Saturday, May 21, 2011

Discipline: The Difference Between Amateur Investing & Professional Portfolio Management

I was recently reminded of a key difference between amateur investors and professional portfolio managers.

Several months ago, a former business partner who had failed to perform according to his obligations, obtained equity selection information for last November. Being information, I could not unsend it, and, with his continued failure to perform, I wasn't going to manage his equity investments for free.

As it happened, he had asked me to accept trading authorization for an equity account, which placed me on the firm's list for duplicate confirms and statements. Thus, I was able to observe his attempts at using the November information.

Despite his having been familiar with my portfolio management approach and discipline for over four years, as an amateur, he stumbled badly in his attempt to emulate my management of his portfolio.

First, he dithered for nearly four months before deciding to buy the equities which my process selected in November. Since each portfolio has a six-month duration, this was a significant mistake on his part. But he compounded that error by investing in some, but not all of the equities in the portfolio.

As I reviewed his holdings at the end of April, when the November portfolio would be traded to conform to May's selections, I noted that his account's performance was roughly 10%, or less than half of my November's portfolio's full term gross performance.

Significantly, one of the equities he failed to buy had the second-highest total return in the portfolio. Omitting that equity not only denied its excellent return, but, due to weighting effects, caused him to buy more of the lower-return equities in the portfolio. Only two of the other issues underperformed the S&P, and not by much, whereas the rest of the portfolio widely-outperformed the index since November, resulting in a gross total return nearly twice that of the S&P500 for the period.

I have taken heed of James O'Shaughnessy's advice to quantitatively-oriented portfolio investors that they should adhere to their model, not second-guess it. My former partner and I had discussed this important point often. Thus, I thought he understood the importance of disciplined investing.

But, in the final analysis, his amateur nature was displayed by his inability to practice the discipline of investing according to an approach which he knew would, when followed faithfully, significantly outperform the S&P.

Friday, May 20, 2011

More Idiocy From Jamie Dimon

I heard Bloomberg report this morning that Chase's CEO, Jamie Dimon, was excoriating Congress for taking the national debt limit seriously.

In a commencement speech in Colorado, Dimon castigated Congress for risking default and all that he believes will follow.

But, as I noted in this recent post discussing Stanley Druckenmiller's interview in the Wall Street Journal last weekend, real bond traders have a different view.

Last I looked, Dimon's formative years were spent carrying Sandy Weill's bags for a living. I don't believe Dimon was ever celebrated for running a successful government bond trading operation.

Druckenmiller, on the other hand, is known for successfully trading government debt. And he disagrees completely with Dimon's opinions, dispensed, such as they are, from 20,000 feet.

Ever since I worked closely with the CEO and Chairman at Chase Manhattan Bank, thanks to my mentor, Gerry Weiss, and with his helpful explanations, I learned how often such executives become pompous and self-important, pronouncing on topics about which they actually know little, or nothing, simply because of the title behind their names.

So, who would you believe? Druckenmiller, who's made a career in investing in governments, or Dimon, who's made a career as a financial services apparatchik and bureaucrat?

Citigroup's Board's Appalling Reward of Pandit

Color me stunned as I opened yesterday's Wall Street Journal to learn that Citigroup's board actually awarded its inept CEO, Vikram Pandit, a potentially lush compensation package worth as much as $23MM, so he won't leave!

I actually heard Dick Parsons, Citi's board chairman, say this with a straight face in a noontime interview on CNBC.

Before I go further, take a look at the nearby price chart of several large US financial firms, Citi and the S&P500 Index for the past five years.
Citi is by far the absolute worst performer. There is absolutely no surviving firm which did as poorly, although Morgan Stanley (Pandit's old firm) and BofA were in the running.

Chase, Goldman and Wells Fargo tracked the S&P, ending the period more or less flat.

Missing, of course, are Bear Stearns, Wachovia, WaMu and Merrill Lynch, all of which either failed or were bought as they became insolvent.

Citigroup should have been in this group, with or without Pandit. Since he was CEO when the financial panic hit in the fall of 2008, his naivete, inexperience and general cluelessness were all good reasons to simply put Citi into court-protected reorganization. Deep-pocketed competitors would have gladly scooped up various pieces of the firm, so it's not like it would have literally disappeared, or that all its employees would have been suddenly jobless.

In fact, by letting more experienced, surviving, better-heeled firms buy the remnants of a failed Citigroup, Schumpeterian dynamics would have been playing out along its natural lines.

Instead, we now have sanctimonious Citi chairman Parsons claiming that Pandit did a great job and the board is concerned with his retention. This despite the fact that Pandit and his team haven't yet been able to give the board a clear, firm picture of Citi's normal expected business performance and income statement in the years ahead.

Mike Mayo, a longtime bank analyst, echoed my thoughts when quoted in the Journal article casting doubt on,

"rewarding a CEO whose company's stock has significantly underperformed other large banks during his tenure, and who got an enormous payday with the acquisition of his hedge fund."

It's unclear, besides lots of platitudes, that Pandit has any idea what he's doing. The same goes for Parsons and his board. How can they, in good conscience, squander their shareholders' money like this? Either Parsons is a fool, delusional, or was just plain lying when he spun his fairy tale version of Citi's recent performance on CNBC yesterday afternoon. It's not like there are any firms left stupid enough to try to hire Pandit if he actually left Citicorp.

The Journal piece details that one of the elements of Pandit's compensation is participation in a profit-sharing plan which is cleverly based only on the "core banking unit, without counting the losses at Citi Holdings, the entity holding the assets earmarked for sale. The profit-sharing payments kick in once the core Citicorp banking unit tops $12 billion in pretax profit over the years 2011 and 2012- less than half the level recorded for 2010." That was $20B.

So Parsons' contention that Pandit 'has to perform' is disingenuous. He and his board cronies set the bar so low that a monkey could be in Pandit's job and Citi would still beat the profit-sharing targets. And the bananas would be much cheaper than what Pandit's going to receive for a bank that is essentially on autopilot.

Parsons also hastily put the past behind, probably because he doesn't want anyone to remember that Pandit was paid several hundred million dollars for a hedge fund that subsequently performed so badly that it had to be closed. Even with various stock options and lockups, it's pretty clear that Pandit made tens of millions free and clear from the deal.

From seeing Parsons' performance on CNBC and reading of Pandit's new compensation package, I can't imagine anyone other than market-timing institutional professional investors going near Citi's equity anytime soon.

Thursday, May 19, 2011

The Fading Fortunes of PC Firms

Hewlett-Packard's warning this week as it announced quarterly earnings threw Tuesday's equity markets into the tank at the market's open.

Predictably, a stream of analysts, portfolio managers and other pundits weighed in on HP, how it was different than Dell, whether it had major challenges ahead of it, etc.

I heard various analyses of HP's businesses, including focusing on corporate services.

To me, however, it simply boils down to HP, like Dell and Microsoft, being a company with the bulk of its fortune still tied to personal computers.

This is clear from inspection of the nearby price chart for HP, Dell, Microsoft, Apple and the S&P500 Index from 1990 to the present. The first three firms, which have relied more heavily on conventional personal or business computing for their revenues and profits, have had their stock prices languish or fall over the past decade.

In contrast, Apple, which transformed itself from a mere computer maker to a special-purpose digital device company early in the decade, has significantly outperformed the other three firms.

That is why, in my opinion, unless you are hoping for a near-term timing play on Dell or HP, or even Microsoft, for that matter, you will be disappointed if you buy or hold those equities anymore. They are obviously no longer the firms they once were, either fundamentally or in terms of market appreciation of their performances.

Apple is a very rare firm in its having arisen from near-disaster during the Scully era and been transformed by Jobs upon his return. Dell, HP and Microsoft are unlikely to duplicate that feat. They are, for the most part, firms, the fortunes of which rose meteorically, then plateaued, with the fortunes of the personal computer.

As iPods, iPads and enhanced smartphones increasingly cannibalize functions and activities PCs once dominated, the firms which remain largely defined by the latter are destined to continue to decline. Even having the largest share of the global PC market does HP little good when it has become a commodity business with a comparatively slow growth rate.

Wednesday, May 18, 2011

Jason Zweig's Questionable Home Mortgage Hedging Column

In this past weekend's edition of the Wall Street Journal, Jason Zweig wrote in his The Intelligent Investor column about hedging your home mortgage. I think it may be time for him to change the name of that column.

First, this is hardly a new idea. I've thought about it for decades, as I'm sure have many other intelligent, educated people who've worked in the financial sector. Why would you not consider how to hedge the value of what, for most people, is their largest asset purchase, when it reaches a lofty value?

My own ideas have included simply selling it to someone while simultaneously leasing it back. Zweig's column mentions a few firms that purport to offer value insurance for about 1.5% of value.

Frankly, that's obviously very cheap if you have had to buy into a housing market that's frothy or even merely tight and probably, at least currently, overvalued.

Of course, your home isn't just another asset. You live in it and it's probably the most ill-liquid asset you'll own. If you get a hedge on it wrong, it could have life-altering consequences beyond those of an IRA gone wrong. Plus, for real estate exposure, there are other ways to invest, if that's what you want.

Perhaps you shouldn't buy into overheated markets, and go long on undervalued ones. Simple and effective, without the major risk I'll get to shortly.

Leaving aside the regulatory hurdles, consider the challenge of making this a truly ubiquitous product. That is, consider it while recalling what happened to AIG due to its financial products unit which sold so many derivatives which were meant to function as hedges.

To me, the primary issue is counterparty risk for something so massive. Sure, it may be feasible for someone to offer home value hedging just for Syracuse, New York, as one firm mentioned in Zweig's article does.

But US home ownership is a large chunk of value. I don't have my fingers on the exact number, but it's very large. So ask yourself this.

What exists as a countervailing asset that can be reliably expected to fund a massive drop in US residential real estate values?

These sorts of bets typically come unglued when reality overwhelms prior expectations, resulting in a "black swan" event that transcends stress tests.

We're not talking about real estate values dropping by 3% or 10%. Let's talk 30% and more.

What other US-based asset class will be likely to remain able to pay off a 50% decline in the value of all US residential real estate?

Long ago, during the first great collateralized mortgage frenzy, when Lew Ranieri ran his famous group at Salomon Brothers, I discussed this issue with my boss, Gerry Weiss, SVP of Corporate Planning & Development. He had sent me to a CMO conference in Manhattan, and wanted to debrief me from my two-day experience.

In short, I said that the repackaging of cashflows into CMOs by the fixed-income wizards, who were suspiciously silent on things like 'negative convexity,'  which would affect the duration and value of longer-lived tranches, could not, by themselves, magically eliminate risks of mortgage lending.

In effect, in exchange for a few percentage points of fees to create, sell and service the CMOs, investment banks were simply recutting and spreading existing risk while extracting a fee.

Risk is conserved- it can't be eliminated. It can be hedged, assuming a perfect, reliable counterparty.

Thus, while many unwashed thought the CMO craze made the world safe for mortgage risk, all it really did was pay Wall Street investment banks to allow troubles S&L's to liquefy their damaged mortgage loans while simultaneously allowing investors to more finely select mortgage risks subject to duration and other factors.

So when I read Zweig's piece, the first thing that came to mind was, just who will be a reliable counterparty for a substantial portion of the value of all US residential real estate?

How will that work? What source of asset value will be either unaffected by, or move in opposition to, the value of US residential real estate at a time of huge value reduction of the latter?

Granted, should such a ubiquitous residential real estate hedge become available, it might provide some minor relief for a family which, due to one of the parents' careers, moves every 5-7 years. But that's a steep price for such short-term coverage.

But for the worst case scenario involving residential real estate hedges, beyond holding an instrument that purports to be that hedge, a reliable party with an asset that will perform on that hedge have to both exist amidst an expected turbulent financial and/or economic environment.

It's not the "greatest idea never sold." It's a mirage.

Tuesday, May 17, 2011

Stanley Druckenmiller's Debt Limit/Default Remarks

It has been frustrating reading and listening to so much misinformation and disinformation from crony capitalists and politicians regarding the soon-to-be-reached federal debt limit and the maneuvering between the House Republicans and the administration regarding it.

So I was elated to read this weekend's interview in the Wall Street Journal. Stanley Druckenmiller, the interview's subject, was candid about the debt limit situation. It seems he shares the viewpoints I've articulated on this subject over on my companion political blog.

Druckenmiller distills his view of the situation in these passages from the interview,

"'A financial crisis is surely going to happen as big or bigger than the one we had in 2008 if we continue to behave the way we're behaving," says Stanley Druckenmiller, the legendary investor and onetime fund manager for George Soros. Is this another warning from Wall Street that Congress must immediately raise the federal debt limit to prevent the end of civilization?

No—Mr. Druckenmiller has heard enough of such "clamor and hyperbole." The grave danger he sees is that politicians might give the government authority to borrow beyond the current limit of $14.3 trillion without any conditions to control spending.

"I think technical default would be horrible," he says from the 24th floor of his midtown Manhattan office, "but I don't think it's going to be the end of the world. It's not going to be catastrophic. What's going to be catastrophic is if we don't solve the real problem," meaning Washington's spending addiction.

"Here are your two options: piece of paper number one—let's just call it a 10-year Treasury. So I own this piece of paper. I get an income stream obviously over 10 years . . . and one of my interest payments is going to be delayed, I don't know, six days, eight days, 15 days, but I know I'm going to get it. There's not a doubt in my mind that it's not going to pay, but it's going to be delayed. But in exchange for that, let's suppose I know I'm going to get massive cuts in entitlements and the government is going to get their house in order so my payments seven, eight, nine, 10 years out are much more assured," he says.

Then there's "piece of paper number two," he says, under a scenario in which the debt limit is quickly raised to avoid any possible disruption in payments. "I don't have to wait six, eight, or 10 days for one of my many payments over 10 years. I get it on time. But we're going to continue to pile up trillions of dollars of debt and I may have a Greek situation on my hands in six or seven years. Now as an owner, which piece of paper do I want to own? To me it's a no-brainer. It's piece of paper number one." "

This has been my view for some time. Merely raising the debt limit is to announce that absolutely nothing has changed. It has to be combined with spending cuts, and a slight delay in a few interest payments, if that even occurs, is a small price to pay for the federal government being forced to begin to aggressively cut its out-of-control spending.

Few things are as convincing as empirical evidence, and on that score, Druckenmiller corrects what passes for that, incorrectly, from the mouths of some pundits and politicians,

"Mr. Druckenmiller had already recognized that the government had embarked on a long-term march to financial ruin. So he publicly opposed the hysterical warnings from financial eminences, similar to those we hear today. He recalls that then-Secretary of the Treasury Robert Rubin warned that if the political stand-off forced the government to delay a debt payment, the Treasury bond market would be impaired for 20 years.

"Excuse me? Russia had a real default and two or three years later they had all-time low interest rates," says Mr. Druckenmiller. In the future, he says, "People aren't going to wonder whether 20 years ago we delayed an interest payment for six days. They're going to wonder whether we got our house in order."

Mr. Druckenmiller is puzzled that so many financial commentators see the possible failure to raise the debt ceiling as more serious than the possibility that the government will accumulate too much debt. "I'm just flabbergasted that we're getting all this commentary about catastrophic consequences, including from the chairman of the Federal Reserve, about this situation but none of these guys bothered to write letters or whatever about the real situation which is we're piling up trillions of dollars of debt."

He's particularly puzzled that Mr. Geithner and others keep arguing that spending shouldn't be cut, and yet the White House has ruled out reform of future entitlement liabilities—the one spending category Mr. Druckenmiller says you can cut without any near-term impact on the economy."

On the subject of current interest rates and the bond market, Druckenmiller is refreshingly candid, 

"Some have argued that since investors are still willing to lend to the Treasury at very low rates, the government's financial future can't really be that bad. "Complete nonsense," Mr. Druckenmiller responds. "It's not a free market. It's not a clean market." The Federal Reserve is doing much of the buying of Treasury bonds lately through its "quantitative easing" (QE) program, he points out. "The market isn't saying anything about the future. It's saying there's a phony buyer of $19 billion of Treasurys a week."

Warming to the topic, he asks, "When do you generally get action from governments? When their bond market blows up." But that isn't happening now, he says, because the Fed is "aiding and abetting" the politicians' "reckless behavior." "

Finally, he echoes my own thoughts on Ryan's budget,

"Mr. Druckenmiller says he's "a registered independent" but says he admires New Jersey Gov. Chris Christie for the way he has explained that the state has to reform its benefit plans if it is going to be able to take care of retired government workers. He argues that the same case needs to be made nationally. "We don't have a choice between Paul Ryan's plan and the current plan, because the current plan is a mirage. . . . That money is not going to be there." "

But so long as politicians and crony capitalists pretend current programs and spending can be sustained, we're going to test the real bond markets at some point. And then the result is unlikely to be pretty or painless.

Monday, May 16, 2011

Yahoo's Latest Problem & The Risks of Investing In China

By now the news regarding Yahoo's latest little problem has circulated for days. It's got to be bad news for Carol Bartz, if only because, in the best case, it would seem that she didn't divulge the information publicly for some weeks.

I won't waste a lot of space on the particulars. Basically, for years, Yahoo has been seen as valuable for its investment stake in Alibaba Group, the China-based online firm. The Wall Street Journal noted, in its Friday piece on this story,

"Hedge-fund manager David Einhorn, of Greenlight Capital, earlier this month disclosed a position in Yahoo while expressing interst in the Internet company's China holdings. He argued Yahoo's stake in Alibaba Group could be "ultimately worth Yahoo's entire current market value." "

In this recent post, I noted Einhorn's investment, and how it might actually represent the best exit opportunity that existing Yahoo shareholders were going to see,

"Einhorn has amassed a position in the company's equity and favorably commented on its China properties and recent 'shareholder-friendly' changes.

I'm sure remarks like that from Einhorn send chills through Bartz. Increased equity accumulation, requests for board seats, and a spinoff of Yahoo's Chinese interests can't be far behind, can they?

I suppose since Yahoo's equity price has been flat for so long, Einhorn is getting a bargain. Assuming, that is, his math on breakup values is correct, and he is able to effect that.

What I wonder, however, is how long his investors tend to wait for payoffs in these types of moves? Perhaps the patient, trusting nature of his investors gives Einhorn time to wait for Yahoo/Bartz to eventually come around to accept his type of bear hug.

But fellow hedge fund/company acquirer Eddie Lampert's Sears reported falling sales just the other day. His foray into retail hasn't had such a happy ending yet.

Of course, Einhorn probably doesn't want to run any part of Yahoo, so much as put pieces into play and hopefully make much, much more on the skyrocketing value of the Chinese properties than he will lose on the rest of Yahoo. In that regard, it's likely a safer play.

Assuming he can get the firm split up reasonably soon.

Then, again, I've argued that Bartz should just sell or liquidate the firm. This may be one of the last opportunities for a Yahoo CEO to create some value for shareholders from a position of any strength whatsoever. Maybe Einhorn's interest should be greeted with an accommodating attitude. It may be quite some time before another suitor with such manners comes calling. "
Now, it seems that my chance remarks about Lampert's Sears foray and the risks for Einhorn seem eerily prescient.
Stories differ on when Yahoo's board or CEO was informed of the event that is at the heart of the flap. It seems Alibaba sold its Alipay unit, according to the Journal report,
"to an entity controlled by Alibaba founder and Chief Executive Jack Ma in response to rules issued last year by the People's Bank of China, or PBOC, that could potentially bar foreigners from owning controlling stakes in Chinese Internet-payment services."
Alipay has been described as a Chinese version of PayPal. Most analysts and pundits were aghast that the crown jewel of Alibaba, itself the crown jewel of Yahoo, had been purloined by Ma.
Yahoo says it was notified of this on March 31 of this year, but Alibaba contends they informed Yahoo's board "in July 2009 that the "majority shareholding in Alipay had been transferred into Chinese ownership."
Oh dear. If Alibaba is correct, Bartz and her board learned of the Alipay sale only about six months after she took the reins of Yahoo in January of 2009. That would seem to mean that Yahoo's board and, probably, senior management team failed to disclose a material event affecting the firm's prospects and valuation for well over 18 months.
Even if Bartz' and Yahoo's version is true, they've waited about six weeks to disclose the surprise transaction. Regardless, the Journal article reported that yahoo shares fell some 13% on Friday in response to the news.
The nearby six-month chart of Yahoo's price, as compared with the S&P500 Index, is informative. It took the post-Einhorn stake price rise for Yahoo to match the index's performance, only to crater on the Alipay story. Given Yahoo's troubled history, I wonder if the May price rise was a function of investors deciding to join Einhorn in his play to extract more value from the equity. It would make sense.
Mind you, Yahoo's price was in the $16 range to start, so a 10% gain wouldn't even get it to $18. Prices were in the $17.48 range before it fell last week.
I have no idea what Einhorn's average cost is for the stock, but he must be seething to learn that such a key asset, and evidently the main reason for his Yahoo investment, is gone.
One Journal article suggested Bartz' exit may be imminent. I'd think Einhorn would be considering a lawsuit for the board's non-disclosure of such material information.
Never the less, this little episode nicely showcases the risks of turnaround investing, whether by ordinary retail investors or veteran hedge fund operators like Lampert and Einhorn. Not to mention that even an astute guy like Einhorn may have been too clever by a half when he bought into Yahoo by failing to realize that the management gang that got itself into such valuation straits may have also mismanaged their control over the China crown jewel for which so many investors evidently prized the company's equity. Especially, it would seem, Einhorn himself.
There's a reason why Yahoo's fortunes declined so in the past decade. Thus the risk of owning the shares of this mediocre internet has-been, hoping that something it once did might, amidst all its mistakes, turn out to rescue the company's valuation fortunes.
Then there's the provocative passage at the end of this weekend's edition Heard On The Street column concerning the Yahoo debacle,
"If investors thought Google had a problem in China with censorship, Yahoo just made it look trivial. China represents a huge chunk of Yahoo's value. Shareholders' hopes of realizing that are now in doubt."
I've never bought into the belief that investing directly in China is a good idea. The government and its economic and financial activities are simply too opaque and quixotic. Similarly, I've opined that, so long as this is true, the US dollar has comparatively little to fear from investors selling their greenbacks for Chinese yuan.
This is a classic example of how risky any Chinese investments, whether bricks and mortar, or financial as part-ownership of a business entity, remain.
What is a major issue for Yahoo could snowball, depending upon its resolution, into a turning point for global investors, whether they be businesses seeking to open or expand there, or simply viewing China as an financial investment opportunity.
The combination of the PBOC's unilateral rule which brought on the Alipay "taking" by Jack Ma demonstrates how tenuous outside investor possession of what they think they own in China to be.