Thursday, June 29, 2006

Moving on up in the capital structure

The recent increase in the awareness of market volatility has left people asking the same question that Vladimir Lenin asked in 1902. What is to be done?

The simplest answer is to move up in the capital structure by owning bonds. Because of uncertainty about the movement of interest rates, the best choice is something that is fairly insensitive to interest rate fluctuations. Sensitivity to interest rates is mostly dependent on an bond's duration and coupon interest rate. Higher interest rates and shorter time to maturity mean less sensitivity.

Both of these desirable attributes are found in floating rate income funds. These are mutual funds which invest in junk bank loans. These loans are repackaged in the form of floating rate notes, which then trade in the OTC market. Although the obligors tend have fairly poor credit (BB and B), the bank loans are the most senior debt in the capital structure. The combination of high interest rates, ultrashort duration, and seniority make investing in bank loans very profitable and yet safer than investing in junk bonds.

For example the Fidelity Floating Rate High Income Fund (FFRHX) is currently yielding 6.16% and over the past 12 months the share price has fluctuated between $9.93-$9.99. That does look quite nice when compared to the current market gyrations.

I think it is silly to talk about reducing market exposure via short ETF and exotic options strategies when the simplest solution is to directly reduce your exposure. I.e. by selling broad based ETF's/mutual funds that are core portfolio holdings.If your portfolio is scattered between 10 different funds, then now is good time to think about consolidating it.

Equity investments are correlated with each other. You aren't gaining much by investing in 10 different slices of the same cake. At the same time you are losing flexibility as well as having higher trading costs when making changes in allocation. Reinvesting capital that is now in stocks into cash assets and fixed income is the best way to reduce market exposure while gaining real diversification.

Sunday, June 25, 2006

Maintaining speed in a falling market with covered calls

I received a funny email today from Bernie Schaeffer of Schaeffer's Investment Research. The subject was "Maintain speed in a falling market - for only $195". Personally, I would not pay $195 to maintain speed in a falling market. To slow down or even reverse in a falling market would be worth paying for, but you can maintain speed for free.

Bernie Schaeffer is yet another investment newsletter huckster. Bernie's particular shtick is options, momentum chasing, and swing trading. The email opens "RIGHT NOW THE MARKET IS UNDER SOME SERIOUS SELLING PRESSURE", and then quickly moves on to Bernie's main message. That you should subscribe to Schaeffer's Covered Call Plus for only $195, an amazing 60% OFF the regular price of $495. But you have to hurry, this incredible savings ends FRIDAY at Midnight.

The service claims to give you a constant supply of buy-write ideas. Buy-write is a strategy of purposefully buying stocks for the purpose of writing call options on them. The net position after writing a covered call is being short volatility. Is this really a good idea in a volatile market?

There are several problems with a buy-write strategy. The problems stem from being short volatility and the transaction costs of an active options strategy.

The main problem is that by writing covered calls on a stock you sacrifice all the upside movement past the strike price, while retaining all of the downside. If the volatility is positive and greater than expected, you get the fixed and limited return of the call premium. If volatility is negative and greater than expected, you get to keep all the downside, offset by the option premium. Only if the volatility is less than expected and the stock price does not move at all; does writing call options give you excess return. This is not a sound or risk averse investment policy.

The other problem is the transaction costs incurred by frequent trading. A single complete buy write trade (buy, write, (buy to close, get exercised) sell)involves at least twice as much commission as a normal stock trade(*). These transaction costs impose a very high hurdle rate.

A simple example: Assume a stock costs $24, and you buy two round lots (2x100) for $10 ($4800). Then you write two three month calls at $25 and receive $288 (10+2*0.75) (Option price for 90 day American call with Implied volatility of %36.44 and risk rate of 5.4%). So far you have spent $22.5 in commissions to set up the position. Assume that six days prior to expiration you decide to close out the position, *and that the stock is still 24. The option price is now 0.12. Your cost to close is (10+2*0.75+2*12+10) = $45.5. Combined with your opening costs of 22.5, your total cost on the trade is $68. Your annualized hurdle rate on your $4800 investment is 5.6% ((4*68)/4800).

While the example buy-write you ended up with net profit of $220 (for an annualized return of %12.7 net of expenses). However if things go badly, it gets ugly. That $220 is equivalent to getting an option premium of $1.10. Your downside protection is at most against a 5.3% drop in the stock price (assuming the options expire worthless). On anything more than 5.3% drop you get not only the losses from the stock's decline but also the addition expense from opening and closing the position. On a single buy-write The gains are limited to 4.6% of your investment ($265.5/4800), the losses are limited to $4,534 (94.4% of your investment). Actually the gains can be even further limited, because of the cost of getting assigned an exercise.

If the best you can do is gain 4.6% and the worst is lose 94.4%; then in the long run you must lose. And if you can consistently beat a 5.6% hurdle rate, the world of hedge funds awaits you. Every time the stock market gets stagnant, volatile, or trends downward some huckster comes along promoting covered calls as the universal cure.

(*) A complete buy-write involves 1.5 times normal commission if the option expires worthless meaning that the final close of the stock is less than strike + $0.25.

Thursday, June 22, 2006

New ETF's from Claymore/Robeco

Claymore continues its drive to introduce new ETF's with the introduction of two ETF based on quantitative indexes from Robeco Group. The two funds are the:

  • Claymore/Robeco Developed International Equity Portfolio
  • Claymore/Robeco Developed World Equity Portfolio

The "Developed International Equity" is Global ex-US fund, while the "Developed World" includes the US. Country weightings are based on each country's aggregate modified market capitalization (which includes liquidity and risk as weighting factors). These funds are intended to be representative of world equity markets, while choosing only the best stocks according to the quant model. Robeco intends each fund to hold between 200-300 stocks. According to the prelimary prospectus:

The stock selection model relies upon various measures of valuation, momentum, earning estimate revisions and management policy. The constituent selection methodology was developed by Robeco as an effective, 100% quantitative, rules-driven approach to identifying those companies that offer the greatest potential for price appreciation with strong risk diversification. Portfolio risk management tools, including a quantitative risk model and portfolio optimizer, are utilized to balance risk and reward.

To the best my knowledge this is the first fund based on an index that uses modern portfolio theory to reduce risk and optimize the Sharpe ratio. This fund takes advantage of the areas where quantitative strategies can add value; stock selection, and portfolio risk management.

Tip of the hat to Naked Shorts for breaking the story.

Wednesday, June 21, 2006

Hexion (HXN) -- Despite our substantial indebtedness

The more we become leveraged, the more we, and in turn our securityholders, become exposed to the risks described above under “Our substantial indebtedness could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry and prevent us from fulfilling our obligations under our existing or future indebtedness.”

Excerpt from the 168 Page Form S-1/A for Hexion Specialty Chemicals (HXN). Assuming the IPO goes as planned, there will be $3.16 Billion in long term liabilities supported by $564 million in equity capital. Lovely.

Hexion is roll up of various large chemical companies (mainly Borden Chemicals) owned by private equity firm Apollo Group. Together they form world's largest manufacturer of thermosetting resins (hard plastics) and are big and fearsome in the world of surface coatings and adhesives. Private equity groups tend to be attracted to large hard asset companies because they are can service a lot of debt.

And Hexion has alot of debt after paying out a $550 million special dividend, as well as redeeming $397 million worth of series A preferred stock, paying a floating dividend of LIBOR plus 8.0%.

Unfortunately the commodity petrochemicals business is cyclical, fiercely competitive and very sensitive to raw material (Oil, Natural Gas) costs. Combine that with thin margins, crushing debt service (fixed charges are covered 2.5x), and possible latent liabilities (from formaldehyde resins) and you have a recipe for success. Hexion would be an attractive investment if it had about a third as much debt. One would expect that Sealy's (ZZ) impressive post IPO performance would put a stop to this nonsense.

Tuesday, June 20, 2006

Savings account interest rates jump higher.

Continuing the recent trend towards even higher savings account yields. Sveral banks have raised rates this months, in some cases even exceeding the yeild on the 90-Day TBill. Because bank deposits are FDIC insured, they are backed by the full faith and credit of the United States, same as treasury bonds. Savings accounts are 100%risk free, and the returns are getting very competative with other investments.

  • OneUnited Bank is offering 5.00% on their Unity Savings Account. The account comes with a free ATM card. One United is unusual in that interest is compounded and credited quarterly, rather than daily and monthly as with most online savings accounts.
  • HSBCdirect has raised rates to 4.80% and also provides a free ATM card. HSBC is also unusual in that they allow for depositing checks by mail.

To give a sense of scale about how much these accounts are affecting the banking industry, Citibank reported gaining $3 Billion in Deposits since March of 2006. Of these deposits, 2/3rds were new money.

Monday, June 19, 2006

EEM and EFA, SPY and VIX

A while back there controversy at seekingalpha after Michael Panzer posted an innocuous chart of iShares Emerging Markets (EEM) vs iShares MSCE EAFE (EFA) suggesting that the performance gap between EEM and EFA was narrowing. I’ve found that the solution to most problems in life is muddy up the water, and statistics are great way to do that. Thanks to data from Yahoo Finance and Software from SPSS (SPSS), I've drawn some conclusions about the relationships between SPX, VIX, EFA, EEM.

The first grand discovery, which many people has also discovered in the past few weeks, is that global stock markets are very correlated and they tend to be able to explain each others variance. If you do factor analysis, the first extracted factor explains 97% of the data. This makes sense because of the global nature of the world economy. The US and EFA economies tend to be synchronized with each other and emerging markets economies depend on exports to the developed world. The net result is that investing in foreign countries doesn't provide much if any diversification against serious market moves. At this point it seems that main benefit of investing in foreign assets is the implied hedge of foreign currency dividends against a weaker dollar. A foreign bond fund would accomplish most of the same effects with much less risk

The other grand discovery is that EEM is strongly negatively correlated with VIX (Implied S&P 500 Volatility). This also isn't surprising because high VIX tends to be associated with market stress. For the past few years hot money has been flowing into EEM investments through hedge funds, mutual funds, and ETFs. Much of this investment is being made without thoughtful assessment of the extra risks of investing in emerging markets. That risk includes a high beta towards the US economy and investor risk tolerance worldwide. Everyone looks like an investment genius when markets are going well. But when investor's decided that volatility is a bad thing, the outflow from EEM was nasty.

The take home from all this is that you can't rely on common stocks to diversify away the inherent risks of investing in common stocks. To do that you need something other than common stock, i.e bonds (TIP). Even things like REITs (ICF) or Gold (GDX) don’t give as much diversification as you would expect. With world markets as interconnected as they are, you can't expect EFA to be a tower of strength when SPX is crumbling.

Wednesday, June 14, 2006

CNBC's amazing google clickfraud video

A specter is haunting Google. Google derives the majority of its revenues from selling tiny text ads. Lots of internet publishers publish tiny text ads. Since advertising is sold on cost-per-click basis, the more clicks the more revenues for (GOOG) and publishers.

Some unscrupulous publishers have tried to accelerate the ad clicking process with click bots and other schemes. Google has a very logical reason to ignore clickfraud, since doing something about it would lower revenues and collapse the share price.

Depending on who you ask: click fraud is insignificant (Google) or upwards of 70% of Google's total ad sales. The problem and issues for abuse are well known in the webmaster community. The broader world is mostly unaware of Google’s fraudulent profits.

Lots of Wall Street analysts, many of them working for companies that have extensive underwriting relationships with Google, continue to maintain buy and strong buy ratings on shares of GOOG. Many of them also engage in fanciful revenue projections.

Today CNBC did a feature on clickfraud. Now everyone on Wall Street knows about the issue and just how bad it is. I predict that real soon now, a wave of analyst reports will come out minimizing the issue and its impact on the demand for tiny text ads from Google. But if advertisers know that at least 70% of their ad spending on Google is wasted, how many will continue to buy ads?.

Google insiders probably know about the problem as well, as collectively they have sold well over $3 Billion worth of shares in the past six months. That is more stock than Enron insiders sold in the six years prior to bankruptcy. Sometimes the sheep do shear themselves.

Tuesday, June 13, 2006

New ETFs from Claymore, Zacks, and Sabrient

Claymore has filed a preliminary prospectus with the SEC covering five new proposed ETFs:
  • Claymore—BNY Brazil, Russia, India And China (Bric Select) Portfolio
  • Claymore—Sabrient Insider Sentiment Portfolio
  • Claymore—Sabrient Stealth Portfolio
  • Claymore—Zacks Sector Rotation Portfolio
  • Claymore—Zacks Yield Hog Portfolio

The Claymore—BNY BRIC select fund covers US listed ADRs of companies based Brazil, Russia, India and China. This fund is based on the Bank of New York BRIC Index. The index is passively market cap weighted.

The Claymore—Sabrient Insider Sentiment Portfolio is based on quantitative model from Sabrient. The quant model picks the 50 best ranked stocks on the basis of insider buying and analyst upgrades, among other factors. The fund equal weights the 50 stocks and is reconstituted at least once a quarter.

The Claymore—Sabrient Stealth Portfolio is also based on quantitative model from Sabrient. This fund focuses on stocks with less than two analysts’ providing research covering. A fairly well known market anomaly is that stocks without analyst coverage tend to outperform stocks that do have analyst coverage. This is believed to happen as a result of inefficient pricing caused by a lack of information. Sabrient’s model picks 250 highest-ranking stocks from a growth-oriented, multi-factor model. My guess is that fund will have a strong micro/small cap orientation, with mild underexposure to technology and healthcare.

The Claymore—Zacks Sector Rotation Portfolio, is the third ETF based on a Zacks index/model. The Zacks Sector Rotation Index is comprised of 100 stocks selected from a universe of the 1,000 largest listed equity companies based on market capitalization. The index methodology tries to overweight cyclical sectors prior to anticipated periods of economic expansion and overweight non-cyclical sectors before periods of economic contraction. This is an interesting version of the classic Valueline model of timely stocks in timely industries.

The Claymore—Zacks Yield Hog Portfolio is IMHO the most interesting. The index is intended to beat the Dow Jones US Select Dividend Index, the basis for iShares (DVY) etf with over $7 billion in assets. The Yield Hog index includes US stocks and ADRs that pay dividends, as well as REITs, master limited partnerships, closed-end funds and traditional preferred stocks. This is the first ETF with a mandate to explicitly invest in MLPs and traditional preferred stocks. With access to higher yielding assets, I expect that this ETF will easily have higher dividends than pure equity income ETFs.

The Zacks Yield Hog index is comprised of approximately 125 to 150 highest-ranking securities chosen using a rules-based quantitative ranking methodology from Zacks. Half of the index will be made of dividend-paying common stocks. Closed-end funds are limited to 10% of the portfolio. Master limited partnerships may make up one-quarter (25%) of the portfolio. Exposure to all other categories of investment type (ADRs, REITs and preferred stock) other than U.S. common stock are limited to a 20% maximum per investment type.

These new ETF’s from claymore are part of growing trend towards semi-active ETFs that are designed for superior investment performance. The Zacks Sector Rotation Portfolio is the first “macro” ETF which explicitly attempts to make investment decisions based on macroeconomic factors. I think we will see more “macro” and dynamic allocation ETFs in the future.

The BIRC ETF may be attractive to investors seeking concentrated exposure to this subset of EEM. Given the high volatility of emerging markets in recent weeks, there are probably less investors seeking exposure to EEM at the present time. This ETF will probably be a component many portfolio’s with macroeconomic focus.

The Sabrient quant models are untested at this time. However each model is based on real phenomena. The informational content of insiders actions and the ignored/unloved effect. Time will tell if Sabrient has been successful at exploiting these known market anomalies.

The Zacks Yield Hog ETF is the most interesting one to me. I like dividends. Zacks’s is acknowledging that fact that if you like dividends, common stocks in general are not the place to find them. DVY only yields about 3.2%. You can do better with an online high yield savings account. If half the portfolio is investing in dividend payers yielding 3.2% and the remainder is invested in REITs and what not yielding upwards of 7.5%, the total ETF should yield around 5% or more. Because of the Yield Hog ETF’s investment in REITs, MLPs, closed end funds, and foreign stocks it should have low correlation to the broader US market while paying out much more.

Tip of the hat to for breaking the story.

Friday, June 09, 2006

What's the matter with GNC

Continuing on a previous theme of LIPOsuction. We present the latest debutante, GNC Corporation.

According the S-1 filed with the SEC GNC is the world's largest global specialty retailer of health and wellness products, including vitamins, minerals, herbal, and specialty supplements. As of March 31, 2006, there were 5,817 GNC locations globally, with 16% of revenues comming from franchised stores. GNC sells alot of diet related supplements. I think every potential buyer ought to understand how GNC intends lose weight before the IPO. Why? because look at how well IPO buyers of Sealy (ZZ) are sleeping.

GNC Weight Loss Plan

  • Series A 12% Cumulative redeemable exchangeable preferred stock: par value of $1000, with a call premium of $1,085.71 as of the IPO date. There are currently 100,000 shares of Series A stock outstanding. Each share is carries $342.18 of dividends in arrears. The total cost to redeem the preferred stock is about $142.7 Million.
  • Restricted payments totaling $49.9 million made on March 2006. The S-1 is unclear about specifics of the payment. But it was paid to the outstanding shareholders, and so is yet another special dividend.
  • A second special dividend of indeterminate amount (i.e the company is not sure how big it is going to be), will be paid to common stockholders of record before the offering.

"GNC Investors, LLC" (the private equity syndicate) spent $733.2 million total (cash equity investment of $277.5Million) to acquire GNC from Numico. In exchange the syndicate got 29,566,666 shares of common stock and in the case of the principal stockholder (Apollo Investment Fund V), 100,000 shares of the Series A preferred stock. The internal rate of return on their investment in GNC is impressive.

GNC Corporation is very leveraged, with $472.8 million of debt supported by $169.7 Million of equity capital. All most all of that pre-IPO equity capital will be removed by LIPOsuction. New investors will contribute all GNC’s post-IPO equity capital, causing them to incur immediate and substantial dilution.

What is really scary is the section of the S-1 labeled "Contractual Obligations" for the next 1-3 years GNC has fixed charges of at least $221.3 Million per year (Combining Leases, Mortgages, and General Corporate obligations). Considering that for the 12 months ended March 31, 2006, GNC generated revenue of $1.4 billion and Adjusted EBITDA of $129.2 million. This does not look good.

Yay! More Powershares RAFI funds on the way!

Powershares Capital Management has filed a prospectus with the SEC for new series of ETFs based on the RAFI's Fundamental Indexation methodology. Fundamental Indexation uses quantitative measures of firm size, rather than market capitalization to build the index. This avoids the unintentional overweighting of companies with market caps in excess of their economic value. RAFI offers a reprint of an article by Jack Traynor in the Financial Analysts Journal on Why Market-Valuation-Indifferent Indexing Works. Over time RAFI indexes tend to outperform cap weighted indexes by about 2% per year.

  • PowerShares FTSE RAFI US 1500 Small-Mid Portfolio
  • PowerShares FTSE RAFI Energy Sector Portfolio
  • PowerShares FTSE RAFI Basic Materials Sector Portfolio
  • PowerShares FTSE RAFI Industrials Sector Portfolio
  • PowerShares FTSE RAFI Consumer Goods Sector Portfolio
  • PowerShares FTSE RAFI Health Care Sector Portfolio
  • PowerShares FTSE RAFI Consumer Services Sector Portfolio
  • PowerShares FTSE RAFI Telecommunications & Technology Sector Portfolio
  • PowerShares FTSE RAFI Utilities Sector Portfolio
  • PowerShares FTSE RAFI Financials Sector Portfolio

These new ETF's will be alternative to the existing Select Sector SPDRs which chop up the S&P500 into nine sectors. I expect that that the Telecommunications & Technology Sector fund will greatly outperform the Technology Sector SPDR (XLK), because that market segment is littered with overvalued companies. The RAFI US 1500 Small-Mid Portfolio compliments the existing RAFI US 1000 Fund (PRF), to create a complete index of the top 2500 US stocks.

I believe that Powershares intends these RAFI funds to be the passive counterparts to a new series of Dynamic Intellidex Funds which will be "semi-active" index ETFs.As usual Powershares is charging 0.60% of NAV as management fee.

Wednesday, June 07, 2006

We got hurt by not speculating

We underperformed in 1999 not because we abandoned our strict investment criteria but because we adhered to them, not because we ignored fundamental analysis but because we practiced it, not because we shunned value but because we sought it, and not because we speculated but because we refused to do so. In sum, and very ironically, we got hurt not speculating in the U.S. stock market.

Seth Klarman: December 17, 1999

Monday, June 05, 2006

Liposuction is fashionable for debutantes

I guess I should stop pointing at flaws in l’affaire Vonage. But there are so many good lessons in it. Of course the main lesson is not to participate in other people’s exit strategies.If current owners are exiting, why should you enter?

In the case of Vonage, most of the company (80% of it)was owned by several private equity funds. A small IPO of 20% of the company is just a tool for “price discovery” on the remaining 80%. Given the gruesome disclosures in the prospectus (We have lost money, We are losing money, We will lose money). It is pretty obvious that the private equity people are not going to stick around after the lock ups expire.

A similar problem took place in the recent IPO’s of Koppers Holdings Inc (KOP) and Sealy (ZZ) and Burger King (BKC). These companies are part of a recent,dangerous, and related trend of LIPO (Leveraged IPO) transactions.In each case, prior to the IPO the Private Equity sponsors paid themselves massive “special dividends”

and received cancellation fees for management advisory agreements.The result is that most (and sadly in some cases all) of the IPO proceeds go towards extinguishment of debt and recapitalization of a crippled balance sheet. Public investors are merely refilling an empty glass from which the private equity people took a big sip

Tip of the Hat to Equity Private for giving form to the inchoate concept of IPOs of companies that are hobbled with debt

Vownage: first vonage VG lawsuit filed.

The law firm of Motley Rice LLC has filed a class action lawsuit in the United States District Court for the District of New Jersey on behalf of purchasers of the common stock of Vonage Holdings Corp (VG). The complaint alleges the Vonage and certain named officers and underwriters violated the federal securities laws by publishing a defective registration statement and misleading prospectus. A PR release claims:
Prior to the Company's Initial Public Offering ("IPO") on May 24, 2006, the Company had spent hundreds of millions of dollars to market its services to potential customers. However, the Complaint alleges, both the Company and Company insiders, who had invested hundreds of millions of dollars of their personal funds in the Company, were losing money. According to the Complaint, these Company insiders, desperate to execute an exit strategy for themselves, embarked on an illegal course of conduct to sell shares of the Company in a public market.

The Vonage S-1 form, made it very clear there is strong evidence for a substantial doubt about the company's ability to continue as a going concern. If you bought shares after reading the prospectus, you have no cause for complaint. And if you bought shares without reading the prospectus, you also have no cause for complaint.

Of course the real reason for the lawsuit is not that Vonage and certain named officers and underwriters allegedly engaged in "illegal course of conduct to sell shares of the Company in a public market". The goal of the lawsuit is to collect legal fees on behalf of Motley Rice partners. My guess is that litigation and indemnification around the IPO will end up costing the company about a tenth of the IPO proceeds, so around $53 million total. If vonage ends up granting rescission rights to IPO purchasers, it will be much more expensive.