The title isn’t my creation, but is rather the work of Michael Edesess, PhD, CIO of Fair Advisors (an investment firm) and author of The Big Investment Lie (which I am currently reading). Michael just posted a review of my book, and he does an excellent job of summarizing the highlights and adding his own commentary. I had a most interesting chat with him a couple of weeks ago when he was writing the review from his office in Hong Kong.
Last week’s Knight Trading (KCG) disaster marked the first time that I can recall when a software glitch actually threatened the surivival of a public company. In recent years computer technology has played an increasing role in the functioning of the equity markets, and KCG’s mis-hap was preceded by the Facebook (FB) IPO mess and the Flash Crash in May 2010. And based on the terms of the $400MM in new capital KCG raised, such that the new investors will own 70% of the company at $1.50 a share, prior KCG investors are all but wiped out compared with the $12 price of recent weeks.
We’ve never considered investing in KCG, but investors might be forgiven for not having contemplated their exposure to bad implementation of a new trading system. KCG’s most recent 10-K is lighter than most in its list of Risk Factors, containing seven although they’re all important. Operational Risk is the relevant disclosure, “…from major systems failures.” which would seem to incorporate what happened. As well as raising further questions for regulators about how well they monitor the increasingly automated activities of the public markets, it also highlights the need for investors in such business to achieve greater comfort around “IT competence” when they invest in such companies.
In late July I had the opportunity to present the ideas in my book, The Hedge Fund Mirage, at the CFA Institute’s Financial Analysts Seminar in Chicago. Flying to Chicago for the day afforded me time to catch up on some reading, and some new ideas.
From time to time we’ve written about the Equity Risk Premium and how it makes stocks a far better investment than bonds. The earnings yield on the S&P500 (which is the inverse of its P/E) is around 7.6% (consensus earnings of $105 divided by current S&P500 level of 1,385). Ten year treasury yields are 1.5%, so the resulting 6.1% gap was last this wide in 1974 following the Yom Kippur War, OPEC oil embargo and rampant inflation. Or to put it another way, as we’ve written before, it only takes $22 invested in the S&P 500 (yielding around 1.9%) to generate the same after-tax ten year return as putting $100 in ten year treasuries (all assuming unchanged dividend yields and 4% annual dividend growth compared with a 50 year average of 5%). The remaining $78 of the $100 could be left in 0% yielding cash and the Math still works. This is how expensive is the relative safety of fixed income. To describe bonds as being for wimps would risk provoking the Market Gods to swiftly prove otherwise, so I won’t go that far. But they are for those willing to accept a guaranteed loss of real wealth after taxes and inflation.
However, the Equity Risk Premium has remained more or less historically wide for some time, and it’s not exactly a secret. Martin Brookes and Ziad Daoud of Fulcrum Asset Management, recently offered a possible explanation. In a paper titled “Disastrous Bond Yields” reported in the Financial Times, they construct a risk/return framework for investors that extends the more normal economic state of two scenarios (expanding or contracting economy) to include a third (“disaster”, a “large decline” in GDP). Such disasters were far more common prior to World War II, and the authors theorize that the subsequent 60 years of comparative serenity caused investors to undervalue the safety of government bonds in such cases, an oversight we might now conclude has been corrected. To the layman, people are scared. Or, as a retired bond trader and friend of mine observed recently, investors are not buying ten year treasuries because they think they’re a great long term investment. I won’t do the paper justice here and it’s worth reading, for the authors go on to show that at a certain tipping point of economic distress the credit risk in government bonds overwhelms their safety. Empirically, when the default probability of a country exceeds 3% its bonds and stocks start behaving far more alike as correlations flip from negative to positive. Greece, Spain, Italy and (interestingly) France have all crossed this threshold.
At the CFA event in Chicago my presentation directly followed that of Professor Robert Shiller, author, Yale professor and co-creator of the S&P/Case-Shiller Home Price Indices. Clearly my inclusion showed the organizers’ flexible standards on speaker selection. Professor Shiller spoke about his recent book, “Finance and the Good Society”, a review of which I had coincidentally just read on my flight. The book makes the case for the benefits of financial innovation to broader society, a lonely position given recent history. One novel idea was that the Federal government should borrow money by issuing securities whose coupons are directly linked to GDP. Specifically, one such bond would pay annual interest equal to one trillionth of GDP, or about $15.09, hence the name “Trills”. I thought it was a clever idea; many investors would surely find use for a security tracking nominal GDP, and while the government’s cost would be pro-cyclical (i.e. fall when the economy’s contracting) it would be less volatile than if the Treasury issued exclusively short term treasury bills and would also provide an inflation hedge to investors. Of course, Professor Shiller noted that TIPS (Treasury Inflation-Protected Securities) were first suggested about 100 years before they became reality so we shouldn’t expect to see these novel securities soon. But I thought it was an intelligent suggestion.
One new idea would be for Congress to resolve the looming “fiscal cliff” before the election, thus acknowledging the supremacy of the economy compared with their respective campaign plans. But any new idea I suggest here will be too dripping in sarcasm to be serious. Suffice it to say that, as we sit here watching the weeks tick by to November with no pre-election solution in sight, it is with a feeling of stunned amazement that we regard the oblivious disregard of Congress for the private sector. Planning for 2013 hiring and capital spending decisions takes place well before the lame duck Congress will limp back to Washington DC in mid-November. Anecdotally, companies are increasingly curbing their long-term commitments until fiscal policy becomes clearer. While we don’t try and time the markets, many companies’ quarterly earnings have shown very weak European demand across varied products and services and a cautious outlook globally. In our Deep Value Equity Strategy cash is a relatively high 10% as a few names have reached price targets we felt fairly reflected their value.
MLPs had a nice month in July following six months of zero total return. The sector had become steadily more attractive as we noted last month, and July’s results made up some lost ground. We think MLPs remain attractively priced with distribution yields still above 6%.
As we head towards another deadline for Greece, during which they must convince the troika that austerity is on track, there is growing speculation that Greece may be forced out of the Euro. A “Grexit” to use a popular term.
Well, maybe, but here’s why it’s not inevitable. First, from Germany’s point of view, Greece’s presence in the Euro isn’t the real problem; it’s the money Greece owes. In fact, Greece’s recession is if anything creating downward pressure on the Euro which helps Germany’s exporters. The notion that Germany may force Greece to leave the Euro is based on the flawed assumption that this would be in Germany’s interests. No doubt popular opinion in Germany may be moving in that direction, choosing to “punish” the profligate Greeks for their poor budgeting skills. But leaders in Germany must know that such a move would be their “Lehman moment”. The risk of contagion swiftly moving to Spain and Italy would be such that perhaps as much as 1 trillion Euros might need to be available to support those countries’ ongoing borrowing needs. Untold additional dominoes might fall. It’d be a foolhardy German government that contemplated such a move.
Moreover, the instant Greek default on their cross border debts which would immediately follow their ejection would hurt their Euro-zone creditors including Germany. Indeed, the ECB itself might need to be bailed out. So there seems little point in kicking Greece out of the Euro while they still owe any significant sums to other Europeans.
For Greece, while a New Drachma may appear an appealing way to generate inflation and allow a drop in living standards to create a more competitive economy, introducing a new currency over even an extended bank holiday is a daunting task. A well run government bureaucracy like Germany’s would be hard pressed to pull that off. Greece is not Germany. It would be a disaster. In fact, for Greece their interests are best served by continuing to negotiate for an ever decreasing debt burden. Regular brinkmanship around austerity targets and the next release of EU/IMF funds is becoming their strategy. It can continue to work as long as the promise of some ultimate repayment is sufficient to outweigh the risks to Germany of kicking them out.
But Greece has an additional option, which is a stealth devaluation. The government could start paying its bills in IOUs, as California has done in the past. The IOUs would promise to repay the holder in full in five years in the then prevailing currency. These IOUs would of course trade at a discount to face value, but over time the Greek private sector’s holdings of these would grow as their government issued more of them. Their discount to par would no doubt fluctuate with the odds of Greece staying or leaving, but over time as the discount stabilized and their volumes grew the “New Drachma Notes” as they might be dubbed, would provide visibility around the type of depreciation the New Drachma might suffer if it replaced the Euro. In fact, it could co-exist with the Euro, but by creating a plausible alternative currency that was slowly introduced over 2-3 years through the Greek government paying its bills, it would improve Greece’s negotiating stance with the troika and perhaps allow them to achieve greater debt forgiveness than would otherwise be possible.
The Greeks have played a weak hand pretty well so far. Their forced exit from the Euro needn’t be as inevitable as it might appear.
Modern financial theory holds that a diversified portfolio of securities is the most efficient way for an investor to access an asset class. Idiosyncratic risk, the risk associated with an individual stock say, can be diversified away and therefore theory holds that investors don’t achieve any additional return for holding concentrated portfolios of their favorite stocks. It’s an idea that makes a lot of intuitive sense. Consequently, you can invest in equities and possess no particular stock-picking skill by using an index fund. Hundreds of billions of dollars are invested passively in this way. Based on many decades of performance from public equities (although admittedly the last decade was no walk in the park) this is a sound strategy.
Using the same construct with hedge funds produces a different result. A key underlying assumption in the “diversification is good” approach is that the underlying asset class has a positive return. However, as I show in my book The Hedge Fund Mirage, if all the money ever invested in hedge funds had been in treasury bills instead, the investors would have been better off. The average hedge fund $ generated a negative return with respect to the risk-free rate. There are great hedge funds and happy clients, but these are not the norm. Since I wrote my book hedge funds have continued to provide empirical support for my findings. YTD performance for the HFRX Global Hedge Fund Index is 1.2% through June – actually outpacing treasury bills (which yield approximately 0%) but for the tenth straight year lagging a simple 60/40 stocks/bonds portfolio.
Since hedge funds in aggregate have been a bad investment, the only way to win as an investor is to be better than average at picking managers. Some people are. But since diversification is intended to draw you towards the average return, and the average return is in this case not something you want, the rational use of hedge funds in an investment portfolio is to select only two or three where you have insight and high conviction. Adding more funds creates more diversification, which for a hedge fund investor is a bad thing.
Some of the smartest people in the hedge fund industry are the hedge fund managers themselves. You’ll rarely hear them advocating a diverse portfolio of hedge funds. They already understand the mediocrity and lack of return persistence so prevalent amongst their peers. And often the happiest clients are those who don’t have many hedge funds, but made a few good choices with a small part of their portfolio. For if a diversified hedge fund portfolio is bad, so is a large allocation to hedge funds. A 1-2% allocation to two or three funds takes the best of what hedge funds have to offer. Hedge fund returns have steadily deteriorated as assets have grown, just as is the case with individual funds.
But the consultants and advisors who promote a diversified portfolio of hedge funds as an important component of an institution’s overall portfolio are misusing the Capital Asset Pricing Model. A diversified hedge fund portfolio is The Dumbest Idea in Finance.
The Energy Information Agency (EIA) is a rich source of data on everything related to energy production, consumption and storage in the U.S. This chart caught my attention, showing that coal use for electricity generation continues to fall sharply, with the result that in April for the first time natural gas was used to produce as much power as coal. The price advantage and environmental issues are both helping drive natural gas consumption higher, and the EIA even project that the U.S. will eventually become a natural gas exporter (though that time is 5-10 years away).
Meanwhile, Patriot Coal (PCX) filed for bankruptcy yesterday as the deteriorating economics of the coal industry proved insurmountable.
We continue to hold positions in three E&P names: Range Resources (RRC), which stands to benefit over the long term from greater natural gas consumption since they have such large potential reserves (50-60 Trillion Cubic Feet Equivalent). Their current market cap of $9.7BN is far less than the cash they can generate if even half of this potential is realized. We also like Comstock Resources (CRK) which we think will ultimately be acquired, although its daily volatility is multiples of the broader equity market so it’s not for the faint of heart.
Back in April some were forecasting that natural gas prices might go negative, such was the excess supply and shortage of available storage. That was around the time prices hit their low.
I am once again indebted to The Economist for writing about my book and noting some of the points I made about hedge funds’ poor performance. On January 7 they covered it in the Buttonwood column, and this weekend they once again discussed the issues I raised. They are performing a public service by highlighting some important concerns for investors.
Last week Coeur d’Alene (CDE) announced plans to issue debt, even though they have no obvious need of any extra cash. It looked very much as if the company was planning to make an acquisition rather than focus on returning value to shareholders, and we commented as such on this blog. It seems the bond market reached a similar conclusion since today CDE announced that unfavorable market conditions had prompted them to withdraw the bond offering.
Of course it’s not hard for any creditworthy borrower to raise funds at today’s rock-bottom interest rates, but evidently the long history of value destruction by prior management combined with CEO Mitch Krebs’ very small personal investment in CDE equity persuaded bond buyers that CDE debt was not an investment the market needed. The irony is that pulling the issue has boosted their stock price by 5% today. What a pity CEO Krebs doesn’t believe more fervently in his company’s ability to create shareholder value, otherwise he’d have a bigger stake and would be benefitting from the bond market’s rejection of their acquisition plans.
Yesterday we aligned our interests with the management of Coeur d’Alene. This gold and silver mining company, like much of the mining sector, trades at a steep discount to our estimated NAV of $31 (based on Proved and Probable Reserves). In addition they’re generating $300-400MM of cash annually and the business looks to be going well. Until recently we believed the best way to bet with CDE was to own shares in the company; however, their debt issuance earlier this week makes it much more likely that the company will make acquisitions in the sector rather than buy back additional stock (they recently announced a $100MM buyback which was positive, but the $350MM debt issuance is cash that they really don’t need for their existing business and it doesn’t appear that they’re going to use this additional cash to return value to shareholders).
Since CEO Mitch Krebs owns so little stock, and former CEO Wheeler owns none, management has little to gain from a higher stock price. In addition, the incentive compensation plan in place at CDE clearly favors efficient production based on per ounce costs, a structure that firmly points management towards a bigger company with SG&A spread across larger revenues rather than increasing per share value.
Consequently, aligning with CDE management requires NOT owning stock in CDE but instead owning other mining stocks (through GDX for example) since any M&A activity in the sector is likely to be at the expense of CDE stockholders but may benefit the mining sector more broadly. We have no position in CDE but are invested in GDX. Mining companies have a well earned reputation of generating value for their executives while the owners do poorly. The chart below compares the return to investors in CDE since 1991 with the compensation earned by CEO Dennis Wheeler over that time. Clearly, providing labor to CDE was far better than providing capital.
Gold and silver miners have been underperforming precious metals for some time. As a result, many names in the sector are priced at substantial discounts to the net asset value (NAV) of their holdings. We have been invested in Coeur d’Alene (CDE) on and off for the past couple of years. The company has historically been a pure silver miner, but in recent years has been producing more gold and by next year gold revenues will probably surpass those from silver.
The company’s market cap is around $1.6 billion and it has debt of $122MM (although they just announced a note issuance – more on that later). They are operating quite well apart from a recent setback at their Kensington mine in Alaska where production was halted while they improved their infrastructure. But the company generated $1Bn in revenues last year for the first time, and looks capable of generating $350-450MM in free cashflow all while reducing their G&A and keeping capex at around $100-120MM.
Based on their proved and probable reserves, we calculate that the company could be worth almost $3BN, or $31 per share. Well-run mining companies provide positive optionality, in that if gold/silver prices rise the operating leverage inherent in their business model will cause their earnings to rise faster. Earlier this month we were happy to see that the company announced a share buyback of up to $100MM, about 6% of the outstandings. Although they don’t pay a dividend they’re returning some of their cashflow to shareholders.
Yesterday CDE announced an issuance of $350MM in senior notes. They have very little debt so the company’s balance sheet can certainly handle modestly more leverage. However, they don’t obviously need the money since their operations are generating plenty of cash. So now we’re going to see whether the principal-agent problem so prevalent in mining companies exists at CDE.
The most obvious use for the cash raised from the debt issuance is to buy back their underpriced stock. This would be an intelligent way to take advantage of interest rates maintained at extraordinary low levels and the cheap price of the company. Their SEC filing said, “The Company intends to use the net proceeds from the notes offering to fund internal and external growth initiatives and for general corporate purposes.” This could mean they want to buy back additional shares, but the “…external growth initiatives…” also sounds suspiciously like an acquisition.
It’s hard to believe there could be anything better for CDE’s spare cash than to buy back their shares. The biggest impediment we can see to this is that senior management holds so little stock that they might be thinking more like agents than principals. CEO Mitch Krebs owns 74,812 shares according to their recent proxy statement, less than 0.1% of the company and currently worth just over $1MM. His total compensation for 2011 was $2.4MM. Mr. Krebs’ incentive compensation is generally tied to production-related metrics, so given his modest ownership of stock his incentives appear to be more closely aligned with a bigger operating company rather than a higher share price.
What CDE does with the proceeds of their debt issuance will provide some insight as to whether it’s better to provide labor to CDE (like Mr. Krebs) or capital (like his investors, including us). His financial incentives clearly direct him towards acquisitions. Perhaps some of the other large shareholders such as Vanguard and Dimensional Fund Advisors will make their views known. Or perhaps CDE will simply begin scooping up some of its cheap stock and return some value to its owners.
We are long CDE.