The Equity Risk Premium has once again drifted up to all-time high levels in recent weeks. The S&P500 has an earnings yield of around 7.9% (assuming S&P earnings of $105 versus current price of 1,330). Ten year treasuries are 1.6%, so the resulting 6.3% spread is back at levels not seen since the early 70s. Yields remain excessively low; JPMorgan pointed out this weekend in their Global Data Watch publication that the yield curve implies negative real rates on government debt going out for ten years, an outcome outside even the experience of Japan. Whatever you think of stocks, bonds have to be a worse bet.

The Math is as follows: a 1.9% dividend yield on the S&P500 will, assuming 4% annual dividend growth (the 50 year average is 5%) deliver almost five times the return as ten year treasuries – assuming (perhaps crucially) no change in dividend yields in ten years. Or put another way, the holder of ten year treasuries could sell them, place 22% of the proceeds in stocks with the rest in riskless/returnless treasury bills and get to the same place, with 4/5ths of his capital available for other opportunities.

Once you figure in taxes (35% on treasury interest versus 15% on dividends) you only need put 17% of the proceeds from selling the treasuries into stocks. This is how distorted bond yields are – and they’re likely to remain so. Recent weakness in economic data, most notably the June payroll data, may result in further Fed buying of long term bonds. They wouldn’t recommend you do this yourself, as I wrote some weeks ago. The Fed is relentlessly driving the return out of bonds.

Investors have good reason to be cautious. This weekend’s Spanish bank bailout seemed inevitable and also inconclusive at the same time. Few believe the Euro’s fundamental problems have been solved. At the same time, in the U.S. current law requires a series of tax increases and spending cuts starting on January 1. The so-called “fiscal cliff” is estimated to be as much as a 3% hit to GDP and an instant recession. Few believe this will actually happen, reasoning that Congress will roll everything back another year and rely on the 2012 election results to settle the fiscal policy argument once and for all. However, while it seems sensible to assume Congress will act in this fashion, there seems little urgency to do so until the lame-duck session following the November elections. Meanwhile, hiring and capital expenditure decision that rely on some reasonable assumptions about positive GDP growth next year are increasingly at risk. One thing on which supporters of both parties can surely agree is that leaving resolution of near term fiscal policy to so late in the year is irresponsible. The Price of Fear is set in part by our elected representatives in Washington, DC.

Our most recent investment has been to increase our position in Coeur d’Alene. Based on our analysis we think it’s valued at around a 30% discount to the net asset value of its reserves, in common with most miners. Having some exposure to gold and silver at a discount is one way to protect against higher inflation, since that will increasingly appear an attractive solution for most people’s problems (there are more debtors than creditors in the world). In addition, CDE recently announced a stock buyback of $100M< around 6% of their equity market capitalization.

May 17^th, 2012 was the 30^th anniversary of my arrival in the U.S. On that day back in 1982 aged 19 I arrived for the first time in New York City fully expecting to be mugged as soon as I stepped off the plane such was the city’s reputation at that time. Although I grew up in England I had spent Summers in Toronto with my father as a teenager and the contrast between middle class North American life and strike-plagued Britain in the 70s could scarcely have been sharper. The IMF had come to Britain’s rescue while I was in school, and gloomy prognostications on the economy were the norm. America was dynamic, exhilarating, the world’s focal point in so many ways. I concluded that the future lay west, and New York’s financial markets drew me here. I needed to move to the U.S. more than anything I’d ever wanted – like all immigrants, I found a way to make it happen. I was part of the biggest wave of immigration the U.S. had seen since the huge influx of new citizens leading up to World War I in 1914. I became a permanent resident in 1985 and a citizen five years later, the shortest possible route for one with no family connections or refugee status.

During those thirty years I have never once doubted that I made the right move. The passage of time has balanced my perspective; London’s a great city too, and I’m very proud of my English heritage. While I doubt I’ll ever live there again, I love returning and one doesn’t always have to focus on the future; nostalgia can be wonderful too. But few Americans appreciate how their country appears to those on the outside wanting to get in. I remember well my urgent desire to go where the prospects were greatest. From afar, perceived through its culture, its impact on world events and unfailingly wealthy American tourists, one sees a place of huge opportunity, excitement, energy, surprises, danger and optimism. It’s an enthralling vision for anyone looking for those things.

In assessing the balance of potential investment returns and risks around the world, my experience is that many non-U.S. investors hold a keener appreciation for the power of the American story. You can talk to wealthy people from almost every corner of the world save North America and you’ll learn they need only reach back a couple of generations to recall war and existential threats, loss of democracy and civil rights, periods of lawlessness and moments when the future was most dire. The comparatively long political stability, rule of law and military security enjoyed in the U.S. are far better appreciated by those who haven’t always lived here. In addition, the dynamic economy fueled in part by a steady influx of type-A immigrants is widely envied. President Reagan was my first president, and his sunny optimism was uplifting for Americans as well as this immigrant just arrived from the Old World. It was then, and is always, Morning in America.

Which is not to discount America’s many challenges, of which the fiscal and political ones remain seemingly insoluble and therefore threaten much that is great. Top-down investment analysis can easily arrive at pessimistic conclusions. The Math of America’s federal and state deficits defy easy solutions, and increasingly partisan politics seems determined to court disaster by avoiding compromise.

Except that (and here’s the still starry-eyed immigrant talking) things have always worked out in the past, and they probably will this time too. It didn’t take me long after I moved here to recognize the difference between the European and American reaction to the insurmountable. Europeans glumly accept what they cannot change; Americans eventually get angry, and the national psyche dictates that when confronted with an apparently overwhelming challenge a commensurate response dedicating attention and enormous resources alters the path of history.

Successful investing combines a belief in a positive future with a healthy respect for the possibility that in the short run things may not work out as expected. The world’s a big place to be sure, but a constructive outlook expressed through U.S. companies represents a sound long-term approach to growing one’s savings faster than inflation. Market timing is ephemeral at best; our analysis of securities is bottom-up, focused on good businesses with low debt that we believe are attractively priced. The risk profile of our portfolios is largely driven by the opportunity set among the individual situations we’ve analyzed. Of the big picture we are perennially cautious optimists. To be so is to remain squarely on the right side of 236 years of history.

Here’s a brief interview I did for ABC Australia’s show “The Business”.

The New York Times has an interesting article today highlighting the dilemma for Louisa, KY, in the heart of coal country. American Electric Power (AEP), which operates the local coal-burning power plant, wants to switch to burning cleaner, cheaper natural gas. As might be expected this has caused an uproar, but there are few easy choices. Following the local outcry about lost jobs through lower coal consumption by one of the country’s largest coal consumers, AEP offered to spend $1BN to fit scrubbers on the Big Sandy power plant so that it could continue burning coal while complying with tighter emission standards. The problem is, they need to increase the average residential utility bill by $472 annually to pay for it and have applied to their regulator for permission.

AEP’s long run strategy is to burn less coal. Their consumption of coal and lignite fell 17% from 2009-2011 according to SEC filings by the company, and natural gas almost doubled its contribution as a source of fuel (from 6-11%) over the same period. This reflects a nationwide trend, and one of the unexpected but positive outcomes of the shale gas revolution which has made this possible is that the U.S. may achieve a cut in greenhouse gases by 2020 equivalent to that included in a 2009 climate bill that never became law. The Sierra Club is helping the process along by highlighting how many “dirty coal-burning plants” they have helped retire, and how many are left.

In these efforts they have Chesapeake’s CEO, Aubrey McLendon as an ally. He has apparently contributed $26 million to their cause. Coal is steadily becoming an export, and helping lead to cleaner U.S. air.

On the radio this morning a journalist from the New York Times confidently asserted that Greece would soon leave the Euro and issue Drachma. Both the new Drachma and the resulting Euro were both likely to plunge as a result and therefore it’s a good time to book an August vacation to Greece (meanwhile German vacationers are avoiding Greece in droves, no doubt wary of an unwelcome reception). While the journalist’s confident forecast of a Greek exit may be right, her analysis of subsequent market reaction (unburdened as it is by the requirement to invest other people’s savings in a commensurate fashion) is subject to the interpretation of the markets. However things turn out, one can be reasonably assured that a Greek exit isn’t going to surprise many people.

For some time we’ve felt that a short Euro represented an attractive hedge on long equity market risk.  Most of the bad things that could derail equities would either start in the EU or hurt the EU harder (such as an Israeli attack on Iran’s nuclear facilities, a concern earlier this year). But now that the focus has moved back to Europe, and we are once again contemplating the previously unthinkable, we think there’s less protection in such a position. The Euro isn’t a good investment, but its current price is more likely an accurate reflection of the balance of risks and as such doesn’t provide much of a hedge any more.

Every time we approach what seems to be a fork in the road, a third option seemingly appears. Such is the case now, with the apparently binary option between Eurobonds and no Eurobonds now joined by a European Redemption Fund, a sort of halfway house between today’s single-issuer bonds and Eurobonds jointly and severally guaranteed by Eurozone members.

But another thought occurred to me. What’s to stop the Greek government from paying its bills with IOUs rather than Euros? It may in any case be an unavoidable choice if lenders refuse to provide additional cash to allow the Greek government to continue operating. The IOU would promise payment in the future (say, 3 years) at whatever is the prevailing currency as determined by the Greek government. These IOUs would presumably trade at a discount, but over time as more of them went into circulation they could start to function as an alternative currency. Not an immediate replacement for the Euro, but a parallel currency that could represent a softer alternative to the shock of a Euro exit. These IOUs might ultimately become New Drachma. No doubt there would be many technical challenges with such a move, but given the large part of Greek GDP represented by the government before long these IOUs could represent a substantial part of the Greek economy. Such a path might offer a more measured form of exit and devaluation, preferable to the chaos of an immediate exit. Countries in the past have operated with two currencies, although typically the US$ has taken hold following a loss of confidence in the local currency. California has even issued IOUs when its disfunctional government has failed to approve a budget.

New Drachma IOUs reverses the sequence, but might offer a less time-pressured solution to the current crisis.

The Facebook (FB) IPO drama has been fascinating and entertaining if you’re comfortable being a Luddite like me and fully confess an inability to “get it” when reading bullish forecasts of their business. A brief glance at their S-1 (the registration document the company filed prior to going public) reveals that FB made $1BN in profit last year. So the trailing P/E of 104 that its $38 IPO price represented shows that it’s only a stock for those unwilling to be distracted by financial statements. A delay in the opening on Nasdaq can scarcely be blamed for altering the value of the company, although many are pointing to that as a cause of its subsequent drop in price.

That a value investor would find FB unattractively priced is perhaps not that newsworthy. But I do think the uproar over how the IPO went, the righteous anger of all those “investors” frustrated in their desire to turn a quick profit, reveals much about what is wrong in investing today. The media-led hype leading up to last Friday’s launch was unprecedented – and it’s not really their fault, CNBC and others are simply providing what their customers want; 24X7 coverage of the Big Event. But the very short term nature of all this interest is so far removed from investing that it barely deserves that description. This is why people call Wall Street a casino. Because so many retail investors look for quick profits with probably little more thought than they use to choose between red or black in Atlantic City.

But it’s not just amateur investors that messed up. One of my favorite quotes is this:

“I’m disappointed that so many seemingly smart people have failed. They raised the range on the offering literally two days after the underwriters called around saying lower your numbers for the second quarter,” said Hugh Evans, portfolio manager at T Rowe Price, one of the largest institutional shareholders of Facebook.

“Those two things don’t go together, ever,” he added.

I wonder if Mr. Evans counts himself among the “smart people”.

If a little more cynicism was applied, and a little more long term investing, there wouldn’t be such destruction of savings that are supposed to cover so many retirements. If you really wanted to invest in FB, the subsequent drop in price to $31 ought to be regarded as an opportunity to add at more attractive levels. Judging from the furor though, and no doubt imminent lawsuits, such an approach is far from prevalent. Investors have only themselves to blame.

I have watched the endless TV hype about Facebook’s (FB) IPO with great interest but from a safe distance. FB is SO not the kind of stock we’d ever invest in – not that anyone should feel dissuaded because over the years we safely avoided Apple and Google amongst others too. So nobody should interpret anything profound – it’s just that if we don’t understand how they make money we just move on to other things.

Although I’m not a stockholder, I use Facebook to stay in touch with friends and family. I’m not on every day, and many people have more “friends” than me. In fact for a while my total was barely in double digits until my children’s friends began to take pity on me and helped me get to a few dozen. The college-age crowd that are the engine for FB often number friends in the several hundred. I am clearly not that popular, but I can claim that my FB friends really are friends.

About a year ago FB e-mailed me to enquire whether I’d like to advertise my business, SL Advisors, on FB. I was surprised. I honestly didn’t know FB carried ads. I’d never spent much time considering their business model or how they managed to exist. So much of the internet is free, and FB was just there whenever I needed it without even the occasional NPR-like pledge drive.

Unable to recall a single ad I’d ever seen on FB, I concluded that my own advertising budget could be more usefully deployed elsewhere. And in fact even now I can’t remember anything advertised on FB. I do know that GM have stopped advertising there due to poor results, and I also know that Ford are very happy with their FB ads. This probably speaks to the average age of their customers, but in both cases I read about these developments elsewhere and don’t know what GM or Ford have actually advertised on FB.

Meanwhile, FB continues to be a fun way to stay connected with friends and family scattered around the U.S., UK and Canada. The price is right, and if advertisers deem it a useful way to spend their budgets they truly don’t even distract me. In spite of what economic theory holds, sometimes there really is a free lunch.

We’ve been invested in Corrections Corp (CXW), the largest private operator of prisons, since 2010. Sometimes we’ve had a large position and at other times not; we think the current opportunity is compelling.  We’ve written about it before here.Around 9% of the U.S. prisoner population is housed in privately run prisons. CXW is the largest publicly traded operator –  Geo Group (GEO) is the other. Private operators are, as you might expect, far more efficient than the public sector – not least because their workforce is not unionized. This is most dramatically revealed in the case of California, where the state spends around $140 per prisoner per day compared with CXW’s per diem rate of $67. Chronic overcrowding in California and other states as well as this cost advantage mean that the long run outlook is for increasing numbers of prisoners to be run in privately operated facilities.

The embrace of private solutions isn’t seamless; prison guard unions are clearly opposed, and California itself represents 13% of CXW’s revenues. Politics can sometimes intervene, but the trend towards increasing market share is robust. It’s a business with limited economic sensitivity, reasonable barriers to entry and good growth prospects.

CXW was once structured as a REIT with the managed business as a tenant. They basically own and manage real estate.  The REIT was overleveraged, was building prisons aggressively and had falling occupancy.  This combined with the requirement common to REITS that they distribute at least 90% of their pre-tax income to their investors made it hard to fund their capex program, and they raised equity and restructured as a corporation. While this gave them more flexibility around managing cashflow, it also burdened them with a 38% tax rate once they returned to profitability.

We’ve long been intrigued at the possibility of the company returning to the REIT structure. As well as reducing their tax liability, splitting into a management company that operates prisons and a REIT which owns them would attract a REIT-type valuation on pre-tax income on the latter and lead to a re-pricing. It’s not a bad investment as a corporation, but as a REIT we think it’s mis-priced.

Eighteen months ago the company had told us they would never consider restructuring as a REIT. But in their 1Q12 earnings call they disclosed that such analysis had begun in the Fall.

CXW manages some prisons, and own/manages others. They break out the segment operating margins for both (13% and 36% respectively). Based on this and other information in their 10K, it’s possible to construct an income statement for a new management company (we’ll call it ManCo) and a REIT entity owning prison properties (call it NewREIT).

Assuming the 13% margins they earn managing prisons applies to those they own as well, it’s possible to calculate pro-forma operating earnings for ManCo and net operating income for NewREIT.

CXW’s market cap is $2.8BN. Their 13% operating margin on managing prisons applied to their total revenues of $1.7BN generates $228MM of operating income, $141MM after tax. A market multiple of 14X would value this at $1.7BN or 60% of their market capitalization.

We calculate NewREIT would generate $313MM of net rental income based on the 23% difference between their operating margins for each segment above, on the $1.36BN of revenues that come from prisons they own and manage. REIT cap rates vary from 8% for industrial properties to 6% for high quality offices and in some cases even lower. Their business is economically insensitive, clients are good credit, maintenance costs are minimal, and they have half the share of the U.S private prison market, so a 6% cap rate doesn’t seem unreasonable (by comparison, Simon Properties Group, SPG, trades at a cap rate of around 5% of Adjusted Funds From Operations or AFFO).

Applying a 6% cap rate to this rental income values it at $5.2BN. We still have to deduct the market value of so far unallocated expenses such as G&A ($91MM) and maintenance cap ex (we estimate at 15% of net rental income or 3.5% of rent, $48MM). Applying a 14X multiple to these pre-tax figures and adjusting for their 38% tax rate deducts $1.2BN in value. The company has another $1.2BN in debt.

CXW Valued as ManCo and NewREIT

Source: CXW SEC filings, SL Advisors

The valuation is of course sensitive to the cap rate. An 8% cap rate reduces the value to $32 per share. And they may not convert to a REIT, although the company has hired JPMorgan and E&Y to do the analysis and has asked the IRS for a private letter ruling related to the conversion. We think their analysis is sufficiently far along that the company believes it’s likely they will convert.

CXW is a holding in our Deep Value Equity Strategy

The Kauffman Foundation in Kansas City, MO is to be commended for the open manner in which they’ve shared the results of their own venture capital (VC) investing. In a remarkably candid appraisal that covers twenty years of experience, the authors reveal that much of the conventional wisdom about this area of private equity is wrong. Larger funds reliably underperform smaller ones; fees eat up disproportionate chunks of performance; investors too easily sign up for second tier managers in order to deploy capital that’s “burning a hole in their pockets” while top tier funds seem to be the only way to justify the risk (as long as they don’t grow too big).

The authors, who include CIO Harold Bradley, note with irony that while venture capital funds search tirelessly for new business models and innovation there has been remarkably little of this in the vc industry itself. Fees of 2&20 with limited transparency around GP compensation have prevailed with oddly little change. The report also notes that while vc funds demand complete transparency around the financials and compensation of the companies in which they invest, they generally refuse to provide anything similar to their own investors.

Kauffman reports that only 20 out of their 100 vc funds beat a public equity market equivalent by more than 3% (a modest reward for illiquidity) and that half of those began investing prior to 1995. They also find that the “J-curve” (which holds that early negative returns quickly improve as investments mature) doesn’t really exist.

In many ways what’s wrong with vc investing is similar to what’s wrong with hedge funds. Their findings echo my book, The Hedge Fund Mirage. Too much money chasing returns; LPs that don’t press for better terms. Poor transparency.

The Kauffman Foundation should be applauded for their open approach to discussing issues that demand more attention. I hope their step forward provokes other investors to similarly examine their own results.

Here’s an interview I did with this Montreal-based website that reports on hedge funds for Canadian institutional clients.