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.