There is some talk that to prevent further financial meltdowns and taxpayer bailouts, we should simply eliminate or ban bonuses at banks.
Whenever someone says "ban" something to solve a problem, warning bells go off in my head. For example, people say that the Fed is the cause of all financial crises in the past few decades. So, eliminate the Fed! Well, OK. Some argue that the Fed is run by unelected officials and hold more power than elected officials. But then you have to think, after their competence in running FNM and FRE, do we really want congress to control interest rates and the money supply?
OK, that's another issue.
Ban bonuses at banks? On the face of it, it sounds reasonable. Outsized bonus potential incent bankers to take outsized risk that eventually blows up a bank and taxpayers have to come in to bail them out.
This is true to some extent for sure. But on the other hand, I happen to remember one of the biggest bubbles and blowups in history that a country hasn't recovered from yet: Japan. Japan had the biggest bubble of all time up until then; bankers made hugely risky and stupid loans. Even manufacturers took huge risk in "zaitech" (where they used their own balance sheet to speculate in the financial and real estate markets to boost earnings).
And guess what? Japan in the 1980s did not have anything close to the outsized bonuses or salaries that Wall Street has had for decades. Japanese management bonuses were and are tiny. Traders and other risk-takers at various banks, investment banks and zaitech-ing manufacturers were not paid big bonuses for their profits. (By the way, this applies to derivatives too. People are all bent out of shape about derivatives and how that is the cause of all problems in finance. However, derivatives in my mind played a very small part in this financial blowup. Japan had very little derivatives during the bubble. The 1929 crash had very little to do with derivatives. The tulip bubble had very little to do with derivatives etc... When the financial crisis came, JPM was the first domino that was supposed to fall because of it's GDP-like notional derivatives exposure. Nope. Also, European banks are in big trouble now. Derivatives? Nope. Simple, straight sovereign debt. Big bonuses caused that problem? Probably not.)
And yet, the bubble happened. I also wonder about the 1920s too, in the U.S. That was quite a bubble. Was it outsized bonuses then? I think not.
So what can we do about it?
Whenever we talk about these things, I am always baffled that nobody talks about the simplest answer.
The answer is quite simply that if the U.S. government (taxpayer) is going to come in to bail out these big financial firms, then we have to get paid for it.
Sure, banks pay FDIC fees and things like that. If the FDIC loses money on bailouts, it means, quite simply, that the FDIC fees are too low. (But I think the FDIC has *not* lost money over time, and the TARP money was paid back for most of the large banks. I think the money lost that people keep talking about include AIG, FNM and FRE which haven't paid back their TARP money).
The problem, as usual, is pricing. If deposit guarantees are priced correctly, it doesn't matter who does it. U.S. government? Fine. Then let's set a fair price.
Ban proprietary trading? Don't get me started on that. Prop trading, in my mind, had nothing to do with the recent financial blowup. They want to ban prop trading, which include startegies that firms like Och-Ziff does but allow customer facilitation and market-making functions.
Well, if you look at the multi-billion blowups in 2008/2009, I tend to think those losses were not on the proprietary desks, but the customer faciliation/market-making desks. At Merrill, it was loans warehoused for future sale that did them in. It was not a proprietary trade, but a huge inventory of loans bought for the purpose of repackaging for future sale. That's a customer business, not a prop trade.
I think it was probably the same at Bear. Morgan Stanley too. I think all of these 'trades' would be allowed under the Volcker rule.
What can you not do under the Volcker rule? Stat arb. Convertible arb. Index arb. Special situations. In other words, strategies that had nothing to do with the financial blowup.
Anyway, back to bonuses.
Eliminating bonuses, I think, will do nothing to reduce risk. We don't know what the unintended consequences are. When they taxed heavily pay over $1 million to clamp down on excess executive pay back in the 90s, it gave birth to the multi-billion dollar stock option pay outs. Oops.
So instead of banning this and banning that on a one-shot basis based on one-dimensional thinking, I think it's probably wiser to get to the essence of the problem: Proper pricing of risk!
Forget bonuses.
Is the bank taking a lot of risk? Fine. Then they have to pay more FDIC fees. It's silly to have a fixed fee regardless of the risk profile of the bank. If life insurance companies can set the rate depending on whether you smoke cigarettes, go sky-diving every weekend and race formula one cars, then why can't the FDIC set rates according to how risky the bank is?
The fact that they don't even consider that and instead choose blanket bans makes no sense to me.
(This is another rant, but why can't health insurance companies charge more for people who smoke and don't exercise? I think the health insurance market can be much cheaper and more efficient if this was allowed. Because it is not, the rest of us have to pay ridiculous premiums; the unhealthy have no incentive to get healthy)
I'm a free market guy and that's my solution. Pricing, pricing, pricing.
This solves a lot of other problems too. Should the federal government guarantee mortgages? People always seem to argue yes they should or no they shouldn't. The real question is, yes, why not if it is priced correctly? If it is priced correctly, then it doesn't matter who does it. If it is priced incorrectly, then nobody should.
I was always baffled at the fixed nature of mortgage guarantees too. They charge a fixed rate to guarantee a mortgage seemingly without regard for any risk factors (like price of house compared to affordability). A mortgage guarantee cost the same whether the house was cheap or very expensive.
Anyway, back to banks and bonuses. Instead of banning proprietary trading and banning bonuses or doing anything so simplistic and silly, why not just change fees according to risk? I am a big believer in setting proper incentives, not legislating/banning this and that.
If you make all of your money in proprietary trading and very little on loans (and your balance sheet is allocated accordingly), you pay a very high FDIC fee. If you make all of your money on loans and do no proprietary trading at all and you have a low levered, conservative balance sheet, then you pay a very low FDIC fee. Maybe even zero.
So Citibank would pay a much higher FDIC fee than, say, M&T Bank. Why not?
Tuesday, November 8, 2011
Monday, November 7, 2011
Investing as a Skill
I am now reading a book by Jerry Yang called "All In". Jerry Yang is an Hmong immigrant from Laos who came to the U.S. and in a very short period of time won the World Series of Poker in Las Vegas.
It is a very interesting book for many reasons, one of which is that I have never read a story about the horrors the Hmong went through in their native country. In the U.S., we pretty much only hear about how bad the Holocaust was. Yes, the Holocaust was horrible, and it's sheer magnitude is astounding.
But that is not the only horror that occured. Many have occured more recently, and continues to this day all over the world.
Anyway, that's another topic.
What struck me about this book is how Yang became a strong poker player and got to the top in Las Vegas.
He watched a lot of Poker on TV and took notes and studied hard. He played freqeuntly in local tournaments and meticulously took notes, asked a lot of questions to learn from better players, he analyzed his own playing to see what he could have done better etc... The sheer effort is very inspiring.
Why does this strike me?
Because a lot of things, for some reason, are taken for granted and people tend to brush things off with words like "talent". Oh, he's talented. Oh, he has a knack for this or that.
But the fact is that behind a lot of success is a lot of hard work. I know this sounds obvious. We all understand that.
But somehow, in certain areas of life, people tend to forget that.
And I think this is particularly true in the world of investing. I have spoken to all kinds of traders and investors, pro and amateur for many years and it's always amazing that a lot of people don't really take investing to be a learnable skill.
Oh, I'm not as smart as Warren Buffett, they'll say, so they'll speculate in penny stocks where people just email me tips. Oh, I have no luck with stocks so I will speculate on 100-1 leverage in the foreign currency markets (they think they can't be Buffett but they can suddenly become a George Soros).
Even for Warren Buffett, it took a lot of effort to get where he is. He was not just some smart guy that tended to have knack or special talent to pick stocks. The guy read all the investment books available at the local library at an early age and spent much of his early career just reading financial reports for many hours every single day (and continues to do this to this day).
Michael Milken (not a hero today, but) used to carry a duffle bag full of financial reports on his long, daily, commutes. He knew more about companies than many other people and that helped him develop his business.
Speaking of Warren Buffett having read every single investment book at the local library, Bobby Fischer too, did the same thing at an early age. He went to the Brooklyn Public Library and read every single chess book they had there, and he actually spent time memorizing information in those books he thought would be useful.
Talent? Knack? Maybe at some level that is required.
But what sets the Buffetts and the Fischers apart from everyone else is the sheer effort they put into trying to get better. (This is not to say that anyone can be a Buffett or Fischer, of course. But it's true that anyone can get better with some work).
Let's get back to investing.
I don't know why, but for a lot of other things, people understand that you have to work at it to get better. Nobody buys a violin and then surfs the internet and tries to find a website that will promise that they can be virtuoso violinists in five days. Nobody buys a piano and tries to learn how to play in a week.
Even sports like tennis, nobody expects to be able to learn how to play quickly. They will commit to weeks and years of lessons to get better, and if they are serious they will enter tournaments (as playing tough competition is a must in improving at anything).
But when it comes to investing, for some reason, many people feel that hard work is not necessary. If only they can find the right website that will show them how to make money without much effort. Or the right technical indicator. Or the right 'system' that promises the an instant fortune with very little money down.
People will buy stocks on a tip, lose money and then condemn Wall Street as a bunch of criminals and swear off stocks.
They will buy internet stocks at the peak of the bubble, lose money and then conclude that stocks are no good. Or they will assume they have no 'knack' for timing the market. Or they will blame the immoral banks and conclude that it's impossible to make money in the rigged markets (this is true if you try to play by *their* rules; yes they will take what they can and cut you up so you have nothing left!).
They will buy a bank stock at 0.8x book and it will go bankrupt and conclude, again, that stocks are too risky and no good.
But many people won't take the time to try to understand the process of investing. It's actually a little mindboggling. I guess for many people, the stock market is no different than a casino (or at least the slot machine side of the casino); they just make bets and hope for the best. Whatever happens is good luck or bad luck.
It's OK to not be interested in investing. For most people, an index fund will do just fine.
As Peter Lynch used to say, he was baffled that people spent more time investigating, analyzing, comparing and studying refridgerators, for example, than when they buy a stock even when the investment in the stock is many multiples higher than the money spent on a refridgerator.
This is so true. People will comparison shop and be very careful about purchasing a PC, tablet or smartphone, but they will tend to spend tens of thousands of dollars on a stock with very little work or analysis.
Anyway, when I read about guys like Jerry Yang, I realize how similar everything really is. It is very inspiring to read about people who worked hard at something and got good at it.
By the way, I also read a couple of books about Ichiro and it's the same story. He spent many, many hours every single day practicing baseball from an early age, and his work regimen continues to this day. This is how he became a great ball player. I haven't read a Ted Williams book, but he was apparently the same. He was obsessed with improving his hitting.
If one wants to improve as an investor, it will take a lot of work and experience. Of course, not everyone will want to do it and that's fine. It's just a little confusing to me when people have a hard time in the stock market and blame all sorts of things and don't really seem to understand that investing is like anything else and will take a lot of work to get better.
It is a very interesting book for many reasons, one of which is that I have never read a story about the horrors the Hmong went through in their native country. In the U.S., we pretty much only hear about how bad the Holocaust was. Yes, the Holocaust was horrible, and it's sheer magnitude is astounding.
But that is not the only horror that occured. Many have occured more recently, and continues to this day all over the world.
Anyway, that's another topic.
What struck me about this book is how Yang became a strong poker player and got to the top in Las Vegas.
He watched a lot of Poker on TV and took notes and studied hard. He played freqeuntly in local tournaments and meticulously took notes, asked a lot of questions to learn from better players, he analyzed his own playing to see what he could have done better etc... The sheer effort is very inspiring.
Why does this strike me?
Because a lot of things, for some reason, are taken for granted and people tend to brush things off with words like "talent". Oh, he's talented. Oh, he has a knack for this or that.
But the fact is that behind a lot of success is a lot of hard work. I know this sounds obvious. We all understand that.
But somehow, in certain areas of life, people tend to forget that.
And I think this is particularly true in the world of investing. I have spoken to all kinds of traders and investors, pro and amateur for many years and it's always amazing that a lot of people don't really take investing to be a learnable skill.
Oh, I'm not as smart as Warren Buffett, they'll say, so they'll speculate in penny stocks where people just email me tips. Oh, I have no luck with stocks so I will speculate on 100-1 leverage in the foreign currency markets (they think they can't be Buffett but they can suddenly become a George Soros).
Even for Warren Buffett, it took a lot of effort to get where he is. He was not just some smart guy that tended to have knack or special talent to pick stocks. The guy read all the investment books available at the local library at an early age and spent much of his early career just reading financial reports for many hours every single day (and continues to do this to this day).
Michael Milken (not a hero today, but) used to carry a duffle bag full of financial reports on his long, daily, commutes. He knew more about companies than many other people and that helped him develop his business.
Speaking of Warren Buffett having read every single investment book at the local library, Bobby Fischer too, did the same thing at an early age. He went to the Brooklyn Public Library and read every single chess book they had there, and he actually spent time memorizing information in those books he thought would be useful.
Talent? Knack? Maybe at some level that is required.
But what sets the Buffetts and the Fischers apart from everyone else is the sheer effort they put into trying to get better. (This is not to say that anyone can be a Buffett or Fischer, of course. But it's true that anyone can get better with some work).
Let's get back to investing.
I don't know why, but for a lot of other things, people understand that you have to work at it to get better. Nobody buys a violin and then surfs the internet and tries to find a website that will promise that they can be virtuoso violinists in five days. Nobody buys a piano and tries to learn how to play in a week.
Even sports like tennis, nobody expects to be able to learn how to play quickly. They will commit to weeks and years of lessons to get better, and if they are serious they will enter tournaments (as playing tough competition is a must in improving at anything).
But when it comes to investing, for some reason, many people feel that hard work is not necessary. If only they can find the right website that will show them how to make money without much effort. Or the right technical indicator. Or the right 'system' that promises the an instant fortune with very little money down.
People will buy stocks on a tip, lose money and then condemn Wall Street as a bunch of criminals and swear off stocks.
They will buy internet stocks at the peak of the bubble, lose money and then conclude that stocks are no good. Or they will assume they have no 'knack' for timing the market. Or they will blame the immoral banks and conclude that it's impossible to make money in the rigged markets (this is true if you try to play by *their* rules; yes they will take what they can and cut you up so you have nothing left!).
They will buy a bank stock at 0.8x book and it will go bankrupt and conclude, again, that stocks are too risky and no good.
But many people won't take the time to try to understand the process of investing. It's actually a little mindboggling. I guess for many people, the stock market is no different than a casino (or at least the slot machine side of the casino); they just make bets and hope for the best. Whatever happens is good luck or bad luck.
It's OK to not be interested in investing. For most people, an index fund will do just fine.
As Peter Lynch used to say, he was baffled that people spent more time investigating, analyzing, comparing and studying refridgerators, for example, than when they buy a stock even when the investment in the stock is many multiples higher than the money spent on a refridgerator.
This is so true. People will comparison shop and be very careful about purchasing a PC, tablet or smartphone, but they will tend to spend tens of thousands of dollars on a stock with very little work or analysis.
Anyway, when I read about guys like Jerry Yang, I realize how similar everything really is. It is very inspiring to read about people who worked hard at something and got good at it.
By the way, I also read a couple of books about Ichiro and it's the same story. He spent many, many hours every single day practicing baseball from an early age, and his work regimen continues to this day. This is how he became a great ball player. I haven't read a Ted Williams book, but he was apparently the same. He was obsessed with improving his hitting.
If one wants to improve as an investor, it will take a lot of work and experience. Of course, not everyone will want to do it and that's fine. It's just a little confusing to me when people have a hard time in the stock market and blame all sorts of things and don't really seem to understand that investing is like anything else and will take a lot of work to get better.
Stunningly Bad Analysis
I can't believe how sloppy and bad some of these credit rating agencies are, and it's really obvious how dangerous they are. We saw how sloppy and bad they were when things melted down in 2008/2009, but this came as a surprise because the perp is Egan-Jones, a small rating agency that wants to compete with the majors, Moody's, S&P and Fitch by being better and more independent (not paid by issuers etc...).
The latest fiasco with Jefferies Group (JEF) is insane. Egan-Jones downgraded Jefferies after the MF Global bankruptcy because JEF owned $2.6 billion or so of problem sovereign bonds in Europe. First of all, this seems highly reactionary to me; to downgrade something right after an event like the MF Global bankruptcy. It's as if they didn't realize that there was a sovereign debt problem in Europe until the MF Global bankruptcy, or didn't notice this $2.6 billion position until then.
And then to only mention a long position in a market-making, hedged book of bonds seems highly ignorant of how investment banks work. Incredibly sloppy thinking.
Thankfully, JEF responded quickly and clarified their positions. However, Egan-Jones refused to back down and made a silly statement.
Here's a cut and paste from a Wall Street Journal article:
JEF did clarify that their short positions were in securities and weren't default swaps or other derivatives with credit risk.
This is no different than a long/short inventory position of equity market-makers. Market-makers have billions in stock inventory but is mostly hedged and this has not been a problem, historically.
JEF responded with a series of releases. Here's one of them:
The position looks fine. It's incredible that an analyst would only use a long position to evaluate a balance sheet without looking at what's on the other side of it.
Sure, Morgan Stanley blew $10 billion on poorly hedged mortgages during the crisis (or some such incredibly high number), but they were in fact highly complex products with risk characterstics that are very different than sovereign bonds, no matter the credit rating of the bonds (JEF does in fact specialize in high yield).
JEF also owns $1.68 billion in equity securities (with $1.57 billion in equity short positions) and $4.2 billion in corporate bonds (with $3.6 billion shorts); a large part of the corporate bonds are probably high yield, too.
Why not mention only the long side of those positions too, which may look even more risky?
Leucadia National (read about here), the largest owner of JEF jumped in and bought 1 million shares for $11.84 and 500,000 shares at $11.35.
It is really scary that this sort of bad analysis can possibly cause a run on a perfectly healthy, fine company (I don't own any JEF, but have positive view about them. Even the very vocal bank critic Meredith Whitney said JEF is run by a very good, conservative CEO).
Anyway, these are scary times to be sure for everyone. People are very trigger happy; shoot first and ask questions later. Or in many cases, just shoot, shoot, shoot and don't think or ask questions!
The latest fiasco with Jefferies Group (JEF) is insane. Egan-Jones downgraded Jefferies after the MF Global bankruptcy because JEF owned $2.6 billion or so of problem sovereign bonds in Europe. First of all, this seems highly reactionary to me; to downgrade something right after an event like the MF Global bankruptcy. It's as if they didn't realize that there was a sovereign debt problem in Europe until the MF Global bankruptcy, or didn't notice this $2.6 billion position until then.
And then to only mention a long position in a market-making, hedged book of bonds seems highly ignorant of how investment banks work. Incredibly sloppy thinking.
Thankfully, JEF responded quickly and clarified their positions. However, Egan-Jones refused to back down and made a silly statement.
Here's a cut and paste from a Wall Street Journal article:
JEF did clarify that their short positions were in securities and weren't default swaps or other derivatives with credit risk.
This is no different than a long/short inventory position of equity market-makers. Market-makers have billions in stock inventory but is mostly hedged and this has not been a problem, historically.
JEF responded with a series of releases. Here's one of them:
The position looks fine. It's incredible that an analyst would only use a long position to evaluate a balance sheet without looking at what's on the other side of it.
Sure, Morgan Stanley blew $10 billion on poorly hedged mortgages during the crisis (or some such incredibly high number), but they were in fact highly complex products with risk characterstics that are very different than sovereign bonds, no matter the credit rating of the bonds (JEF does in fact specialize in high yield).
JEF also owns $1.68 billion in equity securities (with $1.57 billion in equity short positions) and $4.2 billion in corporate bonds (with $3.6 billion shorts); a large part of the corporate bonds are probably high yield, too.
Why not mention only the long side of those positions too, which may look even more risky?
Leucadia National (read about here), the largest owner of JEF jumped in and bought 1 million shares for $11.84 and 500,000 shares at $11.35.
It is really scary that this sort of bad analysis can possibly cause a run on a perfectly healthy, fine company (I don't own any JEF, but have positive view about them. Even the very vocal bank critic Meredith Whitney said JEF is run by a very good, conservative CEO).
Anyway, these are scary times to be sure for everyone. People are very trigger happy; shoot first and ask questions later. Or in many cases, just shoot, shoot, shoot and don't think or ask questions!
Friday, November 4, 2011
Market Volatility
The market seems to go up and down these days depending on who said what, or what the latest development in Europe is. No confidence vote? Referendum?
It is really silly. Someone said to me the other day that it must be hard to deal with markets like this. I said, "What are you talking about? The market is flat on the year".
These days when the market is up or down 200 or 300 points, I really don't care because I assume someone in Europe will say something tommorow that will reverse it.
With all this gloom and doom and fear, the market is flat. Think about that for a moment. We had a U.S. government debt downgrade that everybody feared. We had Fukushima, the biggest nuclear disaster since Chernobyl. We had, or are having a Greece default (or technical non-default). We have occupiers on Wall Street.
If you told someone at the beginning of the year that these events would happen but the market would be flat by November, no sane person would have agreed with you.
As Seth Klarman (and most other good investors) says, you have to look at what a company may be worth in five years and try to buy it at substantially below that price and not worry about what happens in the near term.
There was a great Shelby Davis quote that went like this:
"To sail across the ocean, you must balance making progress in fair weather with the ability to withstand the inevitable storms. Those who think only of the storms will never leave the shore. Those who think only of fair weather will never reach the other side."
There was another one that I can't seem to find. I don't remember where I read it, but it was something to the effect that we must be guided by the light of the lighthouse (or stars) rather than the waves crashing against our boat. In other words, don't let the short term noise distract you from your medium to longer term goals.
In investing, the light is the intrinsic value of something you own. If you understand the business and know it can get through some adversity and it is trading at less than instrinsic value at an attractive level, who cares what is going on in Europe?
I know, I know. Easier said than done.
(Of course, if one thinks that the goings on in Europe is the beginning of the end of capitalism, then they may have other ideas.)
It is really silly. Someone said to me the other day that it must be hard to deal with markets like this. I said, "What are you talking about? The market is flat on the year".
These days when the market is up or down 200 or 300 points, I really don't care because I assume someone in Europe will say something tommorow that will reverse it.
With all this gloom and doom and fear, the market is flat. Think about that for a moment. We had a U.S. government debt downgrade that everybody feared. We had Fukushima, the biggest nuclear disaster since Chernobyl. We had, or are having a Greece default (or technical non-default). We have occupiers on Wall Street.
If you told someone at the beginning of the year that these events would happen but the market would be flat by November, no sane person would have agreed with you.
As Seth Klarman (and most other good investors) says, you have to look at what a company may be worth in five years and try to buy it at substantially below that price and not worry about what happens in the near term.
There was a great Shelby Davis quote that went like this:
"To sail across the ocean, you must balance making progress in fair weather with the ability to withstand the inevitable storms. Those who think only of the storms will never leave the shore. Those who think only of fair weather will never reach the other side."
There was another one that I can't seem to find. I don't remember where I read it, but it was something to the effect that we must be guided by the light of the lighthouse (or stars) rather than the waves crashing against our boat. In other words, don't let the short term noise distract you from your medium to longer term goals.
In investing, the light is the intrinsic value of something you own. If you understand the business and know it can get through some adversity and it is trading at less than instrinsic value at an attractive level, who cares what is going on in Europe?
I know, I know. Easier said than done.
(Of course, if one thinks that the goings on in Europe is the beginning of the end of capitalism, then they may have other ideas.)
How Do You Solve a Problem Like Nomura?
The title is meant to be sung in the melody of the Sound of Music song, "Maria".
Nomura just announced a loss for the first half of fiscal 2012 and a major restructuring. I guess the Lehman purchase isn't really working out. I have to say that this was actually not a bad idea, to buy a business from a failing company at the bottom of a cycle.
My only concern, however, is that these Japanese financial companies, for whatever reason, have failed so far in overseas ventures for the most part. They have tried to build up the U.S. business numerous times over the years and it always seemed to end in tears. In the early 1990s, they did really well in the commercial mortgages market until they blew up. In the late 90s they again built up the U.S. business only to have it fall apart after the 1999/2000 peak again.
They have been rapidly expanding in the U.S. again since the crisis. We have yet to see if this is going to work out over time.
Anyway, Nomura is an interesting situation for many reasons. One of them is that it sort of illustrates what has been wrong with the Japanese equity market. Below is the stock price and book value per share of Nomura (in Japanese yen) since 2000.
You will notice that despite the bad economy over there and stock market, Nomura has been trading way above book value for most of that time.
Here is the P/B ratio over this time period:
In 2000, it was trading at over 4.5x book value. Even after the internet bubble popped, Nomura traded at arouind 2x book until the financial crisis in 2008.
Of course, many U.S. financials traded at way over book value too in the 2000s until the financial crisis hit. But at least they were earning some decent returns on capital, even though it turns out that in some cases those returns weren't 'real' (they gave it back and then some in the 2008/2009 collapse).
Let's look at the fundmantals of Nomura over this time period.
This is the data pulled from Nomura's 20-F filings (so are U.S. GAAP based) of the basic fundamental figures.
In the past ten years, they have earned a return on equity (ROE) of only 3.2%. Of course, this includes their 40% loss in 2009 due to all sorts of problems. This is when many Japanese institutions were feeling good about not owning subprime mortgages. Well, some of these (Nomura) still had to take huge writedowns on private equity holdings and other disasters.
If you exclude that as a fluke (better not to, but let's be generous for a moment), their ROE would still be only 7% or so. From 2000 up until 2007, the ROE was 9.6%, which is reasonable for a Japanese company and I think close to management's goal of earning 10% ROE over time.
The average P/B ratio of Nomura from 2000-2010 was around 2x book. The average p/e ratio is 24x and the average dividend yield is 1.6%.
Is this cheap? Look at the above table and see the ROE, p/b ratio and p/e ratios since 2000 through 2010. I think this is one reason why the Japanese stock market has been such a horrible performer.
Despite awful conditions, the stock market really never got cheap.
This is a big contrast to the U.S., where companies like GS and JPM, as I stated before, are trading at or below tangible book value so soon after the crisis begun. It has taken the stock market in Japan 20 years to take the stock price of Nomura to below book value. Twenty years!
And it took a financial crisis that cut the book value per share of Nomura almost in half to take the p/b ratio down to book value, and another semi-crisis to take it down to where it is now at 50% of BPS.
Of course, the next question is if that is cheap. If Nomura does succeed in realigning the business and starts to generate 10% ROE over time, Then Nomura is certainly worth book value or more.
However, what is worrisome is that they are attempting to expand their business globally; something they haven't been able to do successfully in the past.
Also the 9.6% ROE they earned in the period 2000-2007 seems decent, but with the giant loss they incurred in 2008 (year-ended March 2009), it seems the 9.6% ROE may have been achieved with excessive risk. Of course, it can be excess risk or simply poor risk management. It doesn't matter which one it is because either way the end result is the same for shareholders.
So it is a good question whether Nomura can achieve a 10% ROE going forward.
Why am I doubtful of Nomura success overseas? The people in power tend to be highly educated and intelligent, but they operate in a country that is highly regulated with excessive protection for domestic companies. This may be good for the domestic businesses, but this is bad for development of the industry itself.
This has worked well for manufacturers (where a protected domestic market allowed auto companies to reinvest and improve quality etc...), but this has not been good for the financial industry.
Nomura has been recommended on and off over the years by many people, but mostly as a play on a comeback in the Japanese stock market, the one market with the longest bear market and often gets categorized as the least popular major market.
If Japan does enter a bull market, Nomura will certainly benefit as they do have a very strong franchise domestically. Their domestic business is very good, there is no doubt about that.
But recent moves by management makes this a global expansion play. The stock price may hinge, over time, more on whether they succeed in this global expansion.
The table below shows the large growth in number of employees and shows that most of this growth has come outside Japan (from the 2011 annual report):
The total number of employees has grown 60%, or 10,000 employees since 2007 (which was a peak in the global economy). Of that, around two thousand were in Japan, so 80% of the employee headcount growth has come from overseas. This is a huge bet.
The following shows the number of companies in the global research coverage which show that Nomura is serious about global expansion:
Maintaining research coverage is very expensive. This growth in the fixed cost base must be accompanied by growth in revenues, or else large losses will result. Operating leverage works both ways when you increase your fixed cost base, so it may increase earnings volatility too, especially when you are not the dominant player. In the investment banking business, only the top tier players tend to make money. We will see if Nomura can break into that. What looks like a good move to diversify away from the domestic business can actually become a nightmare if revenues don't pick up.
But let's look at how Nomura has done internationally. Thanks to the SEC required 20-F, regional revenues and pretax income must be reported. Here are the historical figures going back to the year 2000. They are the pretax income figures by region:
What this table shows is staggering. I grabbed these numbers from the various 20F's from the last ten years; sometimes earnings are reallocated and changed depending on which 20F you looked at but I didn't 'fix' any of that as they were small and didn't change the conclusion or message of this table (for example, the 2008 income before tax for a region may differ on the 2008 20-F and then later on the 2010 20F (as they show figures for the past three years)).
Since 2000, Nomura has lost 854 billion yen in their non-Japan business. Yes, the 2008 and 2009 financial crisis accounts for much of that. But even before the crisis, you will notice that Nomura has lost money in almost every single year.
On the other hand, Nomura has made money in their domestic business in just about every year despite the long bear market, or at the very least non-bull market in the Japanese stock market.
Even the Asia business didn't do too well even though there was a big boom in Asia during most of this period. How can say you are getting involved in Asia and not make money in a booming economy?
There was a tremendous global boom between 2002-2007 or so, and yet their overseas business didn't make any money even in those "boom" years. This is truly baffling. How can this be? Poor management?
I tend to think that Nomura stock would be much more valuable if they just simply dropped their global plans. Obviously, they would have been better off in the past ten years, at least.
So what is the domestic business worth?
Just for fun, since Nomura will not drop their global plan for various reasons (even though every few years, they do tend to de-emphasize it only to try to reenter at another later date. Even in the best days of Nomura in the 80s, they failed to make any headway as a global investment bank), let's look at what the domestic operations is worth.
The domestic business earned an average of around 200 billion yen per year. Using a 40% tax rate, you get 120 billion in net income. With 3.7 billion shares outstanding, that comes to around 32 yen per share. At 10x, Nomura's domestic business is worth 320 yen/share.
In a more normal market, it looks like Nomura's domestic business can earn 300-400 billion yen pretax. Let's say 300 billion. Doing the above exercise gets you to 486 yen per share, which is higher than the current 290 yen per share it is trading at now. So all that needs to be done is for markets to stabilize, and for Nomura to just break even on their non-Japan business.
Of course, I have always thought the best option for Nomura is to sell itself to a global investment bank that wants to do business in Japan. Since they have a great franchise domestically and seem to not be able to succeed internationally, it only makes sense for Nomura to become the Japan arm of a major global bank.
But Nomura management would probably never allow that as that would mean they would be reporting to someone else, and also the Japanese regulators would probably not allow that either as Nomura is Japan's largest independent investment bank. So unfortunately, that would never happen.
Nomura is currently trading at half of BPS which is nominally cheap. But I think there are many better opportunities out there in the financials; companies with better ROE histories etc...
On any bounce in the Japanese stock market, though, this is a major player so it will go up. I just don't see it as that exciting due to the above, global expansion issues.
Nomura just announced a loss for the first half of fiscal 2012 and a major restructuring. I guess the Lehman purchase isn't really working out. I have to say that this was actually not a bad idea, to buy a business from a failing company at the bottom of a cycle.
My only concern, however, is that these Japanese financial companies, for whatever reason, have failed so far in overseas ventures for the most part. They have tried to build up the U.S. business numerous times over the years and it always seemed to end in tears. In the early 1990s, they did really well in the commercial mortgages market until they blew up. In the late 90s they again built up the U.S. business only to have it fall apart after the 1999/2000 peak again.
They have been rapidly expanding in the U.S. again since the crisis. We have yet to see if this is going to work out over time.
Anyway, Nomura is an interesting situation for many reasons. One of them is that it sort of illustrates what has been wrong with the Japanese equity market. Below is the stock price and book value per share of Nomura (in Japanese yen) since 2000.
Nomura Stock Price and Book Value Per Share
You will notice that despite the bad economy over there and stock market, Nomura has been trading way above book value for most of that time.
Here is the P/B ratio over this time period:
Nomura Stock Price-to-Book-Value-Per-Share Ratio
In 2000, it was trading at over 4.5x book value. Even after the internet bubble popped, Nomura traded at arouind 2x book until the financial crisis in 2008.
Of course, many U.S. financials traded at way over book value too in the 2000s until the financial crisis hit. But at least they were earning some decent returns on capital, even though it turns out that in some cases those returns weren't 'real' (they gave it back and then some in the 2008/2009 collapse).
Let's look at the fundmantals of Nomura over this time period.
This is the data pulled from Nomura's 20-F filings (so are U.S. GAAP based) of the basic fundamental figures.
In the past ten years, they have earned a return on equity (ROE) of only 3.2%. Of course, this includes their 40% loss in 2009 due to all sorts of problems. This is when many Japanese institutions were feeling good about not owning subprime mortgages. Well, some of these (Nomura) still had to take huge writedowns on private equity holdings and other disasters.
If you exclude that as a fluke (better not to, but let's be generous for a moment), their ROE would still be only 7% or so. From 2000 up until 2007, the ROE was 9.6%, which is reasonable for a Japanese company and I think close to management's goal of earning 10% ROE over time.
The average P/B ratio of Nomura from 2000-2010 was around 2x book. The average p/e ratio is 24x and the average dividend yield is 1.6%.
Is this cheap? Look at the above table and see the ROE, p/b ratio and p/e ratios since 2000 through 2010. I think this is one reason why the Japanese stock market has been such a horrible performer.
Despite awful conditions, the stock market really never got cheap.
This is a big contrast to the U.S., where companies like GS and JPM, as I stated before, are trading at or below tangible book value so soon after the crisis begun. It has taken the stock market in Japan 20 years to take the stock price of Nomura to below book value. Twenty years!
And it took a financial crisis that cut the book value per share of Nomura almost in half to take the p/b ratio down to book value, and another semi-crisis to take it down to where it is now at 50% of BPS.
Of course, the next question is if that is cheap. If Nomura does succeed in realigning the business and starts to generate 10% ROE over time, Then Nomura is certainly worth book value or more.
However, what is worrisome is that they are attempting to expand their business globally; something they haven't been able to do successfully in the past.
Also the 9.6% ROE they earned in the period 2000-2007 seems decent, but with the giant loss they incurred in 2008 (year-ended March 2009), it seems the 9.6% ROE may have been achieved with excessive risk. Of course, it can be excess risk or simply poor risk management. It doesn't matter which one it is because either way the end result is the same for shareholders.
So it is a good question whether Nomura can achieve a 10% ROE going forward.
Why am I doubtful of Nomura success overseas? The people in power tend to be highly educated and intelligent, but they operate in a country that is highly regulated with excessive protection for domestic companies. This may be good for the domestic businesses, but this is bad for development of the industry itself.
This has worked well for manufacturers (where a protected domestic market allowed auto companies to reinvest and improve quality etc...), but this has not been good for the financial industry.
Nomura has been recommended on and off over the years by many people, but mostly as a play on a comeback in the Japanese stock market, the one market with the longest bear market and often gets categorized as the least popular major market.
If Japan does enter a bull market, Nomura will certainly benefit as they do have a very strong franchise domestically. Their domestic business is very good, there is no doubt about that.
But recent moves by management makes this a global expansion play. The stock price may hinge, over time, more on whether they succeed in this global expansion.
The table below shows the large growth in number of employees and shows that most of this growth has come outside Japan (from the 2011 annual report):
Number of employees 2007 - 2011
The total number of employees has grown 60%, or 10,000 employees since 2007 (which was a peak in the global economy). Of that, around two thousand were in Japan, so 80% of the employee headcount growth has come from overseas. This is a huge bet.
The following shows the number of companies in the global research coverage which show that Nomura is serious about global expansion:
Maintaining research coverage is very expensive. This growth in the fixed cost base must be accompanied by growth in revenues, or else large losses will result. Operating leverage works both ways when you increase your fixed cost base, so it may increase earnings volatility too, especially when you are not the dominant player. In the investment banking business, only the top tier players tend to make money. We will see if Nomura can break into that. What looks like a good move to diversify away from the domestic business can actually become a nightmare if revenues don't pick up.
But let's look at how Nomura has done internationally. Thanks to the SEC required 20-F, regional revenues and pretax income must be reported. Here are the historical figures going back to the year 2000. They are the pretax income figures by region:
What this table shows is staggering. I grabbed these numbers from the various 20F's from the last ten years; sometimes earnings are reallocated and changed depending on which 20F you looked at but I didn't 'fix' any of that as they were small and didn't change the conclusion or message of this table (for example, the 2008 income before tax for a region may differ on the 2008 20-F and then later on the 2010 20F (as they show figures for the past three years)).
Since 2000, Nomura has lost 854 billion yen in their non-Japan business. Yes, the 2008 and 2009 financial crisis accounts for much of that. But even before the crisis, you will notice that Nomura has lost money in almost every single year.
On the other hand, Nomura has made money in their domestic business in just about every year despite the long bear market, or at the very least non-bull market in the Japanese stock market.
Even the Asia business didn't do too well even though there was a big boom in Asia during most of this period. How can say you are getting involved in Asia and not make money in a booming economy?
There was a tremendous global boom between 2002-2007 or so, and yet their overseas business didn't make any money even in those "boom" years. This is truly baffling. How can this be? Poor management?
I tend to think that Nomura stock would be much more valuable if they just simply dropped their global plans. Obviously, they would have been better off in the past ten years, at least.
So what is the domestic business worth?
Just for fun, since Nomura will not drop their global plan for various reasons (even though every few years, they do tend to de-emphasize it only to try to reenter at another later date. Even in the best days of Nomura in the 80s, they failed to make any headway as a global investment bank), let's look at what the domestic operations is worth.
The domestic business earned an average of around 200 billion yen per year. Using a 40% tax rate, you get 120 billion in net income. With 3.7 billion shares outstanding, that comes to around 32 yen per share. At 10x, Nomura's domestic business is worth 320 yen/share.
In a more normal market, it looks like Nomura's domestic business can earn 300-400 billion yen pretax. Let's say 300 billion. Doing the above exercise gets you to 486 yen per share, which is higher than the current 290 yen per share it is trading at now. So all that needs to be done is for markets to stabilize, and for Nomura to just break even on their non-Japan business.
Of course, I have always thought the best option for Nomura is to sell itself to a global investment bank that wants to do business in Japan. Since they have a great franchise domestically and seem to not be able to succeed internationally, it only makes sense for Nomura to become the Japan arm of a major global bank.
But Nomura management would probably never allow that as that would mean they would be reporting to someone else, and also the Japanese regulators would probably not allow that either as Nomura is Japan's largest independent investment bank. So unfortunately, that would never happen.
Nomura is currently trading at half of BPS which is nominally cheap. But I think there are many better opportunities out there in the financials; companies with better ROE histories etc...
On any bounce in the Japanese stock market, though, this is a major player so it will go up. I just don't see it as that exciting due to the above, global expansion issues.
Wednesday, November 2, 2011
KKR Cheap?
Having browsed some of the conference presentations from the Value Investor Congress, I noticed that Leon Cooperman of Omega Advisors likes KKR at 5x p/e ratio.
That's interesting because I too happen to be looking at some of the private equity houses (I recently posted about Blackstone). I did spend some time with the financials of KKR and I look forward to their earnings and conference call that will happen tommorow, I think.
Having said that, I do still have one main concern with all of these private equity shops, and it is their size. KKR too, is the same. They have built their track record and reputation since the late 1970s. And they have grown their asset base substantially only recently.
This is their assets under management (AUM) from their 2010 annual report.
That is pretty huge. Don't forget, private equity uses leverage so their buying power is much bigger than the $46 billion shown here. Remember when $20 billion LBO was huge? Well, they would need to do a few of those to deploy this kind of capital.
Anyway, let's see if size really matters. Here's a look at the IRR (internal rate of return) of KKR's funds historical by vintage (private equity funds raise capital for funds with a fixed time period and are not open-ended investment vehicles like hedge funds or other investment funds; they have to return capital to investors after seven or however many years).
This may be hard to see. I just snipped and pasted from the 2010 10K. In KKR presentations and the annual report, they say that cumulatively from 1976 - 2010, funds with more than 36 months investment time period have returned a gross +25.8%/year versus +11.6%/year for the S&P 500 index. This is certainly impressive.
However, you have to be careful with that. A close look reveals that a lot of the high returns were achieved in the earlier years. For example, the 1976 fund had a +39.5% return, the 1982 fund returned +48.1%, the 1984 fund did +34.5% etc...
In fact, all of the IRR's above 30% occured in funds raised before 1987. Since then, returns are pretty decent, but not the 30%+ returns private equity funds have grown to be known for.
The 1987 fund was huge at the time at $6 billion, and returned 12.1% gross, and 8.9% net after fees. The 1996 fund was big too at $6 billion and earned +18%/year.
Current funds ("Included Funds" in the table) are not doing badly at all, but it's hard to not notice that the gigantic $17.6 billion fund has only returned 6.6%/year and it's been five years already. Yes, it's been a pretty rough five years. But still.
As these funds get bigger, the potential number of targets get smaller. This is an inescapable fact. Also, other megafunds will be fighting over the same pool of big deals.
Here's a table from their presentation in September 2011 that shows the performance of their funds during rolling three-year periods:
It really does show the good returns even in volatile market periods which explains the popularity of these funds these days. Much of the tremendous growth in AUM at all of these companies are driven by this factor in these 'alternative' investments. My concern is pretty much that this rush of assets into these funds will ruin them (or at least cause much lower returns going forward due to size).
A quick look does show that their really great returns happened in the 1977-1988 period. The returns there are fantastic. Returns since then are not so bad either, of course, especially in relation to the S&P 500 index.
But again, they now have $50 billion in AUM, not the smaller amounts they managed for most of their history.
Anyway, KKR is doing the right thing and is diversifying like Blackstone (BX) and I am sure they will do fine as they are really smart, competent people (even though the past decade has shown that smart, competent people can screw up too).
In any case, let's still take a quick look at KKR. Is it cheap? What is it worth?
Both Fortress Investment Group and KKR in their presentations show a sum-of-the-parts analysis to show that the stock price for their business is way too cheap.
Here's a slide from a KKR presentation in September, 2011:
The idea is that KKR is worth the sum of three pieces: The FRE, which is the Fee-related earnings (this is the management fees on all of their AUM, and incentive fees on their non-private equity funds. Private equity fund incentive fee is called carried interest and is another piece of the valuation puzzle I will mention later).
The fee-related income is the most stable piece of the valuation. It's a fee they earn no matter what, as long as they retain AUM.
In the Fortress Investment Group presentation, they use a multiple of 13x fee-related earnings to value this part of the business. I think 13x seems fair but not necessarily conservative, especially if this is a pre-tax figure.
The second piece of the valuation is the "balance sheet". KKR does own $5 billion+ worth of interests in their own funds and co-investments in private equity deals. This is recorded in the Capital markets and investments segment of the business. I think the book value of that portion of the business is used here. Unfortunately, the above slide doesn't include figures and details and what the actual values in the chart shows.
In any case, at the then stock price of $11/share, their contention was that the market is valuing the carried interest portion of their business at zero (or negative) when in fact carried interest is a large part of the economic value of their business.
Carried interest is basically their incentive fee. It's usually 20% and 40% of that is allocated to employees in their carried interest pool (bonus pool, basically).
Here's a slide from that presentation that shows the carried interest income over the past few years at KKR:
This is certainly non-trivial, and it is a large part of the business. Why do people start hedge funds and private equity funds? Because of incentive fees and carried interest, of course!
So you can't value a business by putting no value on that. And that is what the market is apparently doing with KKR according to these charts.
Since they don't give full details on their "sum-of-the-parts" slide, I will put some numbers in there myself with my own conservative assumptions, not what Wall Street typically uses.
So for capitalizing fee-related income, which I take to be largely pretax (because KKR is a partnership that gives you a K-1 form to file), I will use a 10x multiple. That seems fair, a 10% pretax yield. AUM can go up and down, depending on the times. I'm sure KKR would argue that's way too cheap.
Anyway, so part one is that the economic net income that is fee-related in the first half of 2011 was $202 million. Annualize that and it comes to $404 million. Put a 10x multiple on that and that comes to $4 billion (OK, I rounded).
The publicly traded shares of KKR owns 30% of the whole business, so the KKR shareholders stake in that income would be $1.2 billion. With 205 million KKR partnership units outstanding (for the public shareholders portion), that comes to $5.85/share.
Part two is the balance sheet value. By that, I will only include the balance sheet portion in the capital markets and principle activities part of the business. Non-investment assets in that part of the business is marginal.
From the presentation, that comes to $7.85/share as of June-end 2011.
Put those together and you get $13.70/share.
As I type this, KKR is trading at $13.59/share.
We didn't look at carried interest yet, so even at this price here and using my own assumptions, the market is giving zero value to carried interest up here at $13.49/share.
So what is the carried interest worth? That's the tricky part. This is obviously a function of how well the private equity funds perform over the next few years.
They have $50 billion or so in private equity assets (fees and income from other AUM is included in fee-related income capitalized above).
If they do 20%/year on these funds, gains would be $10 billion, carried interest would be $2 billion, and of that, 40% would go to the bonus pool so what's left to partners is $1.2 billion. The public partners own 30% so that comes to $369 million. And there is 205 million publicly traded units so that comes to $1.80/share. At 10x, that's worth $18/share
Add this to the above other two parts and you get $31.70/share in value for KKR. I personally think that's a bit optimistic, so let's look at what happens if the funds return +15% and +10%.
The carried interest per share and value per share of KKR at the various IRR levels would be:
Carried interest value Fair value of
per share KKR
At 20% IRR: $18.00 $31.70
At 15% IRR: $13.17 $26.87
At 10% IRR: $ 8.78 $22.48
So if you assume that KKR's private equity funds generate a 10%/year return, KKR is worth $22.37/share.
Actually, it may be even simpler to look at the value of the carried interest piece as viewing it as owning a part of the portfolio outright. If the carried interest rate is 20%, then it's as if KKR itself owned 20% of the AUM of $50 billion. That's $10 billion. Of that carried interest, 40% is put aside in the bonus pool, so the KKR partners own $4 billion. The public partners of the listed KKR owns 30% of the business, so they own $1.2 billion of the AUM. With 205 million partnership units outstanding, that comes to $5.85/share.
Combine that with the $13.70 for the rest of the business, that comes to $19.55/share fair value of KKR. This approach may show a lower fair value than the previous analysis assuming various IRR, but it's conservative in that it doesn't assume any specific return.
KKR stock does, in fact, look cheap on this basis and with these assumptions.
I will take another look at this and Fortress Investment Group when they announce 3Q earnings, but for now, these are the figures I get for KKR.
Again, the assumption for the value is simply the sum of three parts: The fee-related income, the investments on their balance sheets (capital markets and principle activities), and the carried interest.
The valuation was done, all pretax, using a 10x multiple, or a 10% pretax yield, which seems fair as a first pass sanity check.
The carried interest piece was valued assuming various return levels, 20% carried interest rate, 40% of carried interest going to bonus pool (so only 60% of carried interest going to public partners) and a 10x multiple, again a 10% pretax yield.
I don't own any of the private equity or hedge funds, mostly due to my concern with their increasing size (and my skepticism regarding their future returns), their complexity (headache reading their financials), their partnership structure (I get an allergic reaction when someone sends me things like a K-1 form, and they always come late so you have to file for an extension), the risks inherent in this type of business, especially when they are looking to grow, expand and diversify, and my preference for other cheap financials (like Goldman Sachs).
This is not to say that these things can't perform well going forward. They are certainly out of favor at the moment, that's for sure.
Keep in mind, as usual, that this too is a financial stock and financials tend to be pro-cyclical and risky. Private equity funds use a lot of leverage to due big buyouts so an extended recession, bad capital markets can really hurt these companies. This is not one of those businesses that you can just put in your portfolio and forget about like, say, Coca-Cola or Berkshire Hathaway.
As usual, do your own work!
That's interesting because I too happen to be looking at some of the private equity houses (I recently posted about Blackstone). I did spend some time with the financials of KKR and I look forward to their earnings and conference call that will happen tommorow, I think.
Having said that, I do still have one main concern with all of these private equity shops, and it is their size. KKR too, is the same. They have built their track record and reputation since the late 1970s. And they have grown their asset base substantially only recently.
This is their assets under management (AUM) from their 2010 annual report.
That is pretty huge. Don't forget, private equity uses leverage so their buying power is much bigger than the $46 billion shown here. Remember when $20 billion LBO was huge? Well, they would need to do a few of those to deploy this kind of capital.
Anyway, let's see if size really matters. Here's a look at the IRR (internal rate of return) of KKR's funds historical by vintage (private equity funds raise capital for funds with a fixed time period and are not open-ended investment vehicles like hedge funds or other investment funds; they have to return capital to investors after seven or however many years).
This may be hard to see. I just snipped and pasted from the 2010 10K. In KKR presentations and the annual report, they say that cumulatively from 1976 - 2010, funds with more than 36 months investment time period have returned a gross +25.8%/year versus +11.6%/year for the S&P 500 index. This is certainly impressive.
However, you have to be careful with that. A close look reveals that a lot of the high returns were achieved in the earlier years. For example, the 1976 fund had a +39.5% return, the 1982 fund returned +48.1%, the 1984 fund did +34.5% etc...
In fact, all of the IRR's above 30% occured in funds raised before 1987. Since then, returns are pretty decent, but not the 30%+ returns private equity funds have grown to be known for.
The 1987 fund was huge at the time at $6 billion, and returned 12.1% gross, and 8.9% net after fees. The 1996 fund was big too at $6 billion and earned +18%/year.
Current funds ("Included Funds" in the table) are not doing badly at all, but it's hard to not notice that the gigantic $17.6 billion fund has only returned 6.6%/year and it's been five years already. Yes, it's been a pretty rough five years. But still.
As these funds get bigger, the potential number of targets get smaller. This is an inescapable fact. Also, other megafunds will be fighting over the same pool of big deals.
Here's a table from their presentation in September 2011 that shows the performance of their funds during rolling three-year periods:
It really does show the good returns even in volatile market periods which explains the popularity of these funds these days. Much of the tremendous growth in AUM at all of these companies are driven by this factor in these 'alternative' investments. My concern is pretty much that this rush of assets into these funds will ruin them (or at least cause much lower returns going forward due to size).
A quick look does show that their really great returns happened in the 1977-1988 period. The returns there are fantastic. Returns since then are not so bad either, of course, especially in relation to the S&P 500 index.
But again, they now have $50 billion in AUM, not the smaller amounts they managed for most of their history.
Anyway, KKR is doing the right thing and is diversifying like Blackstone (BX) and I am sure they will do fine as they are really smart, competent people (even though the past decade has shown that smart, competent people can screw up too).
In any case, let's still take a quick look at KKR. Is it cheap? What is it worth?
Both Fortress Investment Group and KKR in their presentations show a sum-of-the-parts analysis to show that the stock price for their business is way too cheap.
Here's a slide from a KKR presentation in September, 2011:
The idea is that KKR is worth the sum of three pieces: The FRE, which is the Fee-related earnings (this is the management fees on all of their AUM, and incentive fees on their non-private equity funds. Private equity fund incentive fee is called carried interest and is another piece of the valuation puzzle I will mention later).
The fee-related income is the most stable piece of the valuation. It's a fee they earn no matter what, as long as they retain AUM.
In the Fortress Investment Group presentation, they use a multiple of 13x fee-related earnings to value this part of the business. I think 13x seems fair but not necessarily conservative, especially if this is a pre-tax figure.
The second piece of the valuation is the "balance sheet". KKR does own $5 billion+ worth of interests in their own funds and co-investments in private equity deals. This is recorded in the Capital markets and investments segment of the business. I think the book value of that portion of the business is used here. Unfortunately, the above slide doesn't include figures and details and what the actual values in the chart shows.
In any case, at the then stock price of $11/share, their contention was that the market is valuing the carried interest portion of their business at zero (or negative) when in fact carried interest is a large part of the economic value of their business.
Carried interest is basically their incentive fee. It's usually 20% and 40% of that is allocated to employees in their carried interest pool (bonus pool, basically).
Here's a slide from that presentation that shows the carried interest income over the past few years at KKR:
This is certainly non-trivial, and it is a large part of the business. Why do people start hedge funds and private equity funds? Because of incentive fees and carried interest, of course!
So you can't value a business by putting no value on that. And that is what the market is apparently doing with KKR according to these charts.
Since they don't give full details on their "sum-of-the-parts" slide, I will put some numbers in there myself with my own conservative assumptions, not what Wall Street typically uses.
So for capitalizing fee-related income, which I take to be largely pretax (because KKR is a partnership that gives you a K-1 form to file), I will use a 10x multiple. That seems fair, a 10% pretax yield. AUM can go up and down, depending on the times. I'm sure KKR would argue that's way too cheap.
Anyway, so part one is that the economic net income that is fee-related in the first half of 2011 was $202 million. Annualize that and it comes to $404 million. Put a 10x multiple on that and that comes to $4 billion (OK, I rounded).
The publicly traded shares of KKR owns 30% of the whole business, so the KKR shareholders stake in that income would be $1.2 billion. With 205 million KKR partnership units outstanding (for the public shareholders portion), that comes to $5.85/share.
Part two is the balance sheet value. By that, I will only include the balance sheet portion in the capital markets and principle activities part of the business. Non-investment assets in that part of the business is marginal.
From the presentation, that comes to $7.85/share as of June-end 2011.
Put those together and you get $13.70/share.
As I type this, KKR is trading at $13.59/share.
We didn't look at carried interest yet, so even at this price here and using my own assumptions, the market is giving zero value to carried interest up here at $13.49/share.
So what is the carried interest worth? That's the tricky part. This is obviously a function of how well the private equity funds perform over the next few years.
They have $50 billion or so in private equity assets (fees and income from other AUM is included in fee-related income capitalized above).
If they do 20%/year on these funds, gains would be $10 billion, carried interest would be $2 billion, and of that, 40% would go to the bonus pool so what's left to partners is $1.2 billion. The public partners own 30% so that comes to $369 million. And there is 205 million publicly traded units so that comes to $1.80/share. At 10x, that's worth $18/share
Add this to the above other two parts and you get $31.70/share in value for KKR. I personally think that's a bit optimistic, so let's look at what happens if the funds return +15% and +10%.
The carried interest per share and value per share of KKR at the various IRR levels would be:
Carried interest value Fair value of
per share KKR
At 20% IRR: $18.00 $31.70
At 15% IRR: $13.17 $26.87
At 10% IRR: $ 8.78 $22.48
So if you assume that KKR's private equity funds generate a 10%/year return, KKR is worth $22.37/share.
Actually, it may be even simpler to look at the value of the carried interest piece as viewing it as owning a part of the portfolio outright. If the carried interest rate is 20%, then it's as if KKR itself owned 20% of the AUM of $50 billion. That's $10 billion. Of that carried interest, 40% is put aside in the bonus pool, so the KKR partners own $4 billion. The public partners of the listed KKR owns 30% of the business, so they own $1.2 billion of the AUM. With 205 million partnership units outstanding, that comes to $5.85/share.
Combine that with the $13.70 for the rest of the business, that comes to $19.55/share fair value of KKR. This approach may show a lower fair value than the previous analysis assuming various IRR, but it's conservative in that it doesn't assume any specific return.
KKR stock does, in fact, look cheap on this basis and with these assumptions.
I will take another look at this and Fortress Investment Group when they announce 3Q earnings, but for now, these are the figures I get for KKR.
Again, the assumption for the value is simply the sum of three parts: The fee-related income, the investments on their balance sheets (capital markets and principle activities), and the carried interest.
The valuation was done, all pretax, using a 10x multiple, or a 10% pretax yield, which seems fair as a first pass sanity check.
The carried interest piece was valued assuming various return levels, 20% carried interest rate, 40% of carried interest going to bonus pool (so only 60% of carried interest going to public partners) and a 10x multiple, again a 10% pretax yield.
I don't own any of the private equity or hedge funds, mostly due to my concern with their increasing size (and my skepticism regarding their future returns), their complexity (headache reading their financials), their partnership structure (I get an allergic reaction when someone sends me things like a K-1 form, and they always come late so you have to file for an extension), the risks inherent in this type of business, especially when they are looking to grow, expand and diversify, and my preference for other cheap financials (like Goldman Sachs).
This is not to say that these things can't perform well going forward. They are certainly out of favor at the moment, that's for sure.
Keep in mind, as usual, that this too is a financial stock and financials tend to be pro-cyclical and risky. Private equity funds use a lot of leverage to due big buyouts so an extended recession, bad capital markets can really hurt these companies. This is not one of those businesses that you can just put in your portfolio and forget about like, say, Coca-Cola or Berkshire Hathaway.
As usual, do your own work!
Tuesday, November 1, 2011
Some More Bullish Stuff
The Value Investors Congress was held in Mid-October. This is a conference run by Whitney Tilson of Value Investor Insight and it features some of the best value investors as speakers. After the conference, notes and presentations float around the internet and they make very interesting reading.
Anyway, I was browsing through some of these things and from a stock market outlook point of view, the investors seemed to be pretty positive. Of course, one of my favorite investors Joel Greenblatt was on CNBC the other day (I think I posted a link) saying that the market is very cheap and he sees a higher market a year from now. He made the same case at the Value Investors Congress.
Here are some interesting charts that I cut and pasted from the internet while I was browsing.
This is a slide from Alexander Roepers of Atlantic Investments. He is a real deal value investor with a great track record.
Here is the performance of their flagship fund:
Since 1992, they have generated a return of +18.8%/year versus +7.8% for the S&P 500 index. It is interesting that he shows the return of Berkshire Hathaway A-shares in comparing returns. He has beat BRK-A too since 1992.
This is also from Atlantic's presentation. I wouldn't focus too much on the gap between the stock market earnings yield and the government bond yield as some perma-bulls in Japan have been saying the same thing for years (and the market continues to non-perform).
But the absolute level of the S&P 500 index earnings yield is very interesting, at 8.1% on this chart. It's one thing to say that the earnings yield is twice as high as the bond yield when the bond yield is at 1% and earnings yield is at 2% (50x p/e). In that case, the absolute level of 2% earnings yield is simply unattractive no matter the relationship to bond yields.
In this case, the absolute earnings yield is 8.1%, the highest it's been since the last 1980s according to this chart.
Roepers also mentions the health of the American corporation's balance sheet. Debt to assets is a low as it has been since the mid-80s. This means that there is room for borrowing to fund acquisitions which would support equity prices going forward.
The next batch of charts come from Leon Cooperman of Omega Advisors. He was the head of Goldman Sachs' Investment Management for a long time and also investment strategist. He has a pretty good repuation and track record.
Anyway, here are some charts from his presentation:
This is pretty much the same as Atlantic's, but goes back to 1970. The market does look very reasonably valued over this time frame too.
In the above chart, the equity risk premium history goes all the way back to 1960 and it shows stock market values to be really attractive even going back to 1960.
Bill Ackman also presented and was calling for an eventual and possibly substantial recovery in the housing market. His stock pick was Fortune Brands, but much of the presentation featured his view on the housing market.
Basically, the housing market has been running at a very low run rate over the past four years or so, way lower than the level of household creation, population growth etc... So eventually, when the excess inventory winds down, the housing market can come roaring back. Housing starts at this low level can't continue forever.
The housing market is a large part of the U.S. economy and this may be a key factor in getting unemployment to come down.
In any case, these are just a few things that caught my eye that indicate that things might not be so bad going forward for the stock market as it seems when you turn on CNBC (which makes it seem like the world is coming to an end!).
Anyway, I was browsing through some of these things and from a stock market outlook point of view, the investors seemed to be pretty positive. Of course, one of my favorite investors Joel Greenblatt was on CNBC the other day (I think I posted a link) saying that the market is very cheap and he sees a higher market a year from now. He made the same case at the Value Investors Congress.
Here are some interesting charts that I cut and pasted from the internet while I was browsing.
This is a slide from Alexander Roepers of Atlantic Investments. He is a real deal value investor with a great track record.
Since 1992, they have generated a return of +18.8%/year versus +7.8% for the S&P 500 index. It is interesting that he shows the return of Berkshire Hathaway A-shares in comparing returns. He has beat BRK-A too since 1992.
This is also from Atlantic's presentation. I wouldn't focus too much on the gap between the stock market earnings yield and the government bond yield as some perma-bulls in Japan have been saying the same thing for years (and the market continues to non-perform).
But the absolute level of the S&P 500 index earnings yield is very interesting, at 8.1% on this chart. It's one thing to say that the earnings yield is twice as high as the bond yield when the bond yield is at 1% and earnings yield is at 2% (50x p/e). In that case, the absolute level of 2% earnings yield is simply unattractive no matter the relationship to bond yields.
In this case, the absolute earnings yield is 8.1%, the highest it's been since the last 1980s according to this chart.
Roepers also mentions the health of the American corporation's balance sheet. Debt to assets is a low as it has been since the mid-80s. This means that there is room for borrowing to fund acquisitions which would support equity prices going forward.
The next batch of charts come from Leon Cooperman of Omega Advisors. He was the head of Goldman Sachs' Investment Management for a long time and also investment strategist. He has a pretty good repuation and track record.
Anyway, here are some charts from his presentation:
This is pretty much the same as Atlantic's, but goes back to 1970. The market does look very reasonably valued over this time frame too.
Bill Ackman also presented and was calling for an eventual and possibly substantial recovery in the housing market. His stock pick was Fortune Brands, but much of the presentation featured his view on the housing market.
Basically, the housing market has been running at a very low run rate over the past four years or so, way lower than the level of household creation, population growth etc... So eventually, when the excess inventory winds down, the housing market can come roaring back. Housing starts at this low level can't continue forever.
Ackman included this Buffett quote in the presentation:
In any case, these are just a few things that caught my eye that indicate that things might not be so bad going forward for the stock market as it seems when you turn on CNBC (which makes it seem like the world is coming to an end!).
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