For some time we’ve felt that a short Euro represented an attractive hedge on long equity market risk.  Most of the bad things that could derail equities would either start in the EU or hurt the EU harder (such as an Israeli attack on Iran’s nuclear facilities, a concern earlier this year). But now that the focus has moved back to Europe, and we are once again contemplating the previously unthinkable, we think there’s less protection in such a position. The Euro isn’t a good investment, but its current price is more likely an accurate reflection of the balance of risks and as such doesn’t provide much of a hedge any more.

Every time we approach what seems to be a fork in the road, a third option seemingly appears. Such is the case now, with the apparently binary option between Eurobonds and no Eurobonds now joined by a European Redemption Fund, a sort of halfway house between today’s single-issuer bonds and Eurobonds jointly and severally guaranteed by Eurozone members.

But another thought occurred to me. What’s to stop the Greek government from paying its bills with IOUs rather than Euros? It may in any case be an unavoidable choice if lenders refuse to provide additional cash to allow the Greek government to continue operating. The IOU would promise payment in the future (say, 3 years) at whatever is the prevailing currency as determined by the Greek government. These IOUs would presumably trade at a discount, but over time as more of them went into circulation they could start to function as an alternative currency. Not an immediate replacement for the Euro, but a parallel currency that could represent a softer alternative to the shock of a Euro exit. These IOUs might ultimately become New Drachma. No doubt there would be many technical challenges with such a move, but given the large part of Greek GDP represented by the government before long these IOUs could represent a substantial part of the Greek economy. Such a path might offer a more measured form of exit and devaluation, preferable to the chaos of an immediate exit. Countries in the past have operated with two currencies, although typically the US$ has taken hold following a loss of confidence in the local currency. California has even issued IOUs when its disfunctional government has failed to approve a budget.

New Drachma IOUs reverses the sequence, but might offer a less time-pressured solution to the current crisis.

That a value investor would find FB unattractively priced is perhaps not that newsworthy. But I do think the uproar over how the IPO went, the righteous anger of all those “investors” frustrated in their desire to turn a quick profit, reveals much about what is wrong in investing today. The media-led hype leading up to last Friday’s launch was unprecedented – and it’s not really their fault, CNBC and others are simply providing what their customers want; 24X7 coverage of the Big Event. But the very short term nature of all this interest is so far removed from investing that it barely deserves that description. This is why people call Wall Street a casino. Because so many retail investors look for quick profits with probably little more thought than they use to choose between red or black in Atlantic City.

But it’s not just amateur investors that messed up. One of my favorite quotes is this:

“I’m disappointed that so many seemingly smart people have failed. They raised the range on the offering literally two days after the underwriters called around saying lower your numbers for the second quarter,” said Hugh Evans, portfolio manager at T Rowe Price, one of the largest institutional shareholders of Facebook.

“Those two things don’t go together, ever,” he added.

I wonder if Mr. Evans counts himself among the “smart people”.

If a little more cynicism was applied, and a little more long term investing, there wouldn’t be such destruction of savings that are supposed to cover so many retirements. If you really wanted to invest in FB, the subsequent drop in price to $31 ought to be regarded as an opportunity to add at more attractive levels. Judging from the furor though, and no doubt imminent lawsuits, such an approach is far from prevalent. Investors have only themselves to blame.

Although I’m not a stockholder, I use Facebook to stay in touch with friends and family. I’m not on every day, and many people have more “friends” than me. In fact for a while my total was barely in double digits until my children’s friends began to take pity on me and helped me get to a few dozen. The college-age crowd that are the engine for FB often number friends in the several hundred. I am clearly not that popular, but I can claim that my FB friends really are friends.

About a year ago FB e-mailed me to enquire whether I’d like to advertise my business, SL Advisors, on FB. I was surprised. I honestly didn’t know FB carried ads. I’d never spent much time considering their business model or how they managed to exist. So much of the internet is free, and FB was just there whenever I needed it without even the occasional NPR-like pledge drive.

Unable to recall a single ad I’d ever seen on FB, I concluded that my own advertising budget could be more usefully deployed elsewhere. And in fact even now I can’t remember anything advertised on FB. I do know that GM have stopped advertising there due to poor results, and I also know that Ford are very happy with their FB ads. This probably speaks to the average age of their customers, but in both cases I read about these developments elsewhere and don’t know what GM or Ford have actually advertised on FB.

Meanwhile, FB continues to be a fun way to stay connected with friends and family scattered around the U.S., UK and Canada. The price is right, and if advertisers deem it a useful way to spend their budgets they truly don’t even distract me. In spite of what economic theory holds, sometimes there really is a free lunch.

The embrace of private solutions isn’t seamless; prison guard unions are clearly opposed, and California itself represents 13% of CXW’s revenues. Politics can sometimes intervene, but the trend towards increasing market share is robust. It’s a business with limited economic sensitivity, reasonable barriers to entry and good growth prospects.

CXW was once structured as a REIT with the managed business as a tenant. They basically own and manage real estate.  The REIT was overleveraged, was building prisons aggressively and had falling occupancy.  This combined with the requirement common to REITS that they distribute at least 90% of their pre-tax income to their investors made it hard to fund their capex program, and they raised equity and restructured as a corporation. While this gave them more flexibility around managing cashflow, it also burdened them with a 38% tax rate once they returned to profitability.

We’ve long been intrigued at the possibility of the company returning to the REIT structure. As well as reducing their tax liability, splitting into a management company that operates prisons and a REIT which owns them would attract a REIT-type valuation on pre-tax income on the latter and lead to a re-pricing. It’s not a bad investment as a corporation, but as a REIT we think it’s mis-priced.

Eighteen months ago the company had told us they would never consider restructuring as a REIT. But in their 1Q12 earnings call they disclosed that such analysis had begun in the Fall.

CXW manages some prisons, and own/manages others. They break out the segment operating margins for both (13% and 36% respectively). Based on this and other information in their 10K, it’s possible to construct an income statement for a new management company (we’ll call it ManCo) and a REIT entity owning prison properties (call it NewREIT).

Assuming the 13% margins they earn managing prisons applies to those they own as well, it’s possible to calculate pro-forma operating earnings for ManCo and net operating income for NewREIT.

CXW’s market cap is $2.8BN. Their 13% operating margin on managing prisons applied to their total revenues of $1.7BN generates $228MM of operating income, $141MM after tax. A market multiple of 14X would value this at $1.7BN or 60% of their market capitalization.

We calculate NewREIT would generate $313MM of net rental income based on the 23% difference between their operating margins for each segment above, on the $1.36BN of revenues that come from prisons they own and manage. REIT cap rates vary from 8% for industrial properties to 6% for high quality offices and in some cases even lower. Their business is economically insensitive, clients are good credit, maintenance costs are minimal, and they have half the share of the U.S private prison market, so a 6% cap rate doesn’t seem unreasonable (by comparison, Simon Properties Group, SPG, trades at a cap rate of around 5% of Adjusted Funds From Operations or AFFO).

Applying a 6% cap rate to this rental income values it at $5.2BN. We still have to deduct the market value of so far unallocated expenses such as G&A ($91MM) and maintenance cap ex (we estimate at 15% of net rental income or 3.5% of rent, $48MM). Applying a 14X multiple to these pre-tax figures and adjusting for their 38% tax rate deducts $1.2BN in value. The company has another $1.2BN in debt.

CXW Valued as ManCo and NewREIT

Source: CXW SEC filings, SL Advisors

The valuation is of course sensitive to the cap rate. An 8% cap rate reduces the value to $32 per share. And they may not convert to a REIT, although the company has hired JPMorgan and E&Y to do the analysis and has asked the IRS for a private letter ruling related to the conversion. We think their analysis is sufficiently far along that the company believes it’s likely they will convert.

CXW is a holding in our Deep Value Equity Strategy

The authors, who include CIO Harold Bradley, note with irony that while venture capital funds search tirelessly for new business models and innovation there has been remarkably little of this in the vc industry itself. Fees of 2&20 with limited transparency around GP compensation have prevailed with oddly little change. The report also notes that while vc funds demand complete transparency around the financials and compensation of the companies in which they invest, they generally refuse to provide anything similar to their own investors.

Kauffman reports that only 20 out of their 100 vc funds beat a public equity market equivalent by more than 3% (a modest reward for illiquidity) and that half of those began investing prior to 1995. They also find that the “J-curve” (which holds that early negative returns quickly improve as investments mature) doesn’t really exist.

In many ways what’s wrong with vc investing is similar to what’s wrong with hedge funds. Their findings echo my book, The Hedge Fund Mirage. Too much money chasing returns; LPs that don’t press for better terms. Poor transparency.

The Kauffman Foundation should be applauded for their open approach to discussing issues that demand more attention. I hope their step forward provokes other investors to similarly examine their own results.

So now Reuters reports that McClendon was also running a hedge fund, cementing his reputation as a visionary with a complete absence of judgment. It’ll be interesting to see how his supporters defend this revelation as being in the interests of CHK stockholders. At some point this may become an attractive investment. We’re probably heading into territory where the CEO’s departure would push the stock up, however unlikely that is.

ISS caught my attention today in their criticism of the compensation structure set up for JC Penney (JCP) senor management. ISS describes the peer group JCP used as “aspirational” in that it includes far larger companies such as Nike (NKE) and Target (TGT). ISS would prefer a set of similarly sized companies and their own peer group for JCP apparently includes four auto-parts companies. JCP defends their method as reflecting the market in which they must compete for talent, noting that recent senior hires had come from TGT and other companies in their peer group. ISS recommends shareholders vote against the compensation structure. It’s unlikely to fail because Pershing Square who owns 26% and were instrumental in bringing Ron Johnson on board will obviously vote yes, as will Voronado another large holder. For our part, we’ll vote Yes as well. JCP is a turn around story, and that requires a different compensation model. We are invested in JCP precisely because of the senior team.

To pick a different example, Citigroup’s owners recently rejected the proposed executive compensation structure. Since Vikram Pandit took over as CEO in December 2007 the stock has lost 90% of its value. No doubt he inherited a tough hand, but don’t forget that among the billions in losses was the complete write off of the hedge fund of funds business Old Lane that Pandit had only months earlier sold to Citigroup for $800 million. You’d think he’d have had the good grace to resign right then.

Disclosure: Author is Long JCP

Although this description of hedge funds is provocative, much of the industry has sensibly kept its head down. In fact, few managers promote the industry and most are focused simply on their hedge fund. Many insiders readily acknowledge the disappointing results of the past with little surprise. However, the Alternative Investment Managers Association (AIMA), a UK-based lobbying group, has come to the defense of hedge funds. They recently commissioned a report titled “The value of the hedge fund industry to investors, markets, and the broader economy” in partnership with KPMG and the Centre for Hedge Fund Research at Imperial College, London. Although the paper concludes by noting the substantial social benefits of hedge funds such as employing 300,000 people globally, generating £3.2 billion in UK tax revenues and their stewardship of assets for “socially valuable investors”, I’m just going to focus on whether hedge funds have been a good deal for their clients.

Asset weighted returns, or the return on the average dollar, are poor. My analysis shows in aggregate treasury bills were a better bet. I found this to be the case only through 2010, and while some may torture the data to produce modestly different results, 2011 was the second worst year in history for hedge funds and should pretty much end the performance discussion.

Average annual returns are good. The KPMG/AIMA study referenced above finds that an investment in an equally weighted portfolio of hedge funds starting in 1994 (as far back as data can reasonably be sourced) generated an annual return of over 9%, handily beating stocks, bonds and commodities. Returns in the 90s were good for the small number of investors participating. The 9% figure is the average over 18 years. The question is whether the 12.4% return from 1994-98 is just as important as the 2.6% return from 2007-11, when the industry was twenty times as big.

Hedge fund investors know that small hedge funds outperform big ones; they also know that most big hedge funds they look at performed better when they were smaller. What is true for most individual funds is true for the industry as a whole. Using an equally weighted portfolio to represent returns will be upwardly biased for this reason. An equally weighted S&P500 has outperformed the cap-weighted version too. While equal weights might be a good way to invest, it’s clearly not a strategy available to all investors, since hedge funds are not equally sized. The return enjoyed by a hypothetical investor who started in 1994 investing equal dollars in each hedge fund isn’t representative of the average investor and is more marketing pitch than analysis.

Given how poorly actual hedge fund investors have done how could new investors possibly think that they will make money going forward? To do so they must accept the returns of a hypothetical investor who invested equal dollar amounts in hedge funds and maintained those equal investments in each hedge fund every year since 1994!  As I point out in The Hedge Fund Mirage performance was better both for the industry when it was smaller and for individual hedge funds when they were smaller.

Fees are egregious by any measure. The 2% management fee and 20% incentive fee have resulted in an enormous transfer of wealth from clients to the hedge fund industry. My analysis shows that pretty much all the profits earned by hedge funds in excess of the risk free rate have been consumed by fees. Anybody with a spreadsheet can calculate this using publicly available data without great difficulty. KPMG/AIMA concede that hedge funds have garnered 28% of investor profits, although treasury bills averaged 3.2% over this same period so even using their own numbers reveals that in fact fees took 64% of the returns in excess of the risk free rate. This is for the hypothetical, equally weighted portfolio begun in 1994. It also ignores netting – winning hedge funds charge an incentive fee whereas losing managers don’t offer a rebate. By treating the industry as one giant hedge fund it ignores the fact that whenever an investor holds some losing hedge funds his effective incentive fee will be higher than the typical 20% of profits. Without doubt, for the actual universe of investors whose hedge fund investments performed worse than the hypothetical investor, fees have consumed all the profits.

Those who think the first five years of hedge fund history are as important as the last five will hold out hope for that 9% historic return. Even a 7% return on hedge funds, the typical expectation of many investors, represents $140 billion in annual profits (net of fees, naturally) on the approximately $2 trillion in AUM. It’s a figure the industry has never generated other than in 2009 following a $450 billion shellacking in 2008. Generating $140 billion of uncorrelated, absolute return every year (after fees) has proved to be a bridge too far. Hedge funds are over-capitalized.

AIMA would better serve its constituents by promoting transparency, improved governance and fee structures that are commensurate with a world of near zero interest rates. Instead the 2&20 crowd has spent some of their fees on a glossy marketing brochure. By promoting the status quo they’re ignoring the experience of hedge fund clients, who are struggling with the reality of continued poor results delivered at great expense.  Institutions such as Allstate Insurance, whose global head of hedge funds Chris Vogt recently said, “This is a make-or-break year for hedge funds” will increasingly force change on the hedge fund industry, to the undoubted benefit of the clients hedge funds are supposed to serve.

In case anyone’s forgotten, this is how fees were carved up from 1998-2010.

In January, their median forecast for short term rates was 0.25% at the end of 2013 and 0.75% for the end of 2014, suggesting they expect to raise rates by 0.5% in 2014. Each FOMC member’s forecast for each year is represented by a blue dots on a chart that the FOMC publishes. The eurodollar futures market reflected expectations of only around 0.3% of tightening, though it did subsequently move out to 0.50% before returning to around 0.35%.

Today, the updated forecasts reflect an expectation of a 0.75% increase based on median rate forecasts. The FOMC expects to raise rates by this amount in 2014, a more hawkish forecast than they made in January. The futures market is looking for only half of this move.

The market may be right; the FOMC’s forecast is just that, and they may turn out to be overly optimistic on how the economy, inflation and unemployment will perform. But it does provide a fascinating insight into their thinking as it evolves.

Disclosure: Author is Long the Sep ’13/Sep ’14 eurodollar calendar spread.