I'm in a slight state of shock at the moment. It isn't terribly often that I agree with something that comes out of the mouth of a senior government official, regardless of the administration. However, I just read the transcript of a speech that Under Secretary for International Affairs, David H. McCormick, recently made concerning the oil market.
I don't know where this government employee gets off thinking clearly and making sense. Perhaps you're still permitted these luxuries when you're a mere Under Secretary. Perhaps he's positioning himself for a cozy job at a think tank in a few months. Perhaps he was drinking. Regardless, the piece is a little dry, but Mr. McCormick does a very nice job of summarizing what's been happening in the oil market in recent years.
If you'd like a nice little primer, the full article can be found here.
Tuesday, July 29, 2008
I'm in a slight state of shock at the moment. It isn't terribly often that I agree with something that comes out of the mouth of a senior government official, regardless of the administration. However, I just read the transcript of a speech that Under Secretary for International Affairs, David H. McCormick, recently made concerning the oil market.
What timing. I was just sitting on my couch last night wondering what I'd do if I had a spare $1.68 billion. Then I woke up this morning to find that Merrill Lynch CEO John Thain had issued a press release detailing the company's latest balance sheet developments. I'd like to focus on just one of the announcements -- Merrill's sale of $30.6 billion of collateralized debt obligations (CDOs) .
The sale of this $30.6 billion basket of CDOs is being made to private equity firm Lone Star Funds for $6.7 billion, or a mere $0.22 on the dollar. Better still, Merrill is loaning Lone Star 75% of the funds for the purchase. Furthermore, this loan is backed only by the securities that Lone Star is buying. So, Lone Star is ultimately risking only $1.675 billion of its own capital to purchase $30.6 billion of CDOs. A mere 5.5% of the face value of the securities is at risk for Lone Star! That's like buying a house with only 5% down! How can you lose?! Ok, bad example.
Granted, a good portion of these CDOs are likely to be worthless, but it's hard to imagine a loss in excess of 94.5% if held to maturity. I'm not exactly a fan of CDOs, but I like those odds. I used to want to own a casino, but now I want to buy securitized debt for 5.5 cents on the dollar. If only I had that spare $1.68 billion.
This is clearly a sign of how desperate Merrill is to clean up its balance sheet. It also demonstrates the power of liquidity in a panicky market. It's a buyer's market out there and cash is king. Merrill needed to sell much more than Lone Star needed to buy, and with a limited number of willing buyers available, Lone Star was clearly in the driver's seat.
It's also worth noting that this isn't exactly an arms-length agreement since Merrill is loaning 75% of the purchase price. This means that the actual price of these CDOs would likely have been even lower in a true sale. Still, other financials are carrying similar CDOs at well over 22 cents on the dollar, and this transaction is going to force them to yet again write these securities down.
Disclosure: The Rubbernecker is long distressed debt buying and short about $1.68 billion dollars (rounded).
Saturday, July 26, 2008
It's been a slow week posting-wise thanks to a busy week earnings season-wise. Earnings season is always a bit of a mind-numbing experience. Every day is met with a barrage of press releases, numerous analyst rating changes, and back-to-back conference calls with management explaining how their quarterly earnings would have been an all-time record if you just ignore the write-offs, higher commodity costs, lawsuits, accounting system transition issues, margin shortfall, higher tax rate, options expense, weather impact, goodwill amortization, order push-outs, and poor feng shui. It makes for some long days.
Of course, there are companies reporting good earnings -- mostly commodity-related companies, those benefiting from international growth and the weak dollar, and those that operate pawn shops. Those with the most excuses are the financials. The typical bank conference call this quarter can be summed up as follows:
We’re disappointed to report a record loss of 12 kajillion dollars, but our core business is performing strongly as you can see if you strip out the mark-to-market losses and the charge-offs.
Well, if I ignore my lack of buoyancy and my inability to breathe in the water, then I'm a world-class swimmer. They’re a bank! The purpose for their existence is to attract deposits/funds and invest the proceeds in securities and loans. It’s like Microsoft saying, “We had a great quarter aside from terrible software sales.”
Let’s be very clear. When a bank has to charge-off a good chunk of its loans, it's an admission that prior period earnings were overstated. Prior earnings benefited from these loans back when borrowers were actually making their payments and the bank wasn’t adding to reserves. These guys want the benefit of the overinflated prior period earnings but no penalty for the current period charge-offs. It would be genius if it weren't so ridiculous.
Despite some truly poor earnings in general from the financial sector this quarter, we did witness a very robust rally in the group. This wasn't terribly surprising. As I wrote on July 15th in my Trader VIX post,
...the VIX has had an uncanny ability to predict short-term rallies (lasting between 2 weeks to 3 months) in the S&P 500 (top chart) each time it has exceeded 30 in the past year. As the VIX has approached this level, I've been less inclined to initiate new short positions and more inclined to cover existing shorts. Note that the intraday high for the VIX today was 30.81.
It seems I wasn’t the only one watching the VIX. Almost as soon as the VIX crossed 30, the market made its most recent low and began its latest bounce. With financials having been sold-off so brutally over the prior 2 ½ months, it was no surprise that they benefited the most from the rally.
Also from the Trader VIX post,
In general, I'm expecting plenty of earnings misses and fairly restrained (to put it mildly) earnings guidance over the next month. But, with cash on the sidelines and a pervasive sense of gloom in the market, an earnings season short of cataclysmic may be just enough to spur the next bear market rally.
This also turned out to be the case. Prior to Thursday, the S&P 500 rallied more than 6% over a mere 6 trading days. Generally speaking, the earnings results from the financials were awful, but since they turned out to be less terrible than feared, the group enjoyed a powerful rally.
The other strong move of note this month has been the sell-off in practically every commodity and commodity-related company. I’ve been cautioning that this would happen at some point and that this is normal bull market activity. I had pared back exposure to the group and have been keeping some dry powder ready for just such a pullback.
In recent days, I’ve been gradually putting some of that dry powder back to work, adding to some energy, metals, and agriculture names. I anticipate adding further should investors continue to bail out. As for the financials, I've had no interest in chasing the latest rally. For now, I'm on the sidelines, but should the group rally further, I'll be looking to rebuild a short position in the sector.
Disclosure: The Rubbernecker is long commodities and caffeine and very short sleep.
Friday, July 18, 2008
“When everyone dislikes something it should be examined. When everyone likes something it should be examined.” -- Confucius
One of the biggest surprises to me from the Google conference call was learning that Google employs a Chief Economist. Had I only been aware of this earlier, I would’ve shorted more shares. I’ve been on many hundreds of conference calls over the years, but I’m having trouble remembering any in which a Chief Economist was one of the presenters. This was often one of the few positive qualities of these calls. Whenever I'd find myself struggling to pay attention to the mindless reading of the press release by the CEO, I'd mutter to myself, "Well, at least I don't have to listen to an economist."
The fact that high-flying, vanquish-all-comers, paradigm-changing Google is the first that I can recall offering up an economist to the investment community seems a bit ironic. This is Google! Shouldn't we be hearing from the Chief Envisioneer of World Domination instead? Perhaps this will be one of those little things we’ll point to in a few years as evidence that the days of heady growth for Google were winding down.
I didn't buy the put, opting to short the stock instead as increased volatility made put buying a little too expensive. And, unfortunately, I didn't short the stock as it neared $600. The short was initiated last week in the mid-$540s. Even though the stock had already pulled back 10% from its recent high, It was just too tempting. GOOG had held up better than the market during this latest downturn, and it seemed that the entirety of the sell-side community and press were bullish and expecting yet another outstanding googlerific quarter. On top of this, the concerns I shared from last quarter hadn't diminished, and the economy had deteriorated further. It was an appetizing recipe for an earnings disappointment.
Of course, the sell-side was out after the call defending their buy recommendations on Google. I haven't seen one downgrade. AmTech Research is keeping its "Buy" rating but lowering its target from $750 to $725. Cantor keeps their "Buy" and lowers their target from $750 to $675. Kaufman Bros. maintains their "Buy" and lowers their target from $680 to a nice round $657. $657? 57? 7? I mean, c'mon. You feel that confident in your $657 target that you didn't want to round it down 0.304414% to a nice even $655? How can anyone take this supposed precision seriously given the multitude of highly variable factors that go into that target in the first place? Asinine.
The average target price of these three analysts/lemmings implies 40% upside in the stock. The last downgrade I see is a beaut. Jefferies downgraded GOOG from a "Buy" to a "Hold" on February 1, 2008, the very day the company issued disappointing earnings and the stock opened 36 points lower. The downgrade also came one month AFTER the stock fell from a high of over $700 to about $520. See the station? See the train? No? That's because it's already gone. Over the following 5-6 weeks the stock traded as low as $412. When did the analyst upgrade the stock? He waited until April 18th, the day Google reported their "strong" first quarter earnings and the stock opened at $535. It would be difficult to try and time this stock worse.
So what about this quarter's earnings release? As you know by now, EPS came in a bit light, even with the benefit of currency and a nice low tax rate. Unlike the denials in the last conference call, the company finally owned up to being impacted by the slowing economy. They also admitted that the U.K. business was now large enough that seasonality was becoming evident. Paid click growth actually declined sequentially, and revenue growth (one of the concerns I highlighted last quarter) continued to slow.
Growth is clearly the overriding issue here. Huge early market share gains that could mask seasonality and economic weakness are quickly evaporating, which shouldn't be a huge surprise given the scale of GOOG. The question then turns to what the company is worth and what is an attractive stock price. With the stock now trading at about 20x 2009 estimated EPS, I don't find the stock particularly compelling, but I also no longer view it as ridiculously overvalued. Because of this, I covered the short today (Friday). I'll be watching the stock with an open mind from here and would be inclined to fade any substantial move in either direction.
As for the "Gas" part of this piece, since exiting my natural gas position on June 20th I've been patiently sitting on my hands waiting for another crack at it. With this sector and the price of natural gas now down over 20% from their recent highs, my patience has worn thin. I dipped my toe back in on Thursday afternoon, buying one of my favored domestic natural gas E&P names. As usual, the plan is to pump up the position should investors continue to bail out of the sector.
Disclosure: The Rubbernecker is happy to once again have a little gas.
Wednesday, July 16, 2008
Nobody can consistently predict where short-term oil prices are headed because they just can't know what new news is coming or just how trigger-happy the traders will be on any given day. The near-term fundamentals are only slightly less muddy. Clearly we're experiencing some degree of demand destruction as the global economy weakens, people drive less, and alternative energy substitution makes a very small dent. On the other hand, growth in China, Russia, and India is still robust with more and more people in these countries trading in their bicycles and rickshaws for cars every day. It doesn't hurt that Tata Motors is now mass-producing a $2500 car for the Indian market. Also, it was recently reported that the Russian car market is now the largest car market in Europe by sales, with a 41% year-over-year increase in sales in the first 6 months of this year.
As for supply, Saudi Arabia claims to be ramping production, but no independent verification of Saudi oil statistics exists. Aside from the recent large discovery offshore Brazil by Petrobras, there have been no super-major oil discoveries in over 30 years, so it's really difficult to argue that there's a meaningful amount of easy oil left to be found. Demand, of course, has grown steadily over these past few decades while the existing major discoveries from the 1970's and earlier have been gradually depleting. Additionally, who knows when Bush or Ahmadinejad will provide the next school yard shove and again inflame the fears of further Middle East turmoil and possible oil supply disruption.
The largest oil field in the world is the Ghawar field in Saudi Arabia. As mentioned above, no one outside of Saudi Aramco and the royal family really knows the true size of the field or its production trends. There are some prominent voices, most notably Matthew Simmons, who've raised serious questions about the sustainability of production from the field. I highly recommend his book, Twilight in the Desert. Whether or not Ghawar is actually in decline, it would be difficult to argue that the Saudis will be able to sustainably produce at rates much higher than current levels given what anecdotal evidence we do have.
Since we don't have good numbers with which to analyze Ghawar, let's turn to the second and third largest fields. Number 2 on the list is the Burgan field in Kuwait which began producing in 1946. In the fall of 2005, the chairman of the Kuwait Oil Company admitted that the field would only be able to sustain production of 1.7 million barrels of oil per day versus the 2.0 million they had hoped for. It turns out that production above 1.7 million barrels was actually damaging the field. Although production from Burgan may remain flat for many years to come, it certainly seems to have peaked.
Number 3 on the list is the Mexican super-giant, Cantarell, located in the Bay of Campeche in the Gulf of Mexico. The production changes in this field have been dramatic. The field was discovered in 1976 and began producing in 1979. By 1981, the field was already producing 1.16 million barrels per day. 14 years later the field was only producing 1 million barrels per day, and the Mexican government decided to make a major investment to further develop the field. This included drilling new wells, installing new platforms, and constructing the largest nitrogen extraction facility in the world in order to inject nitrogen into the field in order to help "lift" the oil.
The investment seemed to pay off. By 2001, the field was producing 2.2 million barrels of oil per day. By January of 2006 this figure had declined to a still healthy 1.99 million barrels, but the decline has accelerated since then. In December of 2006, production was down to 1.44 million barrels per day. The latest figures for May of 2008 show yet another tremendous decline to 1.04 million barrels per day. Given domestic oil demand growth and faltering supply, the day when Mexico ceases to be an oil exporter seems to be drawing near. (By comparison, some of the largest deepwater fields produce about 250,000 barrels per day, and the average U.S. well produces all of 10.5 barrels per day).
Yes, there is still plenty of oil out there, but the easy oil has largely (not completely) been tapped. Much of the oil that still exists is expensive to reach and produce. Even the recent mammoth discovery by Petrobras will cost untold billions to develop given the depth of water and the total depth at which the field lies. Sustained high oil prices will be necessary to warrant the investment needed to develop these more challenging reserves that exist in the tar sands, the oil shale, the deepwater, and the Arctic. Over time, rising demand and higher exploration and development costs will provide some strong price support to crude.
In the short-term anything can happen. We certainly should expect to see pull-backs, as we've seen over the last couple of days. a 20-30% retracement in the price of oil would hardly be surprising if a near-term production boost (from the Saudis) runs head-on into slackening demand and an easing of tensions with Iran. There are plenty of weak momentum hands in the energy play currently, and it wouldn't take much to shake them out. But with oil becoming more difficult and expensive to extract and with more people in developing countries wanting a piece of the "American dream," the intermediate-term (at least) outlook still remains bullish.
With that in mind, from an investment perspective, I have had and plan to keep a core energy position diversified across a number of favored energy securities and ETFs. When oil and and oil-related shares are sold-off, I'll continue to step in and augment the core position with an eye towards selling this "non-core" addition on the following run. I've been patiently waiting for this next opportunity to buy. Hopefully, George and Mahmoud will keep their mouths shut for a few days, and the sell-off in oil of the last two days will continue and provide the next good entry point. If a strong market rally accompanies this oil sell-off, I may be rebuilding my overall short (not in energy) position soon as well.
Disclosure: The Rubbernecker is long energy-related shares and short rickshaws.
Tuesday, July 15, 2008
As you may know, I'm not a huge fan of aggressive short-term market calls. Well, it's not the calls so much as the people making them. I'm also not particularly enamored with those who spend their time trying to call market bottoms and tops. Believe me, if they really had any skill at it, they wouldn't be sharing it with you. They'd be holed up in some windowless cell at Goldman's headquarters surrounded by enough computer horsepower to simultaneously manage our nuclear weapons arsenal and run Guitar Hero 2 while the eerie glow of dozens of computer monitors slowly sucked their souls out of their catatonic, colorless, withered carcasses. But I digress.
My "short-term" trading is rarely by design. Rather, it's the result of opportunities presented by Mr. Market. I might intend to hold a security for a few years, but if the crowd drives it well above fair value in a short period of time, I'm not averse to at least taking some of the position off the table. Conversely, if the thesis behind a security purchase quickly evaporates, that security and my portfolio will immediately be parting ways regardless of the length of their relationship.
There is, however, one short-term indicator that I do keep an eye on when thinking about a portfolio's overall long/short position, and that's the VIX index. The VIX index (second graph above) refers to the Chicago Board Options Exchange Volatility Index, and it's a measure of expected volatility for the next 30 days. It's commonly known as the investor fear gauge and is derived based upon the implied volatilities of various S&P 500 index options. In English, when the VIX is rising, investors are taking short, shallow, rapid breaths, cursing their brokers, and heading back to church. When the index is falling, investors are becoming less jittery, regaining continence, and once again putting complete sentences together.
As you can see from the two charts above, the VIX has had an uncanny ability to predict short-term rallies (lasting between 2 weeks to 3 months) in the S&P 500 (top chart) each time it has exceeded 30 in the past year. As the VIX has approached this level, I've been less inclined to initiate new short positions and more inclined to cover existing shorts. Note that the intraday high for the VIX today was 30.81.
Just as bull markets experience retracements, bear markets experience rallies. Even though the sentiment and news in the market right now is fairly dismal, we may be setting up for a repeat of last quarter's earnings season in which bad earnings reports and guidance actually drove the market higher simply because the news turned out to be less horrific than feared. Don't get me wrong. In general, I'm expecting plenty of earnings misses and fairly restrained (to put it mildly) earnings guidance over the next month. But, with cash on the sidelines and a pervasive sense of gloom in the market, an earnings season short of cataclysmic may be just enough to spur the next bear market rally.
So am I making the type of short-term call that I despise? If so, it isn't worth the paper it isn't written on. I prefer to think of it as a tactical, contrarian, rebalancing opportunity. I know. I know. You say tomato, and I say tactical, contrarian, rebalancing opportunity. I'm not making wholesale changes to any portfolios. I'm simply taking profits on short positions that have performed well and are now less attractive from a risk-reward stance. I'm currently sitting with the smallest short position I've had in a few months. Should the VIX continue to rise (and the market fall), I'll be very likely to exploit further tactical, contrarian, rebalancing opportunities.
Disclosure: The Rubbernecker is long semantics and short the interpretation of the meaning of words and phrases.
Saturday, July 12, 2008
"You can't always get what you want. But if you try sometimes, you might find, you get what you need." Rolling Stones
When it comes to commodities, it all boils down to Economics 101. Barring government intervention (not usually a safe assumption), prices will tend to rise when demand exceeds supply, and vice versa. Most commodities have been in a bull market the past few years as demand has been greater than supply, and these bull markets can last for some time. But make no mistake, just like any random federally-chartered, shareholder-owned, implicitly federally-backed, government sponsored housing enterprise, their run will eventually come to an end.
Ironically, one of the signals of the impending peak will likely be that "everyone" starts spouting off that "it's different this time". We're seeing some early signs of that for certain commodities already, but we're really looking for some of that good old-fashioned Greenspanian irrational exuberance. More specifically, I'll be keeping an eye out for the following signs of the top:
- The cover of Time Magazine or the Economist will show a 22-year old hedge fund manager hugging a gas pump.
- MTV will roll out a new show called "Pimp My Deere" which will take run-down tractors and combines and fit them with waterproof woofers, satellite internet access, 19-inch monitors for day trading futures, chrome rims, custom flame paint jobs, and solar-powered espresso machines.
- My plumber will excitedly tell me how he just bought his first soybean meal futures contract and shorted the S&P 500.
- My clients will push me to buy even more gold because it has been going up for so long and their cousin's neighbor told them it was a no-brainer.
- My vegetarian wife will want to quit her interior decorating business to trade feeder cattle futures.
- No one will really care what I think about commodities, because they will have "figured it out."
Once everyone believes in the commodity bull and has invested in it, the upside obviously becomes much more limited. Of course, we don't only focus on crowd sentiment. We have to keep an eye on supply and demand. All else equal, high commodity prices eventually spur the development of new supply. High prices may also result in demand destruction as consumers/purchasers alter their spending patterns and search for substitutes. As a recent example, driving miles in the U.S. have fallen fairly significantly in the U.S. due to high gas prices.
Yesterday, the Economist offered up a tasty little morsel of an article dealing with the issue of demand destruction and substitution as it relates to food. The following are some excerpts from their piece entitled, "Let Them Eat Bugs."
What with rising fertiliser prices, increasing concerns about deforestation and unreliable rains brought on by climate change, how will we find new sources of nourishment?How's that for an Inconvenient Truth? Now, I'm not quite ready to sell my agriculture positions because of a looming surge of interest in locust burgers and potato bug salad. As a "trap-and-release" vegetarian, I'm likely to keep paying up for my soy products, but I can envision this new food source being popular with the 6-8 year old male demographic.
Scientists at the National Autonomous University of Mexico have an answer: entomophagy, or dining on insects. They claim the practice is common in some 113 countries. Better yet, bugs provide more nutrients than beef or fish, gram for gram.Meat provides just under one fifth of the energy and one third of the protein humans consume. But its production uses up a hugely disproportionate share of agricultural resources. Feed crops gobble up some 70% of agricultural land, while a quarter of the world’s land is devoted to grazing. Brazil’s burgeoning livestock industry is responsible for huge swathes of deforestation in the Amazon.
For one thing, the habit could help to protect crops. Some 30 years ago the Thai government, struggling to contain a plague of locusts with pesticides, began encouraging its citizens to collect and eat the insects. Officials even distributed recipes for cooking them. Locusts were not commonly eaten at the time, but they have since become popular. Today some farmers plant corn just to attract them. Stir-frying other menaces could help reduce the use of pesticides.
Those looking for a reliable source of protein might prefer to farm them. Protein makes up a high proportion of most insects’ weight. That makes them much more efficient at converting feed to protein than livestock. For example, a cow yields only 10lb (4.5kg) of beef for every 100lb of feed it eats, whereas the same amount of feed would produce tens times as much cricket.
Environmentally and nutritionally, insects are more appealing than meat: you get more for less. But persuading flesh-loving, ento-phobic westerners of this is going to be tricky. “We’re not going to convince Europeans and Americans to go out in big numbers and start eating insects,” Mr Durst concedes. The trick might be to slip them into the food chain on the quiet. Supplements composed of insect protein could be added to processed food and perhaps also to animal feed. That might help to make meat a little more environmentally palatable.
The key point is that we're probably somewhere in the middle innings of the commodity bull market, and although this bull could run for many more years, we need to keep a close eye out for evidence of new or rising supply and falling demand. Also, it's important to remember that the supply/demand picture for each commodity differs. The ability to quickly ramp supply differs. The cost of increasing supply differs. The ability to substitute differs. And, the willingness of people to eat bugs differs.
Wednesday, July 9, 2008
My hometown newspaper (Raleigh News & Observer) asked me to write a column for this past Sunday's edition, so I decided to touch on oil and gas prices (they were also kind enough to mention this blog and include an excerpt). Keep in mind, I was limited to 500 words so this is hardly a comprehensive examination of the topic. In case you missed it:
Everyone's talking about soaring energy prices these days. My oil industry contacts have informed me that you’ll soon have to hand over your first-born child to cover the cost of a fill-up. Fortunately, my wife and I are soon-to-be parents. With gas prices reaching record levels, we now find ourselves anxiously hoping for septuplets.
To address the energy crisis, Congress has been hard at work trying to pass bills that would allow us to sue OPEC and deter “financial speculators” while the President is threatening to attack
– the world’s fifth largest oil exporter. I don’t know whether to laugh or cry. Iran
None of these steps will do anything to significantly lower oil and gas prices. Rather than suing OPEC and threatening
, it might make more sense for us to be making nice with large oil exporting countries – tell them how pretty their deserts are, send them a nice fruit basket, maybe even stop constantly threatening to bomb them. Iran
The fact of the matter is that oil prices have been increasing primarily because of rising demand in a supply-constrained world. Demand in the developing world (think
) has been growing strongly for years. Global supply, however, has not. The recent discovery off the coast of China is the first major oil find in over 30 years. Add to this the normal depletion of mature oil fields, below-normal inventory levels, inadequate refining capacity, and the increasing chance of an attack on Iran, and it’s not surprising that my neighbor’s gas tank is always near empty or that I can’t get the aftertaste of gasoline out of my mouth. Brazil
Oil prices are likely to correct at some point, especially if the global economy slows sufficiently, but the intermediate-term outlook for oil remains solid. Ultimately, high oil prices themselves will lead to the end of oil’s dominance. An oil price over $100 per barrel is the best thing that has ever happened for alternative energy development. Prices at these levels provide a powerful profit incentive to develop efficient and economic energy alternatives, and thousands of alternative energy companies have been created in recent years as a result. Although most of these companies will eventually fail (think internet), the resulting advances in alternative energy technology will likely be tremendous.
In the meantime, what can you do about high gas prices? There are the obvious suggestions: get a car with better mileage, drive less, carpool, or quit your job and start a home-based adult daycare for ex-Bear Stearns employees. Another option is to hedge the rising cost of energy by owning a mix of energy-related stocks and/or ETFs. If oil and gasoline prices keep trending higher, the gain in these securities may help offset the pain at the pump. If you’re lucky, you may even be able to hang on to your second-born.
Monday, July 7, 2008
By the time you read this, I’ll be gone. I’m sorry for doing this, but it’s for the best. I know this might come as a bit of a surprise to you, especially since I’ve been so happy lately. I’ve certainly benefited from our relationship, but I’ve gotten as much out of it as I should reasonably expect. Although we could have dragged this out a little longer, I think it’s in my best interest to move on.
I’ve come to realize that our association isn't healthy as it was built only on lies, misleading communication, and our differences. Even when it came to finances, we never really clicked. I’m financially independent and you’re not. I’m fairly frugal, but you just can’t stop spending. I care about quality and value while you like chasing the latest fad. I prefer to save, and you prefer to borrow. Furthermore, you’re not nearly as popular as you used to be, you don’t make as much money, your credit score is falling, and you’re always arguing with your supervisor.
Anyway, I’m going online to peruse the Edgar filings for some new friends. I’d still like to keep in touch. Who knows. In another time under different circumstances, maybe I’ll look you up again.
MRP.S. Rumors that I've been seen hanging out with your cousins, Fannie and Sallie, are completely false. They're both girls of low moral character.
Ok. Let's get serious. Per my recent quarterly portfolio commentary, I began reducing short positions in the financial sector at the end of last quarter, and I mentioned that I would be looking for opportunities to further reduce exposure if the sector continued selling off. Today's 20%+ decline in Freddie Mac shares provided just this opportunity.
From the New York Times today:
Shares of Fannie Mae and Freddie Mac, the largest providers of funding for United States home mortgages, plunged Monday on concern the companies need to raise more capital amid larger-than-expected losses.
The corporate “federal agency” debt obligations and mortgage-backed securities guaranteed by the companies also plummeted relative to government debt as investors thinned positions, analysts said.
Those concerns about capital adequacy have clearly been weighing on investors after that mid-March climb as shares have lost about 50% since then, with another 20% getting lopped off today. As I stated back in March, there is a very good chance that the equity holders of FNM and FRE will be wiped out, and I still believe that may happen. Despite that, Aspera's clients have had a very nice gain from the FRE short, and I usually prefer to exit a position a little early and leave a little something for the next guy (FRE was sold today in the $11.30-11.40 range).
I still have a short position in Wachovia, but I've now covered most of the financial shorts. I also reduced exposure to TWM intraday for clients that were overweight the position (double inverse Russell 2000 ETF) as it was up another 5% over the past few days.
We need to remember that bear markets are always punctuated by strong short-term rallies like we experienced this past spring. It would not be at all surprising, from a contrarian stance, to see another rally in the near future given the increasingly pervasive bearishness in the market. Regardless of which way the market moves in the near-term, I suspect that the increased level of volatility will result in further outstanding investment opportunities, both long and short.
Sunday, July 6, 2008
Wednesday, July 2, 2008
"Go for a business that any idiot can run -- because sooner or later, any idiot is probably going to run it." Peter Lynch
Last night, we learned that AIG's former Chief Executive, Martin Sullivan, whose "retirement" was announced on June 15th, will be receiving a $47 million severance package. Poor AIG. Imagine how much better the shareholders would have fared if, instead of Sullivan, the board had promoted "any idiot" to the CEO position 3 years ago.
What exactly did Mr. Sullivan do during the past few years as CEO to "earn" such a ridiculous severance package? According to AIG's press release, "Martin successfully led AIG through the crisis it faced when he became CEO in 2005, and he has made significant contributions over the past three years in executing AIG's strategy and building on its global franchise."
"Significant contributions...in executing AIG's strategy"? Seriously? Does that mean that the management and Board got together three years ago when Sullivan was promoted to CEO and laid out a 3-year plan that included wiping out $70+ billion in market value, taking $20 billion in write-downs, destroying the balance sheet, and being investigated by the Justice Department? That's what I call setting the bar low!
It gets better. In 2005, the year in which he became CEO, Mr. Sullivan "earned" a tidy $13.8 million. In 2006, Mr. Sullivan's total compensation jumped to an astounding $23.5 million. Despite AIG's net income falling an eye-popping 55% in 2007, Mr. Sullivan still pulled down $12.3 in total compensation. Add to this the $47 million severance package, and Mr. Sullivan has pulled down a cool $96.6 million over the past 3.25 years! If we ignore present value and we assume income growth of 2% per year, it would take the average U.S. household 184 years to make as much money.
AIG is a huge financial services company that was generating $9.8 billion in the year before Sullivan became CEO. Let's assume for simplicity's sake that Peter Lynch's "any idiot" was hired as CEO in early 2005, and rather than actually showing up at the office, he spent all of his time on geocaching, Mad Libs, and naked karaoke. A business of AIG's scale could easily grow 3% per year for a few years just through benign neglect. In this example, net income would have totaled $34 billion between 2005 and the first quarter of 2008. Under Sullivan's tenure, net income actually totaled $22.9 billion over this period, so Sullivan actually underperformed "any idiot" by $11.1 billion as CEO. Imagine what the Board would have paid this guy if he had actually added value!
Of course, the Board didn't recognize in 2005 and 2006 just how ugly things would become, but AIG had to take an $11 billion charge in the fourth quarter of 2007 and the company reported a $5.3 billion loss that quarter. Still, Sullivan received $12.3 million for 2007?! Even more outrageous is the fact that $4 million of his severance package is a BONUS for the portion of 2008 that he worked! A $4 million dollar bonus in a year in which he was "down-sized" and in which the company has so far lost $7.8 billion. You can't make this stuff up.
Let's take a look at AIG's stock price. Over Sullivan's tenure as CEO, AIG's stock collapsed by 40% (ignoring dividends). The S&P 500 was actually up 15% (also ignoring dividends) over this same time period, so AIG underperformed the market by an amazing 55% when Sullivan was CEO. "Any idiot" would be hard-pressed to fail so gloriously.
This is beyond comprehension. In Saudi Arabia, citizens who pick-pocket get their hands chopped off. In the U.S., CEOs pick-pocket their companies, and it's shareholder value that gets chopped. The system is badly broken. Incentive pay does not work in its current form, and institutional investors are generally too lazy to use the power of their votes to do anything about it. No wonder the typical individual investor is disgusted with Wall Street and the executive pay issue.
In a fair and just world, here's what should happen:
- Sullivan should be fired rather than allowed to retire. Tarring and feathering should at least be openly debated.
- He should have to forfeit all prior compensation that was based on results that we now know were inflated.
- He should receive no severance for such terrible performance. Actually, he should have to live in the average household and toil at the average household wage for 184 years with all of his earnings going to shareholder restitution.
- He should be sentenced to community service during which time he would have to learn and then teach remedial math to under-priveleged subprime loan originators.
- AIG investors should vote out the entire board of AIG and replace them with far more qualified candidates, such as corpses.
The author is short lazy institutional voters, AIG's board, and asinine severance packages.