A note

In a previous post on how the housing bubble grew, I mentioned two potential guilty parties: banks and individuals. I should have added the role of government to the equation. Uncle Sam was complicit through its drastic loosening of the fed funds rate in the post-dotcom bubble. The government, through friends Fannie and Freddie, also encouraged insane lending and scooped up over half the mortgages originated.

This will be written in history as one of the more memorable unintended consequences of government intervention.


Image source: http://www.princeton.edu/~pkrugman/fed-funds-rate.png

Baby Formula and Special Dividends

If you have children you've complained about the cost of baby formula. Today a baby formula maker had an IPO whose success is built on pricey fake mother's milk. Mead Johnson (MJN), leader in the pediatric nutrition market, sold 30M of 200M shares outstanding. Proceeds from the offering, a carve-out from Brisol-Myers Squibb (BMY), valued the company at over $4.8B.

It appears to be reasonably valued. The company is selling for 1.7x revenue, 10x earnings, has grown sales at 5-10% even in challenging economic times, and boasts of a 22% operating margin.

Now to the obligatory "use of proceeds" section. The $600M in net value the company received from the IPO will go to pay an inter-company note. However, $1.4B will still be left in debt since the parent company, surely through the advice of a strategic adviser, decided to "lever" MJN with $2B in debt prior to the carve-out. Not that this isn't manageable given Mead Johnson's level of profitability, but to put the stockholders' equity at a deficit of $800M to line the wallets of Bristol-Myers Squibb is wrong. BMS will use the $2B to pay a special dividend. That ain't so special a way for Mead to start as a public company, even if it can rest on high-priced milk.

On housing, lending, and advice for my grandkids

As all writers of anything finance-related, I feel compelled to comment on housing’s role in our current economic crisis and end with the clichéd "lessons learned" bit.

It’s tempting to say we all foresaw this. There is no doubt that housing was and is a critical part of our deep economic malaise. The seeds were sewn through low interests rates, poor lending practices, and the cultural notion that a house is more than just a roof over one's head. Though it can be more, speculative short-term gains in residential real estate should never drive a rational person’s decisions.

On the housing bubble, there are two predominate ideological camps: 1) it's the banks' fault; 2) it's the home buyers’ fault.

The first group feels the home buyers were unsuspecting victims, preyed upon by Mr. Burns-type lenders: greedy, cold, and with a profit-only code of ethics. (Not all bankers are like this, but it makes for good imagery). These bankers were eager to rush loan approvals to hasten the securitization process whereby ensuring private school tuition, vacations in Bora Bora, and early retirement. Bankers should be punished, regulated, and striped of the compensation that Croesus himself would envy.

Banks are greedy. Their fees are high, and certain aspects of their businesses need to be regulated (OTC options come to mind). But they do, however, provide a valuable service to the economy. Credit drives our economy. Anyone who’s been granted a loan will attest to that.

The other group believes the home buyers themselves are to blame. Stories of credit-less deadbeats buying multiple houses with the idea of flipping and becoming wealthy, draw the ire of penny pinchers. These reckless borrowers collectively failed to notice the bubble-level home price to median income (the PE ratio of homes) ratio. Somewhere down the road, it would have to correct. They deserved their prize; they too were greedy. The modern corporation does not hold a monopoly on unethical behavior. After all, this is capitalism, and individualism rules.

To mend the housing and credit problems there are no easy solutions. I have no idea which items of the current "stimulus bill" will have the greatest multiplier effect. I only hope that government behaves better than in times past.

Understanding this, however, isn’t the real issue from a personal learning point of view. Financial manias and asset bubbles will reappear. They are “Black Swan” events.

The real value in having lived through 2008 (and beyond) is not learning how we can personally predict (and prophetically time) any future crises, but to examine it from the most micro of human levels. What do these events tell me about how I should shape my behavior and views?

At the risk of being too prescriptive, something that I loath about most business books, I offer advice to my children and future grandchildren.

In anything in life, if there are no significant barriers to entry, it's not worth doing. Medicine requires smarts and time. Athletics begs time and talent. Business demands good ideas, execution, and drive. Anyone could set up a mortgage brokerage business and undercut the professional and legitimate players through lackadaisical lending standards. The barrier to doing it right is ethics, work, and patience. Most don’t have all three.

Lastly, (and not that there are only two, but because two are easier to remember) the further you separate the risk taker from the actual risk bearer, the more likely you are to face an unsavory result. A father, through no intermediary, should know and trust his future son-in-law. Bankers should know and trust borrowers.

Some thoughts on business analysis and macro forecasts.

Posting stock picks creates the obvious pressure: be right and you'll look smart; if you're wrong your sins are on display for all to see. Most either shy away from this or bombard the reader with innumerable "buys" so that it becomes impractical to work through the math to find out how valuable the advice really is.

Naturally, the reader must be weary of either of the two extremes. Outside politics, and in most environments where discussion of the stock market is heated, failure to take a definitive position shows lack of confidence, and an unwillingness to (justifiably) allow others' to criticize your ideas. Being overly sanguine about every idea, on the other hand, is reckless and dishonest.

Thus the logical responses when a stocks attractiveness is considered are: 1) I don't know, 2) It's probably a bad idea, and there are myriad reasons for this: it's too complicated; the business is lousy ; management is inept; My brother-in-law knows I guy who's an insider and he says it's going up. And finally, 3) It's worth owning, usually because the numbers look good and the business is solid--note the nebulous terms "good" and "solid"; I'm being purposefully vague since not all attractively priced stocks are a "buy" for the same reason. But, intrinsic business value rarely changes as much as many of the daily prices quotes would indicate, especially during market malaise.

These three answers may seem painfully simple. In a world of huge egos and image management, however, most are afraid to look like dummies and therefore feel obligated to have a strong opinion about every investment issue. "Oh oil, yeah, it's going up; there's just so much pent up demand." This is a monumental error. I turn to my unofficial and dead mentor Abe Lincoln for a quote that fits nicely with this fallacy: “Better to remain silent and be thought a fool than to speak out and remove all doubt.”

The cure for this vice is to embrace the 50th percentile. Just be average with some things. My answer is, I don't know where oil prices will be in six months. Please understand, however, that references to this are short-term forecasts. One can assume that certain long-term imbalances will lead to glaring macroeconomic consequences (e.g., America's entitlement programs). Also, there are some great macro-economists. But given my understanding of history, very, very few get both the timing and the event correct.

That is why I choose to be a business analyst and not an economist. And so, I move forward boldly, with the philosophy that good ideas are rare, simple, and should be put up to the scrutiny of the economics of the business against the market's perception. I publish ideas knowing what's on the line with the hope I'm right more often than not.

What's the most meaningful way to measure investment returns?

It's being called the biggest investment scam ever. The Economist suggested, partly tongue-in-cheek, that the "Ponzi" scheme be rebranded the "Madoff" scheme due to its size and scope. Newspapers and blogs are humming about the institutions and country club members who fell for Bernie's years of lies. Obviously, especially in retrospect, the flags were crimson. A three-person audit firm was one. The supposedly consistent 10-12% annualized returns was perhaps the biggest; the open interest in the S&P 100 options used to run the split-strike strategy was too low to support $17B of activity.

Even if the volume of options wasn't a deal killer, how would you further critique the steady investment results? This is a problem the investment management business has yet to solve, or at least speak honestly about. What's the most meaningful way to measure investment returns?

Leverage and luck are two culprits. Pile on loads of debt either through margin or options and if things go your way, your returns are juiced. If you're wrong, your bad returns are amplified. Luck can be indistinguishable from skill in the short-term. So track records should count for something.

Naturally, hedge funds and other investment vehicles breed opacity. If they divulged everything than others would simple mimic their strategies and trades and therefore "crowd out" that corner of the investment world and dry up the excess returns. But investors now will demand greater transparency, or at least know that such a way of making money is feasible.

Oddly, most investment managers treat the quality of the return as ancillary--quality in the sense of risk and in probable future results. Since their incentives are to make the coveted 2/20 fees, high risk and high returns go hand in hand. Their traditional tools of return calculation use either beta (the covariance between the asset return and the market return) or the standard deviation of the portfolio, in some relation to returns generated. Again, they're not clear as to how the returns were made, only the final number. They also use a flawed definition of risk, but that's worthy of a separate posting.

Unlevered (equity only), market beating, long-term transparent strategies are the best way to measure investment returns; the final return measured against last year's price movement deviations is not enough. It's fair to ask how a manager justifies his fees and the scorecard that should be used to decide whether he should still have a job. Managers owe their clients restful sleep.

For a group that demands, clarity, loose regulations, detailed financial footnotes, and management candor, the investment management industry needs to come clean on how it measures returns. It would help doctors, teachers, and janitors to know that not everyone that manages money is like Bernie Madoff; some of them actually "add value."

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Disclosure: none
Image: http://www.yu.edu/uploadedImages/Sy_Syms/Dinner_2008/madoff_web.jpg

A Carnival Quiz

I easily get excited about new businesses and what makes them tick. The industry on my mind over the last several days has been the cruise industry. And after having recently finished my first cruise, I thought this little cruise quiz would be a fun test of your cruise business intuition. Questions of this sort were on my mind between meals and while relaxing by the pool. Enjoy. Answers are posted at the end.


1. Which of the following cruise company does Carnival not own?

A) Princess
B) Holland America
C) Celebrity
D) Seaborn

2. The percentage of worldwide cruise passengers sourced from North America is....

A) 40%
B) 50%
C) 60%
D) 70%

3. Cruises have the well-deserved reputation as places to overeat. What percentage of total passenger ticket sales does Carnival spend of food for its chubby guests?

A) 8%
B) 16%
C) 24%
D) 31%


4. A great (and consistent) source of revenue is derived from other income (alcohol, casinos, souvenirs, land excursions, photos, etc.) True or false, this makes up 50% of total revenue?


5. ALBD means what in cruise economics?


6. Carnival and its publicly-traded rival Royal Caribbean have sales/debt ratios of:

A) between 20% and 49%
B) between 50% and 60%
C) between 61% and 90%
D) greater than 100%


7. What corporate action did the industry's cruise operators recently announce?


A) A near-term discontinuance of stock dividends
B) A huge drop in asset-backed securitizations
C) An increase in the share repurchase program
D) A move in corporate offices from Spokane to Atlanta.






Answer Key: 1) A, 2) D, 3) B, 4) False. It's closer to 25% of sales. 5) Costs per available lower berth day "ALBD". ALBDs assume that each cabin offered for sale accommodates two passengers and is computed by multiplying passenger capacity by revenue-producing ship operating days in the period. 6) C, 7) A.

A few words on public vs. private

After balance sheet concerns and the overall lackluster macro economic environment, the decision to be a public or private company must now keep executives wondering. Is it worth it to be a pubic company?

Most public companies have a culture of benchmarking and short-sided metrics. They are faced with quarterly grillings at the hands of mostly out-of-touch analysts who are more concerned about modeling next quarter's capital expenditures and whether earnings are off by a penny. I'm not just being cynical either. If you've listened to quarterly calls you get my point. Though some notable CEOs have the mettle to withstand the institutional imperative, most do not. A study by McKinsey & Co. shows that 50% of execs would forgo a positive NPV project rather than miss next quarter's numbers. My guess is if all were truthful it'd be even higher.

Public companies almost universally decide to grant top employees stock options. However, though these carry a tax benefit, the compliance savings of not having to abide by Sarbanes-Oxley (private co's don't have to follow this), would more than offset the tax advantage for most companies. An alternative to public stock options: a combination of cash incentives and private stock offerings. The only issue is they can't bail and sell with the ease of the the public markets. But who wants a short-term marriage anyway?

I would prefer to own a private business. I don't need to know my net worth every day. I'm in it for the long haul and I'd rather sacrifice next year's numbers for a long-term strategy that makes sense. If you're a company that needs constant access to the capital markets, a daily performace scorecard, and thinks high doses of liquid shares should be granted to top talent, stick with the public model. As for me, I prefer my privacy.

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Disclosure: I still think some public companies are awesome.
Image: http://act.psy.cmu.edu/awpt/pictures/graph.gif