Saturday, May 14, 2011

The Folly of Sector Focus: "The Case for Bank Stocks"

Randall Smith of the Wall Street Journal wrote a weekend edition column entitled The Case for Bank Stocks. It's a fine example of why you should be wary of people who write columns on investing in media for which you pay. I don't follow Smith's writing in the Journal, so I don't know if his piece was a one-off piece that represents his big break in writing at the Journal, or a frequently-appearing column. It doesn't have a clever heading, so Smith probably hasn't yet attained the status of his fellow Journal investment columnist whom I also find dangerously naive and narrow-minded, James Stewart.

Now that I think of it, the only two routinely-appearing Journal writers in the Money & Investing section which I find generally sound and interesting are Kelly Evans and Dennis Berman. Neither is confined to a single sector or topic.

Just like their actual kindred spirits in sell-side analysis or sector portfolio management, journalists who focus solely on either investing, or a sector, have a recurring problem. They must publish tantalizing pieces on a fixed schedule, and the pieces must at least appear to provide some fresh insight or value, regardless of whether, for sector-focused analysts and portfolio managers, it's just a bad time to be in that sector.

But this flies in the face of legendary Vanguard Group founder John Bogle's dictum,

'Don't just do something- stand there,' which captures his well-regarded and  empirically-proven contention that passive index investing will provide most retail investors with comparatively better returns at lower risks for the long term.

However, in keeping with why I originally began this blog, I decided to read and dissect Smith's article to see what sort of sense it makes. Passages from his piece are in italics.

Bank stocks rocketed out of the financial crisis in 2009, helping to ignite a bull market that has lasted more than two years.

This sort of anthropomorphizing of "the market" is an old journalist's trick to get you to regard equities emotionally, and actually believe they possess some sort of animus of their own. They don't. It's also an attempt to portray what may be simple correlation as causation, which also takes much more work to prove.

But in the past year, they have lagged the broader U.S. market. While the Standard & Poor's 500-stock index has risen 15.6%, a widely watched measure of bank stocks, the KBW Bank Index, has fallen 10%.

Now, as the economy moves from recovery mode to full-fledged expansion, some market strategists and advisers say bank stocks should outperform once again.

Christ, is it me, or does Smith sound like the pitchmen on the frequently-appearing 'invest in gold' ads on cable business channels? Does it get more hackneyed than "some....strategists...say banks stocks should outperform once again?"

"As the economy improves, we're seeing capital-markets activity picking up, credit trends improving dramatically, problem loans and delinquencies falling, and loan demand picking up—all the classic signs of an early-stage recovery," says William Tanona, a bank-stock analyst at UBS AG.

Wow, I'm impressed with Tanona's insights. But, wait....he's a bank-stock analyst! At UBS. Which really means he's a bank-stock sales support publicist at UBS. If bank stocks become uninteresting, Tanona's going hungry. So I'm sure his remarks are always totally objective.

The case for bank stocks has three main prongs. First and foremost, banks look cheap. On average, bank stocks trade at just 0.9 times their book value per share, while their average for the seven years before the meltdown of 2008 was about two times, Mr. Tanona says.

While current valuations reflect investors' fears about new regulations and higher capital requirements, Mr. Tanona says multiples should rise "once asset quality normalizes and firms adjust for all the regulatory, legal and capital requirements."

Seriously, I had to stop laughing at this point before continuing my comments. First, we have the old 'they sure look cheap historically' argument. Meaning past is prologue. Except that all investment literature must state that prior performance is no guarantee of future performance, etc. Then that second paragraph, which essentially disguises the truth that nobody knows how Dodd-Frank will hobble these leviathans.

My longtime financial business colleague B, and I, both believe that the largest remaining US banks are now slow-moving utilities incapable of surprising growth for extended periods of time. They are essentially heavily-regulated, quasi-governmental finance arms which are so heavily insured and regulated as to be pointless as investments.

J.J. Schenkelberg, an investment adviser at CLS Investments LLC in Omaha, Neb., says her firm has put about $50 million of its $8 billion of client assets into an exchange-traded fund tracking the KBW Bank Index because the stocks are "quite attractively valued" based on their price-to-book ratio. "With these types of valuations, they are still overly punished" for the financial system's near-meltdown, she says.

I love it when sell-side, or even buy-side analysts stumping as sales people for their funds, use P/E ratios as causal, rather than consequential. My proprietary research found P/E ratios to be meaningless and unrelated statistically to consistently superior performing companies as measured by total return.

The prospect of rising interest rates in the next few years also bodes well for banks, say some strategists. In that scenario, banks' so-called net interest margin, a measure of the money banks earn by making loans, would increase, says analyst Chris Kotowski of Oppenheimer & Co. That's because, in a rising-rate environment, banks can usually raise the rate on their loans faster than they have to raise the rates on their deposits.

Some banks also say they can reinvest some of their assets more profitably once rates rise and regulators loosen controls over their reserves. Two of the largest banks by assets, Bank of America Corp. and J.P. Morgan Chase & Co., "are both positively positioned for rising rates," Mr. Tanona says. Others say Citigroup Inc. is, too.

At Wells Fargo & Co., redeploying just half of a $100 billion short-term cash trove could boost pretax profits by $880 million a year, analyst Chris Mutascio of Stifel Financial Corp. told Wells executives on a conference call last month. "I would not disagree with your math," replied Wells Chief Financial Officer Tim Sloan.

Other potential beneficiaries of rising rates include Bank of New York Mellon Corp., Charles Schwab Corp., and Federated Investors Inc., all of which would be able to recapture fees waived due to rock-bottom interest yields on money-market funds. "These companies automatically get a benefit when rates go up," says Frederick Cannon, director of research at Keefe, Bruyette & Woods.

As profits improve, banks are likely to boost their dividend payments, say analysts. Banks slashed their payments during the financial crisis to preserve capital. Now that the crisis has ebbed, regulators are allowing banks to return more cash to shareholders. Nineteen banks have raised their payouts so far in the second quarter, on top of the 39 that did so earlier in the year. Among those that did so after regulators approved their capital plans: J.P. Morgan Chase, Wells Fargo and U.S. Bancorp.

As a result, while the KBW Bank Stock Index currently yields about 0.9%, KBW's Mr. Cannon expects it to increase to 1.9% over the next year. He says that, in turn, should attract buyers to the stocks.

Not all banks are likely to boost their payments at the same time. Investors were surprised in March when one bank, BofA, saw its dividend plan rejected by regulators.

It's true, and I've written about this in prior posts, from my own knowledge as a Chase Manhattan officer years ago, that most people don't realize banks generally benefit from higher rate environments. But this is the sort of thing that the thousands of sell-side and buy-side bank analysts all spend their time estimating. So it's not on the order of, say, surprise growth at Apple or Priceline. And you'd be basically, according to Smith and his sources, buying now, to hope that, sometime after Helicopter Ben raises rates, or things go wrong in the US economy and nervous investors cause risk-free Treasury rates to soar as they shun debt auctions, these large banks will benefit from some liquid assets redeployed at higher rates.

Never mind that, in this economic environment, those higher rates might actually choke off economic growth and demand for loans. A trivial concern, I am sure.

The banking sector isn't a cakewalk these days. Some analysts warn that banks must adjust to a new lending reality that includes a retreat from the wild-west days of mortgages with zero down payments, no income documentation and other loose lending standards.

"It will take banks years to adapt" to an environment of mortgages with 20% down payments, says bank analyst Nancy Bush, a consultant with SNL Financial Corp.

I'm old enough to remember Nancy Bush as a young sell-side analyst, along with Tom Brown and Mike Mayo. She's seen a lot, and her cautionary words are appropriate. By the way, if it does take banks "years to adapt" to this new environment, doesn't that suggest that resulting profits could be lower and later than the (smirk) totally objective sell-side analysts contend?

One drag on banks' loan growth in recent years has been the need to shed legacy portfolios of toxic assets they either inherited from previous management, in the case of Citigroup, or acquired in acquisitions, in the case of J.P. Morgan Chase, Wells Fargo and BofA. One bank with a big slug of for-sale assets, Citigroup, is only about halfway through that runoff.

Ah, yes. Those pesky "legacy portfolios." That's what sell-side analysts and bank managements like to call the resulting toxic relics of their last big errors in judgement. But don't worry. Really. They've learned all their lessons and nothing remotely like those mistakes will ever happen again. Really. Everybody agrees- the sell-side analysts, the bank managements, the regulators caught napping lasting. Everyone! Even Randall Smith!

So, go ahead, invest already!

Still, Todd Green, chief investment officer at Alesco Advisors LLC in Rochester, N.Y., which owns $15 million of the same KBW bank fund, the SPDR KBW Bank ETF, expects bank stocks to rally as lenders reinstate or raise their dividends, mergers pick up and valuations bounce off their recent lows.

Bank stocks, he says, represent "an attractive opportunity in this market to buy high-quality companies at low prices, in an industry that's essential to the functioning of capitalism in the U.S."

Let's see....Todd Green's funds own a big chunk of bank ETFs. Todd would like you to believe, as he does, that banks will be hot. So Todd's investments, bought at lower values, will benefit from your stampede into, well, hopefully the very same ETFs that Todd's firm bought for its clients.

No lack of objectivity there, huh?

Mind you, these so-called "high quality" companies are the same ones which accepted government bailouts and heavy consequent oversight. Are these low prices? Why?

If the prices rise due to equity index rises, maybe the S&P500 is safer.

Then there's the real proposition that would likely infuriate John Bogle.

This entire article, and all the supportive material, argue for market timing. Pure and simple. But market timing is notoriously unreliable and largely the province, when successful, of seasoned professionals who also have the benefit of legal market intelligence that retail investors lack.

It's always curious to me that analysts expect people to buy and hold in hopes of some future gains, while they know that what investors want is gains now...and in the future. I know of no professional fund managers who believe that telling investors to just wait through poor or negative returns now for future better returns will retain their capital. Market timing propositions, which is what Smith's piece is, fly in the face of seeking consistently good investment performance.

Finally, Green engages in a bit of suspect logic. Banks may be "essential to the functioning of capitalism in the U.S.," but that does not mean they will provide consistently superior returns.

Airlines are "essential to the functioning of ....the U.S." Would you like to buy and hold one? Or are they, too, market-timing equities?
Railroads were "essential" for the opening of the West, yet British investors lost nearly all their capital lending to and investing in them in the late 1800s.
Just because a sector is essential for something doesn't mean it's a worthwhile investment, when other alternatives are available.
In its totality, Randall Smith's piece displays, in one place, many errors of logic and biases which tend to characterize this type of investment journalism.
Proving to me, once again, why the financial sector's continuing insistence on sector-based analysis and investment provides such a helpful confusion to many investors. Meanwhile, other investors, like me, focus on firms of any sector which simply have prospects of providing consistently superior total returns now and in the near future.

Friday, May 13, 2011

An Unheralded Court Win for Ratings Agencies- For Now

Yesterday's Wall Street Journal carried an article describing a recent decision by a 3-judge panel of the Second Circuit Court which found Moody's, S&P and Fitch not guilty of misleading investors by their ratings of mortgage-backed securities during the financial crisis.

The court wrote that the rating agencies furnished "merely opinions" concerning the securities' credit-worthiness.

The court, observers and the ratings agencies all agree that the decision continues to distinguish what the agencies do from underwriting securities, even when the ratings firms are deeply-involved in advising on the securities' structures. The decision also calls into question the value of Dodd-Frank provisions allowing for lawsuits against the agencies for their ratings.

However, a remark by Doug Dachille a few years ago on CNBC comes to mind. I believe he opined that, in the modern era, when so much information is available online to investors about various municipalities and their various agencies and projects, bond ratings are almost superfluous.

Now that the court has insulated the ratings agencies from culpability for doing a poor job of rating securities, perhaps the ironic result will be that more investors will simply ignore the ratings.

And, in time, perhaps the issuers will forgo, where possible, paying for those ratings. This might be a limited alternative, since many pension and other institutional funds are required to invest in securities having ratings equal to or above a certain grade. Or maybe the existing agencies will be discredited, and new competitors will seek to differentiate themselves by offering more than just 'opinions.'

After all, those who relied on the opinions of Moody's, S&P and Fitch paid dearly for such free advice.

More Confusion On Inflation

When a nation's central bank chief misuses the term 'inflation,' it's probably too much to expect the country's premier daily business newspaper to do otherwise.

Yesterday, Kelly Evans' Ahead of the Tape column focused on fears of inflation versus an economic slowdown.

She wrote,

"That suggests investors today pretty much agree with Federal Reserve Chairman Ben Bernanke's assertion that the recent rise in commodities prices will provide only a fleeting boost to inflation."

For about the millionth time, I'll quote Milton Friedman that "inflation is always and everywhere a monetary phenomenon."

Thus, a more accurate statement by Bernanke would have been something like,

'The recent rise in commodities prices will provide only a fleeting boost to overall consumer goods prices. But those price rises are not to be confused with inflation, which, when it comes, will have been caused by overly easy monetary policy.'

The folks on Bloomberg television have been contending recently that we'll see inflation, but not of the cost-push or even demand-pull types so typically expected by many economists. Thus Evans' piece suggested economic sluggishness is the greater worry now, because demand isn't rising sufficiently, nor job growth and wages rising sufficiently, to cause those sorts of "inflation."

Well, to cause price rises, anyway. Whether it's monetary inflation is another matter.
Of course, events such as a Greek debt restructuring and a fall in the Euro could send the dollar higher, temporarily saving Ben's super-easy monetary policy from driving up dollar-denominated commodities prices quite so high.

But, on balance, when debt issuance and dollar creation far exceed GDP, for a long time, the value of the currency is headed for trouble. Even if investors still buy the bonds and grant the currency reserve status, it's likely not to retain its value, and, thus, cause goods price in dollars to become more expensive.

Now that's inflation.

Thursday, May 12, 2011

A Cold-Eyed View of The ECB Intervention

Despite having occurred over two years ago, there is still quite a bit of denial and misinformation on the federal government bailouts and takeovers of late 2008.

Meanwhile, Europe, through it's central bank, engaged in similar bailouts of publicly-held banks.

Timo Soini, the chairman of the True Finn Party in Finland, recently wrote a Wall Street Journal editorial entitled Why I Don't Support Europe's Bailouts. Soini's party is Finland's left-wing populist party, so it's not surprising that it desires more state-directed economic investment and control. But Soini's sentiments regarding how the ECB's bailouts actually worked is rather refreshing.

Here's what he wrote.

When I had the honor of leading the True Finn Party to electoral victory in April, we made a solemn promise to oppose the bailouts of euro-zone member states. Europe is suffering from the economic gangrene of insolvency—both public and private. Unless we amputate that which cannot be saved, we risk poisoning the whole body.

To understand the real nature and purpose of the bailouts, we first have to understand who really benefits from them.

At the risk of being accused of populism, we'll begin with the obvious: It is not the little guy who benefits. He is being milked and lied to in order to keep the insolvent system running. He is paid less and taxed more to provide the money needed to keep this Ponzi scheme going. Meanwhile, a symbiosis has developed between politicians and banks: Our political leaders borrow ever more money to pay off the banks, which return the favor by lending ever more money back to our governments.

In a true market economy, bad choices get penalized. Instead of accepting losses on unsound investments—which would have led to the probable collapse of some banks—it was decided to transfer the losses to taxpayers via loans, guarantees and opaque constructs such as the European Financial Stability Fund.

The money did not go to help indebted economies. It flowed through the European Central Bank and recipient states to the coffers of big banks and investment funds.

Further contrary to the official wisdom, the recipient states did not want such "help," not this way. The natural option for them was to admit insolvency and let failed private lenders, wherever they were based, eat their losses.

That was not to be. Ireland was forced to take the money. The same happened to Portugal.

Why did the Brussels-Frankfurt extortion racket force these countries to accept the money along with "recovery" plans that would inevitably fail? Because they needed to please the tax-guzzling banks, which might otherwise refuse to turn up at the next Spanish, Belgian, Italian or even French bond auction.

Unfortunately for this financial and political cartel, their plan isn't working. Already under this scheme, Greece, Ireland and Portugal are ruined. They will never be able to save and grow fast enough to pay back the debts with which Brussels has saddled them in the name of saving them.

Setting up the European Stability Mechanism is no solution. It would institutionalize the system of wealth transfers from private citizens to compromised politicians and failed bankers, creating a huge moral hazard and destroying what remains of Europe's competitive banking landscape.

Fortunately, it is not too late to stop the rot. For the banks, we need honest, serious stress tests. Stop the current politically inspired farce. Instead, have parallel assessments done by regulators and independent groups including stakeholders and academics. Trust, but verify.

Insolvent banks and financial institutions must be shut down, purging insolvency from the system. We must restore the market principle of freedom to fail.

If some banks are recapitalized with taxpayer money, taxpayers should get ownership stakes in return, and the entire board should be kicked out. But before any such taxpayer participation can be contemplated, it is essential to first apply big haircuts to bondholders.

For sovereign debt, the freedom to fail is again key. Significant restructuring is needed for genuine recovery. Yes, markets will punish defaulting states, but they are also quick to forgive. Current plans are destroying the real economies of Europe through elevated taxes and transfers of wealth from ordinary families to the coffers of insolvent states and banks. A restructuring that left a country's debt burden at a manageable level and encouraged a return to growth-oriented policies could lead to a swift return to international debt markets.

This is not just about economics. People feel betrayed. In Ireland, the incoming parties to the new government promised to hold senior bondholders responsible, but under pressure they succumbed, leaving their voters with a sense of disenfranchisement. The elites in Brussels have said that Finland must honor its commitments to its European partners, but Brussels is silent on whether national politicians should honor their commitments to their own voters.

Say what one will about Soini's motives, it's clear that the crony capitalism of Europe's ECB, member country governments and large banks make for easy targets of his criticisms. And I don't think his analysis is flawed. In fact, his emphasis on identifying and closing insolvent institutions precisely echoes the comments of Anna Kagan Schwartz from 2008, on which I posted here.

Yes, his critics will claim, as did defenders of Bernanke's actions, that entire economies were at risk without such interventions.

But I don't believe that was ever true. In no case was a failing entity, whether it be Lehman, GM or Goldman Sachs, unable to be placed into Chapter 11, reorganized, and either spun back out or its remnants sold to surviving competitors or new entrants at market-clearing prices.

Soini is correct when he parrots the capitalist line that failed institutions must be allowed to fail and free up resources for others to use. But because, in Europe, an unholy alliance of banks and fiscally-vulnerable bond-issuing governments had developed, taxpayers were soaked to shore up the private, publicly-held financial sector entities.

While the specific mechanics of the ECB bailouts differ from those of the US due to the dollar being the world's current reserve currency, the basics are not dissimilar.

Entrenched managements were able to cash in on existing ties, business networks and fears of financial and economic turbulence in order to, in most cases, with very few exceptions (Bear Stearns, Lehman, AIG, Merrill Lynch, Wachovia) retain control of their companies and proceed to earn lush, post-bailout profits.

Managements like to identify themselves with the assets their companies control, in order to scare politicians into forgetting about Schumpeterian dynamics.

No matter what the event, when companies are found to have been managed badly, and succumb to some environmental or self-inflicted catastrophe, the valuable parts of such enterprises will still be desired and acquired by some other parties. The parts which failed should have been liquidated anyway. In America, there is a Constitutionally-assured method, bankruptcy, for orderly management of such changes in control and liquidations. Just because the Fed, FDIC and Treasury didn't engage in such invasive rescues did not mean that there were not more prudent and limited steps these various government entities could have taken to stabilize the financial sector and avoid economic depression.

Intervention of the sort conducted by the ECB and the Fed only serve to make ordinary voters and taxpayers sceptical of political-business alliances and cronyism. And create fertile ground in which socialists like Soini and the current US administration can flourish.

Wednesday, May 11, 2011

Continuning Ignorance of Tax Rates & Their Effects On CNBC

House Minority Leader Eric Cantor appeared on CNBC on Tuesday morning. He was at the NYSE, apparently having accompanied John Boehner to the city the previous evening for the Speaker's address to the Economic Club of New York.

Cantor was interpreting and defending Boehner's pointed remark to the effect that a debt limit rise will necessarily include spending cuts of equal or more size, or there won't be a limit increase.

As usual when he appears on SquawkBox, Cantor was subjected to some economic idiocy, but this time, to my regret and shock, it was from Becky Quick.

Quick is a veteran Wall Street Journal reporter of many years, before joining CNBC. But, as are most other CNBC anchors, she is a journalist by training, not an economist.

Still, I know from watching the network's 6-9AM program fairly often that Quick still reads the Journal regularly.

Thus, it is inconceivable that she would have missed the editorials featured in prior posts here, here and here.

Never the less, she assailed Cantor in what may only be called an exasperated tone why the Republicans just refuse to raise taxes, pass bills to enact more taxes, in order to reduce the deficit. She then disingenuously compared that to a family under financial pressure not only cutting its spending, but having the adults take extra jobs to provide more income.

Well, consider those three Journal editorials.

In the first, from last May, David Ranson updated Hauser's Law, reminding readers that, regardless of tax rates, over time, only about 19% of GDP will be paid in taxes. Period.

In the second post, a recent Journal editorial by and Alan Reynolds reiterated Hauser's Law, then added that the non-business component of that 19% is just less than half, or about 8%. He wrote,

"Both individual income taxes and overall federal taxes have long been a surprisingly constant percentage of GDP- 8% and 18%, respectively- regardless of top tax rates on salaries, small business and investors. It follows that the only reliable way to raise real federal revenues over time is to raise real GDP."

Finally, John B. Taylor provided a simple but powerful graph in a recent Journal editorial displaying the differing percentages of GDP that federal spending would require under various alternative budgets recently proposed by the president and House Budget Committee chairman Paul Ryan.

As a responsible media anchor and occasional reporter, one would think Quick is abreast of current, mainstream, published economic findings such as those written in the Journal by Ranson, Reynolds and Taylor. We're not talking an economics journal, but the very mainstream business newspaper The Wall Street Journal.

So, assuming Quick read these pieces, why was she bludgeoning Cantor about raising taxes to collect more revenue, when the first two editorials presented clear evidence that (top) tax rates are irrelevant. It's total tax revenue that matters, which is maximized by lower rates to foster a growing GDP. The tax/GDP ratio is going to max out at 18%, so the only sensible way to raise more government tax revenue is to lower rates in order to induce more economic activity that will raise the denominator, GDP.

Why won't Quick acknowledge the empirical findings which make this so clear? Why does she continue to badger Republicans to raise taxes when she must be reading the same editorials I do which contain empirical evidence that such strategies are pointless?

Ballmer & Kaminsky On Microsoft's Skype Acquisition

Yesterday afternoon, around 12:25PM, I happened to catch the latter part of a live interview on CNBC with Microsoft CEO Steve Ballmer and Skype's CEO. The two CEOs were, of course, talking up their just-announced deal.

I wrote some initial remarks here mid-morning. What I saw that afternoon only reinforced my initial impressions.

First, Ballmer was dancing like crazy to paint all sorts of nebulous introductions of various Microsoft product and service user bases to Skype. That both are all about communications.

Funny- I thought Microsoft was mostly about operating systems, tools like Office, and some hanger-on internet services like XBox, Explorer and Messenger. The latter two of which are free.

Since Windows Messenger already provides video chatting, why would I pay to use Skype now?

Ballmer mentioned Office products and Skype, but, again, every free chat facility with which I am acquainted also allows file transfers and sharing. So, nothing new there, either. And it's already free.

Basically, as I watched Ballmer bluster about how great the deal is, it occurred to me that Microsoft has been a gigantic disappointment under his reign. As it was under his predecessor and buddy, Bill Gates, since 2000.

But there was more. Being CNBC, they didn't allow any tough questions from David Faber, on whose program the interview was hosted, or his colleague, Gary Kaminsky.

Instead, after they cut away from Ballmer's interview, Faber asked Kaminsky for his reaction. It was scathing. Actually along the lines of, but far more blistering than my post yesterday.

Kaminsky ticked off three things he felt made the deal pointless. First, it's small relative to Microsoft's total assets.

Second, He noted that the firm's stock price has fallen roughly 50% under Ballmer's stewardship. And that, during the time, the CEO had cashed in about a billion dollars worth of his own Microsoft shares.

To Kaminsky, the first point meant that, even if it helps Microsoft, the Skype deal won't "move the needle."

The last two points were his way of saying, essentially,

'Hey, we're talking about Ballmer, who hasn't performed  for shareholders yet, and sold a lot of his own stock in the company.'

Personally, I think I would have paid money to see 5 minutes of Kaminskly on air with Ballmer. But, to preserve their access to the Microsoft's burly, combative CEO, you know that CNBC's producers would never allow that to happen.

Tuesday, May 10, 2011

Regarding Microsoft's Purchase of Skype

The big news this morning is Microsoft's purchase of Skype of $8.5B. I just saw a fairly straightforward financial analysis of Skype's return, on current revenues, earnings and volumes, to Microsoft, for the $8.5B investment basis. I believe the ROE was around 3%.

There are dozens of sell-side analysts who are more plugged into the details of Microsoft's and Skype's financials than am I.

Rather, I tend to view these types of transactions from the larger, simpler perspective which I learned many years ago from, I believe, reading Peter Drucker's editorials in the Wall Street Journal back in the 1980s,

'What does the buyer bring to the purchased business besides money?'

I've been listening to various pundits on CNBC and Bloomberg opine all morning long on the stakes, risks and opportunities of this transaction for Skype, Microsoft, Apple, Facebook and Google. The prevailing sentiment seems to be that Google, which was allegedly also interested in Skype, is the biggest potential loser.

Bloomberg had a very interesting exchange between its on-air anchors about half an hour ago discussing this, in which one of them distilled that point to the question,

'Does this deal cause Google to reconsider their strategies, and worry about Microsoft's new acquisition?'

I'd guess it does not. Besides the $8.5B Microsoft brought to Skype, it brings, well, more money for Skype to burn through. One observer noted the internet phone firm was still losing money as of last year.

But the larger issue can be seen in the price chart above for Microsoft and the S&P500 Index since the former's inception. Since its peak during the technology sector bubble in 2000, Microsoft has stalled and declined, while the Index, as we all know, also spent the decade in neutral.

But, as an alleged technology firm, Microsoft should have been doing something over a decade to move its share price. That it did not causes me to contend that its management won't be capable of doing anything material with Skype, either.

A corollary question of Drucker's which I quoted above is to ask why a joint venture or marketing alliance can't or won't do as effective a job as an acquisition, but with less risk?

In this case, I think that's a reasonable and important question. Everything I've heard about supposed Microsoft benefits with Skype could have been accomplished with a closer collaboration effected by some sort of formalized alliance in which Skype received money in exchange for closer product/service integration, or special Microsoft-Skype offerings, and restrictions on Skype's other alliances during the term of the agreement.

That way, if Microsoft valued Skype's management or simply its customer base, it would have easily retained the value of both. However, by acquiring Skype, Microsoft immediately risks the traditional management and organization integration issues that account for the high levels of failures of this sort of transaction.

Just last month, analysts were calling for Ballmer's replacement. Now he's made what I believe is the largest transaction in Microsoft's history. So the guy who couldn't manage what he had, is going to make his firm rocket back into profitably torrid growth with this one magic bullet?

I just don't think so. Not by design, anyway.

Nor do I think it will particularly affect Google, Apple or Facebook, either. In fact, I just saw a note that Microsoft will support Skype on other platforms. So it is damned if it does, aiding competitors, or if it doesn't, potentially losing the customer base it just bought.

Maybe one of the myriad unpredictable multi-media convergences now developing faster than vendors can predict will result in such a windfall for Microsoft. But I think it would be more of an accident than planned.

My own quantitative equity selection process hasn't included Microsoft in a portfolio in well over a decade. I don't think the Skype acquisition will change that any time soon.

Barney Frank Tries To Re-Centralize US Monetary Policy

Perhaps because his party is now in the minority in the House, Barney Frank's latest zany idea for banking regulation change hasn't had much life after its initial splash on the day he released it and did the tour of business cable channels.

Frank's latest bad idea, to use Gerald O'Driscoll's term (from his Wall Street Journal editorial on Frank's bill) is to remove the presidents of the regional Federal Reserve banks from voting on the FOMC. Currently, the FOMC has 12 members- seven Fed governors and 5 presidents of Regional Fed banks, the latter on a rotating basis.

From this design, it's clear that the FOMC is already composed of a majority of federal political appointees. The Regional Fed bank presidents, meant in the original Fed design to prevent another Bank of the United States, are chosen by the boards of those banks. Thus each Fed district has the potential to be independent in its selection of presidents and the nature of its research. Various indices and research traditions are associated with specific Fed regional banks.

Thus, on one level, it's ironic that a member of the more populist political party would now want to essentially remove all populist influence on the FOMC. In today's financial services sector, restricting the FOMC to political appointees is essentially the same, as O'Driscoll contends, as making it an adjunct of the nation's larger banks and brokerages.

How odd that an institution designed to meet the Democrats' original demands to defuse monetary power from Washington and New York should return, full circle, to this point.

Just knowing Barney Frank was co-author of the monstrous Dodd-Frank bill should be enough to ignore his latest folly.

But there's a deeper theme at play. It may have taken one hundred years, but federalism, combined with the nation's larger capital markets players, never really stop in their quest to concentrate monetary authority among themselves.

Call it the Bank of the US, or the Fed, either way, it represents a consolidation that seems unwise at a time when the Fed has returned to fully monetizing the Treasury's record debt, and then some.

Truly an irony, in an era of global finance and evolution to electronically-based, rather than the older, cronyistic style of open outcry floor trading.

Monday, May 09, 2011

BlackRock's Valuation Business

This morning's Wall Street Journal featured an article in the Money & Investing section on BlackRock's valuation business. Referring to it as a "geeky guys" business, the piece actually confused me to some extent.

By way of background, when I was an internal strategy consultant/troubleshooter at Chase Manhattan Bank, working for my late boss and mentor, Gerry Weiss, the bank's market data and tools unit, Interactve Data Corp (IDC) was one of my charges. I spent quite a bit of time helping them grapple with product and market development issues and, later, worked to put down a mutiny led by the unit's head, who told his staff that he would force a sale of the unit to him and private equity backers.

I well recall how the unit's chief administrative officer referred to their bond matrix valuation service,

"Customers have a choice- we're wrong and Merrill Lynch is biased."

The point was not lost on me.

Bond matrices were essentially multifactor valuation models purporting to estimate the value of infrequently-traded securities by comparing their attributes to those of securities with some of the attributes, combining to hopefully predict a reasonable valuation with some connection to more-frequently-traded securities.

IDC didn't own an inventory of the bonds, as Salomon Brothers or Merrill Lynch did, so it wasn't able to provide valuations based on as rich a data set as Merrill. But Merrill Lynch was obviously biased in its valuation, since it was consulting on securities which were probably in its own inventory.

You can instantly see the same issue at BlackRock. And why the Journal article is clearly influenced by BlackRock's unit's head, Rob Goldstein, to emphasize a Chinese wall between his BlackRock Solutions and the asset management portions of the firm.

Gosh, they even have different elevators! Bet that's foolproof, huh?

It was confusing to read that this was supposed to insulate Solutions from "other parts of the firm that could profit from its knowledge," because I would think the reverse is the actual problem. Solutions provides somewhat sterile valuation information for which traders probably have their own preferred approach. But the Solutions staff would undoubtedly benefit from knowing trading information from BlackRock's asset management activity, and the article is silent on this directional information flow.

Getting past that, and the other details meant to reassure Journal readers that BlackRock really did consider this issue years ago, when it was founded as a separate and separable unit, the piece goes on to highlight the sort of dark assignments the unit has received from the Fed, other central banks, pension funds and even commercial banks.

The article also calls Solutions the risk-management division of BlackRock, too.

Risk management is typically more complex, as it seeks to impute the risk of loss to positions, trading desks and/or larger business units. The focus is on the volatility of valuations of the securities in a position or portfolio.

Valuation involves trying to determine a reasonable market value of a security, position or portfolio, when there are infrequently-traded or non-public securities involved.

But, according to the Journal article, these two services are offered from BlackRock Solutions, which earned revenues of $460MM last year, or 5% of the firm's $8.6B total revenues, with 1,850 people. That's revenue of roughly $250K/person. It leaves little room for profit, considering that risk management talent can be fairly expensive.

So if it doesn't make much money absolutely from this unit, why would BlackRock bother with it? The margins may be much higher than those of publicly-held asset managers, but the relative revenue volume is so small as to make that margin rather insignificant.

Well, maybe it has something to do with a point made obliquely in the article.

BlackRock may profess to have erected a Chinese wall inside of the firm. But that has nothing to do with what may happen outside the firm. Consider the following.

Pension funds like Calpers typically retain some of the best hedge funds to manage all or parts of their investment portfolios. The investment committees of those pension funds don't have the skills to do the actual work of daily investment management, nor risk management.

From the Journal piece, we also know that Calpers has retained BlackRock Solutions. It's not a stretch to envision the California pension giant retaining both parts of BlackRock. And perhaps even discussing the Solutions findings and models with BlackRock's own investment arm, as the client has paid for advice from both units.

Such flow of information from the client's portfolios through Solutions would be completely expected. And BlackRock investment managers could easily be privy to Solutions' tools paid for by Calpers.

It's an interesting twist or solution to an old Wall Street problem- how to get clients to pay for activities that don't seem to directly produce revenue for the firm.

If BlackRock used Solutions activities for its own traders/investment managers, it would probably have to absorb the costs as part of its management activities, because such management business is competitively bid.

But by offering valuation and risk management through a separate unit, it can get clients to pay for services, the value of which, if BlackRock also manages money for the same client, it will probably realize for free.

That said, it's useful to consider a larger issue involving asset managers selling auxiliary services such as risk management and valuation to their clients.

BlackRock is a publicly-held asset management firm.

Thus, you don't read of BlackRock in the same articles in which you read about Renaissance, AQR, or the other firms which were the focus of Scott Paterson's book (The Quants) last year. And BlackRock wasn't considered endangered by the financial meltdown of 2008, as it is both publicly-held and, thus, doesn't have huge pools of partner capital bet in a leveraged fashion.

Still, given the movement of people, ideas and technology among various asset management firms of various organizational stripes- private equity, hedge fund, or publicly-held- it's hard to believe that BlackRock's valuation and risk management services would be very much different or better, or for very long, than those of its competitors.

Hedge funds wouldn't bother to sell their own risk management and valuation services to clients, because, well, they don't really consult with their clients on these issues. But we know, from Paterson's work, that at least a few quant hedge funds nearly went out of business due to inadequate risk management and it's apparent poor implementation in trading.

BlackRock won't go out of business due to its own capital losses if its risk management advice is either of poor quality or badly-implemented. Their clients may lose assets, but BlackRock just loses income and, perhaps, clients.

But it's interesting to try to understand how its risk management tools, employed by some of its largest clients, won't contribute to market valuation effects, given how much money the firm manages. Or how its valuation opinions won't, at moments of maximum market stress, also effect markets.

Those effects nearly wiped out a few hedge funds several years ago. Now we learn that a competing asset management giant sells those services to clients, but not at prices that suggest BlackRock even makes much money from the effort. Margins

As its parent is managed by some very intelligent people, one assumes there is substantial value in operating BlackRock Solutions. If it's not in the operating income, where is it?