Friday, August 29, 2008

Dell's Further Demise

The last time I wrote about Dell was in this post, last January. I contended in that piece,
"Why do you suppose that these CEOs, as a group, mostly failed to move their firms to consistently superior total return performance?
In Dell's and Starbuck's cases, I question if they ever will. I believe, for reasons I've discussed in labeled posts on both CEOs and their companies, that competition, growth and simple Schumpeterian dynamics have worked to end their time of consistent outperformance."
Over a year ago, in April of 2007, I wrote this post, in which I opined,
"Finally, someone there said something with which I can strongly identify. Not that I ever expected it from staffers at firm, founded by Jim Cramer. But one of their number spoke truth to power last week on CNBC, boldly contending, about Dell's recent malaise and accounting troubles,
'who cares? it's an old tech has been,' or words to that effect.
When the CNBC on-air anchor/interviewer sputtered unbelievingly, and stated that many people have a lot of money in Dell, and it's a big company, the Street guy retorted something like,
'so is Xerox. How big is its market cap? Does anyone think it is a leading tech firm anymore?'
Very well put. Big does by no means equal important. Often, it simply means 'still bloated and primed to collapse like a souffle' when sufficient technological change finally sweeps away the last of its ancient underpinnings. Like Kodak. A victim of corporate senescence. Its best days of profitable growth are in the rear view mirror. Consistently superior returns, if they ever happened at Kodak, are a thing long past."
According to today's Wall Street Journal article about the aging PC maker,
"Dell, Inc. reported a 17% drop in quarterly profit, raising questions about the company's 18-month turnaround effort and whether a slowdown in business spending is spreading to Europe and Asia."
I'd say Dell's latest quarterly results answer questions, rather than raise them. Specifically, they confirm that Dell, while still producing laptops and desktops, will probably never regain its prior record of consistently superior total returns for its shareholders.
Dell had to spend heavily to raise its revenues 11% in the last quarter. In effect, whatever goodwill and consumer franchise it once had that enabled it to enjoy higher margins is gone.
The nearby Yahoo-sourced price chart of Dell and the S&P500 Index for the past two years shows that the computer vendor only outperformed the index for the past four months.
For an investor, that means you have been taken for a mostly loss-ridden ride over two years, unless you happened to time your entry- and maybe exit- just right.
This isn't a resurgent performance. It's a technical bounce for a few months.
The fact that most of Dell's initiatives now involve cost-cutting is a pretty good sign that its days of profitable growth are past.
As I've written about this once-great computer maker before, it just isn't going to be coming back as an equity to own. It will make computers, and sell them. But as an investor, you are unlikely to be able to enjoy consistently superior returns from simply holding Dell anymore.

Thursday, August 28, 2008

Current Equity Derivative Market Conditions: Moving Away From Puts

As part of our derivatives portfolio investment risk management, my partner and I keep a close watch on current conditions. We check our proprietary equity-related volatility measure on a daily basis, as well as frequently observe a market return-related measure, to assess whether we should be in calls or puts.

In this post on July 1st, I noted that our equity allocation signal had gone to a 'short' position. Just a few days prior to that, I wrote here that,

"Back in April, I thought we had a good 4-5 months of call options portfolios before we had to worry about weakening markets. Instead, in only six weeks, we're somewhere between neutral and short in our evolving outlook for equity allocations in the next month."

We bought puts in July and August. Marking the absolute point of inflection somewhere in mid- to late-June, when we sold our April, May and June calls, the period for puts has lasted roughly 10 weeks.

Based upon recently falling values in our proprietary volatility measure, and a slowly, stubbornly-rising S&P return for August, we now anticipate liquidating our put positions within the next week.

It would appear that investor sentiment has changed markedly from the mid-summer skittishness. As my partner and I reviewed the recent developments in financial and commodity markets, as well as the economy, it would appear that several sources of investor aggravation this summer have abated. Commodity prices- including energy- have fallen, Freddie and Fannie are presumed to be the object of a takeover by Treasury, and economic performance continues to be lackluster, but not a severe recession.

Thus, the volatility typical of downward-moving equity prices and capitulation has seemingly ended.

Thus, we expect our September's options portfolio to be either a straddle of puts and calls, or just calls.

As we have observed the performance of our put portfolios for July and August, as well as a synthetic June put portfolio, we have noted that puts seem to lack the concentrated energy and consistent advances of call portfolios. Additionally, the time periods over which puts remain the preferred side for investment are, on average, far shorter than those for calls.

Mirroring the infrequency of periods of short equity portfolio allocations, put portfolios don't occur as frequently as call portfolios, either.

Together, these characteristics make the periods during which we invest in puts more risky in general. We condition our expectations to be for shorter timeframes in the puts, and, after observing the performance of the June and July put portfolios, much lower returns, as well.

We still believe that put portfolios can provide positive returns during periods of serious equity market downturns. However, we are learning more about how much shorter are the effective durations of those portfolios, and how much less, on average, their positive returns can be.

Wednesday, August 27, 2008

Privatizing Toll Roads

Yesterday's Wall Street Journal's front page featured an article on the imminent privatization of the Pennsylvania Turnpike. Generalized to other state highways, as well, the piece catalogued the reasons why this trend has become more pronounced.

While the article noted the obvious reason of quick, present-valued money for cash-strapped states, and the predictable cries by labor of the loss of high-paying patronage jobs, it was silent on two important issues attached to this topic.

The first is one of competence and long run cost curves.

Does anyone with a brain actually believe there are sufficient numbers of competent highway system mangers in each state with their own, e.g., Pennsylvania, New Jersey, Indiana, to run these transportation systems well and profitably?

It seems to me that the trend of investment funds buying these formerly publicly-owned and -managed roadways is a very good thing. They clearly can leverage expertise and scale of management of these operating assets across many highway systems.

But what struck me as odd was the issue missing from the Journal article. Nowhere did the piece mention what is really going on with these sudden privatizations.

Any way you cut it, states are turning to private enterprise to lease their toll roads because they simply can't raise revenues. Thus, they are literally mortgaging a capital asset and consuming the asset value as ordinary operating funds.

As I read a webpage discussing the history of New Jersey's Garden State Parkway, I noted the periodic mention of 'self-liquidating' and 'self-funding' toll road. The intent was clear- the highway was to pay for itself with tolls collected from drivers on the road.

If that were true, and a third party bid on a lease for the road, how could they make a profit if the highway were truly self-funding?

Either an unrealized capital value existed in the road, which is now being consumed without telling voters/residents, or the lessee plans to extract income from the road in excess of current tolls, in order to generate their profit.

My guess is the former is the case. These states are silently extracting capital value from the roadways and consuming it to run their states.

In the case of my current state of residence, New Jersey, its spending has long-ago outstripped the viable, continuing tax base for the state. It is living beyond its means.

Thus, while the operating effects of these highway leases are probably ultimately beneficial to taxpayers and drivers, the net effect of the asset value transfer and consumption is to silently tax and spend public money without notifying voters.

This is the phenomenon which is, I think, the most telling in this story. In an era when US transportation infrastructure is becoming suspect, and probably in need of serious investment to maintain commercial viability for our economic growth and welfare, several states are silently going the other way. They are surreptitiously draining capital from their transportation systems, i.e., toll roads, and spending this capital for normal operating purposes. In a matter of months, or, at most, a few years, that capital will be gone.

Tuesday, August 26, 2008

Recent Central Banking Errors

The Wall Street Journal carried an article last Saturday written by ',' the outfit that occasionally targets a good topic with substandard analysis, entitled "Honest Central Bankers..."

According to the crew at the tiny research outfit, the world's influential central bankers committed three mistakes in the recent past:

1. Failure to consider the "dangers of financial deregulation."
2. Excessive pride in managing "steady economic expansion and moderate inflation, but we should have been humble about wild asset-price inflation."
3. They were "remiss in not considering the distortions created by an annual US trade deficit the size of the Dutch economy."

I continue to be mystified as to why, with their equity interest in going to zero, the Journal still publishes these lightweight pieces on the valuable top-left of the back page of the paper's Money & Investing section.

That said, the topic is worthwhile. Looking back over the past 12-14 months, we see the greatest dysfunction in credit markets at least since the late 1990s sovereign reneging on debt by Russia and the LTCM mess.

How much of this recent- and continuing- debacle is really the fault of the two major central banks, the American Fed and the EU's central bank?

If central bankers made mistakes, I don't actually think they were the three identified by breakingviews' analysts.

Once a nation decides to allow substantial private monetization of future valuation potential, the central bank isn't really in control of the supply of liquidity or even 'money,' in its practical meaning, anymore.

When private enterprises can routinely issue large amounts of bonds, similar to what occurs in a Fed open market action, they pump up money supply totally out of the control of the Fed. There's a reason the old 1950s-era credit controls were in place. But having moved beyond that era, we really cannot now return.

The Fed and the EU central bank don't really control asset-price inflation, nor can they, except, for example, by some slight regulatory oversight to at least assure the creation of high-quality mortgage assets, instead of low- or no-down payment mortgages.

Thus, mistakes one and two aren't, in my opinion, valid accusations of central banks in this era.

Alleged mistake number three is also incorrect. Ricardian economics assumes all participants are doing something of value. Exchange rates take care of the imbalances of trade flows.

What, exactly, do the geniuses at breakingviews suggest the central banks should have done to affect commercial trade flows between nations and currencies? Return to old-style, fixed or pegged exchange rates?

Once again, this is a non-issue for central banks.

The one thing I believe of which the central bankers were and are guilty is simple misperception of the consistency and non-normalcy of the drivers of recent inflation- energy and commodities- as Brian Wesbury pointed out in a Wall Street Journal editorial about which I wrote, here. There was another fine editorial covering some of the same ground in the past week in the Journal, although I have forgotten who were its authors. Essentially, they correctly accused Greenspan of freely spending the credibility Paul Volcker had bought for the Fed with his effective breaking of inflation in the late 1970s and early 1980s, in concert with Ronal Reagan's equally-effective fiscal discipline.

Largely due to Alan Greenspan, we now see, the Fed began to unwisely pump money supply in the early 2000s, leading to today's inflation. While there are other monetizers besides the central banks in our modern economy, when the central banks inflate, it still causes inflation.

Between Greenspan's cavalier dissipation of the Fed's inflation-fighting credentials of the Volcker era, and Bernanke's political timidity last year in keeping rates high while using the Fed's discount window to assure liquidity to the collapsing financial fixed-income sector, the US central bank has all but lost its ability to convince holders of dollars that they will not be robbed of value by inflation.

Would it really have been so hard for Bernanke and his colleagues to see recent energy and other commodities price rises as the results of growing demand in economically-maturing India and China for these products in the face of poor demand forecasting by their producers?

That inflation measures including food and energy were valid because what was occurring was not seasonal or occasional price volatility, but a secular, if temporary, upward trend due to forces of supply and demand?

I honestly thought that Bernanke was smarter than he has appeared to be in the past year. Adding his indecision to the results of Greenspan's egotism have given us an inflation rate heading to heights we haven't seen since Reagan took office.

Funny, isn't it, how both US economics and political choices seem to both stand at crossroads last faced when the Gipper- and Tall Paul- were there to help our country make wise choices.

Sadly, too few Americans are of an age who recall this.

Monday, August 25, 2008

What Is Lehman Really Now Worth?

The weekend edition of the Wall Street Journal reported Lehman shares rising 16% on alleged interest in the ailing investment bank by the Korea Development Bank. However, later reports indicated that the bank was not anywhere near a deal to rescue Dick Fuld's house of cards, a/k/a Lehman Brothers Holdings Inc.

With all of the write-downs and drama involving Lehman's fighting with a prominent bearish hedge fund manager regarding its asset valuations and losses, one has to wonder, at this point, just what is the firm actually worth?

What would a buyer presumably be acquiring if it were to bid for Lehman?

It wouldn't seem to be getting good management. Fuld and his obliging lieutenants are now on record, asset-valuation style, as having made disastrous operations decisions in the past few years. To quote the Journal's piece,

"Friday's stock-price surge shows how hungry investors are for nearly any scenario that would help Lehman finally rid itself of the doubts and problem assets haunting the firm."

How'd those problem assets get on Lehman's balance sheet? Did some wicked finance fairy drop them there one night? Or did Dick Fuld's managers buy them of their own free, if misguided and ill-considered wills?

Granted, Lehman owns asset manager Neuberger Berman. This is a classic example, on a par with GE, of how collecting unrelated businesses does nothing much in the long term for shareholders that they cannot do better themselves. It's a good bet that Lehman, being under pressure, will have to sell Neuberger for less than if the parent were not in financial straits. I don't know the accounting, but one would hope that at least Lehman is going to get more for Neuberger than they paid for it.

In the meantime, since Neuberger, being in a different business than the rest of Lehman, presumably was unaffected by the parent's bad risk management decisions, Lehman shareholders are left with the problem of what they actually own that isn't easily sold.

Or won't be sold to someone for more than it is probably actually worth in the long run.

Having messed up Lehman's balance sheet and, due to the write downs, income statement, Fuld's team would not seem to be the reason anyone would buy the firm. More likely are two other reasons.

One would be a bottom-fishing private equity firm that is interested in fire sale prices for exotic instruments that may actually perform reasonably well over time. As I've written elsewhere in prior posts, non-bank, non-publicly-held financial service firms can afford to buy and hold instruments whose market values are now crippling publicly-held institutions.

A second reason for buying Lehman might be the overall pressure on virtually all of its assets, given Lehman's near-death situation. There are probably some decent assets, either for trading or investing purposes, which aren't damaged due to problematic market values, but only because they are on Lehman's balance sheet.

If the dross can be bought sufficiently cheaply and either sold or simply held at little cost, then the decent assets might pay off as they rise in value when held by a going concern with a viable future.

Either way, it wouldn't seem that any of the assets on Lehman's balance sheet are now worth to the firm's shareholders what they will be worth to almost any other firm which can buy them.

And for that, they have Dick Fuld to thank, for having managed Lehman to the point that it's continued existence, being doubtful, has now placed a large discount on the value of any assets which the firm currently owns.

So let's be clear. Are we discussing the sale of Lehman, or simply the sale of its assets, as the firm is dismembered in the wake of bad management?

I believe it is the latter.

And, oh, yes, Dick Fuld (and probably a few very close lieutenants) will keep some juicy past bonuses and other compensation, while shareholders will, as usual, be left holding the empty bag. Don't expect Fuld to offer to repay any of his past lush compensation in exchange for the losses his shareholders will now suffer. This is the Wall Street way. Bonuses for the managers now, losses for the shareholders later.