Posts filed under ‘Themes – Trends’
The Big Short: The Silent Ticking Bomb
A bomb was ticking for many years before the collapse of Bear Stearns in March of 2008, but unfortunately for most financial market participants, there were very few investors aware of the looming catastrophe. In The Big Short: Inside the Doomsday Machine, author Michael Lewis manages to craft a detailed account of the financial crisis by weaving in the exceptional personal stories of a handful of courageous capitalists. These financial sleuths manage not only to discover the explosive and toxic assets buried on the balance sheets of Wall Street giants, but also to realize massive profits for their successful detective skills.
Lewis was not dabbling in virgin territory when he decided to release yet another book on the financial crisis of 2008-2009. Nonetheless, even after slogging through Andrew Ross Sorkin’s Too Big to Fail and Gregory Zuckerman’s The Greatest Trade Ever (see my reviews on Too Big to Fail and The Greatest Trade Ever), I still felt obligated to add Michael Lewis’s The Big Short to my bookshelf (OK…my e-reader device). After all, he was the creator of Liar’s Poker, The New New Thing, Moneyball, and The Blind Side, among other books in his distinguished collection.
Genesis of the Bomb Creations
Like bomb sniffing dogs, the main characters that Lewis describes in The Big Short (Michael Burry/Scion Capital; Steve Eisman/Oppenheimer and Co. & FrontPoint Partners; Gregg Lippman/Deutsche Bank (DB); and Jamie Mai & Charlie Ledley/Cornwall Capital) demonstrate an uncanny ability to smell the inevitable destruction, and more importantly have the conviction to put their professional careers and financial wellbeing at risk by making a gutsy contrarian call on the demise of the subprime mortgage market.
How much dough did the characters in the book make? Jamie Mai and Charlie Ledley (Cornwall Capital) exemplify the payoff for those brave, and shrewd enough to short the housing market (luck never hurts either). Lewis highlights the Cornwall crew here:
“Cornwall Capital, started four and a half years earlier with $110,000, had just netted from a million-dollar bet, more than $80 million.”
Lewis goes on to describe the volatile period as “if bombs of differing sizes had been placed in virtually every major Western financial institution.” The size of U.S. subprime bombs (losses) exploding was estimated at around $1 trillion by the IMF (International Monetary Fund). When it comes to some of the large publicly traded financial institutions, these money bombs manifested themselves in the form of about $50 billion in mortgage-related losses at Merrill Lynch (BAC), $60 billion at Citigroup (C), $9 billion at Morgan Stanley (MS), along with many others.
The subprime market, in and of itself, is actually not that large in the whole scheme of things. Definitions vary, but some described the market at around 7-8 million subprime mortgages outstanding during the peak of the market, which is a small fraction of the overall U.S. mortgage industry. The relatively small subprime market became a gargantuan problem when millions of lucrative subprime side-bets were created through investment banks and unregulated financial behemoths like AIG. The spirits of greed added fuel to the fire as the construction of credit default swap market and synthetic mortgage-backed CDOs (Collateralized Debt Obligations) were unleashed.
Triggering the Bomb
Multiple constituents, including the rating agencies (S&P [MHP], Moodys [MCO], Fitch) and banks, used faulty assumptions regarding the housing market. Since the subprime market was a somewhat new invention the mathematical models did not know how to properly incorporate declining (and/or moderating) national home prices, since national price declines were not consistent with historical housing data. These models were premised on the notion of Florida subprime price movements not being correlated (moving in opposite directions) with California subprime price movements. This thought process allowed S&P to provide roughly 80% of CDO issues with the top AAA-rating, despite a large percentage of these issues eventually going belly-up.
Lewis punctuated the faulty correlation reasoning underlying these subprime assumptions that dictated the banks’ reckless actions:
“The correlation among triple-B-rated subprime bonds was not 30 percent; it was 100 percent. When one collapsed, they all collapsed, because they were all driven by the same broader economic forces. In the end, it made little sense for a CDO to fall from 100 to 95 to 77 to 70 and down to 7. The subprime bonds beneath them were either all bad or all good. The CDOs were worth either zero or 100.”
Steve Eisman adds his perspective about subprime modeling:
“Just throw the model in the garbage can. The models are all backward looking.”
Ignorance, greed, and other assumptions, such as the credibility of VAR (Value-at-Risk) metrics, accelerated the slope of the financial crisis decline.
Eisman had some choice words about many banking executives’ lack of knowledge, including his gem about Ken Lewis (former CEO of Bank of America):
“I had an epiphany. I said to myself, ‘Oh my God he’s dumb!’ A lightbulb went off. The guy running one of the biggest banks in the world is dumb!”
Or Eisman’s short fuse regarding the rating agency’s refusal to demand critical information from the investment banks due to fear of market share loss:
“Who’s in charge here? You’re the grown up. You’re the cop! Tell them to f**king give it to you!!!…S&P was worried if they demanded the data from Wall Street, Wall Street would just go to Moody’s for their ratings.”
A blatant conflict of interest exists between the issuer and rating agency, which needs to be rectified if credibility will ever return to the rating system. At a minimum, all fixed income investors should wake up and smell the coffee by doing more of their own homework, and relying less on the rubber stamp rating of others. The credit default swap market played a role in the subprime bubble bursting too. Without regulation, it becomes difficult to explain how AIG’s tiny FP (Financial Products) division could generate $300 million in profits annually, or at one point, 15% of AIG’s overall corporate profits.
My Take
The Big Short may simply be recycled financial crisis fodder regurgitated by countless observers, but regardless, there are plenty of redeeming moments in the book. Getting into the book took longer than I expected, given the pedigree and track record of Lewis. Nonetheless, after grinding slowly through about 2/3 of the book, I couldn’t put the thing down in the latter phases.
Lewis chose to take a micro view of the subprime mortgage market, with the personal stories, rather than a macro view. In the first 95% of the book, there is hardly a mention of Bear Stearns (JPM) Lehman Brothers, Citigroup, Goldman Sachs (GS), Fannie Mae (FNM), Freddie Mac (FRE), etc. Nevertheless, at the very end of the book, in the epilogue, Lewis attempts to put a hurried bow around the causes of and solutions to the financial crisis.
There is plenty of room to spread the blame, but Lewis singles out John Gutfreund’s (former Salomon Brothers) decision to take Solly public as a key pivotal point in the moral decline of the banking industry. For more than two decades since the publishing of Liar’s Poker, Lewis’s view on the overall industry remains skeptical:
“The incentives on Wall Street were all wrong; they’re still all wrong.”
His doubts may still remain about the health in the banking industry, and regardless of his forecasting prowess, Michael Lewis will continue sniffing out bombs and writing compelling books on a diverse set of subjects.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AIG subsidiary debt, but at the time of publishing SCM had no direct positions in BAC, JPM, FRE, FNM, DB, MS, GS, C, MCO, MHP, Fitch, any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Living Large – Technology Revolution Raises Tide
It’s hard to believe that my kids will never truly know what it is was like to live without a microwave, VCR, GPS device, internet connection or many of the other modern day inventions. In my elementary school days, when I had to write a report about Alfred Hitchcock, I was forced to drag my mom to the public library, chase down some librarians, and comb through floors of book shelves, only to find the book I needed was already checked-out. Today, it’s amazing to watch my kid, barely old enough to pull the milk container out of the fridge, scamper over to the computer, type in a few search words on Google (GOOG) and access an endless pool of information for a homework assignment. Fortunately for my wife and me, my daughter has not discovered Facebook yet.
Rising Tide Lifts All
In the uncertain times we live in, many people lose sight of the incredible advancements achieved over our generation, and ignore the difficult challenges and problems entrepreneurs are solving today. And many of these advancements have trickled down to wide swaths of the population. The minimum wage worker, cleaning dishes at the local restaurant, may not be able to afford the new $500 iPad from Apple Inc. (AAPL), but technology advancements have benefited the less privileged in different ways. For example, similar computing power used in the iPad has also been used in the logistics and sourcing departments of retail chains like Family Dollar (FDO), thereby making goods cheaper for lower-income consumers.
One person who has not lost sight of these advancements of productivity is Mark J. Perry of the Enterprise Blog. In a recent article, Perry compares what a consumer working 152 hours in 1964, earning an average wage, could purchase versus an average consumer today (46 years later) working the same 152 hours. Beyond the average wage of $2.50 per hour increasing to $19 per hour, Perry shows the unbelievable increase in the quality and number of products.
Perry places the continuing technological revolution in context by stating:
“Americans today can purchase low-priced electronics products that even a billionaire in the past wouldn’t have been able to buy.”
Another person that knows a little about technology, Sergey Brin (Co-Founder of Google Inc.), put recent technology advancements in perspective in the company’s 2008 annual report:
“Our first major purchase when we started Google was an array of disk drives that we spent a good fraction of our life savings on and took several car trips to carry. Today, I walked out of a store with a small box in my hand that stores more than all those drives and cost about $100. Similarly, the processors available today are about 100 times as powerful as those we used in 1998.”
Advancements in our standard of living are not only limited to electronic gadgets and internet searches, but also tangible benefits continue to be realized in the most important elements of our human survival. A picture says a thousand words, and these charts speak volumes about our standard of living:
Lives are Extending and Food More Affordable
Obviously, everything is not a bed of roses and some of these improvements have come at a cost. Our country has lost millions of jobs over the last few years, and globalization has significantly increased foreign competition in broad areas of our economy. But before you succumb to the devastation rhetoric of the nay-sayers, please do not forget about the almost imperceptible rising tide of technological innovations that are allowing us to live better lives, even in uncertain times.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, GOOG, and AAPL, but at the time of publishing SCM had no direct positions in RSH, FDO, Facebook, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Private Equity Sitting on Stuffed Wallet
The clock is ticking and private equity (PE) firms need to put some $445 billion in their wallets to work. Otherwise, the dreams of outsized returns and hefty fees will have to wait for another Golden Era of deal making. Why such a hurry to use the cash? According to Andrea Auerbach, a Managing Director at Cambridge Associates, “Most funds legally have five or six years to invest that capital…it’s use it or lose it.”
Shop ‘til Wallet Drops
As easy as it sounds, spending half a trillion dollars can be difficult. Here’s how IBD’s Norm Alster characterizes the challenge:
“To realize the outsize profits investors expect, private equity firms would have to borrow two or three times that amount. But for the most part, credit spigots for such deals are still dry. At the same time, pinning down buyout targets is not that easy. Many potential sellers are balking at parting with corporate assets in the midst of a serious downturn.”
The 2010 private equity environment is quite a bit different than the LBO boom era from a handful of years ago, as you can see from the chart below. Thanks to cheap, free-flowing funding from the banks, $1.4 trillion worth of deals were consummated in 2006 and 2007, including large deals like First Data Corp. ($27 billion deal – KKR); Alltel ($28 billion – Goldman Sachs/ Texas Pacific Group); and Harrah’s ($30 billion – Apollo Management/Texas Pacific Group). Unfortunately, deals done during this period were done when valuations and leverage were at extremely high historical levels.
Chart source: Thomson Reuters via IBD
Deal Timeout
What’s causing the current dearth of deals? In many instances, business owners have not calibrated valuation expectations downward enough to account for the bruising financial crisis. Given the 77 leveraged buyout defaults in 2009, investors have become more reticent in committing capital as well. Refinancing the mountains of debt associated with the troubled 2006-07 vintage of deals will require patience and creative financing skills from the banks.
Because of the logjam of deals created by the financial crisis, PE firms are actively looking for exit strategies relating to their portfolio companies. Since private equity inherently involves illiquid investments, typically the industry creates liquidity through initial public offerings (IPOs), merger & acquisitions, and/or recapitalization structures that partially or fully return investor capital.
If the economic malaise lingers and valuations remain depressed, I have no doubt owners will eventually return to the negotiating table while waving a white towel in hand. Until then, private equity firms will continue begging for capital from the banks (i.e., using “other peoples’ money”) and beating down sellers into submission with regards to price expectations. If PE firms are not successful in using that wad of cash by the end of the fund’s term, then investors will be free to walk away with their money without paying lucrative fees to the PE firms.
Don’t Forget Benefits
The PE field is facing its fair share of trials and tribulations, but PE’s diversification benefits should not be forgotten. The success of the “Yale Model,” implemented by David Swensen, has come under attack with the recent bursting of the credit bubble, but with the ever-swinging performance pendulum of various asset classes/styles moving in and out of favor, I am confident a consistent strategy integrating PE as a portion of a diversified portfolio will yield respectable risk-adjusted returns over the long-run. Like other areas in the financial services industry, fees are being scrutinized and transparency requests by investors (limited partners) have been on the rise. But first things first – before attractive PE profits can be made as part of a diversified portfolio, the wad of cash in the wallets of PE firms must find a home in portfolio companies.
Read Norm Alster’s full IBD article originally referenced on TRB
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including S&P 500-like positions), but at the time of publishing SCM had no direct positions in GS, Harrah’s or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Microchip: Selling Electronic Cake Mix to the World
Microchip Technology Inc. (MCHP) is not in the business of selling cakes. Rather, Microchip is more akin to a chef selling cake mix in the form of microcontrollers to hungry designers with a sweet tooth. All that the customers need to do is add some water to the mix, and voila they have all the ingredients necessary to make a cake.
Endless Opportunities
Making a cake may sound simple, but the real magic comes as a result of the baking chef exploring the endless possibilities across colors, flavors, sizes, frostings, and accessories. The microcontroller business is similar in many respects. Microchip provides the essential tools (ingredients) to efficiently and cost-effectively build solutions for an almost infinite number of applications. Microcontrollers can be found in a diverse mix of products and gizmos, ranging in size from an iPod Nano (AAPL) and Tickle Me Elmo toy to a Whirlpool (WHR) washing machine and a butt-warming car seat in a Porsche 911 Turbo. From a verticals standpoint, Microchip services more than 60,000 customers globally (75% of revenues internationally) in the automotive, aerospace, communications, computing, consumer, and industrial control markets, among others.
What the Heck is a Microcontroller?
You can think of a microcontroller as a computer-on-a-chip, and these mini-computers, which are embedded into all types of applications, allow designers to create all types of products. The low-cost computer chips handle simple functions such as turning products on and off and setting speeds in consumer products, cars, telecommunications and office equipment. More specifically, these microcontrollers provide designers with the ability to introduce or expand functionality, reduce power consumption, and create further efficient designs, thereby potentially leading to lower costs and higher profits. Even though talking about the digital world of 1’s and 0’s sounds sexy, in the real world we are surrounded by analog factors like time, temperature, sound, music, and video – analog functions that require the heavy lifting of a microcontroller to process digital data after it has been converted from analog.
These microcontrollers aren’t multi-hundred dollar microprocessors manufactured in multi-billion fabrication facilities at Intel Corp. (INTC) – rather these more mundane (although essential) components sell often for a few bucks each. What’s more, the pricing in microcontroller and analog land is more stable at Microchip relative to the annual -20-30% price cuts common in the microprocessor world.
On top of performance (speed, power, heat, etc.) and cost, ease of design is a way Microchip gains market share away from competitors through its PIC architecture – the software platform that designers program Microchip’s microcontrollers. The company devotes extensive resources to spreading the PIC gospel to designers around the world and Microchip engineers are constantly upgrading the programming software. To date, Microchip has almost shipped 1,000,000 development tools to designers and developers. The software and design kits add to the company’s revenues, but the real profitability kicks in when the customers reorder chips related to multiyear product life cycles. For example, you can think of a television company that must order a microcontroller for a five-year old, broken TV remote control that a child stepped on…hmm, sounds familiar.
Expanding Pie (or Cake)
This is no puny market; the overall microcontroller segment of the semiconductor market is estimated to have generated $10.7 billion in sales during 2009. Microchip has managed to not only become the 800 pound gorilla in the 8-bit microcontroller space, but in recent years they have also made significant headroom in the higher functionality/performance markets of 16-bit and 32-bit microcontrollers. In total, Microchip offers its customers more than 650 flavors of its microcontroller products.
One would think the company is busy enough with its core microcontroller business, but Microchip is not sitting on its hands. They are employing a Velcro strategy by attaching other embedded features on its “computer-on-a-chip,” including analog, memory, DSP (digital signal processing), and other capabilities. Already, Microchip’s analog business has grown to more than 10% of the company’s revenues (about 600 analog products and > 14,000 customers), and Microchip’s foray into the digital signal controller sector (dsPIC product family) is expanding the company’s total addressable market as well. Consistent with this Velcro strategy, Microchip recently purchased Silicon Storage Technology Inc. (SST) for $354 million, focusing on SST’s high margin flash memory licensing business. Thanks to shrewd negotiating and jettisoning of non-core SST segments, the deal will solidify Microchip’s embedded solution positioning and is expected to add $.14 – $.18 cents to Microchip’s 2011 earnings per share (EPS).
The Head Chef
The head chef of the technology kitchen is Steve Sanghi, and in 1990 (after 10 years of employment at Intel Corp.), when he took over as President of Microchip, the kitchen was a complete mess. Not only was the company losing money, but they were spread too thin across disparate technologies. His accomplishments were recognized immediately and Sanghi became CEO shortly thereafter in 1991. Microchip, which was originally founded in 1989 as a spinoff from General Instrument, eventually went public in 1993. Despite a tough technology market post the technology crash of 2000, Microchip has managed to gain market share from struggling competitors like Atmel Corp. (ATML). Under Sanghi’s leadership, Microchip has more than doubled profits over the last decade and sales have almost multiplied 12-fold to $950 million since the company went public 17 years ago.
Cash Machine
Besides pumping out microcontrollers, Microchip pumps out a lot of cash as well. In their recently completed fiscal year (ending in March), the company generated close to $400 million in free cash flow (cash from operations minus capital expenditures), by my definition. With a market capitalization of around $5 billion this relationship implies an almost 8% free cash flow yield – a bit nicer than the 3.17% yield recently offered on the federal government’s 10-year Treasury Note. Microchip’s cash metrics look even that much more impressive when you consider the company has more than $1.1 billion in net cash piled up on the balance sheet. Since the capital intensity of the microcontroller and analog businesses is so much less demanding than the microprocessor world, Microchip has plenty of flexibility in paying a nice, big fat, 5%+ dividend (about $1.37 per share annually), which has increased modestly in each of the last three quarters. On a Price-Earnings basis (P/E), Microchip’s share price is currently trading at an attractive 13 x’s the company’s $2.11 consensus Earnings-Per-Share (EPS) estimate.
Risks
Microchip is not a risk-free Treasury investment and the company faces significant cyclical sensitivity to global macroeconomic trends, as we saw in fiscal 2009 (ending March). The pace of global design activity will generally be responsive to overall business confidence. In spite of Microchip’s dominance in the 8-bit market, some skeptics also question Microchip’s ability to gain market share in the 16-bit and 32-bit markets.
In addition to those concerns, another hazard relates to the company overpaying for future, potential acquisitions. Traditionally Microchip has focused on internal growth, however in recent years the company’s appetite for acquisitions has increased – most notably the failed merger of Atmel Corporation for roughly $2.3 billion in early 2009. If history serves as a guide, Microchip has been prudent in acquisitions – for example, the timely $183 million purchase of Gresham, Oregon manufacturing plant in 2002 for cents on the dollar or the recent opportunistic and accretive SST deal.
Momentum and Visibility Improving
With the global upturn occurring, Microchip has seen a +189% increase in its backlog (orders in hand for future delivery) to $528 million. Having these orders in hand allows Microchip to plan and invest more appropriately for growth in the coming year. Fourth quarter sales (without SST’s contribution) increased by more than +60% from last year and Non-GAAP earnings mushroomed by more than +200% on a year-over-year basis.
The ease and affordability of new product design will be an accelerating trend of new product proliferation. As I wrote in an earlier article (Revenge of David), the simplicity of design has become dramatically easier. A laptop and internet connection affords any designer the ability of downloading free design software, building a prototype with a 3-D printer, ordering Chinese manufacturing services through Taobao.com (parent Alibaba Group), and waiting for UPS to deliver the product to their doorstep in fairly short order. This design tailwind only serves to increase demand for Microchip’s microcontroller solutions over time.
Ever since the company’s IPO (Initial Public Offering), Microchip has had a phenomenal track record of success led by Steve Sanghi’s direction. Microchip is a much more mature company since going public in 1993 at a stock price of $0.57 per share (split-adjusted), but if the stock price can appreciate a fraction of the +4,623% already achieved, then my clients and I should be able to purchase a lot of cake mix.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, MCHP, AAPL, and Treasury securities, but at the time of publishing SCM had no direct positions in WHR, Porsche, Volkswagen, INTC, ATML, SST, UPS, General Instrument, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Gravity Takes Hold in May
Warner Bros. picture of Wile E. Coyote’s failed apprehension of Roadrunner
Wile E. Coyote, the bumbling, roadrunner-loving carnivore from Warner Bros.’ Looney Tunes series spends a lot of time in the air chasing his fine feathered prey. Unfortunately for Mr. Coyote his genetic make-up and Acme purchases could not cure the ills caused by gravity (although user error was the downfall of Wile E’s effective Bat-Man flying outfit purchase). Just as gravity hampered the coyote’s short-term objectives, so too has gravity hampered the equity markets’ performance this May.
So far the adage of “Sell in May and walk away” has been the correct course of action. Just one day prior to the end of the month, the Dow Jones Industrial and S&P 500 indexes were on pace of recording the worst May decline in almost 50 years. If the -6.8% monthly decline in the S&P and the -7.8% drop in the S&P remains in place through the end of the month, these declines would mark the worst performance in a May month since 1962.
Should we be surprised by the pace and degree of the recent correction? Flash crash and Greece worries aside, any time a market increases +70-80% within a year, investors should not be caught off guard by a subsequent 10%+ correction. In fact corrections are a healthy byproduct of rapid advances. Repeated boom-bust cycles are not market characteristics most investors crave.
It was a volatile, choppy month of trading for the month as measured by the Volatility Index (VIX). The fear gauge more than doubled to a short-run peak of around 46, up from a monthly low close of about a reading of 20, before settling into the high 20s at last close. Digesting Greek sovereign debt issues, an impending Chinese real estate bubble bursting, budget deficits, government debt, and financial regulatory reform will determine if elevated volatility will persist. Improving macroeconomic indicators coupled with reasonable valuations appear to be factoring in a great deal of these concerns, however I would not be surprised if this schizophrenic trading will persist until we gain certainty on the midterm elections. As Wile E. Coyote has learned from his roadrunner chasing days, gravity can be painful – just as investors realized gravity in the equity markets can hurt too. All the more reason to cushion the blow to your portfolio through the use of diversification in your portfolio (read Seesawing Through Chaos article).
Happy long weekend!
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in TWX, VXX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Seesawing Through Organized Chaos
Still fresh in the minds of investors are the open wounds created by the incredible volatility that peaked just a little over a year ago, when the price of insurance sky-rocketed as measured by the Volatility Index (VIX). Even though equity markets troughed in March of 2009, earlier the VIX reached a climax over 80 in November 2008. With financial institutions falling like flies and toxic assets clogging up the lending pipelines, virtually all asset classes moved downwards in unison during the frefall of 2008 and early 2009. The traditional teeter-totter phenomenon of some asset classes rising simultaneously while others were falling did not hold. With the recent turmoil in Greece coupled with the “Flash Crash” (read making $$$ trading article) and spooky headline du jour, the markets have temporarily reverted back to organized chaos. What I mean by that is even though the market recently dove about +8% in 8 days, we saw the teeter-totter benefits of diversification kick in over the last month.
Seesaw Success
While the S&P fell about -4.5% over the studied period below, the alternate highlighted asset classes managed to grind out positive returns.
While traditional volatility has returned after a meteoric bounce in 2009, there should be more investment opportunities to invest around. With the VIX hovering in the mid-30s after a brief stay above 40 a few weeks ago, I would not be surprised to see a reversion to a more normalized fear gauge in the 20s – although my game plan is not dependent on this occurring.
VIX Chart Source: Yahoo! Finance
Regardless of the direction of volatility, I’m encouraged that even during periods of mini-panics, there are hopeful signs that investors are able to seesaw through periods of organized chaos with the assistance of good old diversification.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including AGG, BND, VNQ, IJR and TIP), but at the time of publishing SCM had no direct positions in VXX, GLD, or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Revenge of David: Technology Empowers Small-Fry
The garage tinkerer’s canvas is manifested through these relatively new 3-D printers.
What happened in the virtual world with software and operating systems over the last 15 or so years is now happening in the bricks and mortar world. Linux, a free open source software operating system, was designed in the early 1990s and initially registered its trademark in 1994. The no cost system takes advantage of charitable brainpower by using programming prowess from others around the globe.
The same phenomenon is happening in the real world, and critically acclaimed Wired writer Chris Anderson wrote about it this trend in a recent article, In the Next Industrial Revolution, Atoms Are the New Bits. With the help of a laptop, free design software, and a few mouse clicks to a manufacturing plant in China, Anderson shows how a small fry entrepreneur with a good idea can become a successful micro-factory in weeks. This same process might have taken traditional manufacturers years in the past. Accelerating production from novel idea to output reality are new 3-D printers, robotic-like equipment that can build real time prototypes from molten plastic (see picture above). Sounds expensive, but these former six-figure devices can be purchased for less than $1,000 thereby allowing state of the art products to be made with relatively little capital and inventory. In other words, the small fry entrepreneur David now has the ability to become a fine tuned Goliath with the help of democratizing technologies. The high barriers to entry have been toppled down by creative, risk-taking entrepreneurs.
In describing this manufacturing marvel, Anderson highlights Local Motors, an open source car company that managed to produce a car in months what would have taken legacy automakers years to build. Rather than hire a host of expensive engineers (the company only had 10 employees), Local Motors relied on a global community of volunteers (also called “crowdsourcing”) to design the original “Rally Fighter” automobile. Utilizing a ratio of 500-to-1 volunteers to employees has allowed Local Motors to leverage the power of atoms to bits. What Anderson calls “garage tinkerers” are slowly taking over the world.
Building Your Dream
On the surface, the micro-factory concept sounds fairly straightforward, but how does one practically pursue this strategy? Anderson has five steps to building your dreams:
1) Invent: Come up with idea and check U.S. Patent and Trademark office to make sure idea has not been used before.
2) Design: Use 3-D design tools to model out your idea.
3) Prototype: Upload your design to a 3-D printer and watch prototype idea grow into reality.
4) Manufacture: Find manufacturing partner online through sites like Alibaba.com (1688.HK).
5) Sell: Market your product online to reach the masses.
If you look back in time, the industrialization of America squeezed out the little guys because small time citizens did not have the capital or expertise to keep up with the big boys. Thanks to the internet, the playing field has been leveled and the small-fry David can not only compete with Goliath, but can also defeat him.
Read Chris Anderson’s Famous The Long Tail Article from 2004
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in Alibaba.com or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
General Motor’s Amazing Debt Trick
Now you see it, and now you don’t. General Motors claims that it has pulled off an amazing trick – the CEO of the troubled automaker, Ed Whitacre, claims in a recently released nationwide commercial, “We have repaid our government loan, in full, with interest, five years ahead of the original schedule.” (See video BELOW):
Blushing Pinocchio
Even Pinocchio would blush after listening to those statements. The loan that GM is claiming victory over is roughly $7-8 billion in TARP (Troubled Asset Relief Program) loans made from the U.S. and Canada. What Mr. Whitacre failed to acknowledge was how investors will be made whole on the whopping balance of around $45 billion.
How did GM miraculously pay off this debt? Whitacre would like taxpayers to believe booming sales or an operational turnaround has funded the debt repayment. Rather, these debt repayments were funded through other government TARP loans held in escrow with U.S. Treasury oversight. Effectively, GM has paid down one Mastercard (MA) bill with another Visa (V) credit card, and then gone on to brag about this financial shell game through a multi-million dollar advertising campaign. It’s bad enough that politicians and so-called media pundits attempt to “spin” facts into warped truths, but when a government-owned entity steps onto a national loudspeaker and spouts out blatantly distorted sound-bites, there should be consequences to these actions. American taxpayers deserve more honest accountability and transparency regarding their tax outlays rather than quarter truths.
GM’s Future
As Jedi Master Yoda’s famously quotes, “Uncertain, the future is,” and “Always in motion is the future.” GM is not out of the woods yet – the company lost $3.4 billion in the 4th quarter of 2009 alone and remains 70% government-owned. Nobody is certain how much (if any) of the $43 billion will be repaid by General Motors. For reference purposes, GM lost $88 billion from 2004 until 2009 when they declared bankruptcy (see AP article) If all goes according to plan, the former debt holders (now equity holders) and government stockholders will get a return on their capital infusions if and when GM does an equity offering to the public sometime later in 2010. If achieved, the company will have come full circle: public to bankrupt; bankrupt to private; and private to public.
While executives at GM are confident in their repayment capabilities, less convinced are certain branches of our federal government. Maybe these government agencies have taken note of the horrific train wreck occurring in the automotive industry over the last few decades (see GM Fatigue) Take for example the Office of Management and Budget, and the nonpartisan Congressional Budget Office (CBO) – they see TARP losses exceeding $100 billion, including about $30 billion from the auto companies…ouch.
The probability of success will no doubt hinge on some of the dramatic transformations made over the last year. First of all, GM has axed the number of brands in half (from eight to four), cutting Pontiac, Saturn, Hummer, and Saab. Cutting costs is great, but chopping expenses to prosperity cannot last forever – at some point you need compelling products that will drive sales. The rubber will hit the road late this year when GM is scheduled to release the “Volt,” a plug-in hybrid, which the company is using as a launching pad for new products.
TARP on Right Track but Not to Finish Line
Given the heightened political sensitivity in Washington regarding the banks and Wall Street it’s not too surprising that many of the banks wanted to be out of the governments crosshairs and pay back TARP as soon as possible. Beyond political pressure, banks have accelerated TARP repayments in part due to the massively steep and profitable yield curve, along with signs of an improving economy. According to the Treasury Department less than $200 billion in bailout money is outstanding for what originally started out as a $700 billion fund ($36 billion of automaker bailouts is estimated as uncollectible). Even though there has been progress on TARP collections, unfortunately non-TARP losses associated with AIG, Fannie Mae (FNM), and Freddie Mac (FRE) are expected to add more than $150 billion in bleeding.
I don’t believe anyone is happy about the bailouts, although some are obviously more irate. Accountability and transparency are important bailout factors as taxpayers and investors look to recover capital contributions. The next trick GM and Ed Whitacre need to pull off is paying off tens of billions in taxpayer money with the benefit of sustained profits – now that’s a television commercial I want to see.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and in a security derived from an AIG subsidiary, but at the time of publishing SCM had no direct positions in General Motors, AIG, FNM, FRE, MA, V, or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Digging for iPad Gold with Simplicity
We live in a hyper global competitive world, yet some companies manage to find gold while others unsuccessfully dig for their dreams. What is a major determinant of great companies? Apple Inc. (AAPL), and other companies, may include “simplicity” as a key ingredient. Take the iPad for example. Already the company has successfully exceeded iPad sales target thanks to the shrewd marketing of the simple touch-screen technology. Some call it a glorified iPhone because the iPad uses a very similar interface on a larger scale. Nonetheless, the device is getting rave reviews from the likes of US Today, The Wall Street Journal, The New York Times, Newsweek, and as Stephen Colbert smartly pointed out in his video (below), the iPad even makes salsa to boot. Many estimates point to more than a half million units sold in the first few weeks, making the 2010 estimates of 3-4 million units sold likely too low.
Competition Not a Game Killer
How much more competitive can the personal computer and cell phone markets be? According to the United Nations, we will reach 5 billion subscribers in 2010. With pricing pressure galore, and new Asian competitors popping up all over the place, how can companies grow, let alone make profits? Ever since the revolutionary iPhone was introduced in 2007, rivals have attempted to copy-cat the device. In the meantime, Apple continues to gain market share while they sit on close to $40 billion in cash, not to mention the flood of new cash rolling in the doors ($10+ billion in free cash flow generated in calendar 2009).
Innovation and the Remote Control
One key driver of profitability is innovation, but an elegant solution driven by an out-of-touch engineer with consumer demands will only lead to share losses and headaches. I mean how many times have you pulled your hair out trying to navigate through a 100-button TV remote control or screamed in frustration from attempting to learn a non-Wii videogame?
But Apple is not the only company to find simplicity in its quest for profit domination. In order to be a massive juggernaut like Apple Inc., a company’s product or service must gain mass appeal. A key determinant for mass appeal is simplicity. Beyond Apple, think of other dominant franchises that also operate in massively competitive markets like Wal-Mart Stores (WMT) in retail; Starbucks Corp. (SBUX) in coffee; Google Inc. (GOOG) in internet advertising; Coca Cola Co. (KO) in soda; Netflix Inc. (NFLX) in video rentals, among a host of other category killers. Many of these corporate giants offer products we cannot function or live without. I still find it utterly amazing that my children will never know what life was really like without an internet search on Google or a Caffe Misto Caramel Frappuccino from Starbucks.
All Good Things Come to an End
It’s not clear how much longer these titans of corporate America can thrive. By innovating new products that improve lives in some way, these Dancing Elephants will continue to prosper. But nothing in the stock market is static, so investors should pay attention to several potential derailing factors:
- Valuations: Valuations are extremely important in determining long-run appreciation potential, and chasing winners solely based on momentum (see related article) can lead to problems.
- Market Share Losses: What will be the next computer, cell phone, or e-reader killer? I don’t know right now, but eventually the day will come where these leaders will lose market share to a new kid on the block.
- Rising Costs: Competition is not the only factor in leading to slowing sales and declining profit margins. Inflation either related to labor or other input costs can crimp profits and decay investor appetites.
- Too Big to Succeed: There has been a lot of talk about “too big to fail,” but I strongly believe companies reach a point where they become “too big to succeed.” Either the law of large numbers catches up with these companies making simple math more challenging (think of the supertanker Wal-Mart growing its $400+ billion revenue base), or regulatory scrutiny kicks in (think of Microsoft Corp. [MSFT] and Intel Corp [INTC]).
Size: Peeling More of the Onion
Success can continue for these giants, however at some point “size” becomes a headwind rather than a tailwind. Just as simply as a train can speed down a railway at over 100+miles per hour, under the right conditions the train can derail as well. As Warren Buffett states, when referring to a company’s growth prospects relative to size, “Gravity always wins.”
However, investors should remind themselves that gains can last longer than expected too. Finding “ginormous” winners in many ways is like finding a needle in a haystack. But even if you find the needle in the haystack relatively late in a company’s growth cycle (see Equity Life Cycle story), in many instances there can be a lot of appreciation potential still available. Take Wal-Mart (WMT) for example. If you bought Wal-Mart shares after it rose 10-fold during its first 10 years, you still could have achieved a 60x return over the next 30 years.
Time will tell if Apple will strike additional gold with its iPad introduction, nonetheless Steve Jobs has found an element present in many long-term successful companies…simplicity.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AAPL, WMT, GOOG, but at the time of publishing SCM had no direct positions in MSFT, SBUX, KO, INTC, NFLX, Nintendo or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
John Mauldin: The Man Who Cries Wolf
We have all heard about the famous Aesop fable about The Boy Who Cried Wolf. In that story, a little boy amuses himself by tricking others into falsely believing a wolf is attacking his flock of sheep. After running to the boy’s rescue multiple times, the villagers became desensitized to the boy’s cries for help. The boy’s pleas ultimately get completely ignored by the villagers despite an eventual real wolf attack that kills the boy’s flock of sheep.
Mauldin: The Man Who Cries Bear
John Mauldin, former print shop professional and current perma-bear investment strategist, unfortunately seems to have taken a page from Aesop’s book by consistently crying for a market collapse. After spending many years wrongly forecasting a bear market, his dependable pessimism eventually paid dividends in 2008. Unfortunately for him, rather than reverse his downbeat outlook, he stepped on the pessimism pedal just as the equity markets have exploded upwards more than +80% from the March lows of last year. Mauldin is widely followed in part to his thoughtful pieces and intriguing contributing writers, but as some behavioral finance students have recognized, being bearish or cautious on the markets always sounds smarter than being bullish. I’m not so sure how smart Mauldin will sound if he’s wrong on the direction of the next 80% move?
The Challenged Predictor
I find it interesting that a man who freely admits to his challenged prediction capabilities continues to make bold assertive forecasts. Mauldin freely confesses in his writings about his inability to manage money and make correct market forecasts, but that hasn’t slowed down the pessimism express. Just two years ago as the financial crisis was unfolding, Mauldin admits to his poor fortune telling skills with regards to his annual forecast report each January:
“ I was wrong (as usual) about the stock markets.”
Here’s Mauldin explaining why he decided to switch from investing real money to the simulated version of investment strategy and economic analysis:
“I wanted to begin to manage money on my own… I found out as much about myself as I did about market timing. What I found out was that I did not have the emotional personality (the stomach?) to directly time the markets with someone else’s money… I simply worried too much over each move of the tape.”
Apparently timing the market is not so simple? Readers of Investing Caffeine understand my feelings about market timing (read Market Timing Treadmill piece) – it’s a waste of time. Market followers are much better off listening to investors who have successfully navigated a wide variety of market cycles (see Investing Caffeine Profiles), rather than strategists who are constantly changing positions like a flag in the wind. I wonder why you never hear Warren Buffett ever make a market prediction or throw out a price target on the Dow Jones or S&P 500 indexes? Maybe buying good businesses or investments at good prices, and owning them for longer than a nanosecond is a strategy that can actually work? Sure seems to work for him over the last few years.
When You’re Wrong
Typically a strategist utilizes two approaches when they are wrong:
1) Convert to Current Consensus: Most strategists change their opinion to match the current consensus thinking. Or as Mauldin described last year, “I expect that this year will bring a few surprises that will cause me to change my opinions yet again. When the facts change, I will try and change with them.” The only problem is…the facts change every day (see also Nouriel Roubini).
2) Push Prediction Out: The other technique is to ignore the forecasting mistake and merely push out the timing (see also Peter Schiff). A simple example would be of Mr. Mauldin extending his recession prediction made last April, “We are going to pay for that with a likely dip back into a recession in 2010,” to his current view made a few weeks ago, “I put the odds of a double-dip recession in 2011 at better than 50-50.”
More Mauldin Mistake Magic
Well maybe I’m just being overly critical, or distorting the facts? Let’s take a look at some excerpts from Mauldin’s writings:
A. January 10, 2009 (S&P @ 890):
Prediction: “I now think we will be in recession through at least 2009 before we begin a recovery….We could see a tradable rally in the next few months, but at the very least test the lows this summer, if not set new lows….It takes a lot of buying to make a bull market. It only takes an absence of buying to make a bear market.”
Outcome: S&P 500 today at 1,179, up +32%. Oops, maybe the timing of his recovery forecast was a little off?
B. February 14, 2009 (S&P @ 827):
Prediction/Advice: “Let me reiterate my continued warning: this is not a market you want to buy and hold from today’s level. This is just far too precarious an economic and earnings environment.”
Outcome: S&P 500 up +45%. You pay a cherry price for certainty and consensus.
C. April 10, 2009 (S&P @ 856):
Prediction: “All in all, the next few years are going to be a very difficult environment for corporate earnings. To think we are headed back to the halcyon years of 2004-06 is not very realistic. And if you expect a major bull market to develop in this climate, you are not paying attention.” On the economy he adds, “We are going to pay for that with a likely dip back into a recession in 2010.”
Outcome: S&P 500 up +38%, with the economy currently in recovery. Interestingly, his comments on corporate earnings in February 2009 referenced an estimate of $55 in S&P 2010. Now that we are 14 months closer to the end of 2010, not only is the consensus estimate much firmer, but the 2010 S&P estimate presently stands at approximately $75 today, about +36% higher than Mauldin was anticipating last year.
D. May 2, 2009 (S&P @ 878):
Prediction: “This rally has all the earmarks of a major short squeeze. ..When the short squeeze is over, the buying will stop and the market will drop. Remember, it takes buying and lot of it to move a market up but only a lack of buying to create a bear market.”
Outcome: S&P 500 up +36%.
Now that we have entered a new year and experienced an +80% move in the market, certainly Mauldin must feel a little more comfortable about the current environment? Apparently not.
E. April 2, 2010 (S&P @ 1178):
Prediction: “ I think it is very possible we’ll see another lost decade for stocks in the US. If we do have a recession next year, the world markets are likely to fall in sympathy with ours.”
Outcome: ????
Previous Mauldin Gems
Here are few more gloomy gems from Mauldin’s bearish toolbox of yester-year:
2005: “The market is a sideways to down market, with the risk to the downside as we get toward the end of the year and a possible recession on the horizon in 2006. And not to put too fine a point on it, I still think we are in a long term secular bear market.” Reality: S&P 500 up +5% for the year and up a few more years after that.
2006: “This year I think the market actually ends the year down, and by at least 10% or more during the year. Reality: S&P 500 up +14% (excluding dividends).
2007: Mauldin’s rhetoric was tamed in light of poor predictions, so rhetoric switches to a “Goldilocks recession” and a mere -10-20% range correction. He goes on to dismiss a deep bear market, “In future letters we will look at why a deep (the 40% plus that is typical in recession) stock market bear is not as likely.” Reality: S&P 500 up +5%. Looks like the writing on the wall for 2008 turned out a bit worse than he expected.
2008: Sticking to soft landing outlook Mauldin states, “I think this will be a mild recession … I don’t think we are looking at anything close to the bear market of 2000-2001.” Uggh. Ultimately, the bear market turned out to be the worst market since 1973-1974 – his prediction was just off by a few decades. Reality: S&P 500 down -37%.
Lessons Learned from Market Strategists
I certainly don’t mean to demonize John Mauldin because his writings are indeed very thoughtful, interesting and include provocative financial topics. But put in the wrong hands, his opinions (and dozens of other strategists’ views) can be extremely dangerous for the average investor trying to follow the ever-changing judgments of so-called expert strategists. To Mauldin’s credit, his writings are archived publicly for everyone to sift through – unfortunately the media and many average investors have short memories and do not take the time to hold strategists accountable for their false predictions. Although, Iike Warren Buffett, I do not make market timing predictions or forecast short-term market trends, I see no problem in strategists making bold or inaccurate forecasts, as long as they are held responsible. Every investor makes mistakes, unfortunately, strategist predictions are usually not readily available for analysis, unlike tangible investment manager performance numbers. When forecasting lightning strikes and extreme bets win, every newspaper, radio show, and media outlet has no problem of placing these soothsayers on a pedestal. Thanks to the law of large numbers and the constantly shifting markets, there will always be a few outliers making correct calls on bold predictions. Who knows, maybe Mauldin will be the next CNBC guru du jour in the future for predicting another lost decade of equity market performance (see Lost Decade article)?
Regardless of your views on the market, the next time you hear a financial strategist make a bold forecast, like John Mauldin crying wolf, I urge you to not go running with the motivation to alter your investment portfolio. I suppose the time to become frightened and drive the REAL wolf (bear market) away will occur when consistently pessimistic strategists like Mauldin turn more optimistic. Until then, tread lightly when it comes to acting on financial market forecasts and stick to listening to long-term, successful investors that have invested their own money through all types of market cycles.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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