Friday, January 04, 2008

More Drivel From Henry Kaufman

Yesterday's Wall Street Journal featured another "so what" editorial by the perennially gloomy former Salomon Brothers economist, Henry Kaufman.

Forgive me if I'm growing more than a little annoyed at his seemingly more-frequent, unenlightening prose in the Journal. I'm not sure who annoys me more at this point- Kaufman, for the repetitive, tired observations and ideas, or the Journal's editorial page staff, for wasting so much space, so often, by giving it over to the former economist of a failed investment bank.

I won't even bother quoting from Kaufman's piece. None of it is new. For example, I wrote this piece back in November covering much of the same ground as Kaufman with respect to the misalignment in financial service conglomerates of risks and rewards. And the relative risks to our economy of the existing financial service utilities.

Frankly, much of what I read in Kaufman's pieces lately are echoes of things I wrote months earlier. With the big K, I no longer read anything of note that hadn't occurred to me first. Mind you, I'm not being egotistical. I'm sure the same is true for dozens of other people reading Kaufman's recent tripe. Whereas, with Brian Wesbury, Edward Prescott, or Alan Reynolds, I nearly always learn something new and valuable, with Kaufman, I've already been there and gone.

I continue to differ with Kaufman, as I did, again, last November, here, with respect to financial regulation over the past several decades. It seems that, in Kaufman's world, change brings risk, risk is always bad, so, in conclusion, change is also (usually) bad. It's as if the notion of market-priced risk is nonexistent in Henry K's world.

When I think of Kaufman, the once-chief economist of the failed Salomon Brothers, I think of a doddering old second-tier economist who probably sharpens his own #2 pencils, muttering something like,

"things sure ain't like they were in 1990 anymore. What's a body to do?"

I wrote about him in this post, on the occasion of his 80th birthday, and appearance on CNBC,

"Kaufman was once Salomon Brothers' chief economist, and, as befits a fixed income house, usually a market bear. Then he left Salomon to become a money manager. But, as I recall, he foundered. Salomon didn't participate in his firm, and I believe he failed to attract sufficient funds to make in the razor-thin margin world of fixed income management.

Come to think of it, does anyone else know of a successful institutional investment manager who came out of Salomon and went on to consistent success?

The only name that comes to my mind, of course, is John Meriwether. But Long Term Capital Management ...... hardly constituted a successful example of consistently superior investment management.

Most of the better institutional managers about whom one hears, if they have an investment bank pedigree, more often than not, seem to be Goldman, Sachs alumni.

Could it be Salomon's fixed income heritage somehow biased its managers?

Take the longer term view. Salomon isn't even independent anymore. It was rocked by the Treasury bid-rigging scandal some years ago, which required Warren Buffett to step in temporarily as acting Chairman. Then it was acquired by Sandy Weill in 1997. So it hasn't even been a separate investment bank for over a decade.Goldman, on the other hand, prospered continuously for the past several decades, culminating in its own public offering.

Given the rather checkered history of Salomon, Kaufman's early departure to a rather forgettable career thereafter, as his one-time employer stumbled and was acquired, why does anyone take Henry's views seriously anymore?"

After wringing his hands about opaque CDOs, which nobody forced any institutional investment managers to purchase, Kaufman goes on to chide the Fed on being too transparent.

Honestly, it's just too much. Kaufman is apparently a member of that group of 100+ 'economists,' some with appropriate degrees, others merely self-styled, who all feel they should be on the FOMC, if not Chairman of the Fed.

It's instructive, by the way, that CNBC's Larry Kudlow fell from grace, due to substance abuse, while chief economist at Bear Stearns. Under the legal guardianship of his wife, Kudlow was put into treatment, emerged victorious, and nearly immediately began to write pieces for the Journal's op-ed pages. In short order, he had a co-hosted hour program on CNBC, culminating in his current nightly hour on that financial business-oriented network.

To my knowledge, nobody's ever extended that sort of offer to Kaufman. Maybe the Journal should print less Kaufman, more Kudlow?

With respect to CDOs, and their opaqueness, I would simply note that, in contrast to most financial meltdowns, such as the 1990s technology stock bubble, the 1980s S&L crisis, or the 1960s 'go-go' mutual fund and 'nifty fifty' stock collapse, virtually no retail investors appear to have suffered damage from this latest calamity. This has been a collapse among the smart set- those professional, institutional investors, many on the investment committees of counties, educational institution endowments, and union pension funds.

Kaufman, in my opinion, is barking up at least one wrong tree. These investors thought they were getting a bargain. As I wrote here and here, they, and the salesmen who preyed upon them, each thought there were conning the other party. Surprise- they both lost!

The transparency of which Kaufman writes isn't going to happen. Large commercial and investment banks aren't going to list every security they own. Rather, we can glean some understanding of their risk profiles by analyzing their performance over time. Managements leave trails, and those trails are valued by markets.

I not only don't, and haven't, owned any CDOs, Henry. I didn't own Merrill Lynch, Citigroup, or Bear Stearns. But I did own Goldman Sachs.

Seems there's enough transparency already, if you just know where to look.

Thursday, January 03, 2008

Joe Kernen's Selection for Businessman of the Year 2007

On Monday morning, the co-anchors of CNBC's Squawkbox program each selected a 'businessman of the year' for 2007.

I don't know who Carl what's-his-name chose, but I recall Becky Quick selecting a fund manager who shorted mortgage-related instruments with great success. She was going to choose Warren Buffett because Berkshire had a roughly 28% return. The fund manager did much, much better.

Joe Kernen chose Jamie Dimon, CEO of Chase. According to Kernen, with whom I typically agree, Dimon's firm had 2007 total return of -10%, making it a relative star versus Citigroup's roughly -50% return. As I wrote here recently, much of Chase's outperformance over the past five years occurred before Dimon showed up. This year, the company lost its shareholders about 10% of their value.

How about looking among the 10 best large-cap total return performers this year, Joe? I held Apple and National Oilwell Varco, as I noted in this post. Both were among that group.

Why not name Steve Jobs as the businessman of 2007? He introduced a raft of new products, repriced others to throw his competition off balance, and still managed to outperform the S&P500 Index for his shareholders by a wide, wide margin.

But the so-so CEO of a mediocre money center bank? I don't think so.

I like you a lot Joe, but you could have done much better than that.

Wednesday, January 02, 2008

2007 Equity & Options Portfolio Performances

Today is the first day of the 2008 trading year.

As such, until 4PM today, I can justifiably focus on our terrific equity and option portfolio performances for 2007.

The gross return on my equity portfolio last year was 34.8%. The S&P500 earned a total return of 5.49% according to today's Wall Street Journal 2007 market summary section. Their value is typically pretty accurate.

Thus, my equity portfolio outperformed the S&P500 Index for 2007 by 29.3 percentage points, or, in banker speak, 2930 basis points. On a net basis, if I charged a 1-and-20 hedge fund fee structure, the net performance would be 26%, which still results in an impressive 20.5 percentage point outperformance.

As I mentioned in this recent post, our portfolio held two of the S&P500's and large-cap total return performers for 2007, Apple and National Oilwell Varco. This isn't the first time my equity portfolios have selected at least one of the best ten performers of the S&P500 in a calendar year.

During 2007, the portfolio experienced only two down months, June and November, while the index fluctated all year, with five negative return months.

As can be seen from the illustrative chart on this webpage, 2007 was the best equity portfolio performance since 1999. However, it hasn't been the best performance in the last 17 years, by far.

The average average outperformance of the equity strategy over the S&P500 is just shy of 8 percentage points, or 800 basis points.

With respect to our options portfolios, which are based on the same selections and weights as our monthly equity selections, they ended the year essentially the same as I noted in this post just a week ago. In that post, I noted,

"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.

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."
While we are now primarily focused on investing in the optionized variant of our basic equity strategy, we look to the latter's continued strong performance as an indicator of the basic validity of our equity selection approach.
The reason I mention this here is not to solicit interest in our investment business, because we don't actually seek customers, aside from a few carefully selected, sophisticated investors already known to us.
Rather, we feel that the performance of the investment strategies, particularly their consistently superior performance relative to the S&P500, over time, validates my observations and insights in this blog.
The perspective I take in my commentaries reflects our belief that managing businesses for consistently superior performance is the best way for CEOs and their management teams to reward their shareholders. Thus, the comments I make in this blog are based upon what I have found, through my proprietary research, relates to consistently superior performing firms, in terms of total returns.
And these findings continue to work in today's equity and derivatives markets.
So, today, as 2008 begins, and we reset our portfolio return back to zero, I'm pleased to review a very positive, successful 2007 for our various investment portfolios.

Tuesday, January 01, 2008

The Mortgage Mess: The Lobbyists' & Legislators' Roles

Monday's Wall Street Journal featured an excellent article, by Glenn Simpson, entitled "Lender Lobbying Blitz Abetted Mortgage Mess."

It's a very lengthy article, but a very important one. Between the mortgage companies in California, their lobbyists in Washington, D.C., a publicist related to one of the lobbyists, and various state and national legislators, it's clear that this mess is not simply a case of mortgage lenders run amok.

No, they bought and paid for plenty of legislative help.

In fact, before you start believing Barney Frank or Chris Dodd as they spout off about more regulations and legislation to prevent this from happening in the future, consider telling them to look to their own kind first.

Simpson's article includes some details involving states and specific legislative language that was excised to help the mortgage banking industry. New Jersey and Georgia were two key battlegrounds in which industry political donations turned the tide of legislation in favor of the lenders.

If there weren't a demand for donations, this wouldn't happen. But state legislators take campaign contributions, so lobbyists exist to implement the legal function of distributing industry money to them.

The lack of legislation to curb so-called predatory lending isn't accidental. State-level office holders looked the other way and/or deliberately stopped such legislation in association with cash flowing to them from lenders, through lobbying groups.

Given these facts, what should make us think that the same thing wouldn't recur at the Federal level? It's one thing for windbags like Dodd and Frank to expound on what ought to be done.

How little money will it take from mortgage lenders to gut any future Congressional action? Probably a lot less than you think.

In the end, the recent so-called 'subprime meltdown' had plenty of actors and money flowing every which way. It's your typical mess composed of greedy business people and politicians, lobbyists, and careerist regulators.

It was in nobody's interest to stop the game, and in many people's interest to keep it going. Don't kid yourself that it only took some avaricious lenders to create the subprime situation. They had plenty of paid help. Well paid help, to judge from reading Simpson's piece.

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,

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.

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,

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.

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.