Tuesday, February 26, 2013

JPM Investor Day 2013

So I listened to the JPM investor day via the internet today.  My internet connection, or the PC or something somewhere kept dropping out so I missed a lot, but that's OK.

Anyway, I know I do talk an awful lot about financials and banks.  That's partly because I do tend to have a sort of comfort level with financials (having been in the industry), they seem to still be hated (financially (many still believe financials are dangerous black boxes) and culturally (this popular hatred of banks seemed to have peaked out with Occupy Wall Street, but it's still pretty thick out there)), and they still seem cheap to me.  Not as cheap as in the fall of 2011 or at some points last year, but still cheap.

So that's why I talk a lot about them. If these things were trading at 3x book, I wouldn't talk about them (or maybe I would be looking for shorts).

This is not really a summary or recap of the investor day at all, but just some random thoughts that came to mind while I was listening.

Stock Price Performance
Anyway, there is one chart that I don't believe I've seen before.  Maybe it was in another presentation somewhere.  But I don't remember seeing it.  I do remember recently that Dimon said something about JPM stock; that even if you go back to the Bank One years JPM stock has outperformed other banks and even the S&P 500 index over time.

I sort of always wondered about this as I did own Bank One stock from way back when he first joined.  But this was never a 'hot' stock so my impression wasn't that it performed particularly well (of course, not bad considering how many banks lost most of their value).

So it was very interesting for me to see this page in their presentation:

This is pretty impressive.  It may be hard to see; you can go to the JPM website and actually look at the presentation slides if you want.   In the above charts, the blue line (I'm sure it's Chase blue) is JPM.  The little table at the top shows the annualized returns during the different periods.  I want you to see this so I'm going to actually retype this stuff out:

Annualized Returns
                        3/26/00 -            1/13/04 -              1/1/08 -              1/1/12-
                        2/19/13              2/19/13                 2/19/13              2/19/13
JPM*               +9.4%               +5.4%                 +4.8%                +46.5%
BKX                 -0.1%                 -3.3%                    -6.6%                +38.2%
S5FINL            -0.3%                 -2.6%                    -7.0%                +35.4%
SPX                 +1.9%                +5.6%                   +3.1%                +21.7%

*includes Bank One for 3/26/00 - 2/19/13 period

BKX is the KBW Bank Index, S5FINL is the S&P 500 Financials index, and SPX is of course the S&P 500 index.

March 26, 2000 is the day before Dimon became CEO of Bank One and January 13, 2004 is the day before JPM agreed to take over Bank One.

This is pretty impressive.  In March 2000, the S&P 500 index was close to it's high, so since then if you invested with Dimon, you would have outperformed the S&P 500 index by 7.5%/year.  That's a pretty big outperformance.  And you would have done even better against other bank stocks.

You know, this blog is getting very boring and predictable.  Any time I see a table like the above, I get tempted to do something. You know where this is going.  I have to add one more comp to the above table:

Annualized Returns
                              3/26/00 -             1/13/04 -             1/1/08 -             1/1/12-
                              2/19/13               2/19/13                2/19/13             2/19/13
JPM*                    +9.4%              +5.4%                  +4.8%               +46.5%
BRK-A                 +8.8%              +6.5%                  +2.6%                +28.2%
BKX                       -0.1%                -3.3%                   -6.6%                +38.2%
S5FINL                  -0.3%                 -2.6%                  -7.0%                +35.4%
SPX                       +1.9%                +5.6%                 +3.1%                +21.7%

Since March 2000, JPM has actually outperformed even Berkshire Hathaway!  That really is astounding.  Of course, we can argue about reinvested dividends (which may not be reinvested pretax, even though you can in an IRA) or some other factors.  But still, this is pretty crazy.  Even starting from right before the financial crisis in 2008, JPM has outperformed BRK +4.8%/year versus +2.6%/year.   I don't think anyone would have been able to predict that, given that it was a financial crisis driven by all the insane stuff that JPM was involved in (to a lesser extent than the less fortunate, or rather, less competent banks).

I don't mean to say JPM is a superior investment to BRK.  This comparison is just for fun.  They are different beasts with different risk profiles.  But then again, it's not hard to understand why even Buffett personally owns (or at least until recently) a million shares of JPM.

The Usual Chart
And here is the usual chart that I like showing the growth of book value of JPM:

Bank Value per Share and Tangible Book Value per Share Growth
Tangible book value per share has grown 15% in 2012, an average of 12%/year over five years and 9%/year over 10 years.

JPM closed today at $47.60/share, so it's still trading at 1.2x tangible book value.  This is still very attractive.  Of course, 1.0x tangible book is Dimon's "very conservative" valuation for JPM where it's a no-brainer to buy back stock.  He feels that JPM can earn at least 15% return on tangible book, so that makes perfect sense.  With a 15% return on tangible book being what they can do "at least", then 1.5x tangible book is not an aggressive valuation at all, I don't think.

How to Make 40% by Year-end 2013 (or 23%/year in Three Years)
So even today, JPM is easily worth $58/share ($38.75 x 1.5).  That's 22% higher than the current price.  If tangible book grows 15% again this year, then 1.5x year-end tangible book would take the stock price up to $67.   That would be a 41% return through the end of 2013.

If JPM keeps earning 15% on tangible equity over the next three years, TBPS grows 12%/year (less than tangible ROE due to dividends paid) and the stock price gets up to 1.5x tangible book, JPM would be a $82/share stock.  That's 20%/year over the next three years and with dividends at the current dividend yield, that would come to 23%/year.  Not too bad. 

And keep in mind that this is based on the "at least 15% return on tangible equity", so this may be conservative. It is certainly possible that things can get much better as the world 'normalizes'.    How many large cap stocks project 20%+ returns?

Line of Business ROE
Here's a table of the through-the-cycle ROE targets for the various business lines.  As they have been saying, if current elevated expenses (legal expense etc...) normalize, they can earn $24 billion net as is (without assuming growth or improvement in the environment).

The $24 billion net income is before preferred divideds and other distributions to participating securities, and that comes to around $1.4 billion, so net to common would come to $22.6 billion.  With 3.8 billion shares outstanding, that's around $6.00/share in EPS, and 10x that is $60/share.

Not surprisingly, that comes to 1.5x tangible book value per share.

Anyway, the earnings walk below shows how JPM can get to $27.5 billion in net earnings just from certain items normalizing.

You will notice that if you take out the $3.5 billion in growth initiatives, you will get the $24 billion that has often been mentioned.  I think that is what they would earn when things settle down.  I notice in this chart, though, that there is $1.3 billion earnings improvement on an assumed 100 bps increase in interest rates.  My impression was that the $24 billion they used to talk about didn't assume any increase in rates.  The forward curve does imply rising rates, so that may be where that comes from. 

There is no timetable set for this $27.5 billion to be achieved.  This 'significant' items are expected to go down over time (as well as the litigation expense), and the growth intitiatives will kick in over time too. 

But during the Q&A when someone asked about this $27.5 billion figure, Dimon said that there is no time-table but it can come soon too; he noted that the investment bank is doing better than expected, so other areas might too.

The key is that the earnings power of $27.5 billion is there now (or will soon be in place with ongoing growth intitiatives).  And this doesn't include any growth over time from improvement in the environment.

For example, Dimon said that the investment banking business will see demand double in the next ten years and triple in emerging markets (or something like that).  If JPM just keeps up, they can really grow.

If you flip through the slides, you'll realize that JPM really is a growth business.  This may not really be recognized.

Don't Break Us Up!
OK, nobody said that.  But there were some slides today that sort of focused on synergies/cross sell to show the benefit of JPM being a large diversified business that it is.  This is obviously on the minds of senior management at JPM, and they seem to be getting ready for the debate (where shareholders and/or regulators/government might demand they be broken up). 

Here are some slides.

This is from the overview presentation:

...and this is from the Asset Management presentation:

...and this from the Commercial Banking:

Anyway, I thought it was a good presentation.  JPM seems to be doing well and growing in many areas.  A lot of this doesn't show up yet due to all sorts of recent events, but it seems like it will soon when things turn.

Even without a turn in the environment, they have been doing very well earning record profits.  You don't need heroic assumptions to get 20%/year out of this stock (12% tangible BPS growth, 1.5x tangible BPS valuation etc...), so it looks like a solid stock to own.

Like WFC, this is a company that has grown and benefitted from bad times, so I wouldn't worry too much about bad times.  Maybe we want bad times so they can grow even more.

The stock seems to have done well over time, even outperforming Berkshire Hathaway, and it's still pretty cheap.  That's kind of rare.

(But then again, this is a bank stock so be aware that even if the business does well and benefits from another crisis, the stock market will probably not agree; this can get volatile so beware!  I tend to like highly focused portfolios, like Greenblatt, Buffett and Munger advocate. But remember, even Greenblatt said that if you own 5-8 stocks, they have to be different industries.  Owning 8 banks stocks as your whole portfolio is not going to work.)

Monday, February 25, 2013

What GLRE is Worth to Einhorn

This post is a sort of footnote to my previous post on GLRE.  Think of it as sort of a meditation on the value of incentive fees. I'm just going to think out loud here so I may have some things that may or may not make sense.  I don't claim that anything here is more accurate or new or anything like that.
Anyway, here goes.

What is GLRE Worth to Einhorn?
We know that the hedge fund industry has been looking for ways to raise permanent capital for a long time.  Max Re was started by Moore Capital, for example.  And then we have Greenlight Capital Re.  I have always said that Einhorn is really incented to make this thing work.

If GLRE works out well, this can be really, really good for Einhorn and that's why I think he is going to run this thing really carefully and he is really incented to make it work without blowing up.  Of course, no matter how hard people try, you can't eliminate the risk of something bad happening. 

So let's look at what GLRE is worth to Einhorn. 

Einhorn owns (according to the 2012 proxy) around 6.3 million shares of GLRE (including shares owned by the family trust).  That comes to $155 million.   This should be enough to keep people focused on not screwing up.

But we know that GLRE was set up to raise permanent capital.  So let's see what that is worth.  In the case of GLRE, it's pretty easy to evaluate. 

At the end of 2012, GLRE had $1.2 billion of investments.  All of this is managed by Einhorn (via DME).  The fee structure is straight forward: 1.5% management fee (payable monthly) and a 20% incentive fee paid annually with no preferred rate of return or hurdle rate.  There is a loss carryforward provision, but let's ignore that for now assuming Eihorn can do well over time.

The management fee part is easy to value.  On $1.2 billion in investments, management fees come to $18 million/year.  At the usual 10x multiple, that is worth to $180 million.   The value of this management fee stream alone is worth more than Einhorn's stake in GLRE ($180 million versus $155 million).   If we assume that investments can grow 5%/year through investment returns and/or float growth, this management fee stream can be worth $360 million  ($18 million / (10% discount rate - 5% growth rate).   If they can grow investments at GLRE by 8%/year, then this stream an be worth $900 million.

But then this gets into the argument about the silliness of these cash flow models that go out into perpetuity; who is going to expect GLRE to grow 5% or 8% forever?   (I'm not going to bother with multi-stage models).

You can see, though, why the hedge fund business can be such a lucrative business.  Just moving those assumptions around can lead to some huge numbers.  Anyway, moving on.

Incentive Fee Value
Einhorn gets 20% of the profits without a hurdle or preferred rate.  So this valuation should be easy.  One way to look at this is to think of the manager just owning 20% of the AUM outright.  They get the profits that accrue to that 20% but then don't have to share the losses, so it's sort of better than owning 20% of the AUM outright.  Of course, that doesn't mean there is liquidation value for the manager, though.  But that would be true no matter how you value the incentive fee stream.  You will get a positive value, but in liquidation the manager gets nothing.

But anyway, assuming you own 20% of the AUM is a rough valuation that I use so you don't have to make any assumptions about returns.  This would be a problem with managers that have a hurdle or preferred rate, though, as they don't get paid unless they make their hurdles.  So there may have to be a discount for the years they don't make the hurdles (even though they may make it back over time).

Anyway, the easiest, possibly most accurate way to look at the value of an incentive fee stream is to value it as an option.  You get the upside and don't have to incur losses on the downside.  You don't have to put up any capital up front.  So having an incentive fee contract is simply owning a call option on the AUM (or 20% of the AUM).

And as much as people hate option models, it does work in many cases.

So let's look at what a 20% incentive fee on $1.2 billion in AUM is worth.  The two key inputs in this case is going to be interest rates and volatility of the investments.  Just looking at the annual returns, it looks like GLRE's investments have a volatility of around 14%-18% (was 18% in last five years).

I will just use 15% for now.  The interest rate is an interesting question.  We can just use the risk free rate, but nobody is going to finance a hedge fund position at the risk free rate (after LTCM, I don't know who would finance a stake in a hedge fund at a low rate unless the borrower had other liquid assets against the loan).   So I'll use 3% as the interest rate.  The strike price of the option will be 101.5% (because the 20% incentive fee is paid out only after netting out the management fee, which in this case is 1.5%).

So anyway, here is a matrix of option values, assuming 101.5% strike price, one year term and various interest rate and volatility levels (interest rates of 1%, 3% and 5%; volatility of 10% and 15%):

                             Interest rates
Volatility             1%              3%              5%  
               10%      3.8%           4.8%          5.9%
               15%      5.8%           6.7%          7.8%
               18%      7.0%           7.8%          8.9%

Assuming 15% volatility and 3% interest rate, you get 6.7% in call option value.  One might argue the 15% volatility is too high for a long/short fund as that may be due to the financial crisis.  Equity long/short funds might have more normal volatility of 10%. 

At 10% volatility and 3% interest rate, the call option is worth 4.8%.

So by having this deal with GLRE, the incentive fee value to Einhorn (or DME Advisors) for one year is 4.8% x 20% (you only get 20% of the upside) = 1% of AUM.

This call option is granted every year, though.  So using a discount rate of 10%, this 1% of AUM call option value comes to 10% of AUM (1%/10%).

With AUM at $1.2 billion, this incentive fee agreement is worth $120 million.  Again, this could easily be worth $240 million if we assume AUM growth of 5%/year.  But let's just keep AUM flat.

So summing up all the pieces, this whole GLRE package is worth to Einhorn (and whoever else he shares it with):

Ownership of GLRE stock:   $155 million
Management fee:                   $180 million
Incentive fee:                         $120 million
                                               $455 million

The value of GLRE to Einhorn with the above assumptions is basically $455 million.  The value of GLRE stock that he actually owns accounts for only 1/3 of this total value.

Furthermore, the $155 million of GLRE stock he owns is arguably worth more than a similar amount of his own money he has invested in his funds due to the leverage from float that GLRE enjoys, and the tax free status of GLRE so that book value can compound tax free over time (leveraged and tax free can be pretty powerful).

If you assume that investments at GLRE will grow 5%/year, the above table can be rewritten:

Ownership of GLRE stock:    $155 million
Management fee:                    $360 million
Incentive fee:                          $240 million
                                                $755 million

In this case, the GLRE ownership stake would only be worth 20% of the whole package.

Having said all of that, I do think that this option model valuation is very conservative and is a reasonable lower bound valuation of the incentive fees, particularly the valuation using 10% volatility.  Why?  Because it is a totally blind estimate as if Einhorn's returns will be random going forward. 

But we know that Einhorn and other good hedge funds manage risk actively, so this is sort of a silly assumption.  If we thought Einhorn's returns going forward would be random, we wouldn't invest in GLRE!

I think that the S&P 500 index one year call option value would also be a lower bound valuation.  Why?  Because we expect Einhorn to outperform the S&P 500 index over time.  If someone asked me if I would like to have (for free) a call option on the performance of Einhorn's fund or on the S&P 500 index, it would be an easy decision for me to say I would like the call option on Einhorn's fund.  Right?  If you agree, then an S&P 500 index at-the-money (or 101.5% strike) call option value would be a lower bound valuation for the call option on an Einhorn fund.

Option valuations give credit to volatility regardless of bias; an option holder won't have to take losses to the downside, so the more volatile the underlying, the more valuable the option. 

An active hedge fund (a good one, at least) takes care of the downside and tries to keep volatility of the fund itself low so a normal option valuation would typically undervalue it (in a sense, the better a fund does, the lower the call option value that a model might spit out).

It seems to me that there is a lot riding here for Einhorn in terms of value.   If this works out, it can be really good for Einhorn.  This is why I think he will take a lot of time to make sure it works out.  Of course, there is no guarantee that it works out; history is littered with supersmart people trying very hard and blowing up anyway.

But still, what people think of GLRE will really hinge on what they think of Einhorn.  Those that don't like hedge funds won't like GLRE.  Those that like hedge funds but don't like Einhorn won't like GLRE.  It's almost that simple at this point.

And as for valuation, slightly above book is very cheap if you like Einhorn and think he can do well going forward.  The fact that he hasn't done too well in the recent past may actually be a good thing as there is no froth here, and hopefully Einhorn is getting more focused as a result of his not-so-great performance.  (I remember watching Tepper say his greatest years were preceded by his worst years; so any year he is down is a great time to invest as they perform very well the following year).  It's a no-brainer for Einhorn fans (but again, there is risk here).

Anyway, these are just some thoughts that were floating around in my head over the weekend.  I may notice some logical flaws here and there after posting this, but that's OK.  I think the gist of it is correct even though it may not be of value to many readers (I can already imagine many hedge fund disbelievers laughing at the notion that hedge fund managers can manage downside and lower volatility.   Yes, I remember the big, high profile hedge fund blowups of years past).

Memo from Brooklyn (OAK's Preferred Rate)

Howard Marks released another memo the other day talking about the state of the high yield bond market today.  This is very relevant as I mentioned it as being a concern for Oaktree Capital (OAK) unitholders.  Anyway, here is the memo:   High Yield Bonds Today

There are some interesting points here, and for OAK unitholders, there are some especially relevant points, particularly with respect to the 8% preferred rate of return (he didn't mention it in the memo).

First, Marks reminds us that we can't predict what the markets will do.  Nobody knows.  Rates can go up.  They can go down.  Who the heck knows.  He also points out that high yield bond prices may go down if interest rates go up, but so will other bond prices.  And in fact, high yield bonds may have less price risk than others.  Read the memo to see why.

There are some other things from the memo that is very interesting and makes me scratch my head. 

First, here are some great points about the current OAK high yield portfolio:
  • The average spread  in the current portfolio is 490 basis points, which is actually at the high end of the historical range over the past three decades at OAK.
  • This more than compensates for the average default rate of 1.4%/year in OAK's portfolios over the past 27 years.
  • The portfolio can have a 9% default rate every year and the portfolio would still do better than treasuries.  OAK has never had any single year with a 9% default rate in their portfolio.
  • If they bought or held a bond currently yielding 5.7% and have an average default rate of 1.4% and a loss rate of 50% and lose 0.7%/year, that's still 5% return (before fees and price movements).  This is an attractive absolute return.

Marks says,
"While we believe spreads are attractive given the risks we see in our portfolios, it is true that there is little room for price upside, making the reward for risk taking limited" (my emphasis)
"Considering these factors, should investors sell their high yield bonds and wait for a better time to invest?  We don't think so, as market timing is next to impossible to do right..."

Fair enough.  But unitholders like OAK partly for the incentive fees that it can earn on the funds.  With a preferred rate of return of 8%, and as Marks says, a 5% attractive absolute return at current spreads and rate levels but "there is little room for price upside, making the reward for risk taking limited" can we not expect much in incentive fees going forward until interest rates 'normalize'?

Just out of curiosity, I flipped through the S-1 from last year's IPO again and my eyebrows went up.  I'm just trying to get a better handle on OAK's historical returns.

This chart shows the long term returns of OAK's high yield bond strategy going back to 1986.  The interesting thing here that I'm not sure I noticed at the time is that this is based on gross returns.  I assume that means before management and incentive fees.

So since the end of 1985 through the end of 2011, the high yield strategy gained 1069% and the benchmark gained 776%.  On an annualized basis that comes to 9.9%/year and 8.7%/year respectively.

This may not be apples to apples as this composite may include funds that don't have incentive fees and have varying levels of management fees.  But just looking at this raw data and applying 1.5% management fee and 20% incentive fees, this would show a net return to the investor of 6.7%.  So net of fees, OAK's high yield strategy failed to beat the benchmark index over 26 years?   I just took the 9.9%/year gross return, deducted 1.5% in management fees and then multiplied by 80% to get 6.7%. This may not be correct due to the 8% preferred rate and other things.

This is a little contrary to my image of OAK so I may be missing something here.  I would guess that the incentive fee generating funds are more opportunistic and had higher returns over time while this composite return may include lower risk, lower fee and larger funds.  That would make sense.

But still, I was a little surprised by this.

[Comment/clarification after the fact:  Please read comments in the comments section.  I did miss something. The high yield strategy are primarily the open-end funds which have management fees of 50 bps or so and presumably  no incentive fees.  There are other comments on the returns on the distressed debt funds that do have incentive fees.  So I did miss something! ]

Tailwind to Headwind?
Also, OAK has returned 9.9%/year over the past 26 years but that was during a time of steadily declining interest rates; OAK had a huge interest rate wind at their back that may turn into headwinds going forward.

In 1985, the 10 year treasury rate was 10.6% and that is down to 1.9% now.   Even using the late 1980s as a starting point, 10-year treasuries were in the mid 8% range.

So, two points come to mind:
  • OAK had a huge tailwind (rates from 8-10% down to less than 2%) since 1986.  Yes, 5% absolute returns in this environment is good, but what happens to returns over time without this tailwind?  Or if the tailwind turns into a headwind?
  • I don't know how the preferred rate of return has evolved over time, but if it hasn't changed, then back in the 1980s, they only had to outdo treasury rates to earn incentive fees.  Today, they have to earn 600 basis points more than treasuries before they get incentive fees.  Back then they only had to outdo treasuries, but today they have to outdo even the high yield averages by more than 200 bps before they can collect incentive fees.  Is this possible?! And again, that's with "little room for price upside".

Marks said the other day on the conference call that OAK has done OK with funds raised in good times and really well with funds raised in bad times. 

Here is a visual look at that statement (again, from the S-1):

So it's true (not that I doubt his words!).  The funds raised in 1990/1991 did spectacularly well.  The funds raised in 2001/2002 (when even the quality-loving Buffett was buying junk bonds) did amazingly well too.

And the great thing about OAK is that funds raised in boom times didn't do so bad.  There are basically two periods in OAK's past that this was the case.  The mid-to-late 1990s and the 2005-2007 period.   The returns on those funds were not so bad; 10%-12%-ish figures.

But let's look at what the 10-year treasury rates were back then.  In the 1995-1997 period, the 10-year yielded 6.5%.  In the 2005-2007 period, it yielded 4.5% or so.

Today?  it yields 1.9%.  Assuming they do just as well on a relative basis, this would put their returns below 8%.

[ Comment after the fact: The distressed debt funds have returned 18% after fees over time, so there isn't as much risk to future incentive fees as I thought initially due to the low rates.  The distressed debt funds that have incentive fees have more equity-like returns.  Maybe that should have been made more clear on the conference call with respect to the 8% preferred rate question.  (Maybe it was made more clear and I just missed it!) ] 

Difference Versus the Stock Market
OK, you can say high yield bonds are overvalued (even though maybe not on a relative basis).  But isn't the stock market overvalued too now and then?  Would you sell out of the stock market or Berkshire Hathaway or any other great business just because the stock market is overvalued at any given point?

The quick answer is no.  I wouldn't sell stocks even if the stock market was overvalued.  I would not even sell the stock market in general if I was an index investor.  Why?  

Earnings growth.   Bond coupons do not grow over time, but earnings do.  So if a bond was overvalued based on yield, it will most certainly be a cap on returns (well, there might be capital gains if rates go even lower).

But with stocks, even if you own the stock market at overvalued territory, over time, you can still earn a decent return.  The stock market return in the last century (10%/year or whatever it was) was only achievable to those who owned stocks regardless; they owned through 1929, 1965, 1972, 1987 etc...)

For example, there was no question that the stock market was overheated, overbought and overvalued in August of 1987.  I think it was pretty much as overvalued as it was in 1929 (according to the p/e ratio at least).    The p/e ratio was above 20x, maybe close to 30x p/e. 

The S&P 500 Index peaked out at around 340 in August 1987.  But even if you bought the very high, then, and held for ten years through August 1997, you would have returned 10%/year before dividends.   If you held throught August 2000, you would have earned 12%/year before dividends.  OK, 1997 and 2000 were high valuation years for the stock market.

But even if you held on until today (and I'm pretty sure the p/e ratio is lower today than in August 1987), you would have earned 6%/year, again, before dividends.  

How does this happen?  Earnings growth.  Even if the valuation goes down, if earnings grow, you can still earn a good return over time. 

Bond coupons do not grow so if you buy it dear, then you can't have earnings growth bail you out.  So it's a real cap on return in that sense. It's very hard to make a return higher than your yield at the time of purchase.  A valuation headwind can't be overcome by earnings growth (like the stock market can).

First of all, this is all shorter term stuff.  I do believe if you have faith in the management, it's a good business and you pay a reasonable price, things will turn out well.  I bet the folks at OAK will figure all of this stuff out and will be in a much better place over time.

But even Howard Marks cautions us that even if we can't predict the future, we have to be aware of cycles and where we are in them.

As an investor in OAK, I am very aware of where we seem to be in the interest rate cycle.   People have been calling for interest rates to bottom for a very, very long time.  But at some point, the risk/return becomes highly unfavorable.   Even Marks acknowledges that there is little room for further upside in price.

So where does that leave us?  If rates don't go down further, it seems highly unlikely that OAK will continue collecting incentive fees.  If rates stay flat (which is a high probability scenario given what happened in Japan), then OAK's funds may return the 5% or so that Marks illustrated in his memo.  In that case, OAK also wouldn't collect incentive fees.

The best scenario is a gradual rise in rates to more 'normal' levels.  But this would cause capital losses in OAK's current portfolios.  The trick would be how quickly prices move and how much funds can be raised and be put to work at higher rates to offset losses in current portfolios.  Ironically, a rapid rise in rates may be the best scenario, even though I can't imagine OAK's stock price not going down a lot in that scenario.

In any case, there is a fine line in thinking too much about the near term and being aware of long term trends and limits on what even great companies can do given the environment.  I know OAK is expanding into other strategies and regions, so some of the above concerns will be mitigated, but still...

I really respect Howard Marks and the folks at OAK and am a current unitholder, but given the above, I have to say I am a reluctant unitholder at this point.  

Wednesday, February 20, 2013

Greenlight 2012 Results

So, Greenlight Capital Re (GLRE) announced a not so good quarter/year.  Investment performance came in at +7.1% which is not very good given a +16% stock market last year.  In 2011, the return was 2.1%, same as the S&P index, and 2010 was +11% versus the S&P's +15%.  So that's three years in a row that Einhorn failed to beat the S&P 500 index.   That's not good.

The BPS (fully diluted adjusted BPS) growth hasn't been too hot either over the past three years.  BPS grew 13%, 1% and 2% in 2010, 2011 and 2012 versus +15%, 2% and 16% for the S&P 500 index.   BPS also lagged the S&P 500 for the last three years.

But hold on.  We always advocate the long term.  It may be a mistake to jump to conclusions on recent history.  We know that a lot of investment errors occur due to the overweighting of the most recent data points. 

GLRE has done better over time.  Here is the table of net investment performance (of GLRE's investments) and BPS growth compared to the S&P 500 index:

GLRE Investment Performance and BPS Growth

The GLRE investment return for 2004 is only for two quarters, so I just looked at returns/changes since the end of 2004 (the S&P 500 index return for 2004 is for the full year so is not comparable). 

On this longer term basis, GLRE looks much better.  GLRE's investments returned an average 9% (versus 4% for the S&P 500) over eight years and 5.7%/year (versus 1.7%/year for the S&P 500) over the past five years.  That's an average outperformance of 3.8%/year over eight years and 2.4%/year over five years.

BPS change, which is basically a function of investment return and combined ratio, also outperformed the S&P 500 index by a nice margin (see above table).

Insurance Business
Other than investments, the other piece of GLRE's return is the insurance business.  For that, let's take a look at the combined ratio.  For 2012, it looks pretty bad.  The combined ratio came in at 112.9%, far higher than it's ever gotten, and far worse than the competition.

I just updated the combined ratio table that was in GLRE's presentation last year and this is what it looks like:

GLRE Combined Ratios Versus Comps
TRH was merged into Alleghany (Y) and hasn't reported yet.  But if you look at the others, it doesn't look too good.  The average, too, since 2008 doesn't look good for GLRE's business.

Questioned about this during the 4Q12 conference call, they said it's due to one or two things (commercial autos) and they are working on it.  But you know, does it matter if, for example, all of your stocks you bought went down or if one stock pick really tanked?  I don't know.  Just because the bad combined ratio is because of one (or two) bad idea, that isn't too comforting if it has such an impact on the total ratio.  It just illustrates how concentrated/focused the business is and how important it's going to be to be right.

Hedges did say, though, that some of this is due to timing; GLRE didn't start writing insurance until recently whereas the competitors have been writing for a long time with policies written during the hard market years.  Some of the low combined ratios recently have come from reserve releases from that period which GLRE doesn't have.  There is definitely some truth to that as we know insurers have been releasing reserves for the past few years.

In any case, it looks like over the longer term, Einhorn is fulfilling his end of the bargain (outperforming the S&P 500 index) while the insurance side has seemed to lag (whether it's because of the reserve release issue, one time mistakes or just bad insurance underwriting).

Anyway, I updated a table that GLRE showed in their presentation last year.  It shows how ROE changes according to various scenarios of investment returns and combined ratios.

I used the current balance sheet of net earned premiums of 60% of capital and investment assets of 150% of capital.

Below is how ROE would change according to the two inputs:

Return-on-Equity with Various Investment Returns and Combined Ratios

If the insurance business can just break even and the investments return 10-15%/year, BPS can grow 15-23%/year.   

The big question, of course, is if they can achieve that.   

I did raise some concerns about Einhorn due to his getting into what seems like macro investing.  I may be wrong but my impression has been that he has gotten into this after the financial crisis.  I have said before that so many value investors and equity managers spent so much time on the macro in the past few years that I felt that there is sort of a macro-forecasting/investing bubble going on.   

The yen trade has certainly paid off in the past couple of months but it has been on the books for a while now so who knows if the returns is worth it given how long it's been there.

Whatever happens to these trades, I wonder if these things distract Einhorn from what I think he is supposed to be really good at (stock picking).

Anyway, I do understand that managers want to put on low cost, tail hedges to benefit from large movements that may negatively impact the equity portfolio.  But I have my reservations about that.  Also, managers may want to get into new areas to deploy larger amounts of capital.  It's one thing when you are a $500 million - $1 billion equity manager, but when your assets get up to $5-10 billion, macro starts to get very attractive because of the large, liquid markets that you can deploy capital in.

I won't mention the New York Mets thing (some believe that when hedge fund managers start dabbling in trying to own a sports team, that may signify the end of their good run as their focus seems to be elsewhere.  But David Tepper seemed to do well last year so...).

Increasing AUM, of course, is another factor.  I don't have detailed data on Einhorn, but I'm sure the best years were the early years when he had way less capital.  Can he get back to 10-20%/year performance at this AUM level?  This is a question for all hedge fund managers at some point.  We will have to wait and see.

Anyway, here is a look at GLRE's stock price versus the BPS over time:

Greenlight Re Fully Diluted Adjusted Book Value per Share vs. Stock Price

It seems to have averaged 1.2x book over time and is now trading at $24.57/share, 1.1x book value.
GLRE hasn't done as well as I would have thought in the past couple of years, but they have done well over time.  I don't own a lot of GLRE, but I still do like it.  The potential is there for this to be a really good performer over time and it is reasonably priced. 

Of course, things can go the other way too.   James Tisch, on one of the Loews conference calls recently said (not about GLRE specifically) that these reinsurance companies started by hedge funds may not realize that the insurance business can lose more than the premiums earned (combined ratios can get over 200%).  He seems to feel that some of these entities may not understand the risk that they are taking.  

(Note after the fact:  It may not have been a conference call, but a TV interview that he said this.  And I think he meant that CR can get above 200% or some such thing.  I may revise this if I find exactly what he said, but it's not that relevant to this post, actually; just that insurance can be risky!).

It's a very interesting and scary point.  This is an interesting situation, but it is risky (this is no Berkshire Hathaway).  It is a no-brainer in a sense; get levered return on Einhorn (levered due to insurance float) at close to book value, but not without risk.


Friday, February 15, 2013

Solid Results at Oaktree, But...

Oaktree Capital Group (OAK) announced pretty good earnings for the full year of 2012.  The funds, across the board, returned around 15%.

For those who don't know, OAK is co-founded and run by Howard Marks, a legendary Buffett-like figure in the fixed income world.  It would be well worth your time to google Howard Marks and read his "memos" and watch youtube and any other video interviews you can find on the net.  He also wrote a fantastic book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor.

Anyway, I'm not going to repeat all the stuff that you can get from the earnings release.  If you're interested, you can just go to the OAK website and read about revenues, adjusted net income, distributable earnings, economic net income and all of that.  I'm just going to look at some things that made me raise my eyebrows and then maybe take a quick look at valuing this thing at the end.

I did happen to pick up some OAK last year as it tanked after the IPO so I am sitting on some nice profits on this position but it doesn't feel as much like a no-brainer that it did last year.  Anyway, I am getting ahead of myself.

No Longer Counter-cyclical?
The first thing that made me raise my eyebrows is that on the conference call, Howard Marks said that in 2012, they raised $12 billion in capital for funds which was their sixth year that they raised $10.8 billion or more. 

I thought, great!  That's really fantastic.  They are on fire!

But then I thought, wait a second.  I thought these guys were counter-cyclical.  I remembered a graph they had in their S-1 (prospectus) last year that really impressed me.  Here it is:

So in 2006, while private equity investors fell over each other investing, Oaktree Distressed Debt funds were laid back and not doing much.  The same happened in 2007.  But then when the wheels fell off, Oaktree pounced and made a lot of investments while private equity scaled back dramatically.  See how investments ballooned from $1.5 - $2.5 billion in 2006-2007 to $9.9 billion in the 4Q08-3Q09 period.

OAK can raise a lot of funds to maximize management fees, but this is not who they are.  They won't raise funds just to earn fees. 

But then we see that OAK has raised more than $9.8 billion for the sixth straight year in 2012.  To be clear, the above table is only for the Oaktree Distressed Debt funds and not for all of OAK.  In recent years, they have been adding different strategies (real estate, Europe etc...) so it's not apples to apples (plus the above table is for capital invested, not capital raised).

But still, with default rates and high yield spreads at historical lows, it's hard to imagine where all of this capital will be invested.  I don't mean to second guess Howard Marks or the smart folks at OAK.  They are the pros.  I'm an equity guy so have no clue about fixed income markets.

It seems to me, though, the combination of low nominal interest rates and low credit spreads around the world is at a historical level.  It's hard to imagine how they can earn good returns going forward in this market.

Marks did say on the conference call that he thinks they can still earn 10% returns over time. This was in response to a question of whether OAK would consider lowering the 8% hurdle rate of return (before earning incentive fees) because interest rates are so low.  Marks said that it is a fair intellectual argument to say that that should be lower, but he doesn't want to go to the investor and say they are lowering the hurdle rate due to lower interest rates when he still thinks they can earn 10% going forward.

Marks did say that their funds have done very well when launched in turbulent times but has also done OK when launched in good times.  I suppose we can point to 2006-2007 launched funds.

But even then, interest rates weren't this low even though credit spreads might have been this low. 

In any case, this is just my own reservation.  OAK believes that there are opportunities and that's why they are raising capital.  They are more concerned with deal flow.  It the deal flow is not there, they can't invest, but they feel there is plenty on the way.

I have to say that investing in a fixed income asset manager during the peaking of the biggest bond bubble of all time, and one that particularly specializes in credit analysis when credit spreads are at ridiculously low levels is a little frightening. 

Of course, OAK is just about the best in the business, but even great equity managers suffer during stock market bear markets.   In a real blowup, OAK would definitely benefit as their pool of potential investments would expand.  But their current funds would take big marks against them, so that's sort of a conundrum with owning OAK today.  It can get bad before it gets really great.

Interesting Nugget From Call
By the way, there was an interesting comment from Marks on the call.  Someone asked him about OAK's underperformance (versus benchmarks) in 2012, as they have underperformed by 50 bps or so.

Marks said that nine or ten years ago, some consultant asked OAK to add up their performance in each quarter the markets (benchmark) went up and do the same for each quarter the market went down.  Marks cautioned that this is out of memory, but he said that OAK's funds underperformed by 55 bps in up markets but outperformed by 600 bps in down markets (annualized).

That's a fascinating piece of information.  This should probably go into every OAK presentation.  (I think Och-Ziff puts a similar thing in their filings; how their funds do well in down markets).

Anyway, let's take a quick look at what this thing is worth.

What's it Worth?
At the end of the day, we can't really predict where the bond market and credit markets will go.  People have been calling the bond market a bubble for a long time.  So the most important thing (as Marks would say), I guess, is to figure out what this thing is worth.  The uncommon sense thing for the thoughtful investor to do would be if the stock is trading substantially below what it's worth, buy it (or hold on to it).  If not, sell or don't buy.  Of course, since OAK is a great organization, it makes sense for long term investors to hold on even if it is fairly valued.

We can look at OAK valuation as the sum of four (or five if you include DoubleLine as a separate piece) parts:  Fee-related earnings stream,  incentive fee stream, balance sheet value (cash, treasuries and investments in funds) and off-balance sheet accrued incentive fees.

Fee-related Earnings
In 2012, Fee-related earnings (which is management fee minus compensation expense and SGA) was $307 million.   It was $315 million in 2011.   Management fee-generating AUM has been stable at $67 billion in 2011 and 2012, so I think this $307 million is an OK number to use to value this stream.

At 10x this, that's $3.1 billion value for this stable stream of income.  With 150 million total units outstanding, that's worth $20.70/share.

Incentive Fee Income
This part gets a little funky because it's very lumpy, so we have to make some assumptions.  I think the funds that OAK offers are designed to earn 10% or more over time.

The incentive fee is 20% of what they earn (once the hurdle as passed), and much of that is paid out as performance bonus to the fund managers (and other employees, hopefully).   Looking at the accrued incentive fees at the end of both 2011 and 2012, it looks like employees get 40% and OAK gets 60% (this varies by fund/strategy so may change over time).

So instead of using actual incentive fees earned over time, I'll assume the funds earn 10% (they earned 15% in 2012 so 2012 earnings are obviously better than they would usually be), they get 20% of that and pay out 40% of that for the bonus pool.

Let's assume incentive fee creating AUM of $34 billion.  It was $34 billion in 2012 and $36 billion in 2011.

So the incentive fee earned in a typical year on $34 billion would be $3.4 billion x 20% = $680 million x 60% (40% to employees) = $408 million.

10x that stream would be $4.1 billion.  With 150 million units outstanding, that's  $27.20/share.

Balance Sheet Value
OAK has cash, investments and funds on it's balance sheet and some debt.  This equity value is largely liquid, financial instruments so should be counted at book (funds are carried at market value).

Total assets at OAK was $2.36 billion and total liabilities were $966 million.  Book value comes to $1.4 billion.   If we use $1.4 billion and add it to the above parts, there will be some double counting involved as some of the assets on the balance sheet is being used to generate the above management fee and incentive fee (think office supplies/equipment etc.). 

So let's deduct the $146 million in "other assets".  I don't know what's in there, but we can be sure that PC's, servers and other office equipment isn't in any of the other balance sheet categories.

That would get book value down to $1.25 billion.  That comes to $8.33/share

Off Balance Sheet Accrued Incentive Fee Value
Due to the way OAK accounts for incentive fees (not booked until realized and paid), there is a lot of value that hasn't gone through the income statement and doesn't show up on the balance sheet (incentive fees only hit the income statement and balance sheet when it is paid out (or when it becomes payable)).

This amount of accrued incentive fees held at the fund level is $1.3 billion at the end of 2012.  This comes to $8.52/share.   (If the funds were liquidated today, this is the amount that would be payable to OAK as incentive fees (this is net of what gets paid out as performance bonus too))

Add it Up
So if you add it all up, you get:

                                                   Value of per unit
Fee-related earnings:                      $20.70
Incentive fee:                                  $27.20
Book value:                                       $8.33
Accrued incentive fee:                      $8.52
Total:                                              $64.75

OK, so then there is another piece to this puzzle, and that's OAK's 20% stake in DoubleLine which is on the balance sheet at $29 million. That comes to less than $0.20/share, but it's grossly undervalued there.  

As I said in a previous post, I figured DoubleLine is worth somewhere between 1% and 2% of AUM.  DoubleLine now has more than $50 billion in AUM (versus I think $28 billion at the time of OAK's S-1 filing).   So the value of DoubleLine would be $500 million - $1 billion.  20% of that would be $100 million - $200 million.  That's far higher than the $29 million balance sheet value.

It's already on the books at $29 million, so the incremental value per unit would be $71 million - $171 million.  On a per unit basis that comes to $0.47 - $1.14/unit.

Now, that's not a whole lot given the $50-51 stock price and $64.75/unit fair value.

But Wait!
In the earnings release, DoubleLine's results is included in investment income.  I assume that is a cash dividend distribution to OAK from DoubleLine (I think someone confirmed that on the conference call).   That amount was $22.7 million for 2012.

But on the conference call, OAK said that the DoubleLine stake created distributable earnings of $34 million and that they feel although this goes through the investment income line, it is actually more like fee-related income.  If that is the case, let's put a 10x multiple on that and it comes to $340 million.

That comes to $2.27/unit.  That's far higher than the valuation we would get from a 1%-2% AUM valuation.  Excluding the $29 million already on the balance sheet, that's an additional $2.00/unit in value you can add to the above $64.75/unit  sum of the parts value for OAK.

So the total, total would come to $66.75/unit.

With the stock trading at $50.74/unit right now, that's a 24% discount to what it's worth.

So OAK still looks cheap despite a nice runup.  I don't know the details of the DoubleLine earnings, so I don't know what can be 'normalized' and what's due to a good market last year.  But it seems like using 2012 figures leads to a far higher valuation for DoubleLine than a 1-2% AUM valuation.  I'm still on the fence on that one, but it's certainly possible that DoubleLine can be worth more than 1-2% AUM if they offer more funds with higher fees.   But again, I just don't know the details.

OAK is a solid shop run by solid people and it is definitely one that you can own and be comfortable with over the long term.  I would not worry about management, corporate governance, risk management and things like that.

But what I do worry about is the current state of the fixed income markets and the sub-6% high yield rates.  It just sounds insane to me that junk yields less than 6%.  I don't know how anyone can generate high returns going forward in this kind of market without going further out on the risk curve (and that often doesn't end too well).

I thought initially that OAK would be a great holding in front of a European collapse or something like that; they would raise funds and go over there and pick up the pieces.  But it sort of looks like that might not happen (due to intervention by the ECB etc.).

But seeing how they are doing so well and making so much money in this almost maniacal bull market in credit, I fear what would happen on a hiccup.

I don't worry about OAK over the long term, of course.  But I can't help but imagine that returns on capital raised today will be far lower than any of their funds in the past, and this may not bode well over the short-medium term.

I know, I'm a long term investor and I shouldn't think of things like that; I should just think about the long term.

But there is a part of me that feels like I'm looking at a private equity manager in 2006-2007 when looking at a fixed income manager today.   

Anyway, that's just a quick look and thoughts on OAK today.  I may have more to say or corrections after seeing the 10-k (or more immediate corrections which would be pointed out in comments below).

I still own OAK, but would look to lighten up on further gains.  I wouldn't mind owning a smaller stake as a 'permanent' holding, but wouldn't overweight it too much in my active account.

It's a conundrum for me;  I love the company, management etc., but I don't love the sector at all right now; too much love there... 

Thursday, February 7, 2013

Create Your Own Apple Stub

Einhorn is unhappy with Apple's $137 billion cash hoard on the balance sheet and wants Apple to issue perpetual preferred shares to enhance shareholder value.  He said in an open letter that every $50 billion of preferred shares it distributes (at 4% rate) will increase value to Apple shareholders by $32/AAPL share.

First of all, I noticed that there were some mistakes in talking about this and one press report stated that Einhorn made this claim "without elaborating".   I think he made it very clear how the value would be realized.

So let's just look at this for a second before I go on.

Here are just some basic figures I pulled off the internet:

AAPL shares outstanding:               940 million
Analyst EPS estimates:
      Year-ending September 2013:  $45/share
      Year-ending September 2014:  $50/share

Einhorn assumptions:
          AAPL valuation:             10x P/E
          Yield on preferred:            4%

Before Preferred Distribution: 
          EPS:                                  $45/share
          Cash per share:                  $145/share
          Value per AAPL share:     $595/share (10x p/e + cash per share).

After $50 billion Preferred Distribution:
          EPS:                                  $43/share  (EPS - ($50 bn x 4% pref dvd/ 940 mn SOS)
          Value per AAPL share:
               Cash per share:             $145/share
               AAPL shares:               $575/share (EPS of $43 x 10 + cash per share)
               Value of preferreds
                      (per AAPL share):  $53/AAPL share ($50 bn / 940 mn SOS)
               Total Value:                 $628/AAPL share

$628 - $595 = $33/share (difference due to rounding).


[ Note after the fact: In response to comments below, I revised the above table to include cash per share in the total valuation of AAPL. The result is the same as before as cash per share doesn't change pre and post preferred distribution.  But by not including it, it looked like it would be even more value accretive if AAPL distributed cash instead of preferreds.  Anyway see comments below. ]

This is pretty much the stub stock scenario in Greenblatt's Genius book.  Speaking of which, this is another perfect case of where we can go out and create our own stub, like Greenblatt said we could (and should).

Create Your Own Stub
So the problem with AAPL is basically that it is ridiculously underleveraged.  They have so much cash on their balance sheet that it's a drag on the performance of the whole company.  They have $137 billion cash on the balance sheet that comes to $145/share.  That's just nuts.

But Greenblatt reminded us that even if companies don't do leveraged recapitalizations too much anymore (except private equity owned entities), we can do our own recap and create our own stub.

So here I'll just take a quick look at creating an AAPL stub, which I thought I'd never do.  Who the heck buys LEAPs on volatile tech stocks?  Who needs leverage to own a stock that went from $100 to $700 almost overnight?

Anyway, let's just say we want to lever up 2-1.  I'll just look at the $250 strike January 17, 2015 calls.  You can go up or down the strikes according to your taste.
Apple is now trading at $458.60/share and the 250 strike calls is offered at $211.

So buying the $250 strikes at $211 means you are paying a $2.4/share premium (($250 + $211) - $458.60).  Plus you don't get dividends by owning LEAPs, so you lose out on that.  Dividends now is an annualized $10.40/share.  The $2.40/share premium above is for two years (let's round this to two years), so that's a premium of $1.20/share per year.  Add that to the $10.40 in dividends you don't get and that's an annualized carry cost of $11.60/share.

Since you are 'borrowing' $250 over two years, your annualized financing cost is 4.6%/year.  But this assumes dividends don't go up this year and next.  This may be unlikely given all the talk of too much cash on AAPL's balance sheet.   If dividends go up 20%, then the carry cost will go up to 5.5% (assuming a one time bump up in dividends of 20% for the two years).

But this ignores the put option value of owning a 250 strike call instead of actually borrowing cash to buy shares.  If you bought AAPL on margin and the stock really tanked, you would get margin called.  With a call option, you can't possibly lose anything below $250 as you are only long a call option that becomes worthless (if AAPL goes below $250 and stays there).

A $250 strike January 2015 put option is offered at $8 or so, so to be really accurate, you should deduct $4/year off of the financing cost above.  That gets the carry cost (cost of loan) down to 3% (or 4% if dividends are 20% higher). 

That's not bad at all.  I know interest rates are zero, but for a small investor to be able to borrow money at 3-4% is not bad at all.  I realize there are discount brokers that offer lower margin rates, but still.

All Options Expire Worthless!
I don't want to push this stuff too much (as I don't really know who is reading this), but just to show how low risk something like this can be, let's think about this for a second.

Many people rightly believe that all options expire worthless.  Never mind that that's not really possible, but it's not a bad way to think so as to stay out of trouble and not buy calls and puts out of an urge to hedge or get some 'free' upside on a momo stock.

But a well thought out LEAPs strategy can be very good. 

Let's take a look at this trade, for example.

If you buy a 250 strike AAPL LEAP for $211, you can't lose your entire investment unless AAPL goes down to $250/share in two years.  From what I read, I think that's a low probability (well, more on what I think of AAPL later). 

One thing that kills option investors is the time value decay.  You buy at-the-money or out-of-the-money calls to try to capture upside in a big momo stock that you are afraid to own outright.  Or you buy at-the-money or out-of-the-money SPY puts because you are terrified at what the fiscal cliff will do to your IRA.

When you buy at-the-money options over the near term, you are not really borrowing money.  You are paying more for the volatility; you are paying a premium for the opportunity to buy or walk away depending on what happens to the stock.   This optionality is what you are paying for.  You can test this easily by calculating the financing cost of a position and compare it to the option premium.  For short-dated options, the financing component is tiny compared to the total option premium.

I have no proof, but I think if someone did a study on options and how people lose money in them, I bet that most of the money is lost due to the amount people pay over the instrinsic value of an option (intrinsic value is simply the in-the-money amount of an option).  In other words, it's the time value that kills them.

So using this unproven rule of thumb that I just pulled out of thin air, let's look at this AAPL LEAP trade again.

The stock is at $458.60/share.  The strike price plus option premium on the 250 strike LEAP is $461/share.  So you are paying $2.40/share over the stock price.  Add the $21/share of dividends you won't get and you are paying $23.40 over the stock price.   So if the stock price does nothing for the next two years, this is what you lose.  You lose $23.40/share (or more if dividends go up).  That's just 5% of the notional amount of the trade, or 2.5%/year.  That doesn't sound too traumatic.

If the stock price goes up or down, you make the same amount as if you were holding the stock, pretty much on a dollar for dollar basis (at expiration, of course.  Until then, your option will go up and down according to the delta of the option).   And then under $250, you don't lose any more.

My point is that on a time value basis, you are paying very little premium so you don't lose a lot of money here if the stock goes nowhere.  Compare that, for example, to owning an at-the-money call option which, by the way, is offered at $69 now for the same maturity (2 years).  That means you lose 20% of the notional amount of the trade with the stock flat over two years (including dividends you don't get).

So I would tend to look at these in-the-money LEAP trades (and even shorter maturity options) differently than 'typical' option trades; they act more like financing trades.  Of course it's still risky as you are levering up.

What I Still Think of Apple
Not that I have much to add to the Apple debate going on all over the place, I still view Apple the same way as when I made my previous posts about it last year.  (Why I Left Apple and Apple is No Polaroid)

I still think Apple was a Steve Jobs story and not an Apple Inc. story.  I still think the market breathed a huge sigh of relief after Jobs passed away as Apple continued to perform in the following year.  That's what took the stock up to $700.   I keep reading about how "Apple did this.  Apple did that.  Dell couldn't do that.  Microsoft didn't do that".  And I always think, no,  Steve Jobs did this.  Steve Jobs did that.

I still think that the cell phone market will get more and more competitive and mobile companies will get more and more resentful about the huge subsidies they pay for subscribers to get iPhones.  When price competition heats up in mobile markets around the world, more and more operators will opt not to pay $500-600 subsidies.   I understand that early on it was the other way around.  Mobile operators needed the iPhone to attract subscribers.

Over time, I think the "amazingness" of Apple products will become increasingly commoditized. Sure, Apple may still be able to maintain a premium brand status just as they held on to that over time with the Mac, but that may not be enough to maintain or increase the value of Apple as a company.

I do think that Apple is only cheap if one assumes that Apple will come out with something just as mind-blowing as the iPod was, then the iPhone and then the iPad.  If all we have going forward are upgrades to iPhones and iPads and competitors continue to close the gap, then I tend to believe that Apple is probably not a cheap stock.

Anyway, I know many people disagree with this view (and many agree), and the hard thing about this discussion is that there really is nothing I can point to to prove it one way or the other.  There are plenty of people who know way more about Apple than I do so don't mind my opinion too much.

Advantage for the Little Guys
But having said all of that, this Apple LEAP trade does look interesting.  This is one of the advantages of being small investors.  Someone like Einhorn probably couldn't put this trade on.  He has no choice but to activist management into action. 

But little guys like us can just say, hey, if you don't want to lever up, I'll just do it myself, thank you very much.