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."

------------
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.

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

The Covered Call

The credit bubble has made fools out of many people. Economists assumed housing prices couldn't systematically drop. Banks didn't care about the underlying credit worthiness of the home owners since they quickly repackaged the loans and sold them to Fannie, Freddie, or Bear Stearns. Economics has lived up to its reputation of being a backward looking study whose predictive ability stinks. Financial risk cannot be measured based on distributions of historical returns since history does not repeat itself. This time is, and will continue to be different than '29, '73, '87, or '01. Stockpickers, this site included, have made gutsy bets on downtrodden stocks only to see their market prices plummet further.

VIX

With the CBOE volatity index (VIX), "fear index" at all-time highs, options are steeply priced due to implied near-term volatility. A high VIX index, if you're a contrarian, is a bullish signal since markets tend to place too much emphasis on the recent past.

A short call

This particular strategy is an alternative to the 1.27% yield of a 6-month T-bill or could be a long-term investment with capped upside and limited downside. Here's the play: Find a stock whose fundamentals you aren't too afraid of. Simultaneously buy shares and sell a deep-in-the-money call option. I've selected Discover Financial, a previous long only recommendation.


DFS

Discover Financial (DFS) issues credit cards and processes payments. Charge-offs are rising but Discover has over $10B in cash, only 1.85B in debt, a mere 30M in mortgage-related securities, and $1B in loan loss provisions for those who are indifferent about poor credit records. Loans, like with American Express are securitized and are therefore off-balance-sheet. Lack of willing buyers of receivables is the most serious near-term concern. Yesterday Visa and MasterCard announced a $2.75B settlement with Discover over anti-competitive practices. That adds more of a cash cushion. This is a good business at a good price (not a great business at a fantastic price--these situations are obviously rare).

The possible payoff

A 7.50 Nov 2008 call sells for 2.55/2.95 (bid/ask). If you buy 100 shares at 9.68 + .05 per share commission and collect the 2.51 (2.55 - 4.00 commission) from the short call option you face a 74% loss if the stock goes to zero, a breakeven scenario at 7.27 and a maximum profit of 2.88% if the stock finishes above 7.50. The stock could drop a further 22% from the current price and you'd still make 2.88% (including commission). This could be compared to picking up nickles in front of a steam roller. I think the downside protection is sufficient to justify a short-term alternative for idle cash.

_____________________

Disclosure:
Faro has recently made this trade. Do this with only a small portion of your available cash. Don't get too greedy and only invest in a company whose fundamentals you believe to be sound. If I were long-only one credit card company it would be AXP (a similar covered position could be made with a slightly higher investment and a lower maximum payoff).

Image: http://blog.sellsiusrealestate.com/wp-content/credit-bubble.gif

For Sale?

After the worst week ever for the Dow, the recent drop-off is now worthy of wikipedia. At cocktail parties and dinner tables the topic du jour is the market and the effect on investors' retirement accounts. We love to put the stock market in the simplest of terms, and in an odd retrospective view. The stock market is merely a place where businesses are bought and sold. Contrary to popular opinion, it is never universally wrong or right to buy or sell. But we should at least think about why we're buying or selling a piece of a business.

Cash flows

According to finance theory (and sometimes reality) the value of any asset is equal to the present value of all future expected cash flows. And with some stocks down 80% +, their very existence is now questioned, even without the toxic balance sheets of banks. Peak to trough the market has fallen over 46%, well into what economists consider bear market territory.

So if you have some cash on the sidelines, here's what to look for in companies and in strategies:

• A super clean balance sheet: since credit is a huge part of the problem, debt is now a sin. We have yet to see the coming wave of corporate debt defaults. The 10%+ spread of non-investment grade debt to US Treasuries is a testament to risk and uncertainty.
  

• Tiny market caps: these are thinly traded and have little or no analyst coverage; their price swings can be the biggest and their pricing the most inefficient.

• A large cash pile: this serves as a further cushion, or margin of safety, against a greater collapse.

• A business: a product or service that is needed or wanted in any economic environment.

• Options: covered calls (if you'd like to lower your effective cost basis but cap your upside, consider this) or married puts (to protect the downside).
  

And?

Faro is finding extreme value in global mining, Brazilian poultry, and Chinese education. Timing the market bottom is a fool's errand. However, I wouldn't bet (long at least) on banks or the American consumer (70% of GDP). Shrinking retirement accounts, falling home prices, and tightened credit must eventually bring even the most spendthrift of consumers to question whether to fork out $40.00 for dinner or drop $200.00 for jeans. Though the recent plunge reflects this, the enhanced awareness may likely lead to a self-fulfilling prophesy: an even bigger drop for companies that sell stuff people only think they need.

_______________

Note: Though readers may note the poor record (along with the market) of previous stock recommendations on this site, Faro is happy to report a flat last two weeks due to a short position in a domestic retailer.

Image: http://www.biojobblog.com/for_sale_sign(1).jpg

A Letter to Williams-Sonoma Management

Corporate excess is nothing new. The below is a letter that will be sent today to executives of Williams-Sonoma regarding the firm's use of a leased jet.

---------------------------------


September 29, 2008

W. Howard Lester
3250 Van Ness Avenue
San Francisco, CA 94109

Dear Mr. Lester:

Williams-Sonoma, Inc. has a storied past of brand equity and profitable growth. From its humble beginning in 1956, to its coveted Oprah endorsements of recent years, the company has pushed forward with winning strategies and has an impressive base of loyal customers. This, coupled with an attractively-valued stock, is what led us recently to become part owners (shareholders) of Williams-Sonoma (WSM).

We know things are tough. As shareholders, we salute the company's efforts to maximize returns on advertising by trimming the length of the catalogs and by tweaking both circulation numbers and catalog recipients. To say the market is challenging is an understatement. Home prices are correcting (falling). According to futures on the S&P/Case-Shiller Home Price Index this is likely to continue through the next several quarters.

Though systematic risk is unavoidable, certain expenses are well within management's control. Our concern is the company's use of a leased corporate jet. The related-party nature of this arrangement also raises eyebrows. As you read this, a jet is parked, or is perhaps soaring through the air, at the cost of over $12,328.78 per day (plus use-related expenses). Williams-Sonoma's likely future dealmaking and travel convenience needs do not warrant such lavish travel perks, independent Board approval aside. What could possibly justify such an expense?

We are cheerful about the long-term prospects of the company, and as shareholders, are compelled by its rock-bottom equity valuation. However, saying no to corporate waste and conspicuous luxuries is an important cost-cutting measure in any macro environment. Cruising in style in an owned or leased jet should not be part of the corporate ethos. It costs four cents per share and no measurable value can be expected from it. That money would be better spent increasing the share repurchase program. Now is the time to reverse this misappropriation of shareholder funds.

We welcome your comments.


---------------------------------