Posted by: Simon Lack | June 17, 2013

Buying Emerging Markets From Home

Investing in emerging markets has become de rigeur for equity investors in recent years. If you like stocks, goes the argument, how could you not like stocks in countries where growth is fastest? It’s probably fair to say that investing today with the objective of avoiding emerging markets is a more controversial approach than including them.

No doubt GDP growth and other measures of economic output are favorable in the BRIC (Brazil, Russia, India and China) countries than in the developed world. Frontier markets (for those who find mere Emerging Markets boring) are more loosely defined but include Argentina, Bangladesh and Croatia. Of course not every country gets promoted. The implicit promise is that an Emerging country will eventually emerge into the warm sunshine of the developed world. Sadly for Greece, they were recently relegated from developed and back to emerging by MSCI.

The faster growth enjoyed by these more dynamic economies doesn’t necessarily translate into superior returns for investors. China’s growth has moderated in recent quarters, but the central planners are still targeting 7% annual increases in GDP, around three times the sustainable rate in the U.S. However, investors in the iShares FTSE China 25 Index Fund (FXI) have since the end of 2007 endured an annualized return of -6.4% whereas over the same period the S&P 500 has returned +4.2%. The mechanism that translates increased GDP into investor profits isn’t that reliable in China. And why should this be surprising? Public policy objectives regard both real and intellectual property rights as subservient to government policy. Fair treatment of investors is a fairly low priority. John Paulson lost an estimated $500 million in his hedge funds through an investment in Sino Forest, a Chinese lumber company that on closer inspection appeared to be harvesting trees on property it did not own. Running a Ponzi scheme such as this one doesn’t draw the same ire of securities regulators that we see in the U.S.

Several years ago on a trip to India I found myself in a conversation with a senior member of the Securities and Exchange Board of India (SEBI), India’s securities regulator. “Approximately how many insider trading cases are prosecuting annually in India?” I enquired of a man closely involved in maintaining the integrity of India’s capital markets. “Oh none – there is no insider trading in India.” was his breezy response.

Intrepid buyers of securities in countries where  substantial segments of the population struggle with basic issues of human survival should leave their pre-conceived ideas of fair markets behind.

That doesn’t mean you shouldn’t invest in emerging markets – that is, after all, where the growth is. But it’s far more sensible to do so through large multi-national corporations who are infinitely more able to assess each opportunity, control their risk and wind up with a fair return. P&G (PG) is heavily focused on growing its already substantial sales in developing markets (currently $33-34 billion). Mondelez (MDLZ) reports that 40% of its sales are in emerging markets. IBM (IBM) is targeting 30% of its sales in Growth markets by 2015. We are invested in these companies and others like them, because their brands of products and services continue to have globally attractive growth prospects.

Investors can obtain exposure to the faster growth of the developing world through companies whose brands are sought throughout the world. In addition, they’ll be protected by U.S. standards of governance and accounting. It turns out that you don’t need to go abroad to invest there. Although we don’t invest directly in emerging markets, we profit from their growth through the expertise of global companies like these and others that do business there. Why do it any other way?

Posted by: Simon Lack | June 4, 2013

Les Luddites

France’s culture minister has criticized Amazon for undercutting rivals and being a “destroyer of bookshops”.  Curiously, Aurelie Filippetti went on to claim that “Everyone has had enough of Amazon” although if French subjects weren’t such active customers Mme Filippetti would have to concern herself with less weighty matters.

No doubt online sales have greatly challenged traditional, brick and mortar sellers of books and music. This debate is at least a decade old. Obviously consumers prefer the far wider choice that a virtual inventory can offer compared with a physical one. Many more titles are available, and quite obscure niche writers and musicians can find an outlet for their work given the better business model offered by internet-based selling. I personally buy more books and music because of online availability. Books are the ultimate impulse purchase on a Sunday morning after reading the New York Times book review (online, naturally). Who would now buy a CD without first listening to the music, whereas 15 years ago countless musicians used to sell many mediocre songs bundled with a couple of hits?

Meanwhile, France is looking a bit like DisneyWorld, another American cultural icon that it officially disdains even while the French spend their money there. For Socialist France, like DisneyWorld, is increasingly a wonderful place to visit but definitely not somewhere you’d want to live.

Posted by: Simon Lack | June 3, 2013

Inland American Realty Runs Its Own Hotel California

Summer has finally arrived in the north east United States. Cycling to work provides a pleasant reminder that commuting can be enjoyable, accompanied for now by the curious background chorus of billions of buzzing cicadas emerging from their 17 year subterranean slumber. It certainly beats getting on a train.

The question of the day is, when a company tells you how badly you might expect to be treated as an investor, does that absolve them of any responsibility when they subsequently do what they promised? Well, at least in the Commonwealth of Massachusetts, it turns out that a company’s disclosure doesn’t eliminate the obligation of a financial advisor to steer their clients away from really bad deals no matter how much the advisor may earn in additional fees.

Inland American Realty is a registered, unlisted REIT (Real Estate Investment Trust). Registered securities are available to the general public (unlike, say, hedge funds which are generally not registered and are therefore limited to investors with income and investable assets above a certain threshold). Registered securities must conform to more onerous reporting and disclosure requirements, but have a far larger pool of potential investors as a result. Unlisted securities cannot be bought and sold on an exchange (which is true of hedge funds as well as many other private, unregistered securities). Inland American is therefore a curious hybrid – available to anyone who wishes to invest, but with no obvious means of getting your money out. Being unlisted eliminates the interest of Wall Street research analysts to cover such a company, which given management’s operating history is just as well.

To start with, Inland American’s original prospectus in 2005 disclosed that, of $5 billion in estimated proceeds from their initial offering, $550 million was going to be used to pay “Selling Commissions”, a “Marketing Contribution” and “due diligence expense allowance”. Unashamed of this immediate 10.5% payout of their investors’ money, the company further disclosed that “actual organization and offering expenses may total 15% of the gross offering proceeds.” So your $10,000 initial investment was instantly worth $8,950 and possibly less (assuming, that is, that you could sell it, which you could not).

No doubt on the basis that, if a 15% fee hasn’t put you off many other highly unfavorable features are unlikely to, management went on to disclose additional gems including the complete absence of any prior operating history, conflicts of interest between management and a key service provider, the expected payment of big fees to affiliates of management and the fact that no market would exist in the securities. Full disclosure of anticipated investor-unfriendly acts was evidently an important part of their business model. The 5% dividend has seduced many investors in search of steady income. However, since the company isn’t profitable, paying any dividend simply amounts to giving you back some of your own money (i.e. a return OF capital rather than a return ON capital). Among their real estate assets are, appropriately, hotels in California. The Eagles warned investors how hard it could be to leave.

Perhaps not surprisingly, the investments chosen by this management team didn’t turn out that well either. Evidently skill at fleecing the buyers of your stock in broad daylight doesn’t correlate that well with real estate acumen. The company’s NAV (Net Asset Value) per share duly sank from its IPO price of $10 and was at $4.84 based on their most recent regulatory filing. Of course you can’t sell it there because no public market exists. The company will buy shares back from investors, but only under fairly onerous circumstances such as death. Most would no doubt prefer somewhat better liquidity.

Since 2005 real estate investors have endured some gyrations to say the least. However, the Vanguard REIT Index ETF (VNQ) has risen 35% during this time, so holders of Inland have reason to feel that there were better places to put their money.

In 2012 the company disclosed that the SEC was investigating several issues including fees paid to affiliates, dividends paid to investors, and valuations. Inland American maintained a mysteriously stable NAV through the 2008 financial crisis which possibly helped them sell additional shares at too high a level. This is, in sum, not a story that reflects well on anybody involved in recommending the investment.

Which brings us back to Massachusetts, whose securities regulator recently reached a financial settlement with five brokerage firms who had been improperly selling Inland American and other non-traded REITS to investors in that state. The regulator found, “…a pattern of impropriety on the sales of these popular but risky investments.” The complaint cited high commissions, conflicts of interest, sporadic valuation and the absence of a public market as sources of additional risk for investors. Evidently a few firms in Massachusetts were not overly burdened by the inconvenience of considering client suitability for their recommendations. One of the firms claimed in its defense that its compliance manuals and training materials included appropriate safeguards throughout the time they were inappropriately selling the securities. They obviously have bigger problems.

One would think that the features listed above would render Inland American and other similar securities (apparently unlisted REITS are a $10 billion per year industry) unsuitable for the clients of any brokerage firm whose intentions were to promote sound investments. A brief internet search reveals many more unhappy investors outside of Massachusetts who were guided into supposedly “safe” investments by their broker only to find that they were anything but. Several class action lawsuits have already been initiated. Perhaps the SEC and other state regulators will follow up with further sanctions.

This episode highlights the need for investors to truly understand how their financial adviser or brokerage firm is being paid. Firms recommending securities that result in a hefty share of proceeds to the broker selling them ought to be a clear warning. For a security that takes the public in but doesn’t let them out, the time has surely passed.

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Posted by: Simon Lack | May 24, 2013

Annual MLP Conference

Yesterday I attended the National Association of Publicly Traded Partnerships’ (NAPTP) annual conference in Stamford, CT. It was well attended as is normal, and it provided a welcome opportunity to see presentations by several of our portfolio names. The long run prospects remain attractive although we’ve had two years’ worth of return in less than five months of 2013.

Given the strong performance of MLPs so far this year, not surprisingly there was a certain amount of chatter about taxes. Buy and hold MLP investors have certainly seen their unrealized gains grow and consequently so has their associated tax liability. A high class problem no doubt.

Earlier this year I heard of an MLP asset manager who was advising clients that they should cut back their exposure because the market was overextended. With the benefit of hindsight it was poor advice, but even at the time it was of dubious value. Few money managers publish or even care about their clients’ after tax returns. But consider an MLP investor holding a portfolio worth $100 and a cost basis of $40 (believe me, there are many). Liquidating the portfolio to profit from an anticipated near term decline in prices results in a $60 taxable gain. Some of this gain will be subject to ordinary income tax (coming as it has from the tax-deferred nature of the distributions). The Federal Capital Gains tax rate is now 20%, while the top marginal ordinary income rate is 39.6%. Many states impose taxes as well, and investment income tax in support of Obamacare can also apply, so let’s assume that the mix of taxable income is approximately evenly split between ordinary income and capital gains, and it subject to a 30% Federal tax plus 5% state. The $60 in taxable income will throw off a $21 tax bill.

What this means is that the liquidated portfolio needs to be reinvested at prices of 79% (i.e. $100-$21) of its pre-tax value just in order to break even. The manager needs to accurately forecast a 25%+ drop in prices and be sufficiently nimble to get back in to justify such a move.

However, performance is normally reported pre-tax, since everybody’s tax situation is different.  The tax drag from this attempt to time the market doesn’t show up. If the market does drop 10%, the manager may look good even though he has left his clients poorer. MLPs are a great example of inaction often being more profitable than action. Although there is invariably liquidity to sell what you want, staying with a diverse set of names you’d like to own for years is the best way to maximize the after-tax wealth creation that is possible from the sector.

Posted by: Simon Lack | May 16, 2013

Markets as Theatre

Financial markets are not totally devoid of entertainment value. Sometimes a spectacle unfolds that can rivet one’s attention, rather like a movie in which the reckless driver who’s been handling his car aggressively takes one risk too many, causing his shiny sports vehicle to careen off the road and into the valley below.

This must have been the expectation of the shorts who sold 44% of the outstanding shares in Tesla (TSLA); that the company was over-hyped, relied on unproven technology and was doomed to fail taking its Hollywood investors with it. So imagine the wide-eyed horror of the unwitting passengers on TSLA’s current moon shot as they assess a company now worth over $10BN, trading at roughly 11 X trailing sales and 350 times trailing Gross Profit (there are no earnings). TSLA may be many things, but out of favor is not one of them.

As if a tripling of its price in six months isn’t bad enough, the shorts also have to deal with a CEO with a sense of humor. For Elon Musk, evidently not one you’d want to join at a poker table, has shown his exquisite understanding of markets by committing to invest $100MM of his own cash in the upcoming secondary offering of shares just as the shorts are enduring their own particular tail event. How often do you see that?

So TSLA’s price has moved beyond what must have been plausible for most short sellers, who like all shorts are further dealing with the consequences of a steadily growing position as it loses money. We have no position in TSLA and have no intention of taking one. But watching its stock price in recent days has been entertaining to say the least.

Posted by: Simon Lack | May 10, 2013

Cooper Union Learns An Expensive Lesson About Hedge Funds

The New York Times has a story highlighting what can happen when well-intentioned but financially unsophisticated trustees of a college endowment interact with the wrong kind of financial advisors. It’s a sorry tale of poor portfolio construction and imprudent debt capped off with a Hail Mary type lunge for hedge funds that it was hoped would solve their problems with 10% returns. Regrettably, a desired return is no substitute for a realistic expectation of one, and the consequences are now being felt widely within the school. Where are the consultants today who advised Cooper Union to expect a 10% return from hedge funds? They’re probably investing the fees they earned in something more reliable – perhaps even back in to their consulting business.

Posted by: Simon Lack | May 4, 2013

Through the Looking Glass into Public Pension Accounting

The Economist has an interesting piece in Buttonwood this week about how U.S. public pensions do their accounting. Basically, they discount their liabilities using the expected return on their assets. It results in some curious outcomes. For example, since holding cash typically drags down return expectations, if a pension fund simply gave away its cash (or burned it as The Economist posits) by raising its expected return on assets (no longer burdened by the cash drag) they would reduce the value of their liabilities. Their funded status might appear better even with fewer assets.

This perverse accounting treatment got me thinking about why pension funds continue to invest in hedge funds seeking 8% returns, even though it’s been many years since hedge funds made 8% and it’s not likely they will in the near future either. Certainly not with over $2 trillion competing for opportunities. Based on the accounting, including an asset with an 8% return target helps reduce the value of their liabilities even if the 8% return expectation is an unreasonable one. So the motivation for a pension fund trustee could be to include hedge funds because of their helpful impact on the discount rate on their liabilities even while their continued failure to achieve that target doesn’t cause huge immediate problems. Far better than lowering the discount rate to a more appropriate level and revealing the true shortfall with all its political consequences.

This is how the $3 trillion underfunded position is growing. Sometimes accountants can cause a lot of damage.

Posted by: Simon Lack | May 2, 2013

The Hedge Fund Con Explained

My thanks to Ben Chu of The Independent for articulating the case against hedge funds so clearly.

Posted by: Simon Lack | May 2, 2013

Putting Stocks in a Bond Fund

In “Running Low on Bonds”, the WSJ today notes that bond funds are increasingly holding stocks because of the shortage of attractive bonds to buy. They cite the Loomis Sayles Strategic Income fund as an example. Common and preferred equity is now 19% of its portfolio, versus 5% in mid-2011.

We’re sympathetic to the argument. Bonds are a horrible investment. But if investors choose a bond fund and the manager buys equities, whatever asset allocation decision made by the client is being distorted. What the Loomis Sayles managers are saying is that their clients should hold less in bonds, and they’re going to help you with that asset allocation shift by doing it themselves. It’s not that stocks are necessarily a poor choice – far from it. But in the next bear market Loomis Sales clients may find they have more equity exposure than they expected to have based on their asset allocation.

Posted by: Simon Lack | May 1, 2013

Short Put Options Covered Up As Calls

Writing covered calls sounds like such an innocuous strategy. You own shares in a company that you like for the long term. Its performance has been modestly positive but fairly unexciting. You don’t want to sell but want to make a little more money out of the investment. So you sell call options to generate some income. Covered call writing is widely used. As benign as it sounds, it’s generally not a great way to approach investing.  Most obviously, this is because your underappreciated investment can unexpectedly rise, when the sold calls will deny you the full return you had sought just as it reaches the valuation you expected. It also impedes your flexibility should you decide to sell the stock, since the sold call option will also need to be bought back.

It’s really not as conservative as it sounds. Put-call parity is a Mathematical identity that determines the price of a put option if you know the price of the identical call option and the underlying security. In the jargon of option Math, a long put option can be created by a short position in the stock combined with a long call option. P = C – S. It’s as rigid as 2+2=4. Options market makers routinely make prices based on “conversions” as they’re called. If call options are well bid, traders offset the calls they’ve sold by going long the underlying stock and buying put options. In this case, C = S + P. You can rearrange the symbols following the rules of algebra.

Options 101

Long Stock

AND

Short Call

=

Short Put

What this means is that if you are long a stock and you sell a call option against it, you have created for yourself a short put option (last bit of algebra: S – C = – P). The returns on a short put option and the equivalent covered call position are identical. They are economically equivalent. You retain the risk of a complete loss of your investment, but the short call means you now have only limited upside. Most obviously, if your risk appetite runs to shorting put options on individual stocks, why not just do that instead of going to all the trouble of owning the stock and selling a call? The transaction costs are lower and it’s simpler to execute. More important though, shorting put options can be bad for your financial health. For some, there is a certain appeal to getting paid an option premium in return to agreeing to buy a stock you like if it becomes cheaper. Put option sellers are happy to commit to buy at that lower price and to be paid in return. Others like to retain flexibility around their price targets – after all, maybe the stock has  fallen 10% for good reason and no longer looks so attractive. You might be happy to be able to change your mind based on new information. The difference is a philosophical one. However, not all writers of covered calls recognize that they are in fact writers of puts.

I once met a hedge fund manager whose strategy was substantially one of selling covered call options. I asked him why he didn’t simply write put options and save himself some trouble and commissions. His honesty exceeded his marketing ability, for he quickly pointed out that few clients would consider investing in a hedge fund that sold put options. That is economically what he was doing, but he was sensibly customizing his message for the audience. I can’t say I followed his subsequent progress, but I imagine that the 2008-09 market collapse and subsequent recovery was a memorable experience for his investors. We were not one of them.

For the client whose financial adviser sells covered calls, there exists an additional problem. As skilled as the adviser may be in selectively selling call options that will expire worthless, it’s hard to evaluate the results. Selling out of the money call options may earn you a small premium most of the time, but markets are full of surprises and occasionally the covered call position will deny the investor a substantial return on a long stock position that suddenly appreciates. To say that most of the time selling call options generates a small profit isn’t the same as saying that selling call options is a profitable strategy.

Importantly, you can no longer simply compare the performance of your account with a benchmark such as the S&P500, because in a strong market your account will underperform as your longs get called away. The premium income may compensate at other times, but you’ll never really be able to evaluate your results with numbers. Performance may be reported to you as “quite good”, or “acceptable under the circumstances” as opposed to “2% better (or worse) than the market”.

Investing results that defy quantitative assessment but instead rely on adjectives are to the advantage of the advisor and the detriment of the client. As much as one wants to retain a positive view of the financial advisory business, as new clients open accounts and transfer over the investments that their former adviser had made on their behalf, one’s faith in the judgment of other investment professionals can be challenged. Recently, a new client’s portfolio was transferred and included therein were short call options doing what they’re not supposed to, which is moving into the money and causing the underlying long positions to be called away, thereby limiting the return on the stocks that would otherwise have been retained.

So next time you or your financial adviser contemplate selling calls on a stock you own, consider whether you would just as readily be simply short the put options. Because that’s the position you’ll have.

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