near-50% haircut is pretty serious. So Graseck must be looking for something like another 20% drop in the firm's share price.
At that point, I'd think we are talking a Fed-brokered acquisition by Citi, or its pieces, to avoid truly serious financial system damage.
So perhaps Graseck's call is more for spite, directed Vikram Pandit's meteoric rise, noted in this posts, here and here, from cashiered Morgan Stanley employee to Citi CEO in only two years.
In any event, Patterson's article goes a long way toward explaining why I pay absolutely no attention to analysts' calls on stock price behavior. While an analyst may know a lot about the internal mechanics of their subject companies, this article points up their long, inherent weakness in forecasting things like earnings and stock prices.
Years ago, a one-time partner in my equity portfolio strategy business sent me an article which compared analysts' earnings projections deviations from actual earnings, over time. A decade ago, they were already becoming progressively worse each year. I guess the trend has continued.
Maybe this is a fine example of 'lizard brain' behavior that is the theme of Terry Burnham's excellent book, "Mean Markets and Lizard Brains." Perhaps even institutional investment managers seek safety in the advice of highly paid analysts, even though their demonstrable track record, as a group, are so deplorably bad.