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.

Monday, December 17, 2007

Bob Doll On Citigroup, Sandy Weill & Bob Rubin

Bob Doll, chief equity investment officer at Larry Fink's BlackRock, was the guest host this morning on CNBC's Squawkbox program.

At one point, Doll, Joe Kernen and Charlie Gasparino engaged in a discussion of Citigroup's situation. Gasparino had opined that the company might have to cut its dividend, which, of course, is a current major topic among those observing and analyzing the deeply troubled banking goliath.

Doll seemed to agree with Gasparino. Then the latter launched into a recounting of Citigroup architect Sandy Weill's mistakes, and the cloud under which he departed the firm. He asked Doll directly what he thought, prefacing his question by noting that nobody seems to criticize Weill, even now.

Bob Doll masterfully responded on both sides of the question, crediting Weill with

'growing the top line, while cutting the middle lines and still acquiring businesses,'

or words to that effect.

Then, when reminded of the mess Weill and Citi made of the Smith Barney acquisition, Doll nodded his head in assent.

Gasparino then moved onto Bob Rubin, criticizing the former Treasury Secretary's 'leadership' of the executive committee of the board, while earning outsized fees running into the tens of millions of dollars.

Again, Doll carefully pirouetted around the question, responding carefully on both sides.

As I sat watching Doll, a very powerful and successful guy in his own right, I marveled at how much fear guys like Weill and Rubin clearly induce in other financial service senior executives.

Here is the most senior equity executive at one of the most successful private investment management firms, clearly fearful of uttering a single critical word of a retired sector heavyweight, Weill, and a stumbling, inept current board leader, Rubin.

I don't know Doll at all, other than having seen him on CNBC and read about him in various Wall Street Journal stories. He seems to be a very capable, savvy and intelligent equity manager. You'd think he is relatively immune to reprisals from people like Weill or Rubin.

I guess not. It would seem that Doll is aware, or concerned, that any former or current senior executive in the sector could, one day soon, be either a prospective investor in, a senior executive at, or acquirer of his firm, Blackrock.

This being the case, it causes me to wonder why CNBC even bothers to have such guest hosts on their programs. Or even bothers to discuss current issues involving other companies or sector executives. It was clear Doll was unwilling to give candid, substantive on-camera assessments of Weill and Rubin. He wanted to be able to respond to any comments from the two with a protestation that he had said something positive in their defense.

Doesn't this sort of behavior make you question nearly any positive comments or observations made by one senior financial service sector executive about another?

Sunday, December 16, 2007

"Immelt, Ahead of the Curve?" Or Behind The Eight Ball?

GE published its 2008 earnings forecast this past week. This made it the subject of the weekend Wall Street Journal's '' column, entitled "Immelt, Ahead of the Curve."

I should note, before I go further, that I saw somewhere last week that is minority owned by Dow Jones, or, I guess, now, Muroch's News Corp, now the publisher of the WSJ. More detail on the company may be found here.

According to Rob Cox, US editor,

"We write for the shareholders. What sets us apart is that we're not 'media critics,' Cox said in an interview Monday in breakingviews' sparsely furnished Midtown Manhattan office. "We are 'company critics.' We look at what deal will make the most sense in value creation, earnings potential and new products."

You could have fooled me. Because, starting with the Journal/breakingviews article title, it appears that they are writing to make sure the Journal retains GE advertising business. For instance, their piece on GE observes,

"Most conglomerates have gone the way of the diplodocus. But GE has long preached the advantages of its grab bag of businesses, ranging from making dishwashers to managing mutual funds. Like a portfolio of stocks, GE's diversified structure can allow weakness in one area to be offset by strength elsewhere. And a smoother stream of earnings helps GE maintain its triple-A credit rating, which is a huge advantage in a crunch."

Let's stop right there. Anyone with a degree in finance and a reasonable knowledge of the field knows that for at least two decades, and especially in modern liquid capital markets, GE-style diversification has long since lost any value for shareholders. I wrote a post about this in July, featuring Immelt and GE. In it, I stated,

"So, in actually, Immelt isn't running GE in order to give shareholders the best chance of enjoying consistently superior (to the market, or S&P500) returns, no matter when they own the stock. Instead, he's pursuing some hoary, forty-plus-year-old goal of 'earnings smoothing' via 'diversification.'

I don't think I've seen a single diversified conglomerate among my consistently-superior, high-growth portfolio selections. Ever.

Conglomerates, as I wrote in the reposted passages above, are holdovers from a bygone era. Managing according to the theory that there is value in diversifying to "ride out the inevitable ups and downs of the economic cycle" is simply being backward in this more financially modern era of liquidity, low/negligible trading costs, and easier risk management via derivatives.

What is surprising to me is that nobody in the business press seems to call the few remaining conglomerates, especially GE, on this issue. GE has become a quasi-index, closed-ended fund, with a big management fee discount from its component values. There is simply no way Immelt, as GE's CEO, is entitled the many tens of millions of dollars he is paid annually to essentially manage an index fund."

If Cox and his minions think they are for shareholders by accepting this lame argument, they'd better think again.

The breakingviews piece continues with,

"Investors remain skeptical, however. At $36.91 Friday, GE shares are down about 6.9% from the day Mr. Immelt took the helm in September 2001. The market may not be giving Mr. Immelt sufficient credit."

Let's take another pause here. Look at that phrase, 'the market may not be giving Mr. Immelt sufficient credit.'

What school of thought is that coming from? The market price is right. Period. That's the price at which you can sell your equity shares. In my opinion, what breakingviews probably meant, or should have written, was something like,

"The market is not currently pricing GE shares at a level that Immelt feels is an appropriate value for the performance of the company."

Meaning, basically,

"Jeff Immelt, like many other whiny, non-performing large-cap company CEOs, has failed to do what it takes to get GE shares priced at a level that would yield a consistently superior return for his shareholders, since he took the helm of the company. He believes the company's operating performance merits a higher price, but actual shareowners who price the stock with their buying and selling value it much lower than Immelt would like. Clearly, Immelt has yet to understand the performance profile that a sufficient number of investors need to see at GE in order to drive the share prices up to levels that outperform the S&P500."

Here's another revealing statement from the Journal/breakingviews piece,

"With half its revenue coming from abroad, many of GE's businesses, notably infrastructure, are still going full steam."

Doesn't this beg the obvious? If some GE units are 'going full steam,' maybe they should be spun off as a separate entity, in order to give shareholders something that can outperform the market while King Jeff I reigns supreme at the closed-end mutual fund cum diversified industrial conglomerate.

My proprietary research on large-cap company performance revealed that slow-growth and fast-growth companies are judged by investors using different key performance benchmarks. When slow- and fast-growth businesses are combined in one company, the faster-growth units suffer in valuation because of the tendency for their slow-growth brethren to drag the firm's overall growth rates down, and, thus, reduce the implied valuation of the faster-growth units.

The article goes on to state,

"The stock historically commanded a 20% premium to the S&P 500, according to Goldman Sachs. That suggests a multiple of 19 times earnings. Assuming GE hits its earnings-per-share target of $2.42 next year, that implies a stock price of about $46. Throw in its 3% dividend yield, and the potential upside looks to be nearly 30% -- all on fairly conservative assumptions."

However, my research found that earnings growth, per se, is not sufficient to raise valuation. Further, to say GE historically has had a 20% premium to the S&P misses the point, doesn't it? Over the past six years, it's underperforming the S&P. So GE's returns in the coming year probably will, again, bear little relation to past market-related multiples. With Immelt at the helm, the company's stock has simply failed to beat the market's returns.

GE obviously has little reason to hope for turmoil in either the global economy or financial markets. Yet, in a strange way, a little uncertainty might just be what is needed to vindicate Mr. Immelt's strategy."

Really? 'Vindicate Mr. Immelt's strategy?'

How? By turning in six bad years, then perhaps outperforming on the seventh? Is Immelt's strategy to collect tens of millions of dollars of shareholder money each year, in exchange for maybe outperforming the S&P500 only about 10-15% of the time?

Does this constitute performance that an investor should want? It's as if breakingviews is counseling,

'Buy GE, and hold it for, oh, seven or eight years. True, you'll underperform the S&P for the first six, but, wow, that seventh year!'

How can the Journal, and, be so irresponsible? Contrary to Cox's quote about being for the shareholder, I see nothing in this article but more large-cap CEO ass-kissing, CEO interview access and advertising protection.

Why don't the authors, John Christy and Robery Cyran, quantitatively determine the added risk of holding GE stock, while it underperforms the S&P? And how much less risk, and better performance, their readers would get over, say, a decade of Immelt-like performance at GE, by simply buying and holding a Vanguard S&P500 Index fund?

I can only conclude, sadly, that the Journal, because of its minority interest, gives this highly-visible real estate on the back page of the Money & Investing section. And, because the Journal needs corporate advertising and access, breakingviews is careful to avoid being too candid in its remarks about companies like GE, and their CEOs.