BofA Buys Countrywide Financial Corp.

Today's news that BofA is buying crippled mortgage lender Countrywide Financial Corp. for some $4B is the big news in this sector.

Remember that Ken Lewis, BofA CEO, bought a big stake in CFC back in August for $18/share of the mortgage lender.

CFC closed below $8/share yesterday.

Is this an opportune deal for the money center bank?

As the nearby Yahoo-sourced, five-year price chart comparing BofA, CFC and the S&P500 shows, neither company has shown marked outperformance of the S&P in the past five years.

BofA has only matched the index for most of the past five years, recently underperforming. Countrywide stalled for much of the past five years, after an initial outperformance burst in 2003. After that, housing sector weakness began to affect investor confidence in the long-term position of CFC.

As this morning's Wall Street Journal article on the deal observed, BofA is protecting its own interest in the ailing mortgage company. If it were to go bankrupt, BofA's prior investment would become nearly worthless, and Lewis would look especially foolish.

So, basically, what we have is a very large money center bank using its 'cannot fail' position to buy a potentially dead mortgage lender, in which it already has a significant equity position. It is, in essence, borrowing from the Fed/economy, long, to buy an investment before that investment's value goes to nearly zero.

Of course Lewis casts this as a vote of confidence in the long term viability of CFC and mortgage markets. And he's right, given a very long time horizon.

The question is, were Lewis not already an owner of CFC, and at a much higher price, would he be rushing to buy it now? With his own loan losses potentially looming this quarter, and perhaps a need for more capital?

My own opinion is that two mediocre companies do not, generally, when combined, make a better resultant company. I think this is strictly a case of salvaging a soured investment. On that basis, it may make accounting and short-term capital sense for BofA.

But it begs the larger question of whether Lewis used, and will continue to employ, flawed judgment in both buying a stake in CFC at more than double today's price, and running the giant money center bank in the future.

By the way, I don't own any BofA. It doesn't look like I will be buying any for the forseeable future, either.

Alan Schwartz' Big Challenge At Bear Stearns

Yesterday's Wall Street Journal's Money & Investing section featured Alan Schwartz and Bear Stearns in the article "Can New CEO Repair Bear?"

Coincidentally, I heard parts of Schwartz' interview on CNBC that morning, as well. In the interview, Schwartz was careful to avoid saying anything negative whatsoever about his longtime employer. The recent mortgage excesses are 'old news.' They are, according to the new CEO, well-balanced and focused on sustained growth businesses.

To hear Schwartz describe Bear Stearns, you'd think his ascendancy to the CEO position at Bear is business as usual.

However, the Journal asks,

"How would Mr. Schwartz turn around a company, which is now trading at a level below its stockholders' equity?"

How indeed? In a market already roiled by mortgage woes, partially of Bear's own making. Fueled by its chairman, Jim Cayne's, intemperate, self-serving comments last summer that it was the 'worst fixed-income market (he'd) ever seen,' or words to that effect.

Schwartz' initial comments on his plan to revive Bear, as reported in the Journal piece, include,

"exiting from unwanted positions in leverage loans and in mortgages; find new ways to make profits in the changing fixed-income business; and nurture Bear's healthier business units, like its growing international operations and energy unit."

Oh boy. Not one of these avenues out of Bear's mess involves unique strengths or any sort of competitive advantage for the ailing firm.

As I considered the article, the interview, and this post, it occurred to me to ask a simple question about the major, publicly-held US investment banks:

"What, if any, is the key source of competitive advantage for each one?"

What I came up with, off the top of my head, is:

Goldman Sachs: risk management and focused trading expertise

Merrill Lynch: ostensibly broad, valued retail distribution

Morgan Stanley: perhaps a one-time strength in old-line industrial investment banking contacts

Lehman: focused fixed income trading businesses

Bear Stearns: entrepreneurial zeal and nimbleness borne of small size

Given that Bear took mortal body blows to its capital and reputation in 2007, I think it no longer has a competitive advantage. Its prior strength has become its Achilles heel.

Too bad for Alan Schwartz. He seems to be a very competent M&A guy who has been handed an atrociously bad hand in a long-running card game, but without many chips.

Between the currently volatile financial markets, Bear's competitors, and its own badly damaged reputation, involving the two mutual funds from which Cayne tried to absolve any responsibility last year, I'd be disinclined to believe that Bear Stearns has any significant chance of earning consistently superior total returns for its shareholders for years.

It may get a temporary pop in its stock price at some point, if it simply survives for a while. But I don't see a long term basis for its ability to ever justify investment in it for total return performance.

Another Vote For Microsoft's Breakup

Today's Wall Street Journal contained an article by their minority-owned analyst firm, breakingviews.com, echoing my own calls for breaking up Microsoft, entitled "A Microsoft Midlife Crisis?"

I wrote about Microsoft here, here and here, in some cases, quite some time ago, that it would be better for shareholders if it were split into logically consistent pieces: applications, operating systems, online, and gaming.

Now, Steve Rosenbush, Rob Cox and Martin Hutchinson write,

"Microsoft is spending freely because it has been unnerved by the rise of Google. Google has advertising revenue that Microsoft, despite the billions of dollars it has invested in search technology, has been unable to match. This potentially subsidizes Google's practically free offering of software that competes with Microsoft's core products.

So Microsoft is understandably nervous. But overpriced deals won't solve its problems. Microsoft is behind the curve on developing applications such as social networking and advanced search. Its over-engineered products are still too complex. The answer to Microsoft's problems must come from within. Breaking the company into more-manageable parts, instead of adding layers through overpriced shopping, would be a better way forward."

It's nice to have my analytically-based views reinforced by other observers, albeit much later. Granted, I don't typically give the folks at breakingviews much credit for original or controversial thinking. But in this case, I am pleased that somebody else sees the same irrational, inefficient behavior at the Redmond software giant, the same consequences and probably solution.

McDonalds vs. Starbucks- A Marketing Battle You Just Have To Love

Yesterday's Wall Street Journal featured an article on the marketing battle currently brewing (yes, I know- a bad pun) between McDonalds and Starbucks over upscale coffee.

The Journal article displayed a one-year stock price chart for the two companies. I prefer two other timeframes- two and five years.

The nearby two-year chart for McDonalds, Starbucks and the S&P500 Index clearly show Starbuck's recent decline. It was holding flat, even up a bit in mid-2006, then slumped monotonically beginning in October of that year, rising nearly without pause since then.

McDonalds' stock price over the same period is almost directly opposite. Its price was truly flat for mid-late 2006, then took off in September of that year.

The next, five-year price chart for the same entities reveals how Starbuck's decline is a serious departure from its prior, longterm trend. The red curve, depicting the coffee giant's price over time, enjoyed two years of growth which outstripped the S&P in 2003-4, then flattened in 2005-6, and began to fall.

McDonalds have been on a steady upward trajectory over the entire five year period.

With that backdrop, I found the article suggestive that McDonalds is about to take a major piece out of Starbucks' recently-earned volume growth. McDonalds' move into higher-end coffee is the next in a series of revitalizing moves that have turned around the formerly-ailing fast-food giant.

For Starbucks, however, as I've written in prior posts, here, here and here, their expansion strategy has brought new headaches, as they try to buck the natural limits to growth of their business model. To me, it seems a clear indication of Schumpeterian dynamics at work, signaling an end to Starbucks' salad days of growth and total return superiority.

Particularly worrisome, as was also voiced this morning on CNBC, is Howard Schultz' preoccupation with 'returning to the core' of Starbucks. For example, in this passage from his nearly year-ago internal memo, Schultz wrote,

"We desperately need to look into the mirror and realize it's time to get back to the core,"

Thus, this morning's announcement that Schultz forced out his CEO, Jim Donald, and is resuming that title and role at the coffee roasting titan.

However, McDonalds' push into coffee has more to do with raw market opportunity than simply competing with Starbucks. That is, as the Journal article notes,

"The confrontation between Starbucks Corp. and McDonald's Corp. once seemed improbable. Hailing from very different corners of the restaurant world, the two chains have gradually encroached on each other's turf. McDonald's upgraded its drip coffee and its interiors, while Starbucks added drive-through windows and hot breakfast sandwiches.

The growing overlap between the chains shows how convenience has become the dominant force shaping the food-service industry. Consumers who are unwilling to cross the street to get coffee or make a left turn to grab lunch have pushed all food purveyors to adapt the strategies of fast-food chains.

It also shows how the chains' efforts to adapt to a changing market have had drastically different results on their bottom lines. McDonald's is entering the sixth year of a successful turnaround, while Starbucks has begun struggling after years of strong earnings and stock growth.

McDonald's executives watching the growth of Starbucks at the beginning of this decade realized that they were missing out on the fastest-growing parts of the beverage business. Data showed that soda sales had flattened while sales of specialty coffee and smoothies were growing at a double-digit rate outside McDonald's. Customers were buying food at McDonald's, then going to convenience stores to get bottled energy drinks, sports drinks and tea, as well as sodas by Coke competitors."

The fact that McDonalds wasn't originally remotely considered a competitor of Starbucks makes this a fascinating marketing battle. It's like watching a football wide receiver and his defender both leap for a pass, each having an equal 'right' to catch the ball, neither having especially wanted to collide with the other. But the ball is in only one place, so there they all are- the receiver, defender, and the ball.

In this case, it's the fast food and drink consumer, McDonalds and Starbucks. If McDonalds had identified something else, such as upscale desserts, or pizze, or what have you, somebody else might be in their way. Or perhaps nobody.

But as it is, Starbucks moved so far downscale, and reprogrammed so much of America to drink better coffee, that they created a market too tempting for McDonalds to avoid. And Starbucks developed its business model to be perilously close to that of McDonalds, in terms of satisfying instant consumer demands for food and/or drink, but being less efficient in its provision.

Chance are good you can learn to make better coffee more easily than you can instill a new, faster service ethic in your sprawling employee base. For what its worth, I happened to have sampled McDonalds' upscale coffee salons in New Zealand several years ago, and found it every bit as acceptable as Starbucks or, for that matter, Dunkin' Donuts.

In this passage, the Journal piece provides a wonderful insight into how McDonalds used classic, grass roots market research to unearth the opportunity they are developing,

"McDonald's researchers contacted customers of Starbucks and other coffee purveyors and conducted three-hour interviews where they videotaped the customers talking about their coffee-buying habits. The researchers got in the cars of the customers and drove with them to their favorite coffee place, then took them to McDonald's and had them try the espresso drinks.
"There was a surprise factor," says Patrick Roney, a director of U.S. consumer and business insights at McDonald's. "The people who were on the fence...there was an opportunity to get those." "

And McDonalds is using some of its classic strengths- ubiquity and reasonable prices, to move into the upscale coffee product/market, as seen from this passage,

"Heather Pelis, a 19-year-old babysitter from Rayville, Mo., says she didn't like the McDonald's vanilla latte when she tried it. "It was a little syrupy tasting," Ms. Pelis said recently while drinking a drip coffee at a McDonald's in Liberty, Mo. But she says she'd be willing to try another espresso drink because they are cheaper than the caramel macchiatos she buys at Starbucks, and because McDonald's is more conveniently located. The nearest Starbucks is a 30-minute drive from her, she says.

McDonald's franchisees say they think the new coffee drinks will be particularly helpful in drawing young consumers who prefer them to drip coffee. Gary Granader, a Detroit-area McDonald's franchisee, has started seeing groups of teenagers at some of his restaurants after school since he added espresso drinks a year ago. Mr. Thompson says McDonald's also is considering adding some type of music-downloading service at its locations."

Toward the end of the Journal article, it discusses Starbucks' reaction to its current dilemma,

"Starbucks executives have attributed the slowdown in sales growth and store traffic in the U.S. to the weak economy.

Mr. Schultz has said that new competition actually helps Starbucks by expanding the specialty-coffee category. "Those consumers over time are going to trade up," he told investors in November. "They're going to trade up because they are not going to be satisfied with the commoditized experience or the flavor." He has emphasized that Starbucks's baristas, who are instructed to memorize customers' drink orders and make genuine conversation with patrons, will continue to set the chain apart.

But some Starbucks baristas say that the chain's push into food and drive-through service has made that a lot more difficult. Some workers say their managers instruct them to ask customers whether they want a breakfast sandwich with their coffee -- a selling technique that feels unnatural when they know the customer doesn't want one.

"The more and more business they get in the store, the more it seems like another fast-food job," says Joe Tessone, a Chicago barista who has worked at Starbucks for three years."

To me, having followed this building story for nearly a year, Schultz' and Starbucks' logic and expectations are wrong. They expanded into more price-sensitive, lower-income segments, and are now struggling to make that business more constant. But it will be precisely those customers who are vulnerable to McDonalds and Dunkin' Donuts. Further, the changes in its product strategies is causing confusion and morale problems among Starbucks' workforce.

In today's article on Schultz takeover of the CEO spot, they write,

"Mr. Schultz wouldn't specifically address the coming competition from McDonald's but said he will work to make the experience at Starbucks more distinctive. "We have to be able to restore that in a way that significantly differentiates us from everyone else," he said."

Clearly, this makes sense. It's simple, basic marketing- provide a clearly differentiated offering if you have different price points than your competitors. Doing that, however, after having lost the magic, is a pretty tall, or is that venti or grande, order. However, they also quoted from Schultz' recent internal letter to employees,

"Some of Mr. Schultz's objectives stated in the letter, such as "re-igniting the emotional attachment with customers," are so difficult to measure that it may be hard for investors to know whether they are happening."

Maybe it's me, but I don't really want an emotional attachment to my coffee purveyor, when I do buy coffee from a retailer. I guess that's why I've been a Dunkin' Donuts guy up until now. I only buy whole espresso beans from Starbucks, although my children will sometimes ask to buy a drink when I stop to do that.

Of course, I'm only one coffee drinker, albeit a fussy one. The outcome of this battle royale between two retail food giants, Starbucks and McDonalds, with Dunkin' Donuts also roaming the same terrain, will be fun to watch. If you ever wanted to view a classic marketing struggle between two fairly well-matched firms in a clearly-defined market, this is your chance.

Employment Numbers Revisions & Friday's Selloff

Yesterday morning on CNBC, economist Brian Wesbury shed some light on the employment numbers which caused Friday's sharp equity markets selloff.


When discussing the economy for 2008, Wesbury contended that it is in solid shape, with basic employment and incomes growth intact. He cited the Friday number of 18,000 newly employed and agreed that 'we'd all like that to be higher.'


Then he went on to recall that, in August, the same report caused another market selloff when it registered -4,000 new jobs.


However, Wesbury explained, that -4,000 subsequently became adjusted to a positive 90,000. That's some difference.


Wesbury then remarked that low or negative numbers, in the context of this still-growing economy, typically get revised upward at a later date. But we don't hear about these revisions as front page news.


If you recall, after a lackluster, but positive August, the S&P500 Index registered a gain of almost 4%.


Makes you wonder how equities will fare in February, if the January employments numbers are also revised upwards at a later date.

Cable vs. Telephony Valuations

Friday's Wall Street Journal carried a piece by its minority-owned analyst's shop, breakingviews.com. This particular piece involved the assessment of market valuations of cable companies versus those of ATT and Verizon.

Specifically, Robert Cyran and Lauren Silva argued that,

"The phone companies furthest along in their rollouts are pummeling cable groups. Shares of Verizon and AT&T both rose more than 15% in 2007, while shares in Comcast and Charter Communications have fallen 35% and 62%, respectively. This trend isn't over.

Cablevision and Comcast increased their capital-spending plans last quarter. However, the average cable company has a prodigious amount of debt. In the short term, it could be difficult for them to take on much more in order to build better networks. Despite all this, the average cable stock trades at a 30% premium to the big telephone companies, based on estimated 2008 earnings before interest, taxes, depreciation and amortization. This doesn't look right. Cable companies may be overvalued or phone companies undervalued -- either way they should converge over time. Playing that trend again in 2008 is likely to reward investors."

Whenever I read people quibbling or arguing over valuations, a red flag goes up. In this case, note the use of the word 'estimated 2008 earnings.'

Whose estimates?

Essentially, Cyran and Silva complain that cable stocks are probably 30% overvalued (from their prose earlier in the piece), but that, either way, they should converge to a similar multiple as that of ATT and Verizon. Oh, and, by the way, according to the article's numbers, cable is still 'overvalued,' despite a 2007 decline of as much as 60% or 30% in value among selected cable equities.

Maybe I'm wrong, but didn't I read articles in the Journal over the last year concerning Verizon's difficulties in stringing fiber through every town and hamlet? That local regulatory fiefdoms were holding it up for special deals and payments? That it's not the cost or technical aspect of running fiber, per se, that dogs Verizon, but, to put it bluntly, the extortion money the company must pay to every little 'burb that it wants to serve with fiber-optic.

Perhaps, as the piece alleges,

"Installing fiber may be costly, but it enables the phone companies to leapfrog their cable rivals. While expensive to install, fiber is cheaper to operate because many repairs can be done off-site. Verizon claims a saving of around $900 a customer a year. More important, a fiber connection to the home offers a faster Internet service than the cable companies serve up."

But if the local regulatory/payoff issue hasn't been resolved for the long term, I think that could go a long way toward explaining the valuation differences. Cable has been a community staple for decades. It doesn't have to negotiate for access anymore, if it ever did. Maybe that's why the article stated,

"Verizon and AT&T both offer the so-called triple play: phone, television and Internet service. While the big cable guys have about 10 million customers for their phone service, the phone companies are just getting started in video. AT&T has around 250,000 customers and Verizon about one million."

Clearly, the phone companies have a long way to go to reach the same numbers in high-speed access as cable currently has in telephone. Even my father recently switched his telephone to his cable provider.

Additionally, as I recall, DSL is more susceptible to local traffic congestion, by virtue of its loop technology, than is high-speed cable.

It just seems to me that Cyran and Silva paint an incomplete picture of the various bases of competition and consumer choice for high-speed access. The fundamental regulatory and technical aspects of cable and telephony are still quite different.

Might not that, alone, account for valuation differences?

More Drivel From Henry Kaufman

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Joe Kernen's Selection for Businessman of the Year 2007

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

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

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

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

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

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

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

2007 Equity & Options Portfolio Performances

Today is the first day of the 2008 trading year.

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

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

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

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

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

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

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

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

"While there are a variety of methods for weighting and annualizing the various monthly portfolio returns, the overall return for this year, to date, for uniform monthly investments, is in the neighborhood of 70%.

Since call options have downside loss protection, relative to holding equities, and allow for inherent leverage of as much as 20x, they provide much higher returns than the equity approach, while using the same selection process and weightings.

By applying the results of proprietary research into the performance of large-cap equities over time, our portfolios, both equities and options, tend to consistently produce superior returns, relative to the S&P500 and its related options instruments.

Not every month's portfolio achieves the same high returns. But, on balance, already, they've delivered stunningly good performances in one of the most challenging and volatile seven month periods in the equity markets in the last five years."

While we are now primarily focused on investing in the optionized variant of our basic equity strategy, we look to the latter's continued strong performance as an indicator of the basic validity of our equity selection approach.

The reason I mention this here is not to solicit interest in our investment business, because we don't actually seek customers, aside from a few carefully selected, sophisticated investors already known to us.

Rather, we feel that the performance of the investment strategies, particularly their consistently superior performance relative to the S&P500, over time, validates my observations and insights in this blog.

The perspective I take in my commentaries reflects our belief that managing businesses for consistently superior performance is the best way for CEOs and their management teams to reward their shareholders. Thus, the comments I make in this blog are based upon what I have found, through my proprietary research, relates to consistently superior performing firms, in terms of total returns.

And these findings continue to work in today's equity and derivatives markets.

So, today, as 2008 begins, and we reset our portfolio return back to zero, I'm pleased to review a very positive, successful 2007 for our various investment portfolios.

The Mortgage Mess: The Lobbyists' & Legislators' Roles

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

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

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

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

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

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

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

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

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

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

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

S&P500 Index's Best 2007 Total Return Performance: National Varco

I'm pleased to note that, as of today's market open, the best total return performer of 2007 in the S&P500, according to CNBC's Squawkbox program, is National Oil Varco.

Varco is in my current equity portfolio, with a return, since July, of over 34%. For the full year, it looks to have returned in excess of 100%.

This isn't the first time my equity portfolio has held the #1-performing S&P equity for a given year. The portfolio often holds at least one of the top ten performers, by total return, for the S&P in a calendar year.

It's a testament to how important a company's consistently superior performance is to its total return performance. And to how well our selection process works.

Still, Varco isn't our best-performing equity holding this half-year. It doesn't even have the heaviest weight among holdings in my portfolio. Apple is both our best performer of the second half of the year, with a total return of nearly 50%, and the heaviest weight level in the portfolio. MEM Electronic Materials has had a total return of roughly 43% this half-year, with a weighting similar to that of Varco.

It's reassuring to know that our equity portfolio selections and, by extension, our options selections, continue to feature top performers among the S&P500 membership for yet another year.

MBIA & AMBAC: Bond Insurers Went Astray

Among the casualties this year in the fixed income-related financial sector have been two bond insurers, MBIA & AMBAC. Both have become unstable and caused doubt as to their ability to stand behind their obligations due to mortgage-instrument related losses.


As the nearby Yahoo-sourced, six-month price chart of AMBAC, MBIA, and MGIC versus the S&P500 Index shows, all of these bond insurers have seen their stock prices plummet since July of this year. Why have the three firms suddenly lost so much value?

Mortgage Guaranty Insurance Corporation, MGIC for short, obviously came under pressure for its obligations to payoff on bad mortgage loans and related instruments.

But what about MBIA and AMBAC? I guessed that these firms were not originally in the mortgage-related instrument insurance business. Here's what I found when Googling both firms.


MBIA's history, which reads, in part,

1973
Municipal Bond Insurance Association (MBIA) forms. Managed by MISC, MBIA is formed by four major insurance companies: The Aetna Casualty and Surety Company, St. Paul Fire and Marine Insurance Company, Aetna Insurance Company (then part of Connecticut General and now part of CIGNA), and United States Fire Insurance Company, a Crum & Forster Company.

1971
Municipal Issuers Service Corp. (MISC) forms. It becomes the managing agency of the Municipal Bond Insurance Association, which was created in 1973.


AMBAC's site tells us,

1971
American Municipal Bond Assurance Corporation (Ambac) is founded in Milwaukee, Wisconsin as a subsidiary of MGIC Investment Corp. Ambac begins with $6 million in initial capital and receives a AA rating from Standard & Poor's (S&P). Ambac insures its first issue, a $650,000 general obligation bond for The Greater Juneau Borough (Alaska) Medical Arts Building Company. The issue funds construction of a medical arts building and a sewage treatment facility adjacent to the local hospital.

1974
Ambac's first competitor, Municipal Bond Insurance Association (MBIA), formed as a consortium of four major insurance companies, receives a AAA rating from Standard & Poor's.

As I surmised, both were originally municipal bond insurers. Now, as it turns out, a friend's daughter has the opportunity to interview for a municipal finance-related internship, among other choices, at a large investment bank. In order to help her choose from the options available to her, I gave her a description of what actually occurs in the process of financing a municipality's capital requirements.
Doing so reminded me of a key difference between municipal and mortgage bond insurance. Municipalities have a great degree of authority over the generation of income to pay interest on and, ultimately retire their obligations. True, the occasional situation arises, such as Cleveland, New York City, or Orange County, where mismanagement of the city causes solvency issues.

But mortgage insurance is far riskier. Compared to a municipality's ability to tax and raise fees, a mortgage is typically repaid from the borrower's far more risky and volatile personal income stream.

One has to wonder at the wisdom of AMBAC and MBIA jumping into the mushrooming world of mortgage-backed instrument guarantees. I'd be willing to bet that, compared with the sleepier, slower-growing world of municipal obligations, the burgeoning volumes of CDOs with mortgages underpinning them became too tempting for the two municipal bond insurance firms.

It probably seemed relatively simple to them to hire some experienced mortgage bond analysts, leverage their existing operations into the new sector, and watch the new income invigorate their stock prices.

Instead, both AMBAC and MBIA are ending the year down more than 60%.

It seems that financial excess wasn't limited to just the borrowers and lenders. Even the insurers got into the act. No wonder Warren Buffett has chosen this opportune time to enter the municipal bond insurance business- while the two major competitors are reeling from losses in unrelated market segments.

Financial Innovation in VC-Land

This is probably the last post of 2007 you'll read on my blog. I may write a post tomorrow morning, but whether anyone will be in the office reading it is debatable.


For this post, I want to comment on a WSJ article in yesterday's weekend edition on smaller-scale venture capital operators. Peter Thiel, a former CEO of PayPal, runs Founders Fund, a small VC group. For a half million dollar investment in Facebook, he earned a 50 multiple return. According to the article,


"Mr. Thiel, the former CEO of online-payment company PayPal, is making waves in Silicon Valley with an investment strategy that differs significantly from the traditional approach. His company invests only modest amounts of money, sometimes just a few hundred thousand dollars, and focuses on entrepreneurs Mr. Thiel and his partners often know personally. He also takes an uncharacteristically hands-off approach to company management.

Already, the gambit has yielded several potential winners like Facebook."

Could larger, more stolid VC outfits be seeing the end of their days?

The Journal piece further notes,

"The venture-capital world "definitely needs to be shaken up," says the 40-year-old Mr. Thiel, an avowed libertarian who helped bankroll the movie "Thank You for Smoking," a satire about improving the reputation of cigarettes.

His company also reflects how a new type of venture capitalist is emerging, as start-up costs for Internet companies decline sharply. Many start-ups now need a bankroll of no more than a few hundred thousand dollars to get rolling, compared with the millions of dollars required a few years ago."

This sort of development seems to me to demonstrate new product development and evolution in the largely-unchanged VC world of the past few decades. Someone has developed a way to make good returns on VC investments, but leave the companies in the hands, and control, of the founders. Which doubtless is very attractive to the latter, as they seek funding.

As the Journal article reminds us,

"Most traditional VC companies want to invest larger sums, several million dollars, say, for large stakes in start-ups and then exert control over the companies' operations. Some demand "liquidation preferences," or guaranteed returns if companies are sold.

Venture capitalists often can be too quick to fire start-up founders and replace them with professional managers, Mr. Thiel says. He blames a cultural divide: Many VCs "have these very cushy jobs, they get paid a lot," and often can't relate to founders, he says.

With so much money chasing deals in Silicon Valley these days, start-ups can afford to be choosy in picking their financial backers. They are increasingly turning to companies like his that offer less of a "command and control" model, he says.

Mr. Thiel, who based Founders Fund in San Francisco rather than the traditional VC hotspot of Sand Hill Road in suburban Menlo Park, Calif., is structuring deals differently from how traditional venture capitalists do. Significantly, the fund often buys only a 5% or 10% stake in a company and sets up a special class of stock that start-up founders can sell while they are building their companies -- and before venture-capital investors see profits. That way, the thinking goes, the company founders can reap some financial reward and stay motivated to build the company before an IPO or company sale, which can take years."

It sounds like Thiel had found an edge over his longer-lived competitors. By identifying with his target market, he and his colleagues seem to have discovered a non-price competitive advantage. According to the article, other firms are beginning to follow Thiel's lead, albeit slowly.

On the negative side, though, the article reports,

"Mr. Thiel acknowledges his company faced resistance from blue-chip investors when it set out to raise money for its latest, $220 million venture-capital fund. One large institutional investor, who declined to be named, said he was put off by Founders Fund's anti-establishment pitch. Others wonder whether Founders Fund could soon tap out its close-knit network of entrepreneurs and run out of companies to fund."

Still, what matters most is whether Thiel's approach begins to turn a generation of startups in his direction, and simply take them off of the table for larger, more conventional VC groups.

Then, the 'large institutional investors' may not have the luxury of refusing to play ball with Thiel.

With Larry Ellison's dutch auction IPO last week, and Peter Thiel's novel VC approaches, there are signs that even the clubby worlds of investment banking and venture capital might, over time, be shaken up...and down to their core.

The New Financial Excesses & The Old

Last Thursday's Wall Street Journal contained a wonderful article entitled "Wall Street Wizardry Amplified Credit Crisis."

I wasn't going to write about it, until I happened to be riding an exercise bicycle Thursday night, viewing a rerun of that old, rather misleading cinematic faux classic, Oliver Stone's "Wall Street."

Like much of his other semi-historical films, such as Platoon and JFK, Wall Street mixes some truth with a lot of untruths and improbabilities, delivering it with a straight face that causes the uneducated to believe it as whole cloth truth.

In the movie, as you may recall, Charlie Sheen plays the protagonist, Bud Fox, a young, struggling, newly-minted retail stock broker. Michael Douglas is cast as an Ivan Boesky-like arbitrage trader, Gordon Gecko.

In real life, people like Boesky didn't have anything to do with retail brokers. Instead, they focused on using information sources, sometimes illegally, including underwriters or printers, plus a network of others to help pump interest in positions Boesky and his ilk already had built, such as business media, institutional investors and institutional brokers.

Thus, the artificial pairing of Fox and Gecko made for a lusty, action-packed financial thriller which, in reality, never occurred. Boesky did ultimately go to jail for using insider information and manipulating securities prices by 'parking' stock with, I believe, Jeffries & Co.

What got me thinking about this post was how unreal and seemingly needlessly phony Stone's move was. In characterizing the go-go, 'me decade' financial scandals of the '80s, he simplified the stock price manipulations of the arbs in order to make it salable as cinema.

My, though, how truth can be stranger than fiction.

When I finished the Journal's superb post mortem of "Norma," a CDO facilitated by Merrill Lynch, I was totally incredulous that this sort of thing had actually transpired.

Mind you, I believe it. But it makes for incredible reading. Must reading, if you will.

For quite some time, I thought that the CDO and credit crises were largely the result of simple, bad credit risk practices, pumped by ballooning manufacture of the synthetic securities and distribution of them directly to institutional investors.

Not so, according to the Journal account of Norma.

Rather, according to the article, here is an illustrative example of 'worst practices' a la the late '00s.

Merrill recruited 'managers,' such as Corey Ribotsky, a former penny stock brokerage, to buy, assemble and distribute CDOs from Merrill-originated mortgages and derivatives. Norma is one such CDO which the article traces through its life to date.

By reading this article, I lost quite a few false beliefs in the process which has brought Merrill low.

Merrill didn't merely manufacture CDOs full of mortgages directly to bona fide institutional investors. Instead, they found and orchestrated the 'management' of CDOs full of their mortgages, and associated credit derivatives, by intermediary firms. These firms, such as Mr. Ribotsky's N.I.R., then held the resulting CDO, assembled with help from Merrill. Merrill then found buyers for NIR's CDO.

While NIR was not an SIV in the classic sense, it functioned like one. That is, while funded by buyers of Norma's debt, i.e., the ultimate investors, and wholly off Merrill's balance sheet, it was, nonetheless, wholly a creation of Merrill Lynch.

Norma, the CDO, didn't just contain mortgages. Instead, for reasons best left to readers of the Journal article to learn, it also contained credit derivatives, a sort of insurance policy/bet on mortgage defaults.

Then, later CDOs would use some of the more risky, or toxic, tranches of earlier CDOs. And so on.

What is particularly informative in the piece, and was news to me, is that, by virtue of the use of credit derivatives, CDOs became abundant due to the inclusion of many 'bets' on mortgage rates and defaults.

In essence, then, this allows us to now realize, clearly, why the financial mess of complex credit instrument valuations is quite distinct from the simple, underlying issue of basic home mortgage defaults. The volume of CDOs is far in excess of the value of underlying mortgage loans.

Way back in the 1980s, when my boss, Chase Manhattan Bank SVP Gerry Weiss, sent me to a CMO conference filled with S&L executives, I gleaned a related insight. Upon my return, I debriefed Gerry on what I had learned. The concept of securitizing mortgages to spread risk made sense, I said, so long as the true risk spreading value exceeded the haircut that Morgan Stanley, Salomon, Kidder and Merrill were taking on the business. I speculated that one could endlessly add layers of paper resecuritization to the process, merely massaging risk around, to not greater systemic benefit, but for additional financial fees.

This is, in essence, precisely what has occurred. By mixing in insurance contracts on mortgages, the credit derivatives, securitizers expanded the supply of CDOs far in excess of the underlying mortgage values. It is very much the same as writing naked call options. Anyone can do it, and the outstanding call options on an equity can, at any one time, far exceed the actual shares outstanding.

Thus, when we discuss the basic issues of mortgage defaults, bailouts, and losses thereof, we need to not count any values beyond the basic, first-tier mortgages.

To include CDOs is to begin to double, triple, and perhaps even quadruple count losses. Further, once these CDOs left the simple mortgage content, and became betting instruments, they ceased to really be related to the home ownership issue, and simply became new ways for institutional investors to make market bets on something.

For purposes of regulatory and political involvement in the recent, and ongoing, credit situation, one must, as a result of this piece, distinguish the basic mortgage origination situation from downstream packaging and distribution of securities which contain, but are not limited to, and exist in greater volumes than, the underlying mortgage loans.

To me, from a careful read of the Journal's fine article, one thing remains eminently clear to me- as it has from the beginning of my writing on SIVs and the credit 'crisis.'

Institutional and, if affected, retail investors received what they deserved. Given the incredible complexity, opaqueness, and suspicious provenance of these CDOs, anyone who bought them either: was too naive and inept to be doing so, and/or; thought they were getting 'free' return without commensurate risk.

No amount of regulation or legislation will ever limit the boundlessly creative types on Wall Street from dreaming up new, unregulated ways of packing and selling financial assets and risk to greedy, naive investors.

Wither Goldman Sachs?

In this recent post, I noted that Goldman Sachs is currently the 'class of the class' among US publicly-held large financial service firms.

Nearby is one of the charts I used in that post. If you were to strip away the other banks, Goldman's consistently superior performance would be more obvious.

From my records, it appears that Goldman first entered our equity portfolios a year ago, in January of 2006. Generally speaking, companies don't appear in our portfolios for more than a few years.

From a Schumpeterian perspective, firms typically fall from consistently superior performance after a rather definable time period.

That said, I don't believe Goldman will continue its enviable streak of consistently superior total return performance for too much longer. Perhaps another 18 months.

What will eventually bring GS back to earth?

Looking back to other great firms which eventually became simply average, such as Microsoft, Home Depot, Kohls, Compaq, Dell and Pulte Homes, one or more of four forces usually do the job.

First, natural market saturation can simply bring a firm's business model to a halt. To some extent, that became true of Home Depot, Pulte and Microsoft.

Closely related to this is competitive action. When a firm is consistently superior for too long, it becomes an easy target for one or more competitors to take advantage of the former's business model and exploit weaknesses, or evolving consumer preferences. Again, Microsoft partially fell victim to this force, as did Dell.

Third, regulatory attention can end a consistently superior streak, too. Wal-Mart has encountered some of this, as well as the other two forces. So has Microsoft.

And, fourth, the market simply accepts the firm's stellar performance, and expects it. This effectively destroys consistently superior performance, by pricing it into the stock, and depressing gains back to the index, or lower. Even sell-side analysts eventually wake up to a firm's consistently superior performance after about a decade.

My guess is that Goldman will face a sort of market saturation/push-back, coupled with some nuanced competitive reactions. And, then, the rising expectations among sell-side analysts that the firm will power through various problems, and maintain its performance. Once this happens, the stock's price will reflect expected continued good performance, and end the run of outperformance.

As I described Goldman's diverse business activities to a friend the other day, she quickly observed how many conflicts the firm has created with its proprietary trading operations and various underwriting and advisory businesses.

Already, it has drawn fire publicly from economist/actor Ben Stein. He wrote a New York Times editorial excoriating the firm's chief economist for having allowed the firm to underwrite so much mortgage securitization earlier this year, while privately forecasting a bear market for the instruments.

But, really, everyone knows this is Goldman's game. Stein, while perhaps technically correct, appeared naive by writing that piece.

It's no accident that Goldman publishes its equity recommendations. How better to make sure the rest of the market piles in and drives up the prices of its holdings?

I think eventually various customers/counterparties of Goldman Sachs will begin to back away from the firm, sensing they are being used and abused. Calling into question Goldman's commitment to doing the best for the customer will, I think, eventually curb its growth.

They seem pretty well-managed with respect to risk. But growth may be a different story, as the firm's profile continues to remain so high. With their CEO, Blankfein, earning north of $50MM two years running, and the firm's relatively unblemished performance, counterparties realize they are paying for these phenomena.

Perhaps one other investment banking firm will eschew so much proprietary trading, in order to earn more market share in underwriting.

Or, given that underwriting is really a commodity business, perhaps enough competitors will attract Goldman alumni that its trading approaches will be cloned, depressing the margins earned by proprietary trading among all competitors.

With John Thain running Merrill now, it could easily become a viable competitor to Goldman in a few years. I had a spirited debate last night with an ex-Merrill friend. I contend that Thain will get rid of the retail brokerage business, while my friend heatedly disagreed. But in Merrill, Thain has the perfect vehicle on which to build a newer version of Goldman, keeping what he liked about his alma mater, and changing what he thinks could be improved.

Between Blackstone, a new Merrill, and customer caution regarding Goldman's self-interested conflicts with so many of its customers, I think the next two years will see Goldman's business growth attenuate.

Add to that analysts' expectations, and Goldman's run as the single consistently superior total return performer among US large financial entities is likely to end within the next two years.

Finance Parable

With Christmas Day past, and just 2 1/2 slow, thinly traded market days left this year, I'm back at posting in my blog. I hope you enjoyed the Christmas holiday, and are looking forward to the new year.

Wednesday's Wall Street Journal carried a piece by their affiliate, breakingviews.com, comparing this year's various financial firm follies to a biblical parable involving 10 virgins.



The gist of the column, by one Hugo Dixon, is that, in contrast to the bible story, in which the foolish virgins paid consequences for their mistakes, in the financial version, Chuck Prince and Stan O'Neal left with their pensions intact. Other firms, Northern Rock and Fannie Mae, were either bailed out or left intact, with the assumption that the latter will, if need be, be rescued by the Federal Government.

Hedge funds which took 20% of many years of lush profits from their customers didn't share in this year's losses.

Dixon's point, in his closing sentence, is



"In this financial version, all 10 virgins are invited. The bridegroom looks around the room and scratches his head. Which are the real fools?"



If you ask me, it wasn't the '5 wise virgins,' who, according to Dixon, managed themselves prudently.

No, it would be the shareholders in the unwise virgins.

Whatever loss of options premium we incurred from one position in Merrill Lynch was more than offset by several profitable Goldman Sachs call options this year.

Our overall returns so dwarf any losses from cheaper money that we really weren't hurt by Fed easing, either.

I can't speak as a shareholder of Citigroup, but, from the outside, I'd be thinking twice about leaving my investment in the hands of that board. Same with Merrill, for that matter.

It's not the CEOs of these firms, as much as their boards, that ultimately have been unwise. Prince and O'Neal were each performing inconsistently, or simply poorly, for some years before 2007, as I've noted in prior posts about each of their erstwhile firms.

It's misleading to blame them, when they just worked the system in which they played. Their boards failed to ask about risk, tolerated mediocrity, and paid too well for failure. Is that Prince's or O'Neal's fault?

You, or I, might not like the fact that the two deposed CEOs walked away with so much money. But that's their board's fault.

The best way to discipline or punish those boards is to not buy, or sell, the shares of those companies. You can't change the boards, per se. But you can certainly find better firms, with better boards, in which to invest.

Meanwhile, both Merrill and Citigroup continue to limp along with ailing stock prices, as depicted in the nearby, one-year price chart comparing the two companies' shares with the S&P500 Index.

You could take a chance on their new CEOs, and hope you are buying at a bottom. Maybe each will claw back some of the 2007 40% loss in the coming year, or later. Maybe not.

It's a pretty big risk to bet enough on just these two damaged firms to make it worth your while if either one recovers. And then there are opportunity costs for those investments.

As I mentioned earlier, I'd skip them, with their inept boards, and look at better-performing companies first.

That's Not Possible

This morning, after playing squash, my business partner and I were discussing recent equity and options markets performances.

My website, linked to this blog, provides weekly performance information on the equity portfolio strategy which I run. A chart of monthly gross returns for this year, to date, appears nearby.

As of last Friday, 21 December, the portfolio has realized a 35% return, versus the S&P500's 4.7%, yielding a performance margin for my portfolio of 30.3 percentage points.

When my partner's son related this to some clients of his in one of Deutsche Bank's trading operations, I am told they simply refused to believe this.

Maybe they viewed the rest of the performance information, including the prior year performances of the portfolio's approach, dating back to 1990. Maybe not.

I'm not totally surprised at their reaction, though. I've heard it so often before.

Those who can't do, evidently, simply deny. Especially when the approach differs so radically from that of the critic.

In contrast to institutional traders, we invest in equities for six-month durations. Our options positions are bought and held up to a six-month duration, with sales occurring at return levels established via proprietary options performance research.

It must be difficult, indeed, for institutional equities and derivatives traders to imagine making our returns on simple, unhedged equity and options positions over such timeframes.

If the equity portfolio performance was unbelievable, imagine how my partner's son's clients would have reacted, had they seen our performance data on our options implementation of the same equity strategy. The nearby table is taken from last Friday's closing performance, covering the six active portfolios.

Prior to these six, our May options portfolio had a 41.5% gross return, and June's was 77.6%.

While there are a variety of methods for weighting and annualizing the various monthly portfolio returns, the overall return for this year, to date, for uniform monthly investments, is in the neighborhood of 70%.

Since call options have downside loss protection, relative to holding equities, and allow for inherent leverage of as much as 20x, they provide much higher returns than the equity approach, while using the same selection process and weightings.

Three of the current options portfolios' daily performance charts are included nearby- December, November and September.

The blue curves represent the performance of the options as purchased, without any management. The red curve depicts the performance of a similarly dated and priced, relative to the money, S&P500 call option. No value exists past November, since Yahoo discontinued free index options tracking near the end of that month. The green curve represents the actual performance of our portfolios resulting from sales of call options at pre-determined points throughout the portfolios' durations.

As good as our equity returns have been this year, our options returns have been even better.

By applying the results of proprietary research into the performance of large-cap equities over time, our portfolios, both equities and options, tend to consistently produce superior returns, relative to the S&P500 and its related options instruments.

Not every month's portfolio achieves the same high returns. But, on balance, already, they've delivered stunningly good performances in one of the most challenging and volatile seven month periods in the equity markets in the last five years.

It's been an above-average year for our equity portfolio in terms of the level of outperformance of the S&P500, though not in the mere occurrence of this outperformance.

Our options portfolios, which have been live since May of this year, have met our expectations, considering market conditions.

Are these levels of performance possible? We believe so, because we have experienced them in live investing, including equity portfolios as far back as 1997.

Originally, I began this blog as a way of expressing opinions and analysis about current business topics from the viewpoint of our equity strategy. My partner felt that having a body of written observations and analysis which reflected my proprietary research findings would make it easier to attract equity investments to our portfolio management efforts.

As such, the success of our equity strategy gives us cause to feel that our perspectives on investing and business management are validated.

Others may not believe our live investment results, because they simply cannot imagine strategies which, while simple, rest on quantitative expressions of powerful insights into equity and options performances. More often than not, I think, criticism stems from envy, lack of comprehension, and lack of creativity on the part of the critics. It's easier to simply dismiss what you can't understand, or didn't think of first, than to accept it.

Fortunately, though, in the institutional investment field, most managers will stick with their own underperforming approaches, rather than accept that another approach yields superior returns. And, since our options approach provides return levels which reduce our need for other customers, we don't need to waste a lot of time convincing people that what we do works.

Instead, we now simply treat it as a proprietary approach for proprietary capital.