Monday, July 31, 2006

The evolution of the credit cycle.

The most recent FDIC Outlook (Summer 2006) is now available and highly recommended. This quarter's issue is devoted to topic of credit cycles. One of the most fascinating things about finance is how the markets constantly forget and relearn the lessons of the past. The biggest macro-economic issue facing the US economy is the current state of the credit cycle.

The notion of the credit cycle or a periodic fluctuation in the volume and quality of credit has a long and colorful history. Cycles of expanding, and then contracting, credit volumes are observed in virtually every type of lending, but they may differ markedly across the various bank loan types. Following the late-20th century deregulation of financial services, some argue that cycles in bank lending and loan performance are rising in importance as drivers of banking industry performance. This issue of FDIC Outlook first discusses the credit cycle in conceptual terms, and then examines how applicable the concept may be to the three most important loan types for FDIC-insured institutions.

As British Prime Minister Harold Macmillan noted in 1957 "You've never had it so good". Since the mid 1990s there has been a huge expansion of credit fueled by historically cheap capital, increased demand for borrowings, and higher risk tolerance on the part of borrowers and lenders together. Hence a massive growth in residential mortgages, commercial loans, and commercial real estate lending. Because of strong economic growth, credit performance has been excellent so far. What will happen when economic growth weakens is unknown.(NB: Historical experience is that it ends in the collapse of the over-leveraged party.)

As Fitch ratings noted in their April 5th 2006 report "Loan Volumes Surge, Covenants Shrink in 2005":

One result of this risk receptivity and "borrower-friendly" funding environment has been visible erosion in covenant usage. This trend has been most acute among non-investment grade loans despite a steady decline in the credit quality of newly originated deals.

Loan covenants don't change the credit profile of the obligor. But they do ensure that management behaves responsibly. This is important to equity investors because if any part of the capital structure is at risk, then all of it is at risk.

This is one of the big problems with many recent leveraged IPOs. If the quality of the senior capital is poor, the quality of the equity capital cannot be better. This makes overleveraged companies, weather old or new, uninteresting to risk-averse value investors.

Saturday, July 29, 2006

None of such proceeds will be used to further invest in our business.

Because most of the proceeds from this offering will be used to pay a dividend to our current stockholders, only a portion of the proceeds will be used to repay our existing debt and none of such proceeds will be used to further invest in our business.

The net proceeds from the sale by us of the shares of common stock being offered hereby, after deducting underwriting discounts, will be approximately $175.3 million. We intend to use approximately $25.0 million of the net proceeds to repay certain indebtedness. We intend to use the remaining net proceeds of approximately $150.3 million to pay a dividend to our stockholders existing immediately prior to this offering. This leaves no proceeds to further invest in and grow our business. See "Use of Proceeds."

From the Final Prospectus of Chart Industries (GTLS). Chart Industries is global manufacturer of highly engineered equipment used in the production, storage and end-use of liquefied gasses. The need for Chart Industries' cryogenic gas handling equipment is expanding as demand for liquefied natural gas grows.

And yet the July 25th 2006 public offering of 12.5 million shares was coolly received. The 12.5 million shares, representing 49 percent stake in the company, sold for $15 a share: well below the $19 to $21 forecast range.

This is yet another instance of a meaningless IPO, other than the repayment of $25 million in debt, the total capitalization of Chart Industries is completely unchanged. Given all the glowing discussion of competitive strengths and business strategy, it would seem that fresh capital from public investors could be put better use than paying a special dividend.

Private equity sponsor First Reserve did OK on the deal. Actually they did better than OK. First Reserve bought Chart Industries on August 2, 2005, paying $117.7 million in cash equity and $350 million in debt. Less than one year later First Reserve collected a $142.1 million cash dividend from the IPO. The cash IRR is well over %20, and that doesn't include the residual value of the 13,088,043 shares, whose lock up will expire in 180-days.

Thursday, July 27, 2006

Growth Investing :: Monopoly Matters Part II

If sales growth is driven by commensurate growth in operating assets then nothing is accomplished. The company is bigger but not better. Increased sales from the same asset base, are a sign that assets (including human assets) are used effectively. Sales driven growth companies are steadily increasing their total asset turnover, year over year. Declines in total asset turnover are a hallmark of declining and stagnating companies

Of course if a company is increasing sales by lowering margins, then again nothing is accomplished. While several factors can influence margins, the most important is to what extent is the company a monopoly. Going back to Microeconomics 101, the two extremes of competition are

  1. A perfectly competitive market, in which no excess economic profits is made.

  2. A monopolistic market, in which the maximum amount of economic profit is made.

The classic example would be Microsoft (MSFT) with an operating system monopoly, vs. Intel whose chips are essential to Microsoft’s success, but which faces some competition in each of its product lines, and Wal*Mart which competes with just about every retailer in existence.

Yahoo! Finance Chart of MSFT,INTC, and WMT from 1987-2006

The closer a company is to having a monopoly; the better the chances are for having good profit margins, and earning excess profits. Software and Life Sciences companies are good examples of this; proprietary technologies and patents give these companies mini-monopolies in their niches. Hence the importance of investing in future market leaders that can earn excess profits.

Wednesday, July 26, 2006

Growth Investing :: Future Market Leaders Part I

ThinkEquity Partner's Michael T. Moe has a new post up on the ThinkBLOG about some of what is important in growth companies. ThinkEquity Partners is an investment bank specializing in "companies in the growth sectors of the economy". In some respects growth investing is value investing in the future rather than value investing in the present.

While it is not my style, learning from different perspectives, is essential to success in investing and life itself. Therefore I keep the ThinkBLOG on my hotlist. Let's begin with what Michael T. Moe is looking for in investments.
Companies that dominate a niche and help shape its future are leaders. Companies that may be smaller than the gorilla but have better products, better and more sustainable margins, and/or higher and more visible growth can become leaders. Watch out for them.

There is a central idea lurking behind the many examples and concepts that Michael T. Moe writes about. Growth companies are companies with increasing return on equity. Going back to Finance 101, we learned about the Dupont Analysis. Return on Equity can be decomposed into leverage (assets/equity), turnover (sales/assets) and margin (net income/sales). Crossing out the common factors gives us (net income/equity), which is return on equity.

Companies can grow organically only two ways: they can increase the sales generated by their operating assets, or they can increase the profit from each sale. Increased sales can be driven by many things, but they all start with having a product that people want. After that comes salesmanship and operational excellence to sell and deliver the product. Remember this; it is so important that I am going to repeat it. Increased sales can be driven by many things, but they all start with having a product that people want. After that comes salesmanship and operational excellence to sell and deliver the product.

The combination of an irresistible product and good salesmanship is market share growth. Growing market share is one half of the secret to successful growth investing. Part two of this series will discuss the other half.

Friday, July 21, 2006

A currency share of blue sky

I don't see the attraction of the currency ETFs. Each of the currency ETF's consists of 100 units of the base currency deposited in a savings account with the London branch of JPMorgan Chase Bank. Each deposit account will pay slightly less than the currency overnight interest rate (0.27% less for Euro shares (FXE), 0.40% less for the Swedish Krona trust (FXS) ). On top of being paid less than normal deposit rate, you get the added indignity of paying 0.40% in fund expenses.

Take heed of what the fund prospectus grimly notes:

Neither the Shares nor the Trust’s two deposit accounts maintained by the Depository and the Swedish Kronor deposited in them are deposits insured against loss by the Federal Deposit Insurance Corporation (FDIC) or any other federal agency of the United States or the Financial Services Compensation Scheme of England.

To me, it makes more sense to stick your cash in a savings account with a US Bank, guaranteed by the FDIC. For example, One United Bank offers 5.25% on savings accounts. With an online savings account: you pay no fees to deposit or withdraw cash, and your money is protected by the full faith and credit of the United States.

Why take on the risk of currency fluctuations while earning less interest than a risk free assets? No one has yet come up with a convincing reason for why this is a good idea. The raison d’etre of cash investments is that they are liquid and safe. Currency ETFs are liquid and unsafe. These funds are strictly for speculators and collectors of financial gadgets.

If you absolutely must have direct forex exposure, (which for most people IMHO is needless noisy risk) then something like the PIMCO unhedged foreign bond fund makes more sense. You will have more diversification across currencies, and earn a higher interest rate than most of the currency funds after expenses.

Thursday, July 20, 2006

What to look for in IPOs. Part II

Continuing this series on IPO investing. (Part 1), this chapter will talk about different types of initial public offerings.

Understanding the motivation behind the IPO provides context to the S-1 (IPO prospectus). Because motivation is qualitative, understanding it gives you the nimble investor, comparative advantage over quantitative market participants.

The big question behind every IPO is why isn't this company being financed with cheaper capital? (Refresher from Finance 101: Equity is the most expensive source of capital) The three most common answers are:

  1. No sane loan officer would finance this venture.
  2. This IPO is not about raising money.
  3. This IPO is about raising equity capital

Growth Capital

IPO's motivated by the first reason are not attractive to risk averse value investors. These are the classic IPO's of growth companies raising growth capital. A small plucky company, with the next big thing, needs more capital for growth than can be raised from angel investors and venture capitalists. Loan officers tend to be very finicky about lending on hopes and dreams, hence the need for equity investors to invest in hopes and dreams.

Companies raising growth capital tend to be in the biotech and technology sectors. All very risky. IPOs of junior energy and natural resource companies are a notable exception. If you have a good understanding of the underlying business and its possibilities, there is a real chance of getting in on the ground floor.

The second class of companies raising capital for this reason, are the overleveraged zombies tossed out by private equity investors. These companies would not be speculative expect for the fact they carry an overwhelming burden of debt. IPO proceeds end up being used to repay debt. Often the company remains undercapitalized after the IPO.

Speculative IPO's can be very profitable, but only the price sensitive survive. A later chapter in this series will discuss what to look for when investing in speculative companies.

Liquidity Capital

Some IPO's are not really about raising fresh capital. Sure money is nice, but sometimes liquidity is better than money. This is almost always the case with IPO's of spin outs. Companies want to monetize subsidiaries that can get a greater valuation outside the company than inside of it.

Spinouts are especially interesting for value investors because mostly they involve real companies with a successful underlying business. If the parent company expects to retain substantial control after the IPO, the NewCo typically pays a decent dividend.

The main danger is that companies tend to spin out subsidiaries which are currently hot and trendy. These stocks are likely to be overvalued from the get go. The most recent example being the spin out of Mueller Water Products (MWA) from Walter Industries (WLT). Making water pipes and valves is hot; being part of Walter Industries is not. Spinout and liquidity IPO's often have complex motivations which will be explored in later in this series.

Equity Capital

This is what REIT, Business Development Company [BDC's], Bank and Insurance IPO's do. These IPO's seek to raise equity capital that will be invested and leveraged in financial businesses that require a certain amount equity capital to start with.

These IPO's are a bet on the management and its proposed strategy. Bank strategy is fairly simple: attract deposits and make profitable loans. Insurance strategy is also simple, raise cash, invest the capital and write profitable insurance. Most new insurance companies tend to trip up on the last part. Failure to write profitable insurance always ends badly. Insurance IPO's are no place for the unwary and inexperienced.

Business cevelopment company strategy is somewhat more complex, because BDC's make equity and debt investments in small private companies. The final outcome very dependent on the BDC's target investments and investment style (capital gains or current income).

REIT's strategy can be very complex or very simple, depending on what the REIT plans to invest in. REITs are supposed to invest in property and mortgages. However many newer REITs (especially those with external management) take advantage of tax loopholes to also invest in other things ranging from bank loans to aircraft Leases. All property and mortgages are not alike. It really pays to do your own due diligence

IPO's that are about raising equity capital for a known good business plan, rather than raising capital for an unknown business plan, have the best chance for profit.

Saturday, July 08, 2006

On Vacation :: WooHoo!!

Loyal Readers,
I'll be off on vacation, traveling around the Mediterranean till early August. Thankfully I'll be away from computers during that time, so this site will be updated rarely if at all. To be alerted to any updates, I suggest subscribing to my RSS feed, by clicking this icon. Value investing RSS feed

Market Participant.

Thursday, July 06, 2006

Reply to Dan McCarthy in re Covered Calls.

Dan McCarthy writes up an interesting reply to my fisking of a spam from Bernie Schaeffer promoting buy-write.

I'll begin by pointing out that core of my critique is of the buy-write strategy. That is the strategy of buying stocks for the purpose of writing calls on them. This is bad idea for two reasons. The first reason is that you end up chasing volatile stocks while limiting (censoring) the possible reward and keeping almost all of the downside risk.

The big problem with a buy-write strategy is that it generates plenty of trading costs which become an unbeatable hurdle. That combination of limited upside, downside risk, and a high hurdle rate, ensure that a buy-write strategy is going to be a long term loser.

Dan McCarthy's first point is if you are very confident about a stocks intrinsic value, then you can quickly monetize that portion of the return distribution beyond the intrinsic value via covered calls. Since you plan to sell the stock once its price moves past intrinsic value, you are effectively clawing back some of return that you would have given up. If the stock takes longer than expected to reach full value, then you get some extra return via the option premium.

My response is that at least for me, I am rarely very very confident about a stock's intrinsic value, certainly not enough to make point estimates, and then back up my guess with covered calls. My personal style is to have a big margin of safety by buying stocks that are trading about 30% below my guess of the range of intrinsic value. I think that it's super important to recognize the limits of our knowledge, by being conservative, three times careful, and then admitting that we don't know.

A secondary point is that just because a stock reaches intrinsic value, doesn't mean its time to sell. Often a stock that gets up to full value attracts momentum investors and other stupid money. These folks can bid up the stock far past its intrinsic value. When I own a stock that I think is at intrinsic value, I become somewhat indifferent to owning it.

Dan's second point, has something to do with problems of shorting volatility which is what happens when you write calls. I think that's a bad thing to do in volatile markets simply because we don't know the direction of future volatility, and we probably aren’t getting enough compensation for taking it on that risk. I'm not a huge fan of making directional bets on "squishy" things like volatility or interest rates.

Dan's final argument involves some portfolio theory math, that I'm not afraid to admit I don't understand. I've never believed that investing is particularly complex. It mostly boils down to being price sensitive and diversified. The main difference between a portfolio with covered calls and one without covered calls is that the return distributions are different. Specifically the covered call portfolio has a constrained positive return, which is not a good thing, unless you have a constrained negative return as well.

My personal guess is that after taking into account the censoring of the right tail (positive returns) and the small positive skew (from the options premium) the mean value of the covered call portfolio is less than doing nothing.

I did a quick experiment in SPSS to test this hypothesis. I generated 500 normally distributed random numbers with a mean value of 38 and standard deviation of 14.87. This roughly equal to the value and implied volatility (39.45%) of (GDX) the Gold Miners ETF, as taken from I then priced a 40 August 2006 Call with underlying price of 38, strike = $40, IV 39.15%, and Risk rate %5.4. This call was worth $1.9754.

Using the set of 500 numbers, I then calculated the effect of writing a call by adding the option premium of $1.9754 and censoring the results to a maximum of 41.97 and minimum of zero. Unsurprisingly the mean of the covered calls was $35.41 with a standard deviation of 9.0, compared to the mean of $38.43 and SD of 14.37. As is typical for censored distributions, the covered call distribution has a strong negative skew which affects the mean but not the median.

If you compare medians a different picture emerges. The median of the covered calls is 40.61 vs. 38.70 for the unencumbered. What this means is that that the typical outcome for writing a covered calls is small and positive. So far so good, But, when you calculate returns [(final outcome-$38)/$38], the futility of the covered call strategy becomes obvious.

The mean return for writing covered calls is -6.8% vs +1.04% for doing nothing. Again the typical return for writing covered calls is positive, but the total return is negative. The small positive returns from writing covered calls do not offset the occasional big losses. Taken as a whole, the strategy has a negative return. Ultimately this goes back to Benjamin Graham's observation in Security Analysis [1962ed] that the individual investor should not turn himself into insurance company by accepting a fixed and limited return while suffering occasional catastrophic losses of principal.

Tuesday, July 04, 2006

What to look for in IPOs. Part I

This series will explore some thoughts about IPO investing. IPO investing is about taking advantage of your ability to outrun the institutional investors and so take advantage of pricing inefficiencies. This isn't hard to do, because most institutional investors rely on sell-side research, which is squelched during the pre and post IPO quiet period. Unless an IPO company is famous, (like J-Crew) or obvious (Anything energy related), everyone is working off of the same set of data in the SEC S-1 forms.

But no one wants to read S-1 forms because they are long and boring, so if you are willing to put in the time and effort, you can have an information advantage over many other market participants. Counteracting your potential information advantage is the desire of everyone else involved in the IPO to have the IPO go off at a high price.

Some things exist which counteract this desire. The main contra force is market sentiment. If Mr. Market isn't interested in new companies being offered, then IPO's will be priced downwards. This can also work in reverse as well. There isn't anything you can do about market sentiment other than to be aware it.

The other big contra force is ignorance. What makes ignorance so powerful is that it is so often underestimated, especially by the ignorant. The nature of most economic research is that researchers start with a theory or model, and then go out to collect data to verify it. Without models and without data, most economically trained folks are lost. That's exactly the situation with an IPO.

Since IPO companies tend to be in transition which makes comparisons with the past or future very difficult, it is especially difficult to build models and find data to populate the model. This is where qualitative skills shine through. The ability to look at a bunch of data and get an accurate impression of it, is what separates the men from the boys.