Wednesday, January 25, 2006

Throwing in the Towel

When Georgia Pacific's Chairman Pete Correll oversaw the sale of this venerable company to the Koch family (prounounced "Kock"), some mystifying questions remain unanswered as to what one should infer from the sale itself, and what Mr Correll meant in his comments surrounding the transaction. Apparently it seems, Mr Correll chose to sell due to increasing frustration over the markets' rating of his comapny's shares. The FT of London quoted him as saying: "The credibility of CEO's in this country is at an all-time low and we're spending a lot of time trying to convince the world that we are doing the right thing."

The first thing that went thorugh my head upon reading this quote was Sheryl Crow sadly pining with an accompanying pedal steel guitar ... "No one said it would be easy......No one said it would be this hard....". To be fair to Mr Correll, he ONLY took down USD$4,188,000 in cash compensation last year which really is a paltry sum compared to CEO's of other public companies of similar size so he may have reason to be bitter. And perhaps his board turned turn his request for a gross-up. Although this may have been a hidden agenda, it was not his stated reason for (seeking?), agreeing, and awarding the venerable Georgia Pacific Corp. to the rabidly conservative Kock (sic?) family.

No. His stated reasons were (to paraphrase him): (1) my stock price is not high enough (2) too much of my chiefly time is spent trying to get it up (the stock price, that is), and (3) no one seems to believe in me or have confidence in my decisions. My questions are: (a) Do the Koch's know something the rest of the world doesn't? (b) is one in the hand worth two in bush? (c) is there not something strange in Mr Correll's very quick agreement to the bid, and stated intention to lead the company on behalf of the Koch's after the deal closes? It seems that my "questions" relate roughly in order to Mr Correll's reasons, but they clearly merit some more detail than that.

First, Mr Correll opined, "My share price is too low". My initial thought to this was that maybe he's in the wrong business. Maybe his eye for value is so good, he should be a portfolio manager, since the difference between "too little" and "too much" seeems a paltry sum. But upon closer examination, with GP at approx. 1.4x book, 5.2x 12-month trailing cash flow, 9x trailing free cash flow, and 6.5x trailing ev/ebitda, it's hard to argue that he's wrong (about it being cheap) or that his "frustration" unwarranted. On the other hand, GP has lots of debt, and it's cost of capital is high, while it's returns are low relative to assets. And I've certainly seen better balance sheets. With their BB+ rating, and an avg 250bp spread to US Treasury's on more than $9bn of indebtedness, it sucks up a lot of EBITDA, and raises dramtically raises cost of funds. As a result, many would categorize it as a destroyer of value in the Stern-Stewart sense. But then again, modernity has blessed GP shareholders with the near-perfect capital structure for our times where inflation is increasing, assets are dear (and becoming dearer!), and paper (cash in particular) is duff. So rather than whining about the market valuation, he had the perfect stump speech to give to investors in order to continue talking it up: lots of assets with lots of debt and lots of present and future cash flow - including the "free kind", after creditors have been satiated, that is.

But what if it IS low. So what? Well if you believe Mr. Correll, the market is wrong and therefore inefficient. But THAT is neither Mr Correll's fault nor problem (unless he can convince the Johnson Family to up Fido's stake from a paltry 3% to the 15% that is similar to things they like. IF THAT is his problem, then he best be tuning up his stump speech to include things like "the short run vs. the long run", "the investment horizon of the typical GP project (10yrs) versus the typical institutional stock market investment horizon (of 2 quarters)". He can also talk about "price-making" versus "price taking". He can also talk about how chaos would reign, and capitalism would be disintegrate if management were really measured quarter-to-quarter. Finally, he could speak of patience, Warren Buffett, Joe Steinberg, and how investors should be emulating these giants by beating their own path - especially where the assets are good, and the business is sound.

But what if you believe the market (which by the way one ignores at their peril IMHO)? Maybe it's cheap for a reason, and should be cheap and thus the current price is "fair-value". Maybe 'ol Joe is just "talkin' his own book"? Asbestos, loadsa' debt, poor returns however they're measured, management who can't seem to decide whether its a buyer or seller of assets. Maybe, at 250bp's over, it's the debt that's attractive, not the equity? Maybe, the market is saying that the housing boom is over with direct consequences for building materials, or maybe pulp prices will rise, or deflation is just around the corner which will wreak havoc with leveraged balance sheets everywhere. In such a situation, GP may not only be fairly-valued, but over-valued, from the perspective of the shareholder. All quite plausible, the answer which we'll find out in a few years time.

What's an investor to believe? Joe says $35 is "too cheap", so cheap that he is despondent and his secretary has to hide all the sharp objects in order to keep tragedy at bay. But $47 (the bid price) is "too much". And we can infer that it's "too much" because as fiduciary on behalf of shareholders, he's willing to rapidly and unequivocally "hit the bid". One has no other choice to conclude then that it must be unequivocally too much, such that (1) he is unable to wring further savings or efficiencies out of the company; (2) he thinks margins are as fat as they can get (3) he cannot foresee higher end-prices for tissues, paperboard, or building materials (4) he cannot foresee or envision a probable scenario for growth of GP's mainlines (5) he thinks the capital structure of the company is a liability rather than an asset. Yet despite any or all of these possibilities, no one is forcing a sale. Maybe Joe has confused investors' frustration with the viccissitudes and variability of Mr Market with disappointment in the company and it's chairman (i.e. himself)? Or perhaps it's just a self-esteem problem?

Yet the Koch's are keen. That's precisely what makes a market. Willing buyers and sellers at a price. But one would be foregiven for asking the question: What do the successful owners of America's largest private enterprise know that Joe Correll, the market and "the world" for that matter doesn't? It would be worth meditating upon this question if for no other reason than the Koch's are the owners of the largest private business in America, and you/I/we, are not. And one doesn't arrive (and stay) in this position with some amount of shrewdness (not to mention political campaign contributions and some good tax accountants).

The Kochs, you see, own assets (first and foremost energy & petrochemical). Effectively, their enterprise works like this: They earn paper dollars from the cash flow of their existing assets in excess of the rate of interest on their debt and then use the surplus generated to borrow more money in order to buy more assets. And so on. In the 1920s they called it pyramiding. (And it worked, until 1929).

Like the Kocks, GP owns large amounts of assets. They also have copious amounts of debt though quite sufficient cash flow to service it, and also provide a respectable return for shareholders (though not enough it would seem by shareholders approval of the sale). GP shareholders owned the assets. And Joe Correll, as Chairman and CEO was supposed to be protecting the interests of GP shareholders.

Back to the Kochs. They like swapping depreciating paper (other people's money) for other peoples' hard assets. They are willing to do so at a premium to what the market thinks the current price should be - particularly in "out-of-favor" industries. Mr Correll must therefore believe that shareholders will be better off with paper today (cash) at a slightly higher price, than with the assets (and their cashflow) tomorrow. In other words, "one-point-five (1.5x) in hand" (the proposed takeout multiple) is worth 2-point-something (2.0x) or more in the bush".

Interestingly, Mr Correll will be "chaperoning" these assets to their new owners out of some [altruistic?] responsibility to employees and the new owners. A cynic might suggest that he's been double dealing, not to mention double dipping (golden parachute severance + golden handshake in one deal!) though an honest midwesterner would say it can't possibly be for the upside that the new owners might afford him, since as CEO has has obviously wrung as much value for existing shareholders out of the company as was possible. For if there was more to wring, then he wouldn't (or shouldn't) be selling it to the Kochs at that price since this would have breached his fiduciary duties, not to mention shone a light on his failure as CEO.

It's all rather puzzling. One day, maybe Mr Correll will publish his memoirs and learn "the inside story". On second thought, we should hope he spares potential readers honor. But the nagging question remains: The Kocks are paying above market so they must be bullish right? The real question, is: bullish on what? It might be bullish on economies of scale (but they are a minnow in GP's industry by comparison). Or they might be bullish on the economy...more bullish than Mr Correll and his shareholders. Perhaps, however, there is a third and more interesting reason. Perhaps, given their good republican credentials, and their close relationship with the Bush family and his administration, the Kochs are bullish on continued deficits and monetization thereof, and loose monetary policy to insure there aren't any nasty surprises. There is an old saying "Neither a borrower nor a lender be..." But this was obviously truncated from the original which continued "...unless one has reliable information on the future course of fiscal and monetary policy in which case you should back up the truck and lever up."

Monday, January 23, 2006


Livedoor foudner and momentary celebrtiy Takefumi Horie has been remanded in custody by Japanese authorities, along with cohorts Ryoji Miyauchi, Osanari Nakamura and Fumito Okamoto. Former Livedoor executive, Hideaki Noguchi, would probably have joined them had he not committed suicide last week. All rather bizarre and macabre. Should we be surprised? And what should we think of the Japanese market following these events?

Given the choice between investing with "celebrities" such as Mr Horie, and what I might call the silent substance of the Ian Cumming & Joseph Steinberg variety (Leucadia National), I would chose the latter. This is not because I am hostile towards (or jealous of) celebrity-ism, but simply because the I believe that real profits are most effectively pursued quietly and diligently so as to not attract undue attention, parasitic hangers-on, or the wrath of jealous folk, regulators, etc. Celebrity does have its usefulness in business (free media coverage, development of larger-than-life reputations, obtaining finance etc.), but I believe that it's practical limitations outweigh them.

These are not theoretical comments. I have never, it must be said, owned a share of Livedoor, it's frighteningly-monikered predecessor, "Livin'On The Edge" or any of it's affiliates, nor have I ever been tempted to do so in the slightest way. I have never understood why their business or method of business agglomeration should make money commensurate with their price, and so always saw it as dramtically over-valued. The combination of which typically makes me ignore it completely or, perhaps, look for a placce to short it. Call me "old-fashioned", but why-oh-why would any sensibly minded investor contemplate ownership of a company calling itself "Livin on the Edge"? I thought this was precisely what companies and investors were looking to avoid! Unless of course you are Kurt Cobain, and we all know what happen to him (though I must admit that after seeing the laughable antics of Courtney Love, his demise may have been related).

I have some sympathy for Mr Horie insofar as I myself was once rebellious too. Like Horie, I spat at authority and "the establishment". My path took me through youthful encounters of street demonstrations, Marxist economics and politics before settling upon a more balanced path of enlightened self-interest (as opposed to the unmitigated, unrepentant selfishness of Ann Rand). For Mr Horie (and his contemporaries), Japanese corporatism and society is incredibly stifling to someone creative and youthfully-energetic. But even a rebel would be wise to learn that there is wisdom and there is foolishness when it comes to choosing one's battles. And this would be especially true for someone living on the edge (or over the edge as it now appears) of that grey line between right and wrong, and legal and illegal. "Don't break the law when you're breaking the law", a mentor once advised me, and Mr Horie would have been wise to contemplate it. That is just prudence. But taking everything together - his abashed greed, irreverance, desire for celebrity based upon ostensibly shaky business foundations leads me NOT to compare him with Icarus, but rather with Roy. Roy the replicant, of Blade Runner fame, that is. Why Roy? Because Roy was the best, most brilliant, and strong, of all the replicants that Dr Tyrrell had designed and manufactured. He was the prodigal son. Yet, immortality was out of Roy's grasp and not an option. Roy demanded to meet his maker and demand an explanation as to "Why" to which Dr Tyrrell replied "Roy...the light that shines twice as bright burns for half as long...."

But should we infer something more from this affair? The stock market in Japan has expanded dramatically in the past half-decade. There are nearly 4000 listings now, up from approximately 3000 in the late 1990's. This is even greater when one considers that number of mergers, bankruptcies, delistings. Like Mr. Horie, many of these newly listed companies are perceived as representing "new japan". Creative, energetic, growth-oriented, iconoclastic unlike the stifling old consensus-built corporatocracies that were emblematic of Japan's post-WWII economic might. Investors and speculators alike have sought out these companies and pinned blue ribbons upon many in the form of vastly inflated share prices making them, in aggregate, extremely over-valued by any normal and conventional metric - even taking into account their perceived (and likely) growth potential.

Warren Buffet is often ridiculed for his dinosaur-like approach to evaluating and valuing growth and new businesses. His definition of growth is parochial: it must be tangible and not ephemeral. It must near or present, rather than distant. Even then, he will not pay over the odds for growth potential. This may be open to criticism, but since Berkshire is primarily HIS money, he has earned the luxury. This may seem flippant, but it highlights an important distinction: there are few principals investing their own money at these prices in this new gaggle of emergent growth companies in Japan. There are indeed Japanese domestic speculators risking borrowed funds in a desparate, frenzied, day-trading attempt to strike it rich. And there are agents - money managers (I hesitate to use the word investor) who will risk a dollar of someone else's money on an over-valued new idea for reasons that less-than-fiducariary. And then there are game players who are attempting take advantage of structural SNAFU's to [temporarily] profit. These include small floats, limited marginability, limited short-selling, low liquidity, and possible but unlikely growth scenarios that give an investment manager "plausible deniability" when justifying to overseers precisely why he is holding a 5% position Piece-o-shite Co. Ltd and why he has bought more of it for his growth, value, and hedge funds alike - at higher and higher prices.

In 2000 and 2001, there was a substantial wash-out in both expectations and prices that left many such neophyte listings trading at pennies on the dollar, and their shareholders, subtantially poorer. Most of the companies survived and many have grown admirably. I am less bearish on the companies thesmelves than I am about investor expectations in respect of these companies and the prices of the share of such companies. To the prudent, Livedoor should mark the point at which the liquidity and internet bubble #2 took it's first hit. It's effect may be short-lived and specific to internet companies since it may be viewed as idiosyncratic since fraud and criminal activity often is. But the wise will use any subsequent positive reaction to bail on any like exposure. For the next shot will be more substantive and will probably reflect a failure in reality, of certain expectations that up until now have been inflated with hope and liquidity, to live up to their billing.

Thursday, January 19, 2006

Saved By the Bell

A Google Picture Search for "Saved by the Bell" surprisingly reveals smiling actors with bleached teeth, rather than the boxing metaphor that I myself would have associated with it. By most accounts, "Saved by the Bell" was a shockingly bad American TV sitcom that should have stayed down for the count, but ran more than a few seasons too many.

It is the boxing metaphor, however, that is appropos with respect to the errr .... "hiccup" on the Tokyo Stock Exchange that led to yesterday's early halt of trading. For the mini-panic was apparently caused by a classic margin-puke or cascade of margin sales due to speculators requirement to "sell position to make position" or meet margin calls resulting from mark-to-market losses on collateral. Such is the danger of leverage, and speculation, in combination with dubious underlying value of securities, electronic execution, sell-stops as a risk-management tool, few non-speculative purchasers of securities traded, and high degree of consensus amongst speculators trading said securities.

Nonetheless, in the stock market, as in boxing, it IS possible to be "Saved by the Bell", allowing cooler heads to prevail, and potentially for margin to be located from other sources., or prices to subsequently bounce restoring the value of collateral. Or for the purported "plunge protection team" to come to the rescue. And where the cause of a "panic" is itself speculative and based upon sparse, fragementary or incomplete information, the added time may reveal that prior decisions to liquidiate might have been hasty (though I will withold judgement on this possibility).
In any event, for today, Speculators and holders of speculative and highly acumulated issues have been spared bloody and painful impalement upon their positions. The wise ones will thank their lucky golden buddhist toad and take the next plane to the Hawaiian Islands for a "thank-you, I'm not dead" beach holiday. The others tempting fate will, of course, shortly meet theirs, head-on.

Wednesday, January 18, 2006


Way back when, Wall Street folk seemed to possess a more ironic sense of humour. Earnestness was present in reasonable quantities but more subdued. Everything was "lighter" (in the Kundera sense) and even greed was somewhat repressed and viewed as rather uncouth. "Whooops" back then had a very specific meaning referring to the debt obligations of northwestern utility "Washington Power & Light" that suffered under the weight of red ink that resulted from Nuclear plant construction cost overruns. For creditors and equity holders, it was "whhooops", then "oouuchh!!".

Today, the 18th of January, 2006, and the fourth year of substantive recovery in Tokyo bourse share prices, marked a similar "Whooops-Like" historic event: the shuttering of the exchange early, before the close - alledgedly due to errrr ... ummmm .... "indigestion" experienced from a margin-cascade, and consequential volume surge of sell orders and the (cynical one might chime) direction of trade prices. What should observers make of it?

A simple exercise in Monty Python-inspired word association [football] around my office revealed "whooops" to be intricately linked to the humble yellow utilitarian banana peel. The image is both archetypically and comically delicious, and though my sample size was small (me myself & I!), it is even funnier when imagined with John Cleese (as Basil Fawlty) or Rowan Atkinson (as Mr Bean). I am sure visualizing either of them in connection with the slippery yellow fruit skin made you smile too. But why is it we humans find humour in witnessing others' slapstick misfortune? Why does this not only yield a smile, but gives rise to guffaws and even deep roaring belly laughs? We certainly wouldn't find the same humour if an old woman slipped on the same - even if that woman was for example, the very unfunny Margaret Thatcher or "Tipper" Gore.

The answer is that both Cleese and Atkinson have the magical ability to portary a blatant disregard for the obvious that sets up the comical moment. They are caricatures of misplaced self-confidence leading up to the "whoooops" that allows the observer to feel as if they were somehow deserving of it.

But what does this have to do with Japan, Tokyo, and the TSE? For me, the parallels are indeed striking. Investors (if one can actually call them that) have, of late, displayed a blatant and cynical disregard for prudence, value, common sense, and fiduciary responsibility in both their stock selection and their subsequent incessant ramping of such shares to higher and higher prices for no other reason than "they can" and they would (thank you very much) like to "borrow" some incentive fees from their unsuspecting investors. That they have been doing this individually, in collusion, or "en masse", makes little difference to the observer, who sees arrogance and overconfidence setting up the comical situation that makes laughter (peppered with schaudenfraude) and derision the correct and appropriate response to Tokyo's "whooooops".....

Tuesday, January 17, 2006

New Shock & Horror: Livedoor Fraud

The Nikkei fell nearly 3% today, and the Topix more than 2% ostensibly because of accusations by the authorities that affiliates of Livedoor conspired to manipulate the price of Livedoor shares. Particularly hard hit were "growth" stocks, and issues that had been run up rather quickly during the last quarter, month, weeks, & days.

Although the "F" word was the excuse (fraud, that is, though those specs with large concentrated longs would be forgiven for thinking otherwise), the correction should surprise no one. That the Japanese market is overheated is of similar understatement to positing Dick Cheney lacks charisma, or that Lewis "Scooter" Libby lacks honor. For the JASDAQ, Small-cap, and Midcap indices have all taken out their prior late 1980's bubble-induced all-time highs, and the vaulting of share prices in Q4 of 2005 were carny-like in their provision of fun, amusment (and profit!!) for many investors (though I truly believe that "investors" is a misnomer, and we require a new linguistic or vernancular to describe precisely WHAT they are). Double were positively pedestrian. Triples were commonplace. Quadruples....hardly rare. Even five-baggers were not singular occurances. The result: buyers beware. Value has become more elusive, and though there remain some hiddden asset or undervalued asset plays, and some potential balance-sheet restructurings and some yet-to-be-realized cyclical recovery plays the fundamental business risk, and the market-cap and liquidity risk that one must shoulder is more meaningful than ever before.

But the ironic thing about the Livedoor accusations being the trigger is that the entire move in Q's 3 & 4 of 2005 has been characterized by the rarefied (in Japan) property of price-momentum. And not the non-vintage kind, but uber-momo or super-persistence, of the types that "corners" are made of. Large and well-heeled investors it seems - whether growth or value, or Fidelity, Sparx, Capital Research, BGI, MAC, Alliance, ML, Bleichroder, Steel Partners, T-Zone, or SFP have all come to the realization that it is better to buy a lot of a little and do it more or less continuously (especially when "it matters" like when incentive fees are being paid, than to leave the vagaries of performance (and performance fees!!) to chance or the vicissitudes of "the market".

And it must be said that in 2005 the conditions were remarkably favorable for such undertakings. Shorts were few and far between, and those that were there knew better than to short stocks that were going up. A significant part of the marginal supply of stock was held by government authorities (BOJ, DICJ, etc.), and the small, and mid, and broad indicies were being bought at the expense of more cap-sensitive ETF's, Nikkei larger-skewed TOPIX 300 and core indices. Combine this with an environment where everyone (officials, investors, regulators, maangement) is interested in, and thrilled by, higher share prices that no one cares HOW they get (or got) there.

This assymetry of concern is pervasive in all markets. People only care about manipulation, fraud (whatever the extent), and the impairment of the market mechanism as a means of efficiently discovering prices and allocating scarce resources when share prices are going down and tax-payers are losing wealth. No matter that dark fiber is omnipresent across America or that people's retirements will be more humble than might have been the case had the TMT bubble & fraud NOT occured. The price action in Japan from late August through the present has been positively shameful in many respects, not least of which is the cynical weight-of-money investment styles adopted by the named and shamed investors. Ultimately, they will receive their so-called 'just desserts' since the market typically taketh-away in greater quantities than it giveth, and such now-large and concentrated positions will provide an interesting spectacle in reverse predatory trading.

If you are they, or an investor of theirs, wish them (and yourselves) luck as you will need it. If you are NOT either, then you should be setting your sights upon them and their pregnant positions, flooding the torpedo tubes and arming your weapons.

Thursday, January 12, 2006


Wackiness abounds in the Japanese stock market. Just when you think yesterday's silliness cannot be outdone, you need only at today's prices and action to see clearly that many partipants have quite literally lost their minds. But sanity is not the only thing that's been lost. MIA is the integrity of the stock market's price mechanism as an allocator or scarce economic resources. While I'll admit that the past two decades remarkable manufacture of liquidity may reasonably lead one to question as to whether resources are indeed scarce, we'll ignore such a possibility for the moment. My prior post on
  • Stock Split Anomalies in Japan spilled the beans, and since then recent changes in settlement will do away with this. But not before a few last wicked games are played out.

    Take SEI Crest (Ticker Code# = 8900) which began December as a humble YEN100,000 stock. Since then, little has changed except it's price (today YEN 500,000) following a Dec 9th announcement that they'll split their shares 5-for-1 providing a two-month window for shenanigans. The stock peaked at YEN700,000, sufficient jack for any successful punter to upgrade his on-line trading machine and his high-speed internet connection, Interestingly, volume spiked 10-fold three days before the public declaration indicating at least friends of someone in the know profited from the material non-public information.

    Equally spectacular is Digital Arts (Ticker# 2326) which also began Q3 as humble YEN450,000-priced stock. Having doubled through Dec31 closing the year at a local maxima, it vaulted to a YEN1,300,000 per share, making it a clean triple in the six trading days of the new year until lo-and-behold they announced today and 3-for-1 stock split. And once again, a 10-fold increase in volume was seen three days prior to the split announcement - a sure telegraph of foul play and deception (or at least an information leak).

    One might suspect Philby except he's dead. But someone has the info and is acting upon it. In the case of Digital Arts, that probably amounted to about YEN 1.6 billion in illicit trading gains. Perhaps if we are unsuccessful as exporting manufactured goods to Japan, we can reduce our trade imbalance by exporting Eliot Spitzer to provide some needed help in financial oversight.

    Just in case you doubt my original assertion about the recent market as an efficient allocator, take a look at these other recent split-induced "moves" in Backs #4306, or Toho Titanium #5727. One would hope that some rational investors will be selling into it. Except of course that most rational or prudent investors wouldn't be caught dead holding these securities at these prices.....
  • Courage

    May you R.I.P. Hugh Thompson Jr. (1944-2006). You did the Right thing and displayed courage few others can match, but that many others will hopefully emulate. May friends of Spiro Agnew and any others who might disparage your bravery and good heart, rot wherever they may be.

    Wikipedia on Hugh Thompson

    Monday, January 09, 2006

    On Gold...

    Many friends and acquaintances have been asking my opinion on gold. In an unusual bout of of self-congratulation for a usually self-deprecating observer, I am obliged to tell you that I have had the direction of it's price right from $330 to present. And my reasoning as to the move has also proved prescient: disillusionment and concern over "paper" resulting from unprecedented fiscal and monetary spinelessness, primarily in Washington, coupled with buoyant demand from increasingly prosperous middle classes in India, China and elsewhere. Where does it go from here? More of the same, I think, probably leading to blow-off sometime in '06 coincidental to the markets testing the word of Mr Bernanke by pressing the dollar and watching for his response, before the ripples of lower housing demand and prices makes their impact felt through the macroeconomy.

    But what do I "think" of gold in the philosophical sense? My opinion coincides with that of one Robert Triffin, who was JK Keynes' American counterpart in chiseling out the post WWII monetary system that became known as "Bretton Woods". Triffin, a steady, sober and articulate man would have been horrified at the state of what he built. He would decry Japanese and Asian neo-mercantilism and scowl upon the large trade and current account deficits of the USA. He would disapprove of the leverage encouraged to permeate the USA economy and I reckon he would deplore the systematic debasement of the world's primary unit of exchange. There is little doubt he would recommend positive pre-emptive action to prevent these occurances, such as higher income and/or energy taxes, lower fiscal & household spending, or, in the absence of effective fiscal measures, substantially higher interest rates to cool the jets of imbalances that might threaten the entire system. He would believe it incumbent upon authorities to cooperatively steer our economies through a good, but admittedly imperfect system.

    And what did he think of Gold? To paraphrase:

    There are few human follies that are more amusing or more scandalously wasteful than the one in which man scours the world to discover gold, subsequently digging deep and moving enormous mountains of earth at great expense to remove it from the ground and refine it, then, move it to the other side of the planet (also at great expense), only to dig another great enormous hole, and bury it once again deep in the ground.


    Saturday, January 07, 2006

    ETF/Index Membership & The Liability of Cap

    Hedge Funds are reputed to have wrought many evils upon us: increased volatility; demonstrative increase in unmitigated greed; market-manipulation; massive [undeserved?] transfers of wealth; over-compensation for assymetrical risk-taking; naked short-selling; bending and flouting of market rules; as well as the high-profile Lipper-esque fraud, theft and ponzi-like schemes that directly diminished wealth of investors, to mention but a few of the more prominent charges.

    As a well compensated investment manager myself who also engages in short-selling, I must say that these charges appear excessive, overblown and are probably IMHO somewhat off of the true mark. Yet, kernels of truth are present in all them. But since these truths bite so close to the bone, they are all to often dismissed, denied, then ignored probably at one's kharmic (and possibly one's financial) peril.

    This is because one of the most profound impact of hedge funds' growth and proliferation (at least in global equity markets) has been more subtle: mega-capitalization underperformance. This has been for both technical and structural reasons. For over the last few years as investors have outsourced and off-shored their speculative undertaking to the hedgies, their agents, in perhaps uncoordinated, yet no less herdlike manner, have seemingly arrived at many similar if not common stategies seemingly involving many similar if not common instruments. More specifically, one would conjecture, after looking carefully at the distribution of returns across many equity markets, equity investors are placing more long bets in concentrated smaller-cap positions (where their marginal purchases can have more price impact upon existing positions with obvious benefits), while shorting their composite index or benchmark of choice (all which are market capitalization weighted). Individually, and in itself, there is nothing wrong with a trader or portfolio manager buying what "he knows" (or overconfidently thinks he knows) and selling "a little of a lot" exemplified by a broad market, sector index or ETF thereof. But what if everyone pursues such a strategy? Some, like Joesph Heller's 'Yossarian', believe that whatever the logical contortions, one would be "a fool to do any different" since being contrarian is not just a disinterested philosophical bet, but when expressed in a position, is a bet upon one's very livelihood - something Jeremy Grantham has pointed out on numerous ocassions.

    But is Yossarian wrong? Why should HE be the one who flies missions, while others back in the USA are having a good time? Where is the problem in his logic? Lawyers and risk-managers, who often agree but very rarely, and even then, on very little, both might term this "pari passu". Economists call it a "fallacy of composition" (what's good for a few is not necessarily good for everyone). As result, certain risks (Taleb terms them "the black swan" risk) are elevated. I eschew this term if only because it's imagery is so tame and too far removed from earthly reality of consequence. Instead, I like to call it: "driving really really fast downhill as you near the sharp narrow hair-pin turning adjacent to the 1000' drop into the canyon below-risk". Lots of things can happen: a tire can blow; a bicyclist or large truck could be around the blind corner; brakes could fail; there could be skree or oil on the road. There are lots of plausible, but low-probability, fat-tail like outcomes.

    Back to the distribution, because this is what is fascinating. Take Japan. If you look at something lke the Barra Size factor, which is a cross-sectional regression, it has been a rather poor performer, over the last few years, this year, and as late. And if you look at the top and bottom deciles of some investable universe, and you equally weight them using some monthly rebalance schema, you get a similar picture. And the picture is the same all over the world. In most markets, historically, size and liquidity commanded a discount. Returns to scale, and stability achieved through diversification were attendant benefits to larger size, not to mention the ability to recruit and train higher calibre individuals, all which conspired to command a marginal valuation premium. Yet today, the any premium has waned, and in some cases inverted. Smaller and mid sized enterprises are trading at equivalent if not premium metrics. The Russell 2000 S&P Barra MID Index are far far above their bubble peaks, while TOPIX Mid and Second Section Indicies have also vaulted to all time price highs while their valuation spreads have narrowed to unprcedented levels.

    Couldn't this be just a reflection of the lethargy and inefficiency of the big, and the nimble growth oprientation and possiilities of the small? It cannot be ruled out that such a perception is driving the phenomena. But as market wise-man Jeremy Grantham points out, the "quality" one can buy today relatively is very attractive in comparison to history, and I would add thhat it's attractive primarily because of the diminished relative valuations of larger-cap issues which tend to be more stable, have higher profitability ratios (whether ROE, EVA or CFROI) and have better balance sheets per unit of P/E. Sure there are some sector effects (particularly in the USA, and particularly in energy and energy-related sectors repsen ted in small & mid indices), though I would argue that these affects are secondary to the weight and impact of the huge hedges laid out in cap-weighted indicies and ETFs. The effect, in effect is caused by myopic informationless hedging and aggregation of individuals game playing. Those with the trade on, who are now patting themselves on their respective backs, and collecting larger performance fees for this past year for their stock-picking prowess have really been the fortunate beneficiary of huge structural effect. In this respect, they should be careful of self-attribution bias and attempt to understand where the bonus that bought the Tribeca loft actually came from.

    One might ask, is it permanent? How does it work itself out? I personally do not believe it's here to stay. Since much benchmark-relative net long exposure has gone into smaller-cap at the expense of larger cap, this probably unwinds into a market correction driven either by whiffs of higher rates and diminishing or levelling-off of corporate profits growth or a more general recession where growth retreats and real rates turn positive. Liquidation of smaller-cap will necessarily cause the re-purchase or closing out of the cap-weighted hedge positions in broad indices and cap-weighted sector ETFs thus restoring some off the traditional sensibilities and relative levels of market cap spreads. But I warn allocators to hedge funds, that THIS WILL NOT PAINLESS and the managers that have been riding this filly-of-a-trade will likely be thrown from their mounts.

    Friday, January 06, 2006

    More Moore

    When Stewart Info Corp. (NYSE Ticker=STC) Director and rel estate expert Laurie Moore married her husband, also surnamed Moore, and decided to keep her name (along with that of her spouse), what could Laurie Moore-Moore have possibly been thinking? Moore is better? Perhaps there was another Moore at her firm, or even another Mrs. L. Moore?!?!?

    My wife, too, chose to hyphenate and keep a semblance of her prior identity, so I quibble not at the principle, but I also know what a pain-in-the-arse (not to mention an envirinmental waste) it was to change everything. But in Mrs. Moore-Moore's case, I ask: "for what?", other than derision and laughter at her expense.