Friday, August 17, 2012

Oaktree's Grand Slam

I don't plan on updating things every quarter on companies I mention here; figures will go up and down over the short term due to markets and AUM changes due new fund launches and returning of capital to investors (due to realizations) etc.

But anyway, one of the interesting things about OAK is the off-balance sheet items.  One of the large ones is the accrued incentive fees that is not booked as income at OAK (other managers book these even if not realized which causes higher p/l volatility).  The accrued incentive fee is held at the fund level and not paid out so doesn't show up in earnings or on the balance sheet.  It is itemized in the filings, though, so we always know how much is there.

At the end of the 2nd quarter, there was around $1.1 billion of that held at funds that actually belong to OAK (if realized and paid out). This comes to a little more than $7/share so is not trivial.  It's a nice chunk of the value at OAK.

Doubleline Capital
The other piece that is not reflected on the balance sheet is Doubleline Capital, a fund management company started with the help of OAK by Jeffrey Gundlach.  If you google him, you will find an interesting past to this person; trying to become a rock star in California, seeing an episode of the Lifestyles of the Rich and Famous and wanting to get rich, becoming (or trying to) an investment banker etc.  How can you not love America?

So as of the end of the last quarter, Doubleline already has $40 billion in assets under management (AUM), and has earned OAK $4.8 million in the second quarter alone (this includes their 22% stake in Doubleline Capital LP and an affiliated entity).  Earnings in Doubleline Opportunistic Income LP is stated separately.

This stake in Doubleline Capital LP is on the books at a cost basis of $18 million (the original investment was $20 million, I think, so they must have gotten dividends paid out or some other thing to reduce the cost basis).

Since the equity income passes through the income statement, this is not a completely off-balance sheet item; it is reflected in distributable income, economic net income etc.   It's just on the balance sheet at a really low price that doesn't reflect reality, so any valuation using distributable income or ENI is not affected by this.

The question becomes, how much is Doubleline Capital worth?  

Someone commented on my previous OAK post that it may be worth 2% of AUM.  Using 2% of $40 billion, that makes Doubleline Capital LP worth $800 million.  OAK owns 22% of that so that would be worth $176 million.  That's a nine-bagger ($176 mn / $20 mn)!  Nice trade.

Since there is 150 million total A and B shares outstanding, that comes to $1.17/share.  So currently, it's not a huge part of the total valuation of OAK (trading now just under $40/share).  But Doubleline is growing rapidly.  I think they had $30 billion earlier this year and it is now up to $40 billion.

Valuation Comps:  PIMCO
So I don't really know who the comps are for Doubleline other than TCW itself and PIMCO.  Blackrock used to be a fixed income manager until they bought Merrill's asset management business (which was mostly equities) in 2006.  So before that, they were a fixed income manager.  But those guys were a little different than TCW / PIMCO.

Anyway, thanks to the internet we have some data on PIMCO.   PIMCO was bought by Allianz back in March 2000.  They bought 70% of it for $3.3 billion, valuing the whole company at $4.7 billion.  At the time, PIMCO had AUM of $256 billion (they now have a whopping $1.8 trillion).

From the Allianz / PIMCO purchase presentation, the valuation of PIMCO was 1.8% of AUM and 14.5x EBITDA.  However, at the time back in 2000, 36% of PIMCO's AUM was in equities.

TCW / METwest
SocGen paid $880 million for a 51% stake in 2001 valuing TCW back then at $1.7 billion. They had AUM of $80 billion then, so that's 2.1% of AUM.

In 2009, Gundlach tried to buy TCW (51% stake) for $350 million, valuing TCW at the time at $700 million.  With TCW AUM at around $100 billion at the time, that comes to 0.7% of AUM.

The Carlyle purchase of TCW is said to be worth $700-800 million. With a current AUM of $131 billion, that comes to 0.53% - 0.61% of AUM. 

In 2009, Citibank bankers (hired by TCW to seek strategic options) valued TCW at between $700 - 900 million; AUM in 2009 was $100 billion, so that comes to 0.7% - 0.9% of AUM.

TCW, after Gundlach left, bought Metropolitan West Asset Management to fill the void for $300 million, and the AUM for MetWest at the time was $30 billion, so that's 1.0% of AUM.

So these are the data points from various articles written recently about the Carlyle / TCW deal.

By the way, here is the TCW AUM trend:

2006  $145
2007  $147
2008  $103
2009  $100
2010  $116
2011  $118
2012  $131 (current)

Doubleline Worth 2% of AUM?
Two key data points support a 2% AUM valuation; the PIMCO purchase by Allianz (1.8% of AUM), and the SocGen purchase of TCW (2.1% of AUM).    I think the underlying companies may be close comparables, but the problem is that these purchases were by large European financial institutions (not the most price sensitive?) and the deals were done in 2000 and 2001.  This was at the peak of the bubble so valuations may be peak-ish too.  More importantly, this was before the financial crisis and all financial valuations are far lower now than pre-crisis (if we want to use pre-crisis valuations, we might as well value GS at 3x book and just stay at the beach).

More recent data points suggest something closer to 1% of AUM.  Of course, TCW may be 'troubled' so it may not be such a great comp as far as the Carlyle deal is concerned.

But the Citibank valuation in 2009 of 0.7% - 0.9% of AUM is post-crisis and I assume TCW was still doing well at the time (Gundlach still there?).   Also, Gundlach himself bid 0.7% of AUM for TCW.  Of course, this may have just been a low-ball bid, but if he really wanted TCW he wouldn't bid such a small fraction of what it is worth.   Since it comes in at the low end of Citibank's evaluation, this 0.7% - 0.9% of AUM range is probably not too far off.

Also, TCW paid 1.0% of AUM for MetWest, which was presumably not a troubled firm.  This supports the notion that Doubleline may be worth closer to 1.0% of AUM rather than 2.0% of AUM.

By the way, you can't compare Doubleline with OAK; the big difference is that OAK is a hedge fund manager with higher fees and incentive fees which account for a large part of the value of OAK.

Blackrock (BLK)
Just as a sanity check, I took a quick look at BLK pre-2006 (when they bought Merrill's asset management business) as they were primarily a bond manager at the time. Since this is pre-crisis, it may not be too useful.

But anyway, a quick look shows that at year end 2005 and 2006, enterprise value to AUM was around 1.5% and 1.7% (10k's don't go back that far), and the p/e ratio ranged from 25-29x in 2001-2006 (on a year-end basis).

They are a totally different beast now, with a lot of equity assets and a big ETF business.  I think we will be laughed out of the room if we mentioned a 25x p/e ratio for someone in the financial industry.

P/E Ratio
Just as a cross check, since we know that Doubleline earned for OAK $4.8 million in the second quarter, let's look at some earnings ratios of some asset managers.  This measure will be more stable across different types of asset managers (percent-of-AUM valuation differs drastically according to what type of fund it is; equity, fixed income, hedge fund, mutual fund etc...).  P/E ratios are indifferent to asset type and only look at earnings. 

Since Doubleline is an LP, I assume the equity income that OAK books is a pretax figure.  So we will have to look at pretax P/E ratios (market cap divided by pretax earnings).  These are some listed asset managers in no particular order and their pretax p/e (based on FY 2011) and their trailing twelve month p/e (ttm) which I just pulled from Yahoo Finance.

Asset Manager Valuation

From this, we see that a pretax earnings multiple is pretty consistent across asset managers regardless of type of assets, and they average around 10x pretax earnings.  I put the ttm p/e ratio in there just for reference (note that the time period is different; ttm versus FY 2011).

OAK booked equity income of $4.8 million on their Doubleline stake in the second quarter.  Since Doubleline is growing so quickly, let's annualize this rather than double the six month figure (which happens to be $8.9 million). 

That gives us pretax earnings of $19.2 million.  Assuming little debt at Doubleline and minimal D&A, this may be close to EBITDA.  In that case, we can compare this figure to the PIMCO purchase by Allianz which was at 14.5x EBITDA.   This would give a value for Doubleline (OAK's share of it) of $278 million, or $1.86/share.

Using the above 10x pretax figure, OAK's stake in Doubleline would be worth $192 million or $1.28/share.   This is just a cross check; I can't really get too comfortable with an earnings valuation without a little more data and some more detail.  But if we keep an eye on it, it can be a good sanity check.

So judging from this quick look, it seems that a 2% of AUM valuation for Doubleline might be a little aggressive in this post-crisis market (and what if bonds actually do enter a bear market?).  A 1% of AUM figure sounds totally reasonable given recent transaction trends.

At 1% of AUM, Doubleline today would be worth around $400 million.  OAK owns 22%, so that's $88 million or about $0.60/share  (That means if we double the valuation, it's worth $1.20/share (at 2% of AUM)).

So even though this investment already is a home run for OAK, it's still not a big part of OAK's total intrinsic value.

We looked at the EBITDA valuation, but we can probably throw that out as it's based on a pre-crisis transaction at the peak of another bubble.  Using 10x pretax earnings which many listed asset managers seem to be consistently valued at, and a 2Q2012 run rate earnings, OAK's stake in Doubleline is worth $1.28/share  ($4.8 million x 4 / 150 mn SOS). 

This curiously gets us back to 2% AUM valuation, so maybe Doubleline is worth 2% of AUM after all.  But since Doubleline is still starting up, we have yet to see what their normalized earnings is going to be; we don't know what Doubleline will earn over time.

In any case, either way, Doubleline now is worth anywhere from $0.60-$1.28/share (1% or 2% of AUM or 10x pretax earnings).

But we have to remember that Doubleline is growing dramatically now.  Earlier this year they had less than $30 billion in AUM and now it's $40 billion.

So let's project out what they can possibly do.

Let's say that Doubleline can basically recreate TCW.  From the above table, we see that TCW had AUM in the $100 billion - 150 billion over the years.

Using the 1% and 2% AUM figures (we won't know what the pretax earnings are going to be), here is what Doubleline might be worth to OAK on a per share basis:

The first column is simply the AUM Doubleline will have.  The Total value figures are just 1% and 2% of that.  The value per OAK share is simply the total value times 0.22 (22% ownership) divided by 150 million shares of OAK shares outstanding.

From this, we see that OAK's stake in Doubleline is currently worth $0.59 - $1.17 / OAK share.  If Doubleline can recreate TCW and get AUM up to where they are, then the value to OAK of their stake would be $2.05/share (at 1% AUM valuation) or $4.11/share (at 2% AUM valuation).

Of course, they can keep growing.  If they get AUM up to $200 billion, then Doubleline would be worth $2.93 - $5.87 / OAK share.

If you want to up the AUM assumptions, just double the $400 billion AUM, or just use $1.50 per share per $100 billion etc.   I'm sure some bulls will want to argue that  Doubleline can become more like the $1.8 trillion PIMCO.   Now that would be something.

Doubleline is already a home run for OAK, but if they get AUM up to $140 billion, OAK's share at 2% could be worth $616 million.  Think about that.  A $20 million investment going to $616 million.  That would be a 30-bagger.

But as much a home run Doubleline is for OAK, it would still account for only $4.11/share in value to OAK shareholders.  Doesn't seem like much on a $40 stock (but we'll take it!).

Friday, August 10, 2012

World War III and the Stock Market (and other random thoughts)

I've read the 1934, 1940 and 1988 editions of Securities Analysis but haven't read the 1951 and 1962 editions.  For whatever reason, they slipped through the cracks.  I really love the 1934 edition because it is the first edition and really digs into what went wrong in the 1920s and early 1930s (sounds exactly like the 1990s bubble), and the 1940 edition.

I think Buffett has said that the 1940 edition is his favorite.  He said he has read it at least four times over the years.  A sixth edition was published recently with comments by some of the current great investors and those 'essays' alone are worth the price of the book.   The sixth edition is just a reissue of the 1940 edition (updated) with these essays added. 

The commentators are:

  •   Seth Klarman
  •   James Grant
  •   Roger Lowenstein
  •   Howard Marks
  •   J. Ezra Merkin (?!)
  •   Bruce Berkowitz
  •   Glenn Greenberg
  •   Bruce Greenwald
  •   David Abrams
  •   Thomas Russo

Anyway, here are the links to the various editions (of course, from the Brooklyn investor store; I just set up this bookstore for fun.  I wanted to understand how this stuff works (after following Amazon for so many years) and did it out of curiosity, plus I find myself recommending the same books over and over to people so figured I would put it all up somewhere.  I haven't really finished stocking it up and organizing it, though).

1934 Edition
Sixth Edition (1940 reissue)
1951 Edition
1962 Edition

If you haven't read any of them and only had to read one, I would say start with the Sixth Edition  (The 1988 edition was not written by Graham).

1951 Edition
Anyway, so I started reading the 1951 edition and in the preface dated October 1951, there was a paragraph that struck me as relevant to today (well, everything he says is still relevant today):
This preface is being written when the possibility of a third world war weighs heavily in all our minds.  We need to say only a word about this unhappy subject in relation to our present work.  The effect of such a war upon ourselves and our institutions is incalculable.  But in the field of securities analysis we need consider only its bearing on the choice between various securities and between securities and (paper) money.  It seems sufficient to observe that since war and inflation are inseparable, paper money and securities payable in specific amounts of paper money would seem to offer less financial or basic protection than soundly chosen common stocks, representing ownership of tangible, productive property.

And in the footnote, there was an excerpt from an essay Graham wrote for the Analysts Journal in the first quarter of 1951 titled The War and Stock Values.

Here is a quote from there:
Stock prices as a whole may be expected to rise, sooner or later, to reflect this cheapening of the dollar.  The course of the stock market from 1900 to date (1951) shows a fairly close over-all correspondence between the rise in stocks and the general prices, although there have been significant divergences for fairly long periods.
This is relevant today because most people seem to fear now high inflation due to all the pump-priming around the world.  This is not news to stock investors; many believe that stocks are better than cash and bonds, but others are worried that high inflation will cause stock prices to go down; they think they should wait by holding cash (despite inflation risk), gold or look into investing in 'hard' assets like real estate.

Hard Assets or Stocks?
I wrote a lot about what I think of gold here so I'll talk about other assets.  There is somewhat of a boom in farm land around the world with purely financial buyers bidding up prices.   The story makes a lot of sense; there will be inflation in the future so own hard assets.  Food demand will continue to grow on increasing population so farmland prices will go up.

But it's important to remember (and nobody really talks about anymore) that the housing bubble in the U.S. was driven largely by people wanting to own a 'hard' asset.  They got killed in stocks in the 2000 internet bubble.  They vowed, no more stocks!  And they rushed into real estate.  It's a hard asset, right?  It will hold it's value.  The Fed will always print more money at every economic downtick.  The government will keep spending money.  Inflation is inevitable.  So why not own houses and real estate?  Land bank stocks boomed too back then.  They don't make more land, right?  But they do keep printing more money. 

So it made perfect sense.  Buy houses, land, land bank stocks etc.  And what's more, you can borrow to do so.  Borrowing money is shorting the U.S. dollar.  And sometimes you can do it with positive carry or zero carry (cash savings or rental income pays interest and other expenses so you get the rise in prices for free).

This was a major factor in people rushing into real estate, I think. 

And there are people driven to certain investments today for the same reason and I am a bit skeptical of them.

Stocks are Real Assets Too
People tend to brush off stocks as a piece of paper and forget that it's a partial ownership of real assets, or "tangible, productive property" as Graham called it.  Of course, this is not true for all stocks.  As I mentioned in a post a while back, Coca-Cola has done really well over time despite the inflation that has occured in the past century.  As Graham says, stock prices eventually catch up to the rise in general price levels.  (I wrote about KO and inflation here)

If a business has a good product, good management, good business etc., then inflation won't be much of a problem.  The only problem is that if inflation ticks up, stock prices may go down in the short term (Earnings may go down too, but if it's a good business, they will be able to reprice and do well over time).

I think this is what most investors worry about.  They remember stocks at 7x p/e back in the late 1970s and think it can go back to that level when high inflation inevitably comes.

In the above mentioned The War and Stock Values essay, Graham wrote:
War conditions could be destructive to stock values but the mere possibility proves nothing of significance.  It is the weight of probabilities that is important.

This is another key point.  People worry about inflation, but it is important to weigh the probabilities.  Many smart people do think inflation is inevitable (as I do too), but we don't really know when and how much.  Some feel hyperinflation is inevitable and others have more moderate views.

But nothing is certain.  When a scenario is certain and absolute (and many agree), you should look elsewhere anyway as you can only make money on the divergence between perception and reality.   (There is a conundrum here as gold and other hard asset prices says inflation is inevitable but bond prices say deflation).

Stocks Outperform Inflation Over Time
OK, so I'm going to borrow this chart from Bill Gross' (PIMCO bond guru) recent, controversial letter that I will comment on later.

This shows that stocks over time have handily outperformed inflation, bonds and cash.  But the key words are "over time".  Of course, stocks were flat in the inflationary 1970s.  One might have averted that flat period by successfully timing the market, but I think it's been proven that nobody can time in and out of markets over time successfully (most individual investors lose money or underperform because they get in and out of stocks at the wrong time!).

(I have shown here that there is a class of investors (residents of a village) that can make good returns in a flat market period without resorting to getting in and out of the market.  This group has outperformed in all sorts of market environments over long periods of time.  I have yet to find similiar performance figures for tactical asset allocators and market timers).

Fear of 7x p/e Stock Market
So anyway, yes, if inflation spikes up like in the 1970s, stock prices will go down and may go down really hard. But we don't know when and how much things will go down. One big risk in avoing stocks until such event occurs is that it may not happen as planned. Back in 1987, people thought a 1930s-like depression was inevitable (so they stayed out of stocks). Others thought that the market won't bottom until the market p/e gets to 7x.  They looked at a long term chart of market p/e ratios and they saw that the market went down to that level in 1932 and 1972.  So they figured it must get there in 1987 or 1988 too.   In fact, many called for 7x market p/e's in 1990-1992 too during the Iraq crisis, real estate / Citibank crisis etc.  I heard people call for it in 1997/1998 too.

If there were two times it should have happened, it was after the 2000 bubble collapse and of course the financial crisis.  The market p/e didn't get low then either.    You can fairly argue that stocks haven't done much since 2000 so it doesn't matter; staying out of the market wouldn't have cost much.

But it's still not a certainly that we will get 7x p/e's in the near future. 

So what if it does?  Odds are that people who get out now and wait for a 7x p/e before jumping back in will do worse over time than people who ride it all the way through.

Cheap Can Be Good for Current Stockholders
There is a big difference between thinking that the bear market will bottom at 5x or 7x p/e and thinking that stocks will get to 7x p/e and stay at that valuation forever.  If you think the former, it doesn't matter.  If you think the latter, then maybe you are better off staying out of the stock market (even though you have to calculate the odds that you may be right etc.).

People want to keep cash on the sidelines so that they can buy stocks when they get cheaper, or so they can moderate the losses on the downside. 

This is something each person has to figure out on their own and do what is comfortable for them.  But it's important to remember that even if you are fully invested, that doesn't mean you can't take advantage of a cheap market.

Charlie Munger talked about this at a recent annual meeting.  He said low stock prices is good because it allows good companies to grow.  He said this is how Rockefeller, Carnegie and others got rich.  They were around in bad times to buy stuff on the cheap to get bigger.   Without the bad times, they wouldn't have grown as big and wouldn't have gotten as rich  (I assume Munger meant Rockefeller/Carnegie got big at the company level; strong balance sheet and good cash flow to reinvest in bad times to expand).

If you own a stock that generates good cash flows, then you are going to benefit in bad times as long as the people who run the business know how to allocate capital.  They will get better deals than most individuals and even most professional investors will get. 

This is why it's important to invest in companies with solid businesses with high moats, not too cyclical and strong balance sheets.

Most investors are afraid of the mark-to-market losses they will have to take on a decline in the stock market and they don't think about what happens on an upturn after that.

So even if you have no cash and are fully invested, that doesn't mean good companies you own can't take advantage; in one sense, you are not fully invested.  (Think about the companies that I write a lot about here; BRK, LUK, L etc.  A lot of these companies have good cash flows and excess capital they are waiting to deploy.  This is true for strong operating companies too).

Culture of Equity is Dead
So Bill Gross wrote a letter stating that stocks are basically dead and even said that the stock market is a sort of Ponzi scheme.  He points to the difference in real stock market returns over time of 6.6%/year versus a real GDP growth over time 3.5%/year and says it is unsustainable as the stock market is just skimming 3%/year off the top.  Many have already pointed out the error in Gross' thinking; that difference is basically dividends that get paid out. 

He confused growth in stock market capitalization and total return. 

In any case, there was something else I thought about while reading that letter.  Even if the stock market as a whole can't outdo GDP over time, I do think that great companies can (not that we can always identify great companies).

For example, Walmart has been taking market share from unlisted, small mom and pop shops for decades.   This would show up in an increase in stock market earnings over and above GDP growth.  The same could be said of some great restaurant companies. Roll up strategies might give the same effect.  Globalization can also contribute to this trend; McDonalds, YUM Brands, Coke all get a lot of growth outside the U.S. and yet book earnings here in the U.S.

As usual, regardless of what the macro, top down charts show, at the end of the day, it's all about the individual businesses and the price you pay for them.

P.S. Market Up More Than 11% YTD
Not that short term stock market movements matter much, but I just couldn't resist pointing out yet again the futility of macro-analysis for stock market investing.  All year, we have been worried about a real implosion in Europe and even China.  I too was convinced that a real crash may happen and things really might get out of hand.  Reading the newspapers every day was a scary thing to do; sometimes I just wanted to not read the paper at all.

And yet here we are with the S&P 500 index up over 11% on the year.  As I said many times before, if you took all that has happened this year, went into a time machine to the beginning of the year and told them what would happen, I don't think people would have guessed the stock market would be up at this point.  (On top of the Europe problem, slowing China and the fiscal cliff, we also had JPM's whale problem etc.)

Louis Bacon recently gave back some of his investor's capital saying the markets are too tough to trade with all of this macro noise (or more the government interference).  He is supposed to make money off of that.  He complained that political meddling / interfering in the markets has made it hard to make money.  I scratched my head because it seems that that has always been the case.  Remember the Greenspan put?  Remember the Plaza accord?  Central bank intervention in foreign currency markets?  Rubin's bailing out of Mexico?  LTCM bailout?

I think it has always been pretty hard.  I would guess that Bacon's problem is size, and possibly even information flow.  I think some hedge funds were privy to some good, advantageous information (not necessarily illegal inside information) in the past and due to the crackdown on banks, independent research firms, insider trading busts and overall heavier regulatory scrutiny, maybe that sort of information doesn't flow as much as it used to.   But that's just a shot in the dark guess.  (I noticed that a high performance hedge fund's return started to slow dramatically also around the time that independent equity research companies started to be investigated.  This may be a coincidence, but I always wondered about that. Still, size is probably the biggest hurdle to high performance).

For equity oriented hedge funds, Sarbox and Reg FD may be a factor too in flattening the information flow; previously analysts were able to get access to more information and pass that on to favored institutional investors including hedge funds.  These new regulations made it harder to get good information.

This is nothing new; I am not making any allegations.  Michael Steinhardt himself has said in one of the Money Masters books that one advantage he had was that he paid Wall Street so much in commissions that he was a valued client.  Therefore, he often got the first call on upgrades, downgrades etc.  And when he didn't get the first call, he would go ballistic.  

The world has changed quite a bit since then, and this may be a factor in the moderation of hedge fund returns lately.

Tuesday, August 7, 2012

Knight Capital Group

As a long time Wall Street apologist, how can I not comment on this Knightmare (KCG)?  Here are some of my quick thoughts on this.

HFT, Trading Bots Killing Markets
First of all, there is a lot of commentary about how the HFTs and algorithms are killing the markets and scaring investors away from the market.  Andrew Ross Sorkin had a thoughtful article in the New York Times today.  His point was that these computer generated blowups aren't what is causing people to move away from stocks; it's other factors such as poor performance of stocks in the past decade or so and other external factors (fiscal cliff, Europe etc.).  I completely agree.  If the stock market has been going up 15%/year over the past ten years, I bet people would be jumping into stocks regardless of insider trading busts, flash crashes and any of that other stuff.

Sorkin has become a much more well-balanced reporter, I think, after he wrote the book "Too Big to Fail".  It's almost as if all that time spent interviewing people for the book has enhanced his understanding of how things actually work.

Anyway, this Knight trading error is pretty scary but I don't think it's a reason to move away from computer trading.  I'm sure when people crashed their cars early this century, some called for going back to the horse and buggy.  Or what about automated traffic lights?  I have no information but I wouldn't be surprised if some of them malfunctioned early on causing car accidents.  This may have prompted someone to call for going back to people directing traffic, or outright just banning cars.

I don't know if it happened, but it's easy to imagine many situations where technology caused problems.  This is no reason to back away from it.  We just have to make it better.  As someone said, you can't put the genie back in the bottle.

As far as market-making is concerned, I am convinced that computers are far better than humans.

For most individual investors, none of this stuff should be relevant.  If you like a stock and you buy it and hold it, what difference does it make if an errant computer sells a $70 stock at $40, or if some 'dumb' firm blows up because of faulty software?   As for bots trading too much, that is also irrelevant to people who don't trade stocks often.  The more someone trades, the more 'taxes' they pay to the street.   But it's always been that way; it's just different people that walk away with the money.

I think these bots are the most frustrating to the day traders.    (Does Buffett care if HFT's trade a billion KO or IBM shares a day?  Probably not as it doesn't impact the intrinsic value of the business).

Institutions Will Get Biggered
Another thought I had reading about this incident is that contrary to public sentiment, political pressure etc., this may actually accelerate the biggering of financial institutions.  If a small firm like KCG can blow up on a normal market day without any triggering event, who can you trust?

This would be a non-issue, normally, but this comes after Lehman (which proved that even prime brokerage clients are exposed to the credit of their brokers), MF Global (which proved that even clients with segregated accounts and with no theoretical credit exposure can lose money).

The 2Q 2012 Morgan Stanley (MS) conference call was interesting in that they said that volumes were down due to clients holding back business from MS to see how much they would be downgraded.   People were worried about even the prestigious MS.

Goldman Sachs (GS) learned during the crisis that even if you have no problem positions and are in good shape, clients can run (Druckenmiller even famously took money out of GS accounts and transferred them despite a close relationship with GS' Cohn).

If you are an institutional investor or hedge fund, why would you take the risk of something happening?  Is it worth the risk?  Why not just keep your assets at a large, supersafe bank like JPM?

Almost everyone is calling for big banks to be broken up, but it seems to me that people are actually wanting to run to the big banks for their own money; they want big, diversified and safe.   When times are turbulent, it's nice to be on a huge cruise ship rather than some ferry or yacht, however high tech and cool they are.  Of course, there is the Titanic to worry about, but those are rare.

I think this JEF incident will reinforce this trend.  (I do suspect that MER and JPM's investment bank are doing way better than GS and MS partly for this reason.  I don't think GS has ever said that is a factor, though).

It does seem a little odd that a CEO that oversaw such a large blowup is allowed to stay on board.  Under any other circumstance, the CEO would have been blown out immediately.  But Joyce is a street veteran and it seems like he was bailed out by his friends so maybe the new owners will allow him to stay.   There are all sorts of motives for bailing out KCG.  Some see a decent business and an opportunity.  Others wanted to keep KCG alive for game theory-like reasons.

What is KCG Worth?
This is not a deep dive into KCG at all, but just a quick look.  Most seem to agree that KCG is worth tangible book value at this point. 

Before the $440 million loss, KCG had $1.5 billion in equity capital as of the end of March 2012.  They had 98.2 million shares outstanding. 

The deal was for $400 million for 2% preferred shares that are convertible into common stock at $1.50/share.  There is a mandatory conversion if the KCG stock price trades at 200% of the conversion price for 60 consecutive days (that's $3.00/share at this point).    This $400 million preferred is convertible into 267 million shares.

So you have $1.5 billion that went down to $1.2 billion due to the loss ($440 million pretax loss, or $264 million after tax) and then replenished with this deal to $1.6 billion.  Now you would have diluted shares of 365.2 million shares.

Post-deal, the book value per share comes to $4.38/share.

They had $338 million in goodwill and $89 million in intangibles as of March-end 2012, so tangible book was $1.17 billion post-deal.  That's $3.21/share.  This figure will vary according to how people round figures, whether they use pretax or after tax loss figure and which number of shares is used (I don't know why the shares outstanding implied in the KCG presentation is much lower than the 98.2 million shares shown in the latest Q.  It seems there is a large gap between diluted shares used in EPS and shares outstanding at period-end; this may be due to a lot of stock option/stock repurchase activity and the timing.  I think BPS usually uses period end and not average SOS used in EPS calculations.)

KCG Historical Performance
Here's a table that shows how KCG has done in the recent past.  

Over time, KCG has earned an ROE of 8% and a ROTE (return on tangible equity) of around 11%.  This includes the boom times of 2006/2007 and some bad years like 2002 and the financial crisis. 

From this we see that if KCG can continue as before with no negative effects from the recent debacle, KCG may well be worth tangible book.

However, I don't know how strong the moat of this business is.  As you can see, this business has been under considerable pressure.  The market-making business used to be very lucrative because the bid-ask spread was 1/8 even in the highly liquid stocks.  So if you just sat there and bought at the bid and sold the offer, you made 12.5 cents on every share.

Of course not every trade is going to be a buy at the bid and sell at the offer.  It's not that easy.   By the way, this is why firms like KCG want your "dumb" money flow.  The more market orders they get, the more money they will make.  Filling a limit order is like clerical work and not as profitable, even though I suppose you can take advantage of limit orders of inactive traders (option value).

In 2001, the market went decimal, and this sort of 'decimated' the industry.

The right hand column in the above table (Revenue capture per dollar traded) is how much money KCG made on every trade (this is in basis points).  You can see how the trend has been down over the years.   They used to capture 2.5 basis points on every trade but now only makes a little over a single basis point.

But that's not even the biggest decline.  They didn't provide this figure in basis points prior to 2003; they reported dollars per share traded.   This metric was $0.0092/share back in 2000 and that declined to $0.0015/share in 2002.  That's a stunning decline of more than 80%.

Here's a table to show the 'crash' in revenues per shares traded (and in bps next to it):
               Revenue captured                  Revenue captured
               per share                                per $ traded
               traded   ($/share)                    (bps)
1999       $0.0095     
2000       $0.0092
2001       $0.0032                                  3.62 bps
2002       $0.0015                                  2.41 bps

This discontinuity is just because KCG switched from reporting revenue captures from a per share basis to a per dollar basis.  These figures are net of clearing and other direct costs.

I am not so sure if their institutional business will ever make money, and how long the market-making business will continue to make money.  As the markets evolve, I do think that the moat gets lower and lower.  There is plenty of capital available too for this sort of operation.

So KCG may very well be fairly valued here at around tangible book.  I am not particularly interested in this sort of business model but I don't really have a strong opinion on KCG either way.  I have looked at it off and on over the years and was never particularly interested (for the reason I stated; declining moat, increasing irrelevance).

So Who Benefits?
If KCG is not interesting to me, of course the other side we have to look at are the guys that bought into this deal.  If the reporting is correct, Jeffries took $125 million of these preferreds.   Blackstone and Getco each took $87.5 million and TD Ameritrade took $40 million.  This doesn't add up to $400 million as there are others; I haven't seen the full list (I don't think it was in any of the related SEC filings, but maybe it's somewhere).

If KCG is worth $3.00/share (around tangible book), then these preferreds are worth twice as much as what they paid.  Jeffries bought $125 million, so these are now worth $250 million; not a bad trade for one day.

JEF has shareholders equity of $3.3 billion so this deal puts almost 8% of that into KCG.  The investment, though was only 4% of equity.  Of course this means that JEF has earned an immediate 4% on book just by doing this deal.  Not a bad day at the office.

Given the low returns on equity these days at investment banks, this will be a nice bump to earnings this year and to book value. 

Of course, this is assuming that KCG can continue as before.  This is not a certainty but it's also not completely unreasonable to assume.  If this loss was a one-off event however unfortunate, and people are convinced that it was caused by a single software malfunction and is assured that it won't happen again, KCG may continue more or less as before but perhaps with more focus now on costs and earnings as there will be vested board members that will have an interest in enhancing value there.

  • KCG is not a particularly interesting business to me, but may be a so-so business; its seems like an OK business at best, and may be a declining, bad business (notice how ROE didn't pick up after the crisis in a strong market).  Tangible book is not a bad starting point for valuation, though.
  • Bots and computer trading is getting another black eye from this incident, but I really don't think this tells us necessarily that computers are out of control.  It is unbelievable that KCG was unable to stop the trading even when they realized what was happening (and it apparently took the NYSE to shut them down).  But again, this to me indicates really bad management and doesn't mean all computer based trading is equally dangerous.  These things will keep happening, and we will just keep improving our systems, especially checks and safety mechanisms (just like we improved cars and airplanes over time).
  • Financial institutions, I think, will get bigger.  With all of this uncertainty and fear in the markets, money will flow to the large banks.  Why worry about what will happen to independents in another crisis or near crisis?  Why not just move money to the large, safer banks?
  • JEF made a great deal.  It's nice to know that these opportunities do pop up and JEF is there to take advantage of it.   Leucadia (LUK) owns a bunch of JEF, so I'm sure Cummings/Steinberg are having a good week.

Thursday, August 2, 2012

Nomura Update

Last November, I wondered if Nomura should abandon their global ambition and just focus on their domestic business.  I have thought that for a long time since they have run into problem after problem over the years in their overseas business.

The recent insider trading scandal forced the resignations of the CEO and COO and the new CEO is someone who comes up from the domestic sales business and the talk is that they will be scaling back their global operations.  I do think that's not a bad idea at all.   The CEO/COO that resigned were responsible for the Lehman acquisition too, which seems not to be turning out too well.

Anyway, here is an update of the tables I showed last year.

First, this is the GAAP data from their 20-F filings through the end of March 2012:

For the full year ended 2012, they managed an ROE of 0.6%.  Since the end of the crisis, they have not been able to post any earnings to speak of.  The average ROE since 2000 has been 3.01%.

Global Nightmare
OK, so here's the big problem.  Below is the pretax profits by region since the year 2000 through the end of March 2012.

Check it out:

So their non-Japan business lost money in 10 out of the last 13 years.  It is absolutely mindboggling.  I took a quick look at Goldman Sachs and they didn't lose money in Europe last year. 

OK, so last year was bad for Europe, and yes, 2008/2009 was the financial crisis. But even without those years, look at how often they lose money overseas.  During the bubble period of 2004-2007, they still lost money in their international business.  What the heck is going on?!   And the Asia region has been doing well too over the past 10, 15 years and Nomura has been active there, and yet there are no profits from that region either.

Look at the right-hand column labeled "Japan".  The Japan business has been profitable in 11 of the past 13 years despite the lost decades in Japan, ongoing bear market etc.  Conditions are horrible in Japan for the financial markets, and yet they have been profitable in just about every single year over that time period.

I haven't worked out the figures, but there is no doubt that Nomura would be a much more valuable business if they didn't bother trying to expand globally.  They would require much less capital so their returns on capital would have been higher, they would have avoided the hugely dilutive capital raise after the financial crisis etc.

Why Do They Fail Consistently Overseas?
I really haven't done research on this, but my impression is that one major problem is that Nomura tries to keep too much control of their overseas operations.  For example, the CEO of Nomura in the U.S. is an expat from Japan.  This has been the case for most of the time Nomura has operated in the U.S.  

This may be the same with Toyota and Honda, for example, but there is a major difference.  In the case of Toyota, when they come to the U.S., it is the Japanese headquarters that has the skill, knowhow etc. to run the business; the factories etc.  This is why it's totally fine to have Japanese employees come to the U.S. to run factories here; they are implementing the knowledge used in the Japanese factories which is their strength.

In financial services, for the most part, this is not the case.  The financial industry in Japan is way behind the financial industry in just about any other developed country.  You can't have someone without the skills and experience try to run an operation here and think it will work.  It won't.  The proof is in the above table.

Didn't Einstein say that insanity is doing the same thing over and over and expecting a different result?  Nomura is insane.  Really.

I may be wrong, but I think the European banks in the U.S. finally started to succeed only when they abandoned that and gave authority to the locals.  They stopped trying to co-CEO and even co-head every division with someone from Germany, for example.

So anyway, I don't mean to pick on these Japanese companies.  Of course I would love to find a reason to buy these stocks as they are cheap (nominally).  As I said before, I have been wanting to be bullish on Japan for a long, long time.  That's why I still keep looking, and I will keep looking at these large names (more to chew on than smaller companies where I may not have much information and therefore not much to say even if they may be reasonable investments).

I think the best scenario for Nomura is to focus on their domestic business and eventually be bought out by a large international bank that might want exposure in Japan (more likely is that they merge with a Japanese bank to create a Japanese version of JPM).  This won't happen until Nomura cleans up their global operations (which may be very costly to unwind with severances, buying out contracts, unwinding legacy private equity positions and other investments etc.). 

Some things just seem so simple and yet seemingly rational people will just not act rationally.

Sony Disaster Continues

So I was travelling a little bit and wandered around in a large mall nearby (living in NYC, I don't do malls that often) and took some interesting pictures.  OK,  maybe not so intesting to most of you. There is nothing new here as this is something we all know:  Apple stores are always packed and busy wherever you go and Sony stores are totally empty. 

I found it interesting that at this particular mall there was a Sony store right next to an Apple store.  I took these photos one after the other so I didn't pick and choose the timing; they were basically simultaneous.

Apple Store Packed (as usual)

Sony Store Completely Empty (as usual)

Walking around in the Sony store only seems to remind us of how lost Sony seems to be.  I walk around in there and don't know what to look at.  If you walk into an Apple store, you just naturally want to play with the iPad, iPod or a Macbook Air.  It's well lit and there is plenty of help.

When you walk into a Sony store, it's dark and gloomy with bored looking employees just walking around or talking to each other.  They don't seem very interested in the very few customers in the stores.  There is zero energy/excitement in there.  It's just creepy and you want to leave as soon as possible.  That's no good.

I know Sony stores is not a big part of Sony's business, but it does sort of illustrate what is wrong with the company.

Earnings Disaster
Sony announced earnings too which seems to be a complete disaster.  You would think that Sony is going up against easy comps as they had so much trouble last year, but it doesn't seem like things are improving there at all.

Of course, the new CEO just came on board so it may be too soon to judge the future of Sony, but I remain skeptical.  Sony seems to be in a horrible position in most segments.

Other than booking another loss this quarter, they reduced their earnings outlook for the full year ending March 2013:

They reduced their sales estimate by 8% and their operating earnings by 30% and are only expecting to earn an operating margin of 1.9%.  

It's just way too typical of Japanese companies to make tiny adjustments here and there and cutting costs marginally in response to what seems to need a dramatic overhaul.  Because of the corporate culture in Japan, I doubt that would happen (aversion to mass layoffs etc.)

The Yen
The strong yen is hurting Japanese companies for sure even though this is an issue they have been dealing with since the 1980s.  Toyota and Honda too are hurt by the strong yen, but they seem to manage these issues a bit better. 

There was an interesting article about the yen and the Japanese government's response to it in the Wall Street Journal recently.  The gist of the article was that the increasingly large retired population is an important constituent for politicians and they are the big beneficiaries of the strong yen (deflation = lower cost/expense), so politicians aren't motivated to help the large corporations and weaken the yen.

Obviously, the government with the huge debt probably also worries about inflation leading to higher debt service costs which would be disastrous in Japan with their PIIG-like government debt.

Einhorn's Yen Trade
Einhorn still has a big put position on the yen according to their 2Q earnings announcement.  I guess he is playing the cheapness of the option but I always wondered about this trade as I wonder if currency crises occur in countries with net external asset positions such as in Japan.  I actually don't have data, but I thought that currency crashes usually occurs in countries with net external debt positions.  

I always thought that if things really started to fall apart in Japan, the yen would actually go UP, probably to 50 or 60 yen/dollar at this point as Japan rushes to repatriate overseas assets. 

This may be one of those things where it may be true in the long term that if Japan can't sustain it's debt, everything will come crashing down including the yen and the JGB market, but that doesn't mean things can't happen in between.

This reminds me of what has happened in the U.S.:  with all the Fed money printing, inflation and interest rates are supposed to be going UP and yet interest rates have gone down dramatically since the crisis.  Yes, if we can't get the government budget under control, eventually, interest rates will go up.  But in the meantime, due to deflationary pressure, they continue to go down.

This is sort of how I see Japan; the yen may in fact keep going UP despite prominent people calling for the yen to fall (a best-selling author in Japan has been calling for the yen to go down for years.  I think he has a new book out still calling for a yen crash).

So What?
So back to Sony.  I am still short this thing and it is now down to $11/share.  This is not a brilliant short at the current price as the book value of Sony as of the end of June 2012 was $24.40.  I don't think you get rich shorting stocks at 0.4x book value.

I will think about covering the short and maybe adding to some puts (I do own deep-in-the-money puts, which is a way I like to take short positions (in-the-moneyness reduces time-value/theta decay or whatever you want to call it).

Any positive development can cause a huge rally in this stock so it is definitely risky.  At 0.4x book, a double would take that up to 0.8x book.  And some conventional equity managers may see 0.8x book as cheap even though I have shown in a previous post that Sony hasn't returned much on equity over long periods of time.   But markets don't always make sense.  For much of that period, Sony has traded at a huge premium to book value. 

But on the other hand, there is so much going against Sony these days.  I think they face huge competitive pressure in just about every segment from their PC's, mobile phones, games, cameras etc.  At this point it's hard to say what their real strength is.

The macro situation doesn't seem to favor Sony either.  The very issues that yen bears talk about is very bad for companies like Sony.   Doubling the sales tax in Japan can't be good for these consumer goods companies.  The yen situation, to me, seems to be a problem that the Japanese government hasn't been able to deal with and as the WSJ reminded us, they may not even want to solve it.

The corporate culture in Japan is not favorable for turnarounds.  In the U.S., a company like this might become subject to a takeover or some sort of shareholder activism.  The Olympus situation and many others have proven to us that shareholders don't mean squat to large Japanese corporations. 

They are run for the officers and their employees (ironic, isn't it that I make such a claim when people say that about investment banks?  I defend the investment banks because they make money and have earned decent returns on equity over time despite the egregious pay.  What I look at is returns to shareholders after all that egregiousism.) 

So What's My Point?
I may be a bit late to the game here in saying this but maybe the better trade here is short select Japanese companies if not the Japanese market overall.  Maybe this is the 'easier' trade versus trying to short the JGB or the yen.

Yes, shorting stocks is a risky, dangerous business and not for everyone.  And yes, there may not be the risk/return asymmetry hedge funds look for (underpriced puts, Burry/Paulson trade-like mispricing of CDS).

But when you have declining businesses with no real prospect for a turnaround, competitive pressure coming from South Korea, China not to mention strong U.S. and other companies combined with a generally inept government and unmotivated management with stiff macro headwinds, it would seem to be a no-brainer.

I know, I am a long value investor (that does short stocks too sometimes) so the above description would seem to be an ideal place to look for values, and yes, I have been looking at Japan for years (without ever getting too excited about anything) just wanting to get into some of these big blue chips.  But everything I see and read seems to indicate more of the same: status quo.

(By the way, I am aware of some interesting smaller caps and I notice that some people have done well investing in net-nets in Japan recently.  I have generally stayed away from Japanese net-nets mostly because of Jim Grant's experience with them; he ran a Japan net-net fund for 12 years, I think it was, without making much money and he shut it down.  And smaller cap companies are hard to evaluate from afar;  some Japanese managers have done really well with Japanese small caps, but they are generally people who go and talk to management and have a good understanding of what's going on beyond what we can get in the financial statements.  I would still rather just invest in something interesting here in the U.S.).

What About Ignore Macro?
Yes, I still believe that.  When you evaluate a business, you see if it's a good business, see what it can earn normalized and then figure out what the fair value is.  You don't need macro input.  You just have to assume a more or less normal environment and then make sure that the company is well-capitalized enough to survive some bad years.

So I don't care what the economic outlook is when looking at things in general as long as the business is a good one at a great or good price. 

The Japan call is not really a macro one.  For me, it started more as a micro one.  I look at company after company and see the total incompetence of managements and the government and it makes me wonder if things will ever change in Japan.  This is not a macro call, really.  It's a call on the corporate cultures, managements etc.

When you overlay that with the macro headwinds they will be facing; declining population, unsustainable debt, competition from S. Korea, China, etc.  not to mention the ongoing problems in Europe then it turns into an untenable situation.  

Don't forget that a company like Sony was barely able to register an ROE in the double digits in the best of times back in 2006/2007.  And this was before the iPhone, iPad, etc.

Again, it may not be too smart to stay short a stock at 0.4x book even if they can't earn much return on that book (in Japan with low interest rates, people may gladly pay book value for a 4% ROE company; who knows.  Sony has been valued much higher in the past so it can happen again).

But I will still maintain this short and a short on Japan in general via the EWJ (I have shorted this off and on over the years).

The risks are obvious; collapsing yen, strong recovery in global economy, new hit product from Sony (maybe the next generation Playstation) etc.

And yes, I know, I am really at risk here of putting in a low in Japan.   When someone is so convinced of something, well, we have to assume that the rest of the world has already come to that conclusion too. 

Oh, and I finally started reading this book which has been sitting in one of the many stacks of books I have around here and it's a fascinating read.  It's an old book from 2007 or 2008, but it's about how Samsung came to dominate while Sony dropped the ball in the digital age.

The general story of Sony is really simple.  Their franchise value was in their manufacturing expertise (miniaturization/microelectronics) but when the world went digital, their moat was gone.  They tried to defend their business which made them late into the game when the world went digital etc...  and gave companies like Apple and Samsung time to take what might have been Sony's businesses.

But there is much more to it than that.  One interesting thing was how Sony was broken up by segment / product line.  They wanted each unit to have their own p/l and operate like independent companies.  This sounds reasonable in a company where much of the middle management didn't think about costs/expenses.  But this backfired as it 'silo-ed' the various businesses so there was lack of cooperation, reduced R&D spending, turf wars etc.   This contributed to their losing out in TV's (as they wanted to extend the life of the factories they built (for CRT TV's); this made them late when LCD's started selling), and everywhere else.

It is certainly an interesting read.  Here's a link:

Sony Versus Samsung