Friday, July 20, 2007

The Market, She Be Toppy?

I've been giving this sort of anthropomorphic type of analyst drivel a lot of thought recently.

Not that I believe markets are 'alive,' or have an inherent, intrinsic life force. But I do observe patterns.

Right now, despite the fact that the Dow and S&P are at record highs, I do not think investors have driven them to frothy, unsustainable levels. Rather, given the S&P500 Index returns of the past few years, I think what we are witnessing is very sustainable.

For instance, unlike the late '90s, when the index had a string of not just double-digit returns, but a string of annual returns above 20%, this is not the case currently.

The average for the last four years may not even be above the long-term S&P annual average return of 11%. And prior to that, we had the two years of a market bubble bursting, which sent the index down in the 40 percentage point range over two years.

Thus, I don't see this recent rise in equity values particularly worrisome. It seems to me rather overdue, as good global growth and low inflation are finally being acknowledged by US market investors.

For all the hand-wringing over inflation, it's way, way below the levels of the 1970s. Sub-prime woes represent a rather small sliver of asset values, amidst the total American capital markets. Large-cap US companies are thriving across the globe in various growth markets.

If anything, equity values may be too low. But, right now, I would venture to say they are not too high.

So, as my partner and I continue to implement our monthly options variant of our basic equity strategy, I expect consistently good returns due to superior selections in a growth environment, for at least the rest of this year. Barring things like significant terrorist acts which disrupt global trade or its underpinnings.

Thursday, July 19, 2007

Commercial Banks and Bridge Loans

Yesterday's Wall Street Journal ran an article in the Money & Investing Section which focused on Chase's, Citi's and BofA's exposures to bridge loans to private equity firms.

According to the article, the three banks have $33B in bridge loans outstanding to private equity groups for deals yet to be refinanced with longer-term money. Last year, these loans totaled only $12.9B among the three banks.

Although some analysts contend that these banks are so diversified that there is negligible risk, I am not so sure. First Boston was finally shoved into the arms of Credit Suisse over its losses in a bridge loan for the now-infamous Ohio Mattress deal in 1989. At the time, a liquidity crunch cratered the junk bond market, causing the Ohio Mattress loans to lose most of their value, along with the holder of those loans, First Boston.

True, a liquidity pullback might not destroy the balance sheets of any of the three commercial banks. But it will certainly put a dent in them, and damage earnings for the year. For example, if Chase owned one-third of the bridge loans outstanding, or $11B, that would be just shy of Chase's recent $15B full-year NIAT figure.

That sort of loss can certainly retard growth in the financial services sector for a time. Despite the hoopla over sub-prime mortgages, I would venture to guess that this private equity-related bridge loan situation is a greater source of risk to these three banks. As the banks have supplied bridge loans, their investment banking units are sure to be wanting to participate in private equity deals, too, as John Mack, CEO of Morgan Stanley, has gone on record as wanting to do. That sort of activity will add equity price risk to the mix, and lodge the total financial risk of such a deal with a commercial bank.

With private equity having become such a driver of merger and acquisition activity of late, I sense that this will be the area that sees the next large asset meltdown for the large commercial banks.

Wednesday, July 18, 2007

Nassim Taleb's Hedge Fund Strategy and Return to The Business

Last month, in this post, I wrote about how Nassim Taleb's writing on options, distributional statistics, and investor misperceptions about risk, influenced my partner and I to move to an options expression of my long-running, consistently superior equity portfolio strategy.

That modification has been doing very well, as I wrote recently, here.

In last Friday's Wall Street Journal, one of its writers discussed Taleb's return to hedge fund management- actually, advisory- after several years away from the business. I hadn't even realized he left!

The firm, Universa Investments of Santa Monica, CA, expects to raise $1B for deployment in Taleb-inspired strategies.

I found the Journal article very reassuring. In it, Taleb's approach is described in more detail than prior articles I have read. It reinforced my feeling that his is a very inconsistent strategy. That is, he is constantly buying puts, losing a little money routinely, in hopes of profiting from the really big market meltdowns. This is what I more or less sensed from my prior reading about Taleb's hedge funds.

In the Journal piece on Friday, however, Taleb's performance is discussed. His last fund earned a 60% return in 2000, then lost money in 2001 and 2002, with only low single-digit gains for the next two years. He closed the fund on the heels of such mediocre performance, during years when conventional hedge funds rack up much higher gains.

Ironically, Taleb's thinking regarding the risks associated with buying call or put options, rather than the underlying equities, made a lot of sense to my partner and I, and we have developed a very effective variant of our equity strategy as a result. However, whereas our returns are already showing signs of tracking with our consistent basic equity returns, they are, of course, many times higher, because of the natural leverage inherent in the use of options.

Thus, Taleb's approach, and, probably, that of the new fund using his ideas, tends to be erratic, and depend upon high volatility to earn large returns.

Our approach is just the opposite. We strive for consistent, reliable gains in any type of market, and try to become less sensitive to volatility.

I can't help but feel that, for investors who do not wish to be forced to time the market, or fund investments, ours is the more attractive approach to earning consistently superior returns in equities or options.

Tuesday, July 17, 2007

Blogging & Chatting CEOs

This month is surely becoming a weird one in terms of CEOs and their use of new media to express themselves.

First, we have John Mackey, CEO of Whole Foods, admitting that he frequented a Yahoo chat room, frequently trash talking his competitor, now acquisition candidate, Wild Oats.

Yesterday's Wall Street Journal editorial defended Mr. Mackey's right to express himself, and chided the FTC and SEC for witch hunting. In a rare parting of the ways with the Journal's editorial page, I beg to differ.

Mackey purposefully disguised his identity, then made accusations about his competitor, and eventual acquisition target, in a Yahoo stock discussion chat room. Because he hid his identity, one is led to believe Mackey had ulterior motives. Further, since his actions can easily be seen by even a disinterested observer, like me, to be attempting to cause people to sell Wild Oats and, thus, perhaps lower Whole Foods' acquisition price of Wild Oats, they may be in violation of laws regarding manipulation of stock price.

The Journal editors downplay this, suggesting that Mackey just wanted to "sample the mood of his customers." Really? Aren't market research studies the way most companies do that? See my recent piece on Tesco for more details.

While Mackey may not, in fact, be able to be prosecuted for a securities law violation, I think most business people would find his behavior to be, at best, questionable, unethical and undesirable and, at worst, completely reprehensible, wrong and illegal. The use of a false identity when dealing with public opinion and statements involving his own company and a competitor, just smacks of something seriously wrong.

In a sort of related vein, the Journal published an article last Friday spotlighting CEOs who blog. Among these are: Jonathan Schwartz of Sun Microsystems, Bill Marriott of Marriott International, Michael Critelli of Pitney Bowes, and Bob Lutz of GM (not actually a CEO, but a Vice-Chairman of the struggling auto maker).

I've pasted a Yahoo-sourced, five-year price chart of these companies and the S&P500 Index. From what I can see, I'd skip reading Lutz' and Critelli's blogs, if you are looking for business insights. The Journal article's mentioning that most of the blogs are business-oriented in some form or another, but that they also mix personal items.

If these CEOs hope to somehow impress the business world, wouldn't they be better off first demonstrating that they can operate their company in a manner that consistently outperforms the S&P, so they can actually claim to have some basis on which to opine from a position of useful knowledge?

Even Sun's performance is questionable, in my opinion. IT's had a few up periods, relative to the S&P, but significant down periods, as well. Only Bill Marriott looks like whatever he wishes to impart about his business acumen might be useful to read.

Maybe the inferior-performing CEOs/senior executives should focus on improving the performance of the companies at which they work, first, before being so presumptuous as to begin blogging for the business world at large from such a position of demonstrable ineptitude.

Monday, July 16, 2007

More on The Decline of Detroit

Finally, after several years of reading about how GM's, Ford's and Chysler's messes are the fault of 'legacy health care costs,' an article that focuses on, in my mind, the real issue- making better cars. Here's a sample of my thinking, from a May, 2007 post on Cerebrus buying Chrsyler from Daimler. There are others, if you read through the posts under labels on this post.

The Wall Street Journal carried an article by John Schnapp, retired head of Mercer Consulting's auto industry practice, in their Saturday/Sunday edition.

Schnapp cites some really chilling statistics. He points out that, as of the late 1990s, the Big 3 were surprisingly healthy. Chrysler had a 4.8% net profit on sales in 1997. GM was at 3.8%, and Ford at 4.5%. Their total returns were, respectively, 17% and 12.2% for Chrysler and GM for the decade of the 1990s.

I loved Schnapp's comments on CAFE standards,

"But a 35 mpg mandate will surely not shoehorn motorists unwillingly into tiny clown cars like Mercdes's European money loser, the Smart. Nor is it likely to affect occupant safety or even performance. It will involve broader availability of hybrids, already well underway, and application of incremental technologies like turbocharging, continuously variable transmissions and variable valve lift engines.

The overriding challenge, though, for the Detroit Three remains neither their cost burdens nor Congressional fuel economy activism. Rather it is overcoming their continued inability to win in the marketplace.

A decade ago, before any of the recent red ink began to flow, the stewards of these giant enterprises had ample resources to compete. Events have proven that they didn't use them very effectively. In 1996-97, with all of the same cost burdens now bemoaned, Chrysler- for one- made itself the world's most profitable automaker, generating rates of profitability roughly the same as Toyota does today."

To me, Schnapp's closing paragraphs clearly lead one to see this sector as simply, finally, falling afoul of Schumpterian dynamics. Schnapp's observation that the Big Three "had ample resources to compete.....they didn't use them very effectively," is the key passage. It looks like Detroit has just run out of competitive gas, so to speak, and ought to be harvested by competitors. Thus, Chyrsler is bought by a private equity group, Ford still labors as the lone, small US auto maker, and GM continues to believe it can 'turnaround,' if it can just blame everyone else for its problems.

I think the Detroit auto makers fiddled too long, and now, have squandered their final chance to remain competitively profitable, and, potentially, earning consistently superior total returns for their shareholders. The industry has changed, they have failed, and others will now lead it into the future.

United Airlines' New Challenges

A few weeks ago, before vacation, The Wall Street Journal ran an article entitled, "United Struggles to Navigate New Course."

What came to mind as I read the piece was a recent CNBC guest hosting stint by Bob Crandall, former AMR Chairman, and one of the best airline CEOs to come down the pike in ages. Crandall reiterated that the entire industry is plagued and crippled by the ongoing rift between labor, their unions, and management. You can't have a successful company when employees and management are basically in an ongoing war.

Thus, reading this passage from the Journal article meant a lot,

"Capt. Mark Bathurst, chairman of the pilots union and a UAL director, took the management team to task a month ago for not transforming the airline into a top performer,"

and then Bathurst is quoted as saying,

"Alone among the traditional carriers, United seemingly is without a vision for the future."

The article further notes employee morale problems over cuts and givebacks by labor, while management received largish equity positions as UAL exited bankruptcy recently.

Overall, the article suggested that UAL didn't really fix itself in Chapter 11, and that its woes reflect that- insufficient capital, labor-management strife, high costs, and accounting issues, related to the bankruptcy, that apparently just give institutional investors pause.

Overall, the story adds to my perception that the airline sector continues to labor under shared liabilities- a poorly-managed and funded air traffic control authority, labor union discontent, cost problems, and capacity issues. It's too easy for new entrants in this sector, yet too hard for them to actually fly once they get in.

My guess is, UAL was rushed out of Chapter 11 far too early, and is probably destined for rougher skies in the near future.