Sunday, December 5, 2010

A Primer on QE2 - Alpha

What is QE2?
QE2 is a second round of quantitative easing (“printing money to buy high-quality bonds”) by the Federal Reserve System (“Fed”), America’s central bank. It’s the world’s biggest spending spree. The Fed announced after the mid-term elections, on Nov. 3rd, that it would buy $600 billion in long-term Treasuries over the next eight months. The Fed also announced it would reinvest an additional $250 billion to $300 billion in Treasuries with the proceeds of its earlier investments (QE1). If the Fed were to print money to buy lower-quality securities like stocks or REITS, that would be both quantitative and “qualitative” easing. Economics like to use big words to hide outrageous actions.

What is the Fed?
The Fed is America’s central bank; it is the bank where every other bank stores their “reserve” deposits. The Fed’s main goals are to keep inflation low and unemployment low. These goals often conflict. For example, one easy way to create jobs in the past has been to print a lot of money and boost the economy in the short run; in the long run, this extra money chases a fixed supply of goods and services, creating inflation. Most central banks are just supposed to keep inflation low (prices rise within a 1% to 3% annual level); they have no jobs goal. The Fed also has other goals like: ensuring the financial system is stable and doesn’t collapse; regulating banks and mortgages; controlling the money supply and how much banks in the US lend. Only the Fed has the power to print money in the US; even President Obama could not do it to buy dresses and helicopters for Michelle and the kids (though he appoints the Fed Chairman and board).

Wikipedia entry on the Federal Reserve System:

Meltzer’s Multi-Volume History of the Fed:

Why is the Fed doing QE2?
It means the Fed is printing money because it has two worries. First, the Fed says it is worried about deflation, that is, falling prices. This is nonsense because prices have been rising between 1-3% in the last year (as the chart below shows, prices only briefly fell in mid-2009). Second and more importantly, the Fed says it’s worried about high unemployment, about 10% in the US (16-17% by some broader measures, like the U-6). Yet the Fed is disingenuous since few economists think that QE2 will create jobs (though many think it can act as insurance to keep more jobs from being lost). See the discussions by Fed Chairman Bernanke and NY Fed President Dudley here where they justify QE2.

Bernanke’s Speech on QE2:

Dudley’s Speech on QE2:

Does the Fed actually print money? Where can I get some of this cash?
No, the Fed creates money electronically, at the touch of a button; it doesn’t need to print cash. After the 2008 crash, the Fed created a lot of money (over a $1,200 billion, over a trillion dollars!) to buy “agency securities”, which are basically bonds backed by mortgages and a US government guarantee on top. This was QE1 and it was done to support the economy and the housing markets. In quantitative easing, the Fed creates money electronically and then buys high-quality bonds such as US Treasuries or agencies. This reduces the supply of high-quality bonds and forces investors to buy other assets, which tend to be lower-quality and riskier. The Fed’s actions are one big reason that stock markets in the US took off after May 2009. Anytime the Fed prints money to buy bonds, its balance sheet (a financial statement showing what it owns) gets bigger.

The Fed’s balance sheet (H41):

Fed Official Sack Explains the Fed’s Balance Sheet:

If I can’t get the cash and QE2 probably won’t create jobs, why is the Fed really doing this?
Informed observers are speculating on the Fed’s real reasons. First, QE2 acts as insurance and makes the odds of a “double-dip” second recession less likely. This would prevent more jobs from being lost. Second, QE2 puts more dollars into the global financial system and basically lowers or “depreciates” the value of the dollar compared to other currencies like the Euro. A “cheaper” or “weaker” dollar helps boost the US economy and US exports, but hurts foreign countries who then have a “dearer” or “stronger” currency. Third, the US federal government is running large fiscal deficits. This means the government is spending much more than it raises in taxes. When it does that, the government has to go to the markets to sell US Treasuries to raise money, just like any other large borrower. The easiest person to sell Treasures is to the Fed because the Fed can print money and pay for it that way. The US government needs to raise hundreds of billions of dollars every month, and the Fed has now committed to buying about $60 billion every month.

US Government Borrowing Announcement:

Why are foreign governments so angry about the Fed doing QE2?
Foreign governments are angry for two reasons. First, they (correctly) think the Fed is starting a “currency war” by making the dollar cheaper. A cheaper/weaker dollar makes the US economy grow more strongly, but saps the strength of foreign countries like China, Japan, Germany, and Korea, since their currencies become more expensive and so their exports fall. Second, the Fed is devaluing or cheapening some country’s holdings of US Treasuries. For example, more than half of all privately-held US debt is held by foreign countries (it was as high as 61% in June 2008)! Analysts estimate China itself owns over a trillion dollars in Treasuries, with Japan holding nearly half a trillion. When the Fed weakens the dollar with QE2, it is basically making these countries poorer. It also adds rocket-fuel to the fiery price of gold.

Largest Foreign Holders of US Debt (2005):

Largest Foreign Holders of US Debt and all US Securities (2009 TIC Report):

What are the long-term consequences of what the Fed is doing?
As I’ve written about before, the big macro problem the US (and much of the rich, Western world) faces is too much debt at all levels of society, especially government debt. Congress in the US is deadlocked and can’t implement the optimal solution (stimulus through tax-cuts and/or spending in the short run coupled with a deficit reduction plan in the long run). Hence the Fed is doing the best it can to prevent a double-dip recession, weaken the dollar, and meet the excessive borrowing needs of the US government. It is effectively the only responsible, functioning part of the US government. Given the lack of decisions from Congress, the Fed is taking the “least painful” or “least worst” path, given a very bad set of options.

Eventually, the Fed will want to start selling the bonds it has bought to shrink its balance sheet again. However, there’s a high chance that will cause financial instability or “an extreme market reaction associated with the Fed's exit from potential purchases”, as the TBAC (an expert panel advising the US government) notes. If the reaction is too intense, the Fed won’t be able to “exit quantitative easing”, “reduce its balance sheet,” or “sell the bonds it bought” (all the same thing). That means that the money it printed is here to stay and whenever the US economy starts to grow strongly again, there’s a high probability that inflation will return and be high (above 5%). The Fed itself explains in a “goals” page why high inflation is bad (high inflation hurts economic growth, makes decision-making hard by people and businesses, hurts the tax system, and redistributes wealth).

US Government Debt Position and Activity Report:

Minutes of the latest TBAC Meeting (Q4 2010, on Nov. 2nd, 2010)

The Fed on its Goals and Why Inflation is Bad:

Wednesday, November 17, 2010

QE2, QE3? - Ari Paul

On November 4th, the Federal Reserve announced a second round of quantitative easing (QE2). Bernanke will buy an additional $800 billion in treasury bonds; this represents roughly 100% of all new treasury issuance. Over the following week, equities rallied about 3%, while gold and most commodities surged higher out of inflation fears. China and Germany loudly criticized the US for deliberately debasing the dollar in a currency war. The newly elected Republican majority in the House began applying political pressure to prevent the Fed from printing more money. Will the combination of external and internal political pressure be enough to reduce the Fed's credit easing? Over the last few days, equities have sold off moderately and commodities have collapsed as interest rates have risen. Some market participants are speculating that either the Fed's easing will be insufficient, or they will not be able to continue easing for political reasons.

The other big story has been the continuing collapse of the EU. It never ceases to amaze me how for most people, "out of sight" equals "out of mind." Early in the year there was widespread talk of how an EU breakup may be inevitable because of the huge differential in labor productivity across EU countries. The IMF announced a nearly unlimited bailout of the PIIGS and the talk vanished, but the fundamental problem remained. Now, Greece has already violated the terms of their bailout by running too high a fiscal deficit, and Ireland is teetering on the brink of bankruptcy. I continue to believe that there are only two feasible outcomes: a very sharp devaluation of the Euro, or a break up of the Euro. The third path that we are currently on would require a new massive bailout every few years. Eventually, German voters will get sick of continually providing "emergency" support to their neighbors.

Back in the last quarter of 2008, many pundits predicted imminent inflation, because the Federal Reserve had just doubled the monetary base. I quoted Milton Friedman who wrote that there's generally a 2 year lag between money printing and its effects. Well, here we are two years later, and we're starting to see significant inflation in just about everything. Food prices, gold, healthcare costs, rental prices etc, are all rising faster than the fed's inflation mandate. The official inflation gauge, the CPI, is a poor model at best and chronically understates inflation. Moderate inflation is here. Some brilliant hedge fund managers like John Paulson believe it will escalate quickly and become double digit inflation in the next couple of years. Others like John Hussman believe that moderate inflation is sustainable, while others like Chanos believe the world will soon experience further deflationary shocks.

My focus remains on the credit cycle. This time last year I thought the credit cycle was near its peak. I failed to anticipate that Bernanke would launch a second round of quantitative easing equal in size to the entire monetary base that existed in early 2008. At the time, the idea that the Federal Reserve would buy 100% of new treasury issuance seemed extremely unlikely to me for political reasons. Bernanke has proven his willingness to print an unlimited amount of money, so we return to the question, will the external pressure from China and Germany, and the internal pressure from the House Republicans, be enough to halt the credit expansion? Without QE3, and QE4, I believe the equity market and risk assets in general will perform poorly.

With 10 year bond yields still below 3%, we are likely much closer to the end of the credit easing cycle than its beginning. The trend of cheap money (and the desire to bid up risky assets that comes with it) is likely close to an end. Unfortunately, I have no particular insight into whether the tightening cycle began this week or will begin in two years. Even if credit expansion has peaked, there remains the risk that inflation could surge out of control and become self-sustaining.

Tuesday, November 9, 2010

Commodity Markets - Ari Paul

Commodity Markets
In this issue:
1) The Basics
2) The Players
3) Speculation and Manipulation
4) How to be Eddie Murphy from "Trading Places"

For a PDF version of this newsletter, please look here:

Dear Friends, Colleagues, and Investors,

In this edition of "Risk over Reward" I'll provide a primer on how commodity markets function and delve into the effects of speculation and manipulation.

1) The Basics
Commodities are fungible, physical products like gold, crude oil, sugar, and soybeans. Commodities can be traded in a few different forms. One common contract is the deliverable future. A deliverable future trades on an exchange with a specific expiration date. Let's say I buy 1 crude oil future for $80 with an expiration date of January 23rd 2011. On that date I will be obligated to take physical delivery of crude oil at a specific location at a price of $80. The contract specifies the quality of the product I will receive and the logistics of accepting the product. A deliverable future may change hands thousands of times on an exchange before expiration; most of the traders having no intention of dealing with the physical commodity.

Non-deliverable futures (also known as "cash settled futures") are similar, except that no product is ever delivered. Instead, the contract expires at a specific date and the holder receives the difference between the contract price and the price of the product. For example, if I paid $80 for the crude oil contract, and oil is now trading at $85, I will receive $5 from the seller of the contract. Another common type of commodity contract is the "forward." Forwards differ from futures in that they do not trade on an exchange. Instead, they are between two parties. This allows the contract to be more customizable but exposes both buyer and seller to counterparty risk.

For any given commodity, there are a series of futures with various expiration dates. For example, crude oil futures exist for every month from now through at least 2018. The contracts with nearer expiration tend to trade much more frequently. All of these futures taken together are called "the curve", because they tend to form a relatively smooth shape. Some commodities typically form an upward sloping curve known as contango. For example, a gold future with a later expiration date will almost always cost more than a nearer date. This is because the future with later expiration includes the price of storing and insuring the gold, as well as the cost of capital. If it costs me $1 a year to store an ounce of gold and another $1 to insure it, I would rather own the right to buy gold in a year for $1000 than buy it today for $999.50. Below is a graph of the gold curve.
Gold Curve

Some commodities frequently form a downward sloping curve known as backwardation. This generally occurs in commodities that are costly or difficult to store for lengthy periods. It can be caused by a short-term lack of supply, but may persist if producers hedge more than consumers. I'll discuss this at greater length in the next section. Below is a graph of the crude oil curve in 2007.

Crude Contango in 2007
2) The Players
Natural Sellers - The natural seller of a commodity is the producer. For example, a coffee grower must sell his coffee. He could eschew the commodity market and wait to sell his coffee until it is harvested, but that would be risky. In this scenario, he will invest in equipment and fertilize without knowing what price he will eventually receive for his product. Instead, he can enter into a contract to deliver his coffee in 3 years at a specified price. He will know today exactly what price he will receive in 3 years, so he can make smarter business decisions about how much to invest in production. He can also reduce his earnings volatility from seasonal weather fluctuations. The downside is that the farmer will not benefit from an unexpected increase in the price of coffee.

Natural Buyers - The natural buyer of a commodity is the consumer. For example, Starbucks is a massive consumer of raw coffee. Over time they can pass some price increases on to their customers, but their profit margins are still hurt by sudden increases in the price of coffee beans. To reduce their risk, they buy coffee in the forward market.

In some commodities, the natural sellers are more active than the natural buyers. This causes the commodity curve to slope downward in a condition known as normal backwardation. The future price of the commodity keeps falling until market makers or speculators believe they have a high enough expectation of profit to buy the futures.

Market Makers - The market maker effectively serves as a middleman between the natural buyers and sellers. The coffee farmer may wish to enter a contract to sell his harvest in May, while Starbucks may wish to enter a contract to buy coffee in July. The market maker will take the other side of each trade and bear the risk that the price of coffee moves significantly between May and July. Another service the market maker provides is in preventing temporary supply and demand imbalances. For example, let's say the farmer wishes to sell his coffee today and Starbucks will be buying tomorrow. The market maker will buy from the farmer today and sell to Starbucks tomorrow. In exchange for the risk and the time it takes to facilitate these exchanges, the market maker can expect to earn a profit by slightly underpaying the farmer and overcharging Starbucks.

Speculators - Traders at hedge funds, large banks, and commodity companies speculate on future price moves. These speculators generally have no interest in the physical commodity itself, they are simply betting on what the natural buyers and sellers will do. For example, a speculator may sell coffee futures as a bet that the weather will be conducive to a healthy coffee crop. If the weather is good, farmers will produce more coffee and have more to sell, so the price will drop. The speculator will be able to buy back his futures later at a lower price and earn a profit.

3) Speculation and Manipulation
Speculation in commodities takes many forms. The price of commodities is ultimately driven by supply and demand, so any factor that influences supply or demand is a potential source for speculation. In the previous section, I mentioned that speculators bet on how weather will impact the supply of an agricultural crop. Another common weather bet is to speculate on the extent to which hurricane activity in the gulf of mexico will decrease crude oil production.
Speculators also make longer term bets on both demand and supply. For example, a speculator may believe that global GDP growth will surpass expectations leading to higher than expected demand for commodities. Another speculator may wager that aggressive investment in production will increase supply and depress prices.

These speculators serve a valuable function of researching commodity fundamentals and sending price signals to the market. For example, crude oil supply and demand may be balanced at a price of $80 today. However, speculators may believe that in 5 years, demand will far surpass supply causing a severe shortage. The shortage may send prices flying up to $300 and reduce global GDP. The speculators bid up crude prices to $120. The price increases is noticed by oil executives, who respond by investing in new production. In 5 years, this increase in production could result in a crude price of $150 and mitigate the damage to global growth.
Commodities are generally believed to be an inflation hedge. Theoretically, they should rise at the same rate as inflation and produce a 0% real return. However, since many investors become attracted to commodities when they fear inflation, commodities tend to surge as inflation rises. A speculator may buy commodities on the expectation that inflation fears will soon cause other market participants to buy commodities. In the last year, gold surged 30% as investors desired a hedge against the effects of the US Federal Reserve tripling the money supply.

Other speculators try to profit directly from the trades of others. For example, a speculator may notice a pattern that at the end of every month, a corn farmer sells futures, resulting in a temporary decrease in the price of corn. The speculator will sell futures an hour before he expects the corn farmer to sell. An hour later, the corn farmer will still sell futures, be he will receive a lower price. The speculator will buy back his futures for a profit. The speculator's profit comes directly at the cost of the farmer.

In general, studies suggest that speculation reduce the volatility of commodities by reducing temporary supply and demand imbalances. However, a growing number of speculators are "momentum traders" who increase volatility.

Commodity speculation is generally short-term and performed by specialists. However, in 2007 and 2008, a large amount of new money began chasing commodities. Fund Managers and Mom and Pop retail traders looked at charts of commodities over the previous 5 years and decided they wanted to participate in the commodity rally. They bought commodity ETFs, which in turn bought commodity futures. This price insensitive buying pushed all commodity prices higher and caused a bubble. Crude oil was pushed up from a fair value of around $75 to $145. Like all bubbles, the commodity bubble soon burst and sent crude oil below $40.

Commodity markets are much less regulated than stock markets. There is no clear definition of "insider trading" and very few traders have ever been prosecuted for manipulation. "Manipulation" of some kind is a daily occurrence in the commodity markets. A minor example is of a trader pushing the market price of a commodity a few pennies to trigger stop market orders. A much more serious form of manipulation is cornering a market. In 1979, the Hunt brothers bought up 1/3 of all the world's silver, mostly on credit. By controlling such a large percentage of supply, they were able to control the market price of silver and drive it artificially higher. In 1980, the COMEX created a new rule that limited the purchase of commodities on credit, and effectively forced the Hunt brothers to sell a portion of their silver. This triggered a 50% price collapse over four days.

A common form of manipulation is forcing out the "weak hand." A trader puts on a position against a known counterparty. The trader estimates that if he pushes the position far enough against his counterparty, the counterparty will give up and close the position, pushing the bet further in favor of the trader. For example, let's say you bet that corn prices in 2013 will rise and I bet they will fall. If you control several billion dollars and I only control a hundred million, you can keep bidding up corn prices far longer than I can sell them. Eventually my loss will be so great that I will be forced to buy back my futures and drive prices up even higher. Whether you are right or wrong about corn prices in 2013 is irrelevant - you will earn a profit by forcing me out of my position.

4) How to be Eddie Murphy from Trading Places
In the movie "Trading Places", Randolph and Mortimer Duke try to corner the market for orange juice concentrate. They bribe a government official to get an early look at a critical crop report. Billie Valentine (played by Eddie Murphy) and Louis Winthorpe (Dan Akroyd) foil their plans by stealing the crop report and passing on a fake report to the Duke brothers. Even in the lightly regulated commodity markets, stealing a government crop report and using it to manipulate prices is illegal. So, unfortunately we won't be getting rich following Eddie's lead any time soon.

The closest we can come is trying to identify situations where a speculator is overexposed. The Duke brothers committed their fortunes to a leveraged position; when the futures began moving against them, they were forced to sell and this dramatically increased the volatility, and potential profit for a savvy trader. When Brian Hunter of Amaranth made an oversized bet on Natural Gas futures, another trader was ready to sweep in for the kill. John Arnold of Centaurus let Hunter push the market far from equilibrium and then swept in to take the opposite position. Arnold profited from Hunter's bust.

Your speculating trader,

Monday, November 8, 2010

Startup Reading List - The Best of It - Alpha

After reading dozens of books on startups, here is what I recommend. The books below are a great introduction into business thinking, experimentation, and how to invest (not just money, but time and other resources too).

– these books all have good information and complement each other – I recommend buying all four. You will read them many times.

ART OF THE START (Kawasaki): (basics for a tech startup – Kawasaki focuses too much on pitching to angels/VCs/funders as opposed to bootstrapping)

START SMALL FINISH BIG (DeLuca): (basics for all new business creation, from the Subway founder DeLuca – lots of great bootstrapping tips – how to get from small to very large)

DO MORE FASTER (TechStars): (more detailed basics for tech startups, from the venture incubator TechStars in CO/NY – most important tips are on how to create a good initial team and how to iterate quickly from bad ideas to products that sell soon – I think a committed team of people who trust and complement each other matters more than an initial idea for most startups)

REWORK (Fried): (conceptual basics from the 37 Signals founders on how to build a solid business and conceptualize a product – many new ventures face these issues)

“HOW TO MAKE WEALTH” (Graham): (the single best essay on startups and one of the best things ever written about business and wealth). Graham has written a few other excellent essays on startups:


ADVANCED READING – explore here as you need more specific information or some great inspiration – you can borrow these or consult them at libraries (I own them).

ENTREPRENEUR’S GUIDE TO BUSINESS LAW (Bagley): (basic info/guide to all the legal issues – you’ll never need anything else)

FOUR STEPS TO THE EPIPHANY – CUSTOMER DEVELOPMENT (Blank): (a great process/way to talk to customers and develop a product that they want iteratively – geared toward tech)

MADE IN AMERICA (Walton): (how Sam Walton built Walmart from one store to the largest US company by sales)

BEHIND THE CLOUD (Benioff): (how Marc Benioff, a serial entrepreneur, built Salesforce, with great tips on doing a tech startup)

DELIVERING HAPPINESS (Hsieh): (how Tony Hsieh, a serial entrepreneur, built his tech companies, and his vision of a company not just selling things but actually improving people’s lives, making them happier)

COPY THIS (Orfalea): (how Paul Orfalea built Kinkos from one store after graduating from college – lots of great stories and personal growth advice)

“THE GOLDEN GUT” (Kirkland on Adelson): (how Sheldon Adelson, a serial entrepreneur, built multiple businesses and sold them, getting bigger every time and taking smart risks and experimenting)

The Recent US Mid-term Elections Analyzed - Alpha

The mid-term elections were a big deal for two reasons. First, it’s the first time since the 1940s that the voters removed the party in control of the House for three consecutive elections (the GOP lost both houses in 2006 and the Presidency in 2008, only to win the House back in 2010). Second, it was the largest change in House seats since 1948. The GOP’s strategy of gridlock and non-cooperation worked.

The election results fell in line with consensus expectations. Basically, with unemployment stuck at 9.6%, voters kicked the Dems out of the House early due to the lack of JOBS.

The irony was that while the House was passing many bills, the Senate is where the bills went to die, thanks to the self-imposed filibuster, 60-vote Senate rule used by the GOP mostly (and some wavering Dems). However, voters left control of the Senate to the Dems, with 53 Senators and so a 3 vote margin.

While NBER dated the recession’s end to mid-2009, the flatlining jobs situation (and so stagnating income and skills) has made voters furious.

Jobs are a big deal. A landmark study in the Economic Journal followed 130,000 people for a few decades, allowing researchers to look at major life events, like marriages, divorces, births, deaths, and so on. It found that unemployment for over one year might be the only major life event from which people (esp. men) do not recover within five years. People were more likely to recover from the death of a spouse than from prolonged unemployment. See Clark, A.E. et al. Lags and leads in life satisfaction: A test of the baseline hypothesis. Economic Journal, 118(529), 2008, F222-F243.

By that measure, the US has a crisis on its hands. Politicians may say “Jobs!” while not actually doing anything, such as providing leadership, enacting pro-stimulus or pro-business policies, or reducing political risk and uncertainty for businesses to expand and hire.

Sunday, October 10, 2010

How to Invest Your Savings - Alpha

These are some thoughts for an ordinary person who doesn’t follow markets or business much, but needs to invest his or her savings.

First of all, congrats. The most important financial decision is to pay down expensive debts (credit card debt, especially) and to live within your means. To save. If you’ve done that you should pat yourself on the back. I would suggest you try to save 50% of your after-tax income.

Now to markets and investing.

Generally, for periods longer than 15 years, stocks have higher returns than bonds. However stocks can go down a lot in a single year (a 40% drop or more), whereas bonds usually go up every year (3-5% gains). So you need nerves of steel to buy stocks and hold them (they can also go up over 30% in any given year). Also, stocks follow the business cycle. Every 5, 7, or 10 years (the number isn’t exact), business goes through a cycle when times are good and fat, and then a peak is reached and times become bad and lean. Ideally you would own more stocks at the beginning of the cycle and more bonds at the end. Buy low, sell high. Easier said than done.

So, how to invest?

1) Hold diversified index funds, not individual stocks.
Index funds are meant to match broad markets like the S&P 500 Index (largest US stocks), Barclays US Aggregate Bond Index (broad US bonds), or MSCI AC World Index (largest global stocks) at low cost. Index funds generally beat most mutual funds. Vanguard and Fidelity provide good, low-cost index funds. Generally the biggest index funds are the best (size gives liquidity and pricing discounts – it’s like buying bulk at Costco).

2) Divide your holdings between bonds and stocks.
The percentage of your holdings to bonds should equal your age. So if you are 30 years old, invest 30% in bonds and the rest (70%) in stocks. I would hold about half in a domestic fund and half in an international fund. This is called “asset allocation.” Here are diversified Vanguard funds (International stock fund and a diversified bond fund - note that most of the Fidelity index funds are just as good):

3) Re-balance your holdings every 2 years or so to match your age.
Check your statements every 6 months.

You’re done. That was simple.

So what could make this more complicated? Two things.

First, there’s the business cycle.
If you have a perceptive eye for the world and go to many cocktail parties, you’ll notice that at the top of a business cycle many people will tell you about the killing they’re making in stocks. They’ll brag and then show you something fancy they bought (car, house, boat, trophy wife, other toy, etc.). When you see this happening a lot, sell all your stocks and hold just bonds for a while. When people reach the other extreme (a disgust of stocks due to large market drops and their new toy being taken away due to a foreclosure), go back to your regular allocation, or put more in stocks. The whole process is called “market timing” and experts often discourage it. I call it “going against the herd” and encourage it. At the very least, don’t run with the herd.

Second, there’s inflation. In today’s world, the bank and money system is controlled by central banks, namely the Fed in the US. Every few decades the central bank comes under enormous pressure to create inflation. In the US, the 1970s was one time. I suspect 2011-2019 will be another because of all the deficits and debts that people don’t want to deal with. Inflation is generally bad for all bonds and most stocks. Older people who hold more in bonds are hurt the most. The best things to hold when you expect inflation are energy/metal/commodity stocks and real estate. Vanguard and Fidelity have index funds for these. Generally I think it’s better to hold and manage local real estate, bought at foreclosure sales or from banks. But that takes some gumption, skill, and effort. So most people should stick to index funds. Here are three funds to consider (precious metals, energy, and REITs):

SUMMARY - Some guidelines for investing:
-Buy 3-5 index funds (no more) from Vanguard or Fidelity (they have the lowest fees - no one else can match them).
-Rule of thumb is that the portion of your portfolio in bonds should equal your age.
-Suggested 3 index fund portfolio: 30% intl or US bonds, 40% intl stocks, 30% US stocks.
-Rebalance annually - sell stocks when you feel a bubble is coming (when people talk too much about stocks at cocktail parties). Wait till the crash and recession to go back into stocks.
-Over very long periods of time (20 years), stocks will always beat bonds and cash. For shorter periods, 1-5 years, it's a toss-up between stocks, bonds, and commodity funds - depends on many factors (GDP growth, inflation, corporate profits, TFP, etc.).

Suggested Further Reading for Beginners
Personal Finance:
Personal Finance for Dummies:
Millionaire Next Door:

The Intelligent Investor:
Essays of Warren Buffett:
Peter Lynch on Investing:
Anything in the "Little Book" Series

Reading Financial Statements (Required if you buy individual stocks instead of index funds)
Bernstein on Financial Statements:
s=books&ie=UTF8&qid=1341789924&sr=1-12&keywords=interpreting+financial+statements Buffett on Financial Statements:
s=books&ie=UTF8&qid=1341789924&sr=1-2&keywords=interpreting+financial+statements More on Financial Statements (Intermediate):

(NOTE: I have no tie or connection to Vanguard or Fidelity, and I get no compensation from them. I've found that these two are generally well-run financial firms that mostly try to do the right thing - this is something quite rare in the world of finance and unlike the rest of Wall Street, which is simply greedy and amoral.)

Sunday, September 19, 2010

Causes of the US Economic & Financial Crisis in 2008 - Alpha

by Alpha and Vega, an Investor and a Trader
September 19th, 2010

In this issue:
1) A difficult question
2) Long-term structural economic problems
3) Short term catalysts for the financial crash
4) Bluto’s revenge in the movie “Animal House”

In this letter we answer the question: “What caused the US economic and financial crisis in 2008?” We look at long-term structural causes and short-term catalysts. This is a longer piece than most, and we try to present many arguments, data points, and references for further reading.

1) A difficult question

What caused the US economic and financial crisis in 2008?

Whatever it was, it was enough to cause former Fed Chairman Alan Greenspan, a free-market disciple of Ayn Rand, to sit in front of a Congressional panel and admit, while squirming in front of lights and TV cameras: “This crisis has turned out to be much broader than anything I could have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount. . . I don’t know how significant or permanent [the flaw in my ideology] is. But I’ve been very distressed by that fact.” Greenspan was one of the few intellectually honest people in admitting his own ignorance and error.

Greenspan Admits Mistakes in 2008 (Testifying to Congress in 2008)

No one has given a cogent, comprehensive answer that is brief and non-technical. Economists have responded like ducks by sticking their head in the water and blaming one another, with debates between “saltwater” and “freshwater” economists. Historians point to disparate episodes and facts like the Great Depression and Asian Crisis of 1998 (while ignoring the US depression of 1870-1890 and the Japanese balance sheet recession of 1990-2008). Financial experts point to short-term catalysts and trends, like MBS or CDO issuance and the failure of ABCP or money markets (acronyms are one tool Wall Street uses to screw people); but these experts ignore the big picture.

This letter will attempt an explanation for what caused the 2008 crisis in the US while acknowledging its global context. I shall also link the insight that numerous thinkers and writers have brought to the issue and try to frame a robust answer. For further reading beyond the books and articles in this letter’s references, the St. Louis Fed has a nice repository of academic articles about the US financial crisis (and a first-rate glossary).

Two types of problems created the crisis. First were deeper, long-term structural problems, such as:

a) Too much total debt accumulation per person and per unit of GDP from1980-2007
b) Looming structural deficits from Medicare and Social Security (off-balance sheet debt) make the US even more insolvent
c) Consistent trade deficits powered by the US’s reserve currency status, an undervalued Chinese yuan, and the resulting decline of the US export and manufacturing bases:
d) A financial industry acting as a giant tax on the US: Too much deregulation of financial markets, leading to spurious innovation that enriches the financial sector at the expense of consumers (corporate and retail)
e) A massively inefficient tax code, with too many complex rules and hidden “tax expenditure” subsidies to wasteful interest groups
f) Resources wasted on two wars (2002-2008) and US military protection for the rest of the world

Most politicians, economists, and the news media personalities have tried to conceal the structural economic problems of the US rather than honestly deal with them. Within the structural environment of economic degradation, there came second a group of short-term catalysts. When these combined, they were toxic and led to a period of financial fragility from 2007 on and a tipping point in September 2008:

a) Low interest rates and weak mortgage regulation: this enables speculation leading to the mortgage boom and real estate bubble
b) Bad bank balance sheets due to excessive risk-taking and agency costs: Weakening regulation of large banks causes re-consolidation and dangerous investment bank debt levels
c) Black-box derivatives: The development of a complicated and unstable, even destabilizing, derivatives market
d) The trader mentality in the US: The short-term price appreciation and momentum mentality of professional investors versus long-term yield oriented mentality (average holding period for stocks has fallen from 8-10 years (pre-1960 average) to 4 years (pre-1980 average) to about six months in 2007. Very few investors left (some VCs and corporate investors).
e) Extreme financial fragility through 2007 into 2008:
-Early signs: Bear Stearns hedge funds blowing up and the implosion of the shadow banking system (an old fashioned bank run)
-Inflection Point: From Bear Stearns going bankrupt in March 2008 to the failure of insolvent Fannie/Freddie in early September 2008 – largest financial institutions in the US (maybe the world) based not on their actual balance sheet, but their guarantee liability for mortgages (above $5 trillion combined)
-Phase Shift: Failure of insolvent Lehman Brothers and illiquid AIG causes phase shift in markets in late September 2008

To read the full letter, please see the pdf on Scribd here:
Causes of the 2008 US Economic and Financial Crisis (Sept. 2010)

Thursday, September 16, 2010

Common Stock Analysis of Collective Brands (PSS) (Formerly Payless Shoe Stores) - Alpha

Collective Brands (PSS - $12.50 on Sept. 2, 2010) was a Topeka Kansas company founded in 1956 with a strategy of selling low-cost, high-quality family footwear on a self-service basis. It was bought by May Department Stores in 1979, went public again in 1996, and in 2007 bought Stride Rite (a Mass. Shoe company started as Green Shoe in 1919). PSS is one of the largest shoe retailers in North and South America, with 4,500 stores selling 140 million pairs of shoes and 40 million accessories in 2009. Its wholesale division is PLG, selling shoes to a range of stores in North America. Here’s how the company defines its strategy in its 10-K:

“We seek to compete effectively by getting to market with differentiated, trend-right merchandise before mass-market discounters and at the same time as department and specialty retailers but at a more compelling value. North American stores are company-owned, stores in the Central and South American regions are operated as joint-ventures, and Middle East stores are franchised. Stores operate in a variety of real estate formats. Approximately a quarter of the company-owned stores are mall-based while the rest are located in strip centers, central business districts, and other real estate formats. We also operate® where customers buy our products on-line and store associates order products for customers that are not sold in all of our stores. At year-end, each Payless ShoeSource store stocked on average approximately 6,700 pairs of footwear. We focus our marketing efforts primarily on expressive moms and expressive self-purchasing women ages 16-49. These consumers use fashion as a means of expressing their personalities, but also place importance on low prices. They tend to have household incomes of less than $75,000 and make a disproportionately large share of household footwear purchasing decisions. We believe that over one-third of these target consumers purchased at least one pair of footwear from our stores last year.”

Here are the financials:



Key Stats:

-Cash-flow generating healthy retail company, selling the staple of shoes - trades at cheap levels and is paying off debt. Fair Value range of shares between $32 to $40.

-Health of the core business: Seems positive but needs further investigation by talking to store managers (esp. in intl. locations). Most of the PPE seem to be in store fixtures, not the actual real estate which they tend to lease (financials are not fully clear about this). So the real value of the PPE is prob. less than the book value. All their inventory is made abroad (China, Vietnam, etc.). SG&A has held consistently around 29%-30% since 2006 – not worried about that (recent gross margins at 35% are at the high end though – not sure if this is cyclical or a positive trend). Turnover slowed because their assets went up (growth of book value) but sales basically stayed flat or slightly decreased (peak was $3440mn in 2009 and the TTM is $3320mn).

-Negative same store sales growth has slowed: This has flattened as of Q1 2010, going from -5% in Q1 2009 (the worst) to -1% (total net sales were up 2%, as US sales fell by 4% but international sales were up by 18%). COGS were down and margins up. The biggest question is PSS’s relative competitive position compared to discounters like Walmart, Target, etc. (do people go to a special shoe store for cheap shoes, or are they happy buying them on a discount store trip?). This isn’t a shoe business (like Nike or Asics), but a shoe retail store business.

-Earnings don’t matter much, cash does: The numbers are volatile. The margins and earnings are about par with the comps, but this business is selling much more cheaply. After hitting a low in May 2009, cash balances are coming back up. More importantly, OCF and FCF are holding up quite well. Total current assets at $1050 is about equal to total liabilities and LT debt at $1150. The company has been paying off debt steadily.

-The business is cheap: Then you have the net book value of PPE at $450mn, along with an OCF of $310mn and FCF of $210m. This is for a current equity market cap of $914mn (as of Sept. 10, 2010).

So basically, for $914-450= $464mn in equity invested, you’re getting $210mn of FCF a year. A pretty decent return of 45%. Even at the full $914mn, you’re getting 23%.

-Current CEO is a Cole Hahn and JCrew vet – he knows branding.

- Recent big strategic investor is Blum Capital in SF, whose MO is to take a large stake for 3-5 years and then work on building value over that period.

- Sales uncertainty: The biggest question is whether intl. sales growth can keep strong and domestic sales decline can be stemmed. The retail shoe business isn’t going anywhere, though, and Payless/StrideRite own the bottom end of the market (strategy is to focus on “expressive women”, i.e. moms and young women who want cheap but fashionable shoes for themselves and their kids). People still have to buy cheap shoes in a recession (millions of working class people go to PSS’s stores). Still some uncertainty about this large topline risk.

-Some valuation risk, maybe not enough of an asymmetric bet: Tangible book value is close to 0 (does BV matter anymore?), they've been experiencing negative same store sales growth over the last 3 years, margins stink (and have stunk for the last 4 years). So, all you're getting is current earnings. This quarter earnings are $0.83 per share, and last year they were $0.59 so let's go with the more conservative number. Simply annualizing that and applying a PE of 6 (treating this as a utility with no growth prospects), we get a fair stock price in the area of $14.16. If they get a couple of good quarters and people get optimistic, I could easily see investors applying a PE of 12 with earnings of $.90 which would produce a stock price of $43.20. So, potentially plenty of upside, but the true economics are not attractive. I wouldn't consider this a value investment unless I could it buy it for <$9. On the positive side, customers are very spread out, and average price increases in a year were 4-6% (pretty strong), as same store sales fell 2-3%.

- Company's cost structure is bad: It has high fixed costs and low margins. It may take little to send them on to a road of bankruptcy, despite a strong cash position (a risk for all companies with such debt levels, though PSS is paying off its debt fairly quickly and the maturity wall doesn’t seem to be a problem).

-We anticipate a high change (60-70%) of a general US stock market sell-off, making the business even cheaper (a 40% FCF return on market value would be perfect).

Tuesday, September 14, 2010

Negative Yields, Inflation, and the Bernanke put - Ari Paul

We’ve had mixed economic data for the last couple months, early hints of inflation, severely negative real yields, and a promise from Ben Bernanke to do whatever it takes to keep the US growing.

Mea Culpa and an Agro Bull

My call for an immediate stock market downturn was wrong. The stock market has rallied moderately on the pledge by Bernanke to support the economy and mixed economic data (more on this later). Fortunately, my bullishness in agriculture has offset my mistake in equities. The one commodity I’ve consistently held (and recommended that you hold) is sugar, which is up 40% since July. I still like the agricultural commodities as long-term fundamental bets and as medium-term inflation hedges. I’m not an agricultural specialist though and I have no idea how much gas sugar may have left in the tank. Any asset that rockets up 40% in a short period is at risk of a significant pullback, so it’d be safer to wait for weakness to buy.

Data Revisions:

Last quarter’s (annualized) GDP number was revised down from 2.6% to 1.6%. This huge change helps explain disagreements between bulls and bears. Six months ago the bulls were pointing at a string of seemingly bullish economic data to support their case for a V-shaped recovery. Bears like me had to question the validity of the data (most of which has since been revised lower) and point out that all the “growth” is just a result of deficit spending and fed monetization. The moral of the story is you can’t trust current economic releases.

Unlimited Support and First Hints of Inflation:

In response to a string of weak economic data in July and early August, Bernanke announced a new round of quantitative easing. He said he will do whatever it takes to keep the economy growing. “Whatever it takes” could include purchasing more treasuries, corporate bonds, or possibly even stocks. There is no limit to how much money Bernanke can print, but excessive printing will eventually lead to severe inflation. We have begun seeing the first signs of moderate inflation. Prices are rising at a pace of about 2% a year. This is not meaningful in itself, but has significant policy implications. When the country was experiencing deflation, Bernanke could print money with impunity. Now that we have low inflation, more printing could quickly lead to high inflation. To be clear, without a significant negative shock to the economy, significant inflation is a high likelihood within the next year or two. A negative shock like a debt crisis or severe double dip recession would likely postpone the inflationary pressure for at least a few more years.

Negative Yields:

The Federal Reserve has been buying treasury securities, which forces yields lower. 2 year treasury notes currently yield a little over 0.5%. Compared to the 2% inflation rate, this means that holding a 2-year treasury is equivalent is having 1.5% of your cash confiscated every year. This encourages even prudent investors to seek higher yielding securities even if that means higher risk. In other words, the negative 1.5% yield is a tremendous incentive to gamble, since the alternative is a sure loss of purchasing power. If you’re told that 2% of any money you hold in a bank or in short-term treasury securities will be confiscated each year, you’re very likely to “discover” attractive high yielding investments somewhere. I put “discover” in quotes, because if you look hard enough, you can always find an excuse to buy an asset as a gamble and call it an investment.

Double Dip or Not?

Economic data for July and early August was generally bad but the data of the last few weeks have been positive. Specifically, manufacturing and housing data were significantly better than expected. The current evidence suggests that we are not yet experiencing a double dip recession, but maybe a “new normal.” “New normal” is a term popularized by Bill Gross at Pimco, the world’s largest bond fund. Gross argues that the next 5-10 years will be characterized by very weak GDP growth and sustained high unemployment. He is predicting a weak recovery. The stock market is currently pricing in something slightly more optimistic, but not far off.


The world is engaging in an unprecedented experiment in economics. Is it possible to print our way out of a credit collapse? No country has ever succeeded before, but every situation is unique. I remain convinced that the government will be unable to “thread the needle” and we’ll either get a deflationary collapse or severe stagflation, with the former being more likely. To position myself to profit in either scenario, I remain short US equities and long specific commodities as an inflation hedge. I remain a gold agnostic, but with inflation beginning to rear its ugly head, I have taken on a tiny long gold position as a hedge to my short equity position.

Wednesday, August 11, 2010

Out of Bullets - Ari Paul

The economic data of the past week strongly suggest we’re entering a double dip. Payrolls, inventories, and economic optimism are all terrible. Yesterday, all eyes were on the Federal Reserve. They met market expectations by extending quantitative easing. They acknowledged that the economy is not rebounding the way they anticipated, so they will be reinvesting the proceeds from their mortgage purchases into treasuries. The $2 trillion dollars they threw into the economy will not gradually fade out of existence. That extra money will be shifted from mortgage backed securities into treasury securities to keep interest rates very low. Many analysts estimate the Fed will not raise interest rates for 2-3 years. Just a few months ago, many were predicting a rate hike within 6-12 months.

The market sold off today because investors recognize that this was the last bullet. Long-term interest rates are already incredibly low, and it’s just not enough. 2-year interest rates are at 0.5% and 10-year interest rates are at 2.7%. Our situation is very reminiscent of Japan in the 90s when central bank policy ceased having predictable impact. When interest rates on mortgages and long-term investment grade debt are already incredibly low, the Fed is “pushing on a string.”

While the fed is out of bullets, they do have a remaining nuclear option. They could directly purchase stocks. The Fed has never done this before, but Bernanke has openly discussed the possibility. The Fed is extremely reluctant to do this because it sets a terrible precedent and would create all sorts of nasty market dislocations. I also believe there isn’t the political will for this. Just a few weeks ago Bernanke was brought before Congress and attacked for spending too much taxpayer money on bailouts.

In trader lingo, the “Bernanke Put” may have expired but Bernanke can still declare “limit down” on the stock market. Although, I wouldn’t count on it.

Tuesday, July 20, 2010

How to Read Financial Statements – Evaluating Value Drivers and Searching in Footnotes (Part 3) - Alpha

by Alpha and Vega, an Investor and a Trader
July 20th, 2010

1) Finding the Value Drivers that Make a Business
2) The Credit Card Industry – American Express and Capital One
3) The Airline Industry – Southwest and JetBlue
4) The Cable and Satellite TV Industry – Comcast and DirectTV
5) Footnotes are like Snowflakes: No Two are the Same
Appendix: Ben Graham’s Satire on Accounting, or How to Abuse a Footnote (only in pdf version)

The first letter in the “How to Read Financial Statements” series went over basics on finding them and how to approach them. The second letter got into the guts of a 10-K, into the first level of analysis. This third letter shows how to finesse the footnotes and creatively assess the value drivers behind a business.

One final note: We publish information on the website and over Twitter that we do not include in the newsletter. If you want to follow those, visit the website, set up an RSS feed, and follow us on Twitter.

You may view this week's newsletter in PDF format here (the PDF has useful graphics and tables that this html post does not have):

1) Finding the Value Drivers that Make a Business
The million-dollar skill in reading financial statements is simplifying complexity. I’ve seen valuation analyses that fit on 25 Excel tabs, more than a hundred printed pages (murder by model). Other analyses could fit on one double-sided page. Shorter is harder and often better. KISS – Keep it simple, stupid. That is, an analyst must know how to read and understand dozens of tables of numbers, such as revenues, costs, margins, earnings, cash flows, assets, debt maturity walls, etc., to find the value drivers of a business. She must condense.

A value driver is a fundamental, causative business variable that effects accounting data (revenues, margins, earnings, cash flows, etc.). Accounting data are then used to calculate ratios to show the strength of a business and the intrinsic value (or estimated value range) of its securities. Value drivers make up the economic ghost inside the financial machine. They are the economic forces that drive financial outputs and metrics. Value drivers tend to be specific to industries or sub-industries, sometimes even specific to an individual business. Good management teams focus on value drivers; the bad teams don’t even know what they are.

Here are some examples of value drivers in different industries:
• Retail banking: At its core, retail depository banks make their profits/earnings from borrowing cheaply and lending at a higher rate. The core value driver is the “net interest margin” (NIM), a measure of the difference between a bank’s interest income and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets. NIM is usually expressed as a percentage of what the financial institution earns on loans in a time period and other assets minus the interest paid on borrowed funds divided by the average amount of the assets on which it earned income in that time period (the average earning assets). NIM takes both rates and dollar amounts into account, whereas the “net interest spread” just looks at the rate differential or “spread.”
• Apparel Clothing: Niche business like Polo Ralph Lauren Corp. (RL) may have many products and lines of business (basic, middle-market, premium, etc.). However, the vast majority of earnings are generated by a handful of product staples, and for RL the basic items are polo and cotton shirts, khaki pants, sweaters, and so on. While RL has many outlets, by far the most profitable are its wholesale and internet outlets. Hence a business with hundreds of products and many outlets can be simplified into: How many units of staple goods are being sold, and in what channel? Also, are the total costs of marketing worth it, and are the dud goods not eating up all the profits?
• Property-Casualty (P-C) Insurance: The basic model for insurance is to take in premiums (up front protection payments) and pay out expenses (claims for losses plus operating expenses). An insurer’s “combined ratio” is basically claims plus operating expenses divided by net premiums (this can be broken into a loss ratio and an expense ratio). However, the net premiums that insurers collect, the “float”, can be profitably invested while the company holds it. So if an insurer has positive investment returns greater than the loss from the combined ratio, it can still be profitable. To wit, an insurance company can be poor at underwriting and make up losses through good investing. A low combined ratio along with high investment returns (good use of float) is what makes a great insurer. Warren Buffett explains float well in his 2005 Chairman’s Letter in the Berkshire Hathaway annual report:

“Float” is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled.

Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an insurer earns an underwriting profit – as has been the case at Berkshire in about half of the 39 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money. For most insurers, however, life has been far more difficult: In aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so.

Other insurance industry value drivers are: renewal rates for policy holders; the costs to acquire a new policy; and the composition/attribution of investment returns.

The second most valuable skill in reading financial statement footnotes is being able to verify/validate/examine basic accounting figures, and to catch fraud and shenanigans. This is detective work.

Some examples of why footnotes are important:
• All revenues are not equal. Some revenues are generated through cash payments, others through IOU slips call receivables which may never be paid. Footnotes discuss revenue recognition policies. Also, a company may get most of its revenues from 2-3 buyers, and this is a dangerous and unhealthy relationship (I know because one of my early, bad investments, in 2000, was in a company which derived 80% of its revenues from 4 customers, who then faced their own difficulties and stopped buying – there’s no learning that sticks better than losing money).
• Earnings may be manipulated. A company may report high earnings but a negative operating cash flow, suggesting earnings are being gamed. Enron (formerly ENE) did that for a few years, and then came up with a complicated scheme to create fake operating cash flows. Footnotes explain why reported positive earnings differ from reported negative cash flows.
• A healthy company could go bankrupt due to debt. The debt maturity wall of a healthy, levered business may signal an impending default, severely hurting unsuspecting equity holders (a healthy business may be poorly financed). In the 2008-2009 credit crunch, General Growth Properties (GGP) was a healthy mall company that had a bad financial structure, leading it into technical default. Footnotes explain the cost and timeframe for maturing debt.

This letter will look at pairs of companies in three industries: credit cards, airlines, and cable/satellite TV to further delve into the importance of value drivers and footnotes. The point isn’t to illuminate any industry in particular, but more generally to suggest how one should think about a company’s value drivers and footnotes within the context of its industry.

2) The Credit Card Industry – American Express and Capital One
American Express (AXP) and Capital One Financial Corp. (COF) are two of the largest stand-alone credit card companies in the US (if not the world). Their market caps as of early June 2010 are $46 billion and $17 billion, respectively. Credit card companies make money by borrowing money from capital markets to: i) make loans to cardholders at higher rates, and ii) hold an investment portfolio earning high returns.

The value drivers behind a stand-alone credit card business such as AMX aren’t horribly complicated:
• Spread Revenues: The company lends to cardholders and then charges them a high interest rate (in the 10% to 30% range) and also fees galore. Multiplying the spread by the size of the loan book generates most revenues. In the footnotes to AMX’s 2010 10-K on p. 51, it had interest-bearing liabilities of $79 billion, at an average rate cost of 2.8%. Roughly $24 billion was invested in investment securities (mostly state and muni debt, agencies, and USTs), yielding 4.3% on average (p. 53). Roughly $33 billion was loaned to cardholders, earning 11-17% (p. 49).
• Write-off Costs: The biggest loss is through written-off loans (and the probability that nonperforming loans will have to be written off). The operating expense of running and marketing a large card network is also high. A card company with good underwriting standards has write-offs that are less than its allowance for losses (its planning account set up to estimate write-offs). To see how much AMX is losing to writeoffs, compared writeoffs to its entire cardholder loans outstanding. The table on p. 60 shows this is a high (and unsustainable) 8.5%, much higher than previous experience of 3.5%. If AMX can only charge 11% for loans, and has to pay 2% for funding liabilities (see below), it has 9% left for write-offs and all operating expenses. So 8.5% just for writeoffs is too high (operating and marketing expenses are much more than 0.5%).
• Liability/Debt Funding Costs: Most credit card companies allow cardholders to keep a balance. The card companies therefore need to borrow money through bonds and the wholesale funding market, and they relend that out to cardholders who have a balance. In the footnotes to AMX’s 2010 10-K on p. 66, its short term borrowing fell from $17.7 billion in 2007 to $2.4 billion in 2009, as the funding markets shut down (AMX almost went bust trying to hustle and obtain longer-term funding, but TARP money from the US government helped ease the transition). Note that the cost of the short-term funding fell from 4%-5.15% in 2007 to 0.7%-1.50% in 2009. So AMX is getting cheaper money to borrow, but also much less of it. More importantly, AMX has $52 billion in long-term debt, with an average rate of 4.11%, plus customer deposits of $26 billion (cost not stated). The maturity wall of when debt comes due is put on a table in p. 96 in the portions of the annual report:

Securitization and other fee income make the AMX credit card business model more complex, but I won’t go into that now.

The value drivers behind Capital One (COF) are slightly more complicated, as it has three businesses: credit cards ($23 billion in reported loans), commercial banking ($30 billion in loans to real estate and middle market firms), and consumer/retail banking ($38 billion in loans). However, COF’s core credit card business is similar to AMX, as shown below:

• Spread Revenues: COF states metrics in the “Selected Financial Data” table, showing that the NIM is 5.3%, the net charge-off (writeoff) rate is 4.58%, and the return on overage assets is 0.58%. In the footnotes to COF’s 2010 10-K on p. 48, it had total deposits of $116bn and other borrowings of $12 billion. COF’s average revenue margin on its domestic credit card book (about $65 billion in loans) is about 15.5%, of which 12.8% comes from yield (the rest, presumably, being fees). The table on p. 82 lists the domestic yield as 10.3%, which is inexplicably lower. COF also holds about $39 billion is securities, from which its yield is 3.6% to 5.0% (pp. 118-119).
• Write-off Costs: COF’s net domestic charge-off (writeoff) rate of 9.7% is higher than AMX’s 8.5%. If you add the 30+ day performing delinquency rate of 5.9%, COF will have to writeoff nearly 16% of its total credit card loan book!
• Liability/Debt Funding Costs: The vast majority of COF’s liabilities are interest-bearing deposits, at nearly $116 billion. It also borrows another $12 billion from other sources (which COF admirably gives a full listing of the notes, with their coupon, par values, and maturity date (p. 133). The interest-bearing deposits have a very low cost of 2.0% (see footnote one to the footnote on page 133). This is the killer competitive advantage for COF, buried very deeply in its footnotes.

One can see that the credit card industry reduces to a few value drivers: the size of the loan book; the average interest rate yield and the average cost of funds; the net writeoff rate. Of course, the SG&A expense structure matters too. Next I turn to airlines.

3) The Airline Industry – Southwest and JetBlue

Southwest Airlines (LUV) and Jet Blue Airways (JBLU) are two of the largest discount airplane companies in the US, both known for their great service, innovative business models, and profitability (unlike most airlines, which are unprofitable and poorly run). The largest value drivers are:
• revenue passenger miles (the total number of revenue-paying passengers multiplied by the number of miles they flew);
• passenger revenue yield per revenue passenger mile (how much was made on each passenger for each mile they flew);
• fuel costs (average cost per gallon), which is the largest single cost for an airline;
• the load factor (how many revenue passenger miles were booked for the available seat miles that an airplane could fill, a higher number showing that an airline is operating efficiently and closer to “capacity”);
• and average fleet age (as older fleets need to be replaced sooner, at high cost, and are more expensive to operate).

Southwest, because it is so efficient, is the largest air carrier in the US (measured by the number of originating passengers boarded). It runs a point-to-point service instead of a typical hub-and-spoke service, and keeps costs down by having only one type of plane, a Boeing 737.

Southwest, being a very well-run company, prominently lists the value drivers on page 23 of its 2009 10-K.

JetBlue is also a very well run company, emphasizing high quality service (ranked the best in the US by JD Power for the last 5 years) and focus of running planes out of the New York metro market. JetBlue even states openly the nature of the industry on pages 4-5 of its 2009 10-K: “Airline profits are sensitive to even slight changes in fuel costs, average fare levels and passenger demand. Passenger demand and fare levels historically have been influenced by, among other things, the general state of the economy, international events, industry capacity and pricing actions taken by other airlines. The principal competitive factors in the airline industry are fares, customer service, routes served, flight schedules, types of aircraft, safety record and reputation, code-sharing relationships, capacity, in-flight entertainment systems and frequent flyer programs.” JetBlue has given both the value drivers and the competitive factors behind the value driver metrics. It offers the actual metrics on page 26.

JetBlue conveniently explains the metrics in detail:
• “Revenue passengers” represents the total number of paying passengers flown on all flight segments.
• “Revenue passenger miles” represents the number of miles flown by revenue passengers.
• “Available seat miles” represents the number of seats available for passengers multiplied by the number of miles the seats are flown.
• “Load factor” represents the percentage of aircraft seating capacity that is actually utilized (revenue passenger miles divided by available seat miles).
• “Aircraft utilization” represents the average number of block hours operated per day per aircraft for the total fleet of aircraft.
• “Average fare” represents the average one-way fare paid per flight segment by a revenue passenger.
• “Yield per passenger mile” represents the average amount one passenger pays to fly one mile.
• “Passenger revenue per available seat mile” represents passenger revenue divided by available seat miles.
• “Operating revenue per available seat mile” represents operating revenues divided by available seat miles.
• “Operating expense per available seat mile” represents operating expenses divided by available seat miles.
• “Operating expense per available seat mile, excluding fuel” represents operating expenses, less aircraft fuel, divided by available seat miles.
• “Average stage length” represents the average number of miles flown per flight.
• “Average fuel cost per gallon” represents total aircraft fuel costs, including fuel taxes and effective portion of fuel hedging, divided by the total number of fuel gallons consumed.

One final footnote about airlines is worth examining: their debt levels and fuel hedge books. First, airlines are highly levered businesses, in that their financial leverage is high, and their operating leverage (their ability to bring down their operating cost structure) is moderate to high. It’s a bad combination for the equity investor, as unexpected events could push companies into bankruptcy (the 9-11 terrorist attacks pushed the entire industry to the edge, and even with monies from Congress some companies filed for Chapter 11). Second, fuel hedges are important because they can save a company much money, or destroy much capital, based on prudent hedging or reckless speculating (the line between the two is thin) in the derivatives markets.
• Southwest, in a footnote buried on pages 38 and 54 lists its “Contractual Obligations” (more than $14 billion, split three ways between long-term debt, flight equipment obligations, and financing obligations). One great thing about Southwest is that most of its debt is long-term, with maturities from 2014 to 2039 (far better than many indebted companies).
• Southwest discusses its hedging strategy in the footnotes on pages 70-73. Their strategy: “Our current approach is to enter into hedges solely on a discretionary basis without a targeted hedge percentage of expected fuel needs in order to mitigate liquidity issues and cap fuel prices, when possible.” (p. 71) Economically, Southwest hedged between 23%-59% of its fuel needs from 2007-2009, making $77 million and $17 million in 2007 and 2009, but losing $104 million in 2008 (in comprehensive income).
• JetBlue lists on total contractual obligations of $11 billion, of which $5 billion is long-term debt or interest commitments, and $5.8 billion is in operating lease or aircraft purchase commitments. (p. 36)
• JetBlue claims it has a broad management/governance oversight structure for its fuel hedging program. It does not forswear trading, like Southwest, but rather states: “The Company utilizes financial derivative instruments, on both a short-term and a long-term basis, as a form of insurance against the potential for significant increases in fuel prices.” (p. 45) As JetBlue has done a poor job in hedging, it shows a negative position of $480 million in fuel derivatives and has given or pledged $510 million in cash and assets to its counterparties.

As you can see, the value drivers behind airlines are very different than those behind credit cards. Even analyzing liabilities is a different exercise, as credit card companies rely on short-term, ultra-cheap debt, whereas airline companies have mostly long term-debt, and commitments to purchase aircraft or rent large facilities that are expensive.

4) The Cable and Satellite TV Industry – Comcast and DirectTV
The cable and satellite industries sell a monthly subscription service. Cable companies can provide TV, internet, and telephony, whereas satellite companies usually just provide TV and internet. Comcast (CMCSK) is the largest cable company in the US, and DirecTV (DTV) is the largest satellite TV company (and arguably the biggest competitor to Comcast, at least in line with Time-Warner Cable, DISH, Cablevision, etc.). The value drivers behind these businesses are simple, and these include:
• What’s the total market size that a company can physically serve (due to load and infrastructure constraints)? What percentage is actually being served (the penetration rate)?
• What is the average monthly subscription fee or cash flow from each subscriber? What percentage of customers are subject to rate regulation (how easy is it to raise prices)?
• How much pricing power do the distribution companies have over the content/programming companies, who charge them top dollar for access to their product?
• How sticky is the business? Basically, what is the customer retention rate?
• What is the cost of acquiring a new customer, and is this less than lifetime total estimated value of a customer?

Instead of focusing on the many value drivers in the cable/satellite business, I shall focus on the debt, property and equipment, and legal footnotes. These are asset-heavy companies with mounds of debt – they also get sued often. Being debt-heavy is tax efficient, as the businesses have a steady, monopoly-like cash flow stream, so large of amounts of debt can be serviced, while the companies pay reduced taxes due to depreciation and the debt/interest payment tax shield.

Below are some key debt footnotes to look at:
• Comcast Debt Profile: Comcast has $28 billion of debt (almost as large as its tangible plant, below), with most maturing after 6 years ($22 billion) or 10 years ($12 billion). It has various sources of financing: a commercial paper program ($2.25 billion), a bank loan facility ($6.8 billion), lines/letters of credit ($6.4 billion), and subordinated debt. Comcast also has commitments to content creators in the form of programming license agreements that it must honor, and these add up to another $9 billion.
• DirecTV debt profile: With over $20.2 billion in total obligations, $9.1 billion is in long-term debt, $9.7 billion is in purchase obligations (for content), and the rest is mostly for capital and operating leases. Much of the long-term debt comes due from 2014-2016.
• Security ratings on the debt: DirecTV gets a stable, investment-grade rating of BBB-, Baa2, and BBB from S&P, Moody’s, and Fitch, for its sizable $8 billion of debt.
• Collar loan: DirecTV has a complicated equity collar and collar loan it set up in relation to a Liberty transaction (as presumably John Malone likes to protect his transaction values with collars).

Below are some key plant and equipment (P&E) footnotes:
• Comcast has a gross plant and equipment of $52 billion, charged $28 billion in depreciation (a stunning number!), and has a net P&E of $24 billion. The two biggest pieces are cable transmission equipment ($16 billion) and customer premises equipment ($20 billion).
• DirecTV’s biggest asset is their satellites, with a gross value of $3.2 billion and a net value of $2.4 billion.

Legal proceedings against or by a company are a final item that is required in all 10-Ks, something that most investors just don’t want to consider. Yet it is a legitimate risk:
• DirecTV is engaged in numerous lawsuits regarding intellectual property, early cancellation fees, and an inherited lawsuit against Liberty Media. None so far looks to be significant.
• Comcast is embroiled in antitrust cases, ERISA pension litigation, and so on. None so far looks to be significant.

The bottom line is that an analyst should examine the footnotes relevant to each industry and sub-industry. Debt levels don’t matter in the software industry (where most companies take little debt). It matters a lot in the cable/satellite industry, as large asset and debt loads are the norm.

5) Footnotes are Idiosyncratic
No footnote is the same. Despite clear, stringent rules from the SEC and FASB on how a 10-K should be organized and how detailed footnotes should be, accountants have creative control to jigger financial statements and bury key information in footnotes. The only way to get better at reading footnotes is to know the economics behind an industry and to read many footnotes. Thousands and thousands of them. Each year. Below are some further reading recommendations.

Three great books I suggest on reading between the lines and dissecting footnotes:
• H. Schilit, Financial Shenanigans
• K. Staley, The Art of Short Selling
• C. Mulford, Sustainable Free Cash Flow

Two books on understanding business models and industries:
• M. Porter, Competitive Strategy
• R. Suutari, Business Strategy and Security Analysis: The Key to Long Term Investment Profits

One great resource to consult regarding footnotes:

I also recommend Ciesielski’s “Accounting Observer,” but you need to subscribe to the (costly) service:

Your footnote loving analyst,


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