Thursday, December 18, 2014

FMOC Statement

David Merkel of the Aleph Blog publishes a redacted FMOC statement with his own commentary after every meeting.

It is required reading at the Strategic Investor.

David, I think it is fair to say, is sceptical of the wisdom of committees of academic central bankers.  He is also a critic of the wordiness of the Fed Statement.  He believes (rightly, in my view) that in the effort to be clearer, the Fed has introduced lots of commentary on current conditions and the effect has been to reduce clarity, because the economy is a complex system about which it is difficult to make conclusive judgments.  Thus, the Fed highlights various uncertainties and often confuses the public.  A growth in 24/7 financial media which desperately needs something to talk about multiplies this as they attempt to parse every word.  I digress.

While I share much of that scepticism, I think that the narratives have become too rutted and categorical - as in - QE is great, the only problem is there  hasn't been enough and QE is bad, inflation is coming.

I think there are some other views of QE that should be expressed, and so I sent David an email, which I reproduce hereafter.

Broadly, I think that in terms of unemployment and combating deflation, QE has largely been ineffective.  This is by design.  Let me say it clearly, I do not believe that the underlying logic of QE is the dual mandate of the FOMC, but rather serves the regulatory function of the Federal Reserve, ensuring that sound institutions are able to operate.  QE hasn't obviously helped employment much - while employment has been rising, this has not been due to large amounts of credit expansion.   Moreover, it has not led to inflation.  This should not surprise us, as the Central Bank went to Congress at the outset of QE I and asked for permission to pay interest on reserve balances at the bank, which enabled the Fed to sterilize its new "money" by ensuring that the banks would keep it all at the Fed and not relend it.

What QE has done are two things - first, it has reduced the interdependency of the banks and banks' dependency on the money markets to provide short term liquidity.  This means that for the time being, there are likely to be fewer credit shocks that threaten any bank of size and that even if one bank is hurt, that the others are well insulated.  Thus QE allows the Fed to support the banks and protect the banking system while the banks build capital required in 2019 under Dodd-Frank.  It does so in a way that voters and perhaps Congress don't see, so it doesn't get labelled a "bank bailout".

The other thing that QE has enabled is for the Federal Government to run large (temporary) deficits without raising interest rates.  This might have been a problem over the period 2010-2012.  But should be be surprised that as the deficit has declined by $600bn per year since 2013, that the Fed has reduced its purchase of Treasuries ($45bn / month) by about the same amount?  The effect has been to bridge the government while the "core" buyers of treasuries, who were prepared to snap up $500bn of the things at "low rates" while the Fed was exercising QE are similarly prepared to accept similar rates for a similar volume of bonds today?  This is the real reason rates haven't risen.

Quite frankly, I think the Fed executed this move far better than anyone imagined.

Given that, I expect that in spite of short term volatility driven by Fed comments, that the economy will continue on about the same course for the forseeable future.

Below my letter to David, and hopefully a response from him.

I can understand if you are sceptical about Central Banks.  They are human constructs, and as such make mistakes.  But quite frankly, none of the doomsday scenarios appears to have occurred (I realize that fear that developing markets will experience a credit shock as a result of Fed tightening is possible).

Your specific criticisms have generally been of two sorts: first, that the Fed can’t really do anything about employment and therefore that we should expect no impact, and second, as today, to decry that the Fed’s policy hasn’t fixed anything and that unemployment is still horrible.  It seems to me you are trying to have it both ways - blaming them for taking action AND blaming them for not fixing the problem.  Which is it?  Or do you simply believe that the economy would have recovered faster without QE?  I think there is a case to be made here, but then make a case that QE has been harmful, not simply ineffective.

(FWIW, the case to be made is that to the extent that in a debt deflation savers are the consumers with the highest marginal propensity to spend, so don’t cut their income, because borrowers - who are largely overleveraged - cannot offset the belt-tightening by savers who find the yield on their savings cut).  Not really sure if it is true, but it seems possible.

I tend to lean in the direction of your first criticism - that the policy has largely been ineffective, at least by the metrics outlined in the FOMC.  Unemployment AND inflation are impacted most heavily by an aging society.  Retirees like low prices, tend not to spend and don’t like to work.  That the participation rate would decline after 2008, as demographic Boomers started being able to collect social security and tap into retirement plans is unsurprising.  In fact, to the extent that asset prices have risen (we can debate the extent to which the FOMC is responsible; I am a sceptic) we are ENCOURAGING lower workforce participation, as near retirees and those over 62 see a recovery in their nest eggs.

In other words, the Fed is getting the blame for a demographic challenge known since the late 1970s and quite frankly, one global in nature as fertility falls worldwide.

My own view, as I have stated before, is that QE is actually a bridge to Dodd-Frank.  What I mean by that is that banks have to build capital buffers to prevent insolvency, but they have until 2019 to do so.  In the meantime there is more than a bit of risk that a credit crunch could, through counterparty interconnectedness, lead to another infection of the banking system.  To avoid this, the Fed has built up massive Federal Funds at the banks which enable them to have a ready source of “safe” assets to trade with the other banks, and they can avoid resorting to commercial paper and other forms of short term financing.

After all, if the intent of QE were to actually flood the economy with cash, as many believe, the Fed would not have gone through the process of securing Congressional approval to pay interest on the reserves (thereby sterilizing them and preventing them from being fuel for new credit).  This also explains somewhat why the impat has been muted.

Friday, July 12, 2013

More evidence that China's rise is not inevitable

Some time ago, I wrote a post about three China predictions, in which I argued that China was likely to become the worlds largest economy due to some basic factors in its economy: it was growing in real terms, it had positive inflation and had a nearly fixed exchange rate to the dollar.  This means that in dollar terms the inflation China experiences counts toward its economy's size (unless you measure in PPP).

I also suggested that longer term, China would be surpassed, not only by India, but also again by the United States, which simply has better fundamentals.

Recently, there has been mounting evidence that China's rapid boom is coming to an end.  Today I saw this, which shows that the evidence is now so compelling that it is turning even the general media's narrative.  In the short term, China will likely take the steps necessary to keep the economy growing at a 5-6% rate.  Premier Li has already indicated that 8% is no longer the target (and with a declining workforce, is most likely unattainable).

These are growth rates to which India can aspire (it needs to make some structural changes in its economy).  Indeed, India has at times exceeded these levels and could do so again.

Meanwhile, the US can keep chugging along at 2-3% and remain larger than China on PPP terms for a very long time.

Good news for China, however, is that the absorbtion of cheap labor means it can focus more on quality of the labor, and on quality of life, as it moves up the income scale.  Bad news is, most countries fail when they get caught in the middle income trap of too many skills (and too high prices) for cheap work, but not enough skill for higher wages.

We shall see, but I believe that if you work or invest in businesses / industries that rely heavily on Chinese growth to function as an escape valve (or as the primary driver of growth), you have to be very concerned that many of the capital investments undertaken to capture Chinese market growth may be written off.  The risks are rising that this will happen.

The Federal Deficit: The REAL Reason the Fed will Taper

In the media, there has been much knashing of teeth over the scaling back of QE3.  Supposedly, the move to reduce purchases of US Treasury securities will lead to higher interest rates and from there to recession and then armageddon.  It is a delightfully linear thesis, which means it plays well in the media.  Ironically, much of the moaning comes from the same people who moaned about the introduction of QE to begin with (distorting the markets, perverting risk/reward, and eliminating price signals for investors).  So, QE is terrible, but withdrawal is worse.  One wonders what the addict is to do.

The Fed has maintained all along that factors in the economy overall would be dispositive, and highlighted unemployment (as part of the "dual mandate") as the main driver.  While labor markets have been improving (creating over 200,000 jobs per month for the past year and showing more strength this summer), there is another factor that is surely starting to come into focus: a dwindling supply of newly issued Treasury paper to buy.

A year ago, when the Fed started buying $45bn a month in Treasury securities, the Federal government was running a deficit of almost $100bn a month.  Thus, the Fed was buying about half of all newly minted securities, leaving the public (and foreign central banks) to buy the rest.

Due to several positive factors released in the monthly Treasury statement yesterday, including rising employment, higher corporate profits, higher rates of tax on incomes and the end of the payroll tax holiday driving higher revenues, and the sequester and the military drawdown leading to lower spending, the deficit is shrinking rapidly.  If CBO is right, the deficit will be about $640bn in FY2013, or $500bn less than the previous year.  (The same teeth knashers are suggesting that the economy is suffering from the withdrawal, though this doesn't seem to be true.  Makes you wonder how important all that "stimulus" really is.  I digress).

Were the Fed to keep purchasing at the same rates as before, it would purchase effectively 100% of new issuance, leaving no bonds for pension funds, and others looking to match assets with long term liabilities.

Indeed, to maintain this pace, the Fed would very soon have no choice but to purchase off-the-run bonds from prior periods of issuance.

This is why the Fed has moved off of the 6.5% unemployment figure that was its target for tapering before.  Mind you, reducing its purchases by half, to maintain its share of overall absorbtion of new Treasury issues will still leave a much smaller pool of assets for private parties.  In fact, if private demand reflects the $50bn or so the Fed was not buying each month in the fall of 2012, then the Fed would have to cut to zero just to maintain a large enough supply to feed the private market.

This is also why this is a great time for the Fed to "exit" or "taper" purchases.  Supply is more in line with private demand.  If the Federal government can manage a second and third round of sequester controls, along with some modest tax reform, the budget could realistically be in balance in FY2016.

Even if the deficit remains in the $200bn range, the Fed will have the option to sell some of its off-the-run bonds into the market to meet the demand of investors for bonds.  (With a balanced budget, the effective buyer could be the Federal government which could redeem the bonds at par).  All of which means that Bernanke might have been right all along.  There may be some capital losses associated with this.  But done moderately, the incredible interest generated by the portfolio will help to offset this.

Now, on the mortgage market side, things might be somewhat different.  However, again, as natural supply of Federal debt securities decline, investors looking for long term income will need to migrate to other asset classes with the most similar risk/reward characteristics: e.g. mortgage securities.

It will be fun to watch the knashers complain about how QE didn't really work, it just "got lucky" as policy was enacted as the economy was taking off on its own.

Thursday, April 19, 2012

Bassett Stock Price Movements - Mattresses or Fundamentals?

Bassett Furniture has seen significant movement in the stock price of late.  Moreover, as I have mentioned in previous posts, here and here the trend of the stock price has been pretty much one way - up almost every day (though not yesterday).  There are three good reasons for the stock price to rise, though none explain the consistency of the increase. 

One possibility that only recently crossed my radar screen is the stock performance of mattress manufacturers such as Sealy, (which sells mattresses under the Bassett name and through Bassett furniture outlets), Terpurpedic and several others.  All of them have seen strong gains in the last several weeks, in part because of speculation that strapped homeowners and recently rehired employees are choosing to make small purchases to improve their lives and that one of htese is a better mattress.  For myself, I can say that I believe a mattress is an investment in better sleep, which in turn leads to more energy and less stress - in short, a better life.  In this way, a mattress is a special piece of furniture, unlike most of the other functional stuff in the home.  A mattress helps to protect your health, and it is not worth sleeping on a bad one.

So perhaps Bassett is participating in general market moves in the mattress sector (though it hardly seems possible that Bassett's performance would be strongly influenced by only the mattress segment, I doubt it is big enough to influence overall earnings that significantly).

The real reason I believe Bassett stock has been rising is that the fundamentals of the business are coming to look much better, and this is converting the furniture business portion of the stock valuation to a positive figure and allowing the balance sheet items to receive full valuation (2 years ago it appeared that management might burn all of the investments that were not directly deployed in the business in a possibly futile attempt to keep the business afloat, rather than shut it down).

Keeping it short - I believe the true reasons for the improvement are the following:
  • Strong balance sheet has been strengthened by the sale of IHFC
    • Converted an accounting liability into an asset (cash)
    • Provides added liquidity to restructure and invest and be opportunistic in a weak market
    • Provides means to ride out an extended period of housing weakness
  • Shareholder friendly management 
    • Paid several special dividends
    • Restored quarterly dividends
    • Repurchasing shares at low valuation enhances intrinsic value per share
  • Restructuring of the business seems to have positioned the business for profit at reduced volume
    • Finally able to close or take over underperforming licensee stores and improve ops (company stores open more than 1yr are earning a profit as a group)
    • Able to invest in capturing additional share in local markets
  • Growth into new markets
    • Adding locations for the first time in some time
    • Positioning business for growth / upswing (assumes no recession)
    • Able to invest in operations at a time when real estate and labor are relatively inexpensive, good opportunities to sign leases at low rates and lock in low rents
  • Recovery in housing 
    • There are some signs that housing is making a turn, or at least, that the pace of decline is slowing
    • Many households have been aggressively reducing debt, positioning them to make larger purchases in the next few years and to trade up from IKEA.
So, I maintain that Bassett is well positioned to ride out the next few years and to invest in key markets that will be the drivers of growth in the years ahead, and to do so while locking in lower fixed costs, providing terrific operating leverage whenever a pickup in consumer durable spending materializes.

Saturday, April 14, 2012

That was fast - Unusual activity in BSET

An reported story - on Friday, Bassett Furniture, BSET, (Disclosure, I am long BSET), saw a massive rise of 5.5% on volume of 200,000 shares, 10x the normal amount.  There was no news nor any press release from BSET.

As I posted earlier this week, the chart of Bassett stock indicates that someone is on an acquisition spree for a stock that is undervalued compared to the sum of its parts.

As I have said, the company is really two halves - one is an investment company with a strong balance sheet (though relatively few investments at the moment).  The balance sheet already reflecats over $20mn of impairments, much of which could be reversed, particularly if business improves.

The other half is an operating company that manufactures, designs, distributes and retails furniture.  The open question has been, can the business make a go of it, in the face of sharp declines in consumer spending.  This past quarter, we received the first indication that, so long as business does not deteriorate further (on the top line), yes, Bassett can be a modestly profitable venture.  The natural operating leverage in the business (which has increased with the acquisition of several retail outlets from former licensees) means that with a modest uptick in volume, profitability should recover nicely (leading to reversals of the valuation adjustments on upto $19mn in deferred tax assets).

Looking at massive liquidity, and the opportunity to use BSET to shelter income tax for some profitable venture (if not from the Bassett furniture business itself) the company looks like a good acquisition target for a private equity firm.

Up to now, whoever has been acquiring shares has been doing so quietly, trying not to increase the price dramatically.  However, with the very large volume on Friday, I expect an announcement over the weekend or latest sometime next week that someone will have to announce something.

What do you all think?

Wednesday, April 11, 2012

BSET Posts Encouraging Results

Bassett Furniture, BSET, is an interesting play on a recovery in consumer spending and housing.

Last week, the company released its 1st Quarter Earnings statement and there was much to like, but with some caveats that suggest the questions around the business have not been fully answered.

The company is primarily engaged in designing, manufacturing, distributing and retailing custom furniture with a more "grown-up" and traditional style than say, IKEA, which engages in the same set of activities.

The stock, is actually a hybrid of two components: one is an incredible balance sheet that historically has included investments in other firms, real estate and hedge funds.  Indeed, much of the company's profits in recent years have been the profits of these investments.  The other part is the operating business, which has struggled.

At the moment, the company is valued at $100mn or so.  This essentially values the company at its working capital.  The net working capital as of 28 Feburary was $90mn, but in a subsequent event, the US government announced that BSET was entitled to $9mn in anti-dumping offsets.  This sum is the result of actions taken years ago by the Federal Government, but the monies have been only dispersed slowly. If we add this as a receivable, we have about $99mn in working capital, almost exactly the price of the stock.

(The US for a time had an anti-dumping law that saw the US government impose penalty tariffs on firms that were "dumping" products on the market and then use the monies collected not to fund the government, but to provide subsidies to the "harmed" firms.  This strikes me as a double down on protection, since the tariffs should already raise competitors prices, to then pay an additonal subsidy seems silly, perhaps this is why the law was amended).

Much of the working capital, it should be added, is in cash, raised by liquidating several of the company's investments, including hedge funds and it's large share in the IHFC in North Carolina (this asset was actually carried as a liability on the books, because dividends received exceeded the entity's income, so it had a shareholder deficit), It was able to sell this "liability" for $80mn.  Accounting is so much fun, sometimes.

This effectively values teh company's long term assets, most of which are property, plant and equipment, as well as some rental real estate and a large deferred tax asset, at zero.  This seems silly, since it is likely that even in a weak real estate market, much of the real estate the company owns could be sold at a price higher than its carrying value.  After all, land that the company owns in Bassett, VA has been on the books for decades, still shown at the lower of cost or market.  Most of the company's retail store fronts owned are rented (admittedly to itself or to licensees), but rented commercial property usually gets good prices and cap rates are still low.

Better yet, the company has taken massive valuation allowances against many of its assets, including a $19mn valuation allowance against its deferred tax assets.  At present, the company cannot predict that it willl earn enough to reverse this allowance, but if earnings improve, it could be sitting on a $19mn gain (or at least a portion thereof) because it can use these assets to reduce taxes in the future.  The company has noted that the $9mn in antidumping subsidies would allow the company to reverse over $3mn in DTA.

It also has valuation allowances against its remaining interest in one hedge fund, which will likely have at least a partial reversal, and $4mn in allowances against notes receivable (mostly from struggling licensees).  If business were to improve, and licensees were better able to meet their obligations, these allowances could also be reversed.

All in all, if we were purely evaluating the balance sheet, we could value the company at $13-$15 per share.  But what of the struggling furniture business?  For a great balance sheet supporting a crappy business is worth less than it seems.

Well, much of the new-found liquidity raised by selling long-term investments, has been used to restructure its operations, especially retail, and the efforts are finally producing some results.

The company's wholesale operations, which design, source, manufacture and distribute furnishings to both Bassett's branded retail network (much of it company owned) and to 3rd party retailers has traditionally made a profit.  In 2011, huge write downs caused wholesale to lose money, but evidence is that the wholesale segment finally has its cost structure aligned with volumes, as the company still made a good operating profit with lower volume.  Given operating leverage in the business, and improved gross margins, any lift should see nice profit growth at the wholesale level.

The retail level has struggled and has traditionally lost money.  This is still true, however there are many encouraging signs that the company has finally turned a corner.  Stores open and manageed by the company for a longer period, actually earned a small operating profit as gross margins improved and SGA were held to reasonable levels.  Other stores still spend.

If the furniture busienss can earn $0.30 per share per quarter (approx $3.3mn) which can definately be achieved by the wholesale segment, requiring simply a break even at retail, the business can be valued at $6 a share ON TOP of the balance sheet, from which many cash distributions can be made (more on this below).  If retail can also make a contribution, so much the better. 

Growth would help at both levels.

Here the results are more mixed, as actual sales in the quarter declined.  But this was tempered by a 10% increase in orders taken.  It is not clear yet whether this was just order shifting (from Q1 to Q2), perhaps because of slower delivery times, or whether this indicates a greater willingness of Americans to purchase bigger ticket items.  Only time will tell, so I remain a patient holder of the stock.

The final bit to notice is that the company has been using its cash to pay dividends and to repurchase stock.  The company repurchased nearly 1% of shares oustanding in the first quarter, and there is continued evidence of slow but steady accumulation.  Take a look at this chart, the 1 month price movement, courtesy of Yahoo! Finance.


I have never seen a stock with such a steady set of rises.  The stock increases almost every day, but only in small increments, as though someone is trying to prevent large buying from raising the price too much. 

I am certain that there is active accumulation of the stock.  Slow but steady accumulation which is driving the price higher, but enabling the shares to be purchased at the lowest possible price.  It could be the company's purchases, or it could be an investor or a fund, but I believe there is enough to drive the stock higher from here.

Tuesday, March 20, 2012

Buffett's Biographer Accuses him of Hypocracy

Alice Schroeder, who wrote the "authorised" biography of Buffett, The Snowball, is now arguing that Buffett has been making major mistakes in the past few years, including an increasing focus on partisan politics and policy, engaging in investment practices he condemns in others and - gasp - mediocre investment returns.

Just before we explore her argument - a word about Schroeder, as I have read her biography of Buffett.
Schroeder's biography is a must read for any Buffett follower.  If you have not read it, buy it NOW.  You will quickly realize why what only Buffett does what he does.  Quite simply - if you are an Outside Passive Minority Investor (OPMI) you are not following Buffett's investment style.  This doesn't mean you shouldn't use Graham/Dodd principles or look for great growth companies like Philip Fisher.  It just means, don't be fooled by mutual funds and newsletters selling their "Buffett-like" investing advice.

The most amazing story in the book to me was hearing about how Buffett would pour over the Value Line Investment Survey and the Moody's stock profiles.  In the days long before the internet, these were essential tools for doing stock screens.  You had to request the SEC filings of companies, unless you owned their stock, so there was more than a bit of effort required.  Buffett, not wanting to miss any good opportunities, noted that he reviewed and valued EVERY SINGLE company in the books.  He notes that there were many on which he didn't spend much time, but here was a guy putting a value on each of 2000 companies about every 3 months.  So dedicated was he to this practice that he piled the books into the back of his car when he went on his honeymoon.  Most of us just look at a few companies we know of or have heard of.  Some more of us look at various screens and the like, Buffett set out to value every listed US company.

Back to Schroeder's argument - I rather agree with some of her points.  Buffett has become a celebrity businessman, and most celebrities like having the floor.  Since politics is simply the biggest stage their is, it may be that he is drawn to it like a moth to a flame. Schroeder is right, he is entitled to his opinions and to enter the public space to share them.  But she is also right to argue that Buffett's true legacy is Berkshire and that the company operates in lots of heavily regulated industries, including insurance, banking, transport and energy and that it all seems rather well, not right, that Buffett should be so tightly wound up with the people who should be setting policy for his firms.  It is worse when Buffett argues that policies from which he has benefitted should be denied others.  This is a ladder pull by someone high up the economic slope.  Should future investors really be denied the same opportunities to build wealth that he has enjoyed?

Likewise, she notes that the same person who decried derivatives as "financial weapons of mass destruction" himself runs a book of derivatives with billions in nominal value.  True, Buffett sold the options, so he hopes (and expects) the options to expire worthless - enabling Berkshire to keep the money - but in acknowledging that like nuclear energy or chemical engineering, or kitchen knives, derivatives have potential to be employed usefully and productively as well as destructively - Buffett has done an about face on the topic.  Yes, his current position is more correct - the danger lies mostly with the user, since the thing itself is morally neutral - but it is his earlier position that is used to argue for overhauls of the global financial industry.  And if he thinks that the main problem is the banks can't handle derivatives (and prop trading) then why is he buying them and saying how smart they are?

Her biggest criticism is that Buffett is earning poor returns.  Since 2000 this has largely been true - even measured by Buffett's yardstick, growth in Book Value per share vs. the S&P.  There are a few reasons for this - one is that the sums of capital Buffett needs to deploy are now so large that paradoxically, his investment universe is shrinking.  He needs investments that enable him to deploy billions in capital on a single deal, and there are only a few hundred firms where this is possible.  Most of these firms do not have significant amounts of undervaluation, since they are solid businesses and so it is more difficult to make outsized returns on these investments, (though I believe that large and mega cap stocks have actually represented the best values in the market over the past 5 years).  In general, I believe his purchases of large cap stocks have been sound, they are all strong companies trading a reasonable prices (although their growth may be suspect).

Buffett's other problem is legacy.  He has acquired a stable of good businesses, but since "trees do not grow to the sky" many of these businesses are reaching maturity, and in some cases may even be in decline (the Washington Post comes to mind.  For the first time, the company did not make the list of significant equity investments).  Buffett is not at liberty to sell them, however, because he made a deal with the owners of those businesses that Buffett would be a permanent home for them.  This means the full range of strategic options for businesses in such a situation, which normally would include mergers, are not available to his companies.  Berkshire's investors got the gains up front, now they have to pay the piper.  This is not to say they got a bad deal, only that slower growth is in Berkshire's future.  If decline is managed well, as it was with the original textile businesses, it can even produce value for shareholders.  But is the board prepared to manage these firms into what may be terminal decline in some cases?  Hard to say.

It seems reasonable that the share price is undervalued.  Berkshire has incredible earning power, but future returns on equity are likely to be satisfactory, not extraordinary, and so the company will trade nearer to book value than in the past.  Whether that is Buffett's fault, in the sense of making poor current decisions, brought on, as she believes by declining acumen, or whether it is really just the burden of historical investments now earning normal returns, remains to be seen.

I think the jury is still out on this, even if Schroeder is right to question Buffett's judgment.

Thursday, March 15, 2012

Buybacks vs. Dividends - McKinsey weighs in


This week the McKinsey Global Institute published a study indicating that most stock buyback programs are value destroyers, in that they tend to buy high and not low.  Their specific example is a technology company that repurchased increasing amounts of shares during the stock market boom into 2008, but then stopped buying shares, even as they plunged during 2008 and 2009.


 


This seems a fitting academic underline of my point about why dividends are better than buybacks: management rarely buys shares at a significant discount to intrinsic value, whereas investors who receive dividends and reinvest them benefit from dollar cost averaging and can also choose to make opportunistic purchases (without an automatic reinvestment plan).
Management faces thre, e hurdles that almost guarantee that it will make poorly timed purchases of its own stock:
·         Management rarely has lots of spare cash when the stock is cheap.  Buybacks require significant free cash flows.  When a company is generating significant free cash flow, however, the market often places a premium on the price of the stock.  The corollary to this is that when markets are weak (and buybacks represent the best value) management usually has better priorities for its funds, including: preserving cash to ensure adequate liquidity in the face of difficult credit conditions, opportunistic acquisitions – everyone else’s stock is cheap, too, after all, and reinvesting in operations when goods, materials and labor are readily available.

·         Timing of buybacks often coincides with option exercises, which are more likely to occur when the price is high.  If the company makes corresponding open market purchases to offset dilution, the company is allowing sellers to pick the timing of the transaction, which is rarely going to work in the buyer’s favor.  Stock buybacks at nearly all firms are partially aimed at eliminating the dilutive effects on EPS that stem from new (or treasury) shares being issued as part of employee compensation.  Naturally, those employees want to exercise their options at a high price, and since multi-year fixed value options offer the holder significant discretion in when to exercise, options are more likely to be converted at cycle highs.

This is one of the most important misalignments of shareholders and management – the classic agency problem options were supposed to fix. When the same management that is selling high for its own account on the one hand is also directing the company’s cash to buy at the same time must be committing the company (and the other shareholders) to buying high.

·         Large scale buying by one investor tends to drive prices higher.  The kind of buyback activity that drives EPS and sometimes share prices higher requires significant acquisition of shares – at least a few percentage points of shares outstanding.  Such significant buying is best done by those who do not have to report their purchases, and who do not move markets.  Companies that pile up their repurchases (say in the run up to the end of the quarter) can become major market participants buying large quantities of shares in bulk and bidding up prices.  Even if management tries to buy opportunistically when share prices are weak, their own buying may eliminate the weakness.  This is good for shareholders in general – ideally share prices would always trade near intrinsic value so that all shareholders would get paid full value when they sold – but it inhibits management’s ability to create value for loyal shareholders.
Given these limitations, I generally agree with McKinsey that managements that want to repurchase stock should do so using a method calculated to minimize the disruption of the markets.   Moreover being sellers themselves they have a fiduciary responsibility not try to steer the purchases of those to whom they are selling – this is sitting on both sides of the table.
Instead, management that wants to repurchase say 25 million shares in the course of a year should simply buy 100000 shares per day on each of the 250 days or so the market is open and trading normally.  If these can be purchased in blocks near market price, fine, if they have to be purchased in lots, also fine.  If this means that the shareholders are not big enough buyers on days when management is exercising lots of options (which expire on the same day) so much the better.  This may lower the spread on the option – so what?
Finally, this raises a question about whether options should be used for compensation at all.  This is another topic, for another post.  Suffice it to say, I am not a fan of incentive programs that turns management into sellers of shares.

Tuesday, March 13, 2012

Bank shares rally on JPM

This week, we find out about how banks have fared on the stress tests to which they are being subjected by the US treasury.  In an interview a few days ago, Brian Moynihan, CEO of Bank of America indicated that the banks would be shown to be fine, even under extreme conditions (including unemployment of 20% with the related cases of default).



Today JP Morgan demonstrated that they are in the strongest position of all of the US banks by announcing a dividend hike and a massive buyback, equivalent to almost 10% of their market capitalization.  With a payout ratio of 25%, JPM appears to have lots of room to increase the amount of its dividends go forward.

I believe that BAC is in a similar position, even though operational changes have allowed Chase to take over leadership in branches, I firmly believe that BAC is a stronger franchise.  (I cannot believe that I am saying this given that J. Pierpont Morgan is a personal hero).

By 2013 BAC will also be paying a dividend and buying back some of the nearly 11bn shares outstanding.  The stock, which had a nice rally today, will trade at $16-20.  Even with the rally since December, the stock is well positioned to post nice gains over the next 12-24 months.  This is why I am very long the stock, it is by far my largest position.

Monday, March 12, 2012

Some investing wisdom

I haven't had much time to write lately, so I figured I would share some investing wisdom I have come across recently.


Matt Schifrin over at Forbes has written a great synopsis of the investing habits of some extraordianrily successful individual investors.

Jason Trennart raises and interesting argument that successful investing may require less of the technical tools taught in busineses schools and more of the social sciences contextual approach to problems, with the ability to synthesize data of various (and often qualitative) sorts.  Personally,  I believe this is true.  As an historian (undergrad) with an MBA, I can say that while financial skills are important (value is a financial concept), evaluating the risks around the estimate of value often require imprecise contextual thinking.  This is most true in evaluating the managers who hold investors assets in their hands.

Aelph suggests that buy and hold investing is neither dead nor a bad idea.  Admittedly, returns on equity do fall for most businesses over time as it gets harder to redeploy cash generated by the business in initiatives with the ROI of previous investments, but this is an argument for dividends, not an argument against buy and hold.

And a two-for-one: Aelph also has eight rules of investing.  I generally agree with them, though I think he puts too much emphasis on relative valuation, which is a strategy for long-only mutual funds and investment "professionals" who cannot afford to appear to be too passive (especially if the market is rising).  Personally, I believe a real advantage of the individual investor is the luxury of looking at absolute valuation, and mitigating risk by NOT INVESTING when there aren't attractive risk/return opportunities (e.g. US equities in 1999 and 2000).

Finally, I have to give Aelph huge credit for the diligence with which he posts.  I aspire to have that much to contribute.