On Wednesday the Federal Reserve released their third set of detailed interest rate forecasts this year. Following Ben Bernanke’s philosophy of open communication, the FOMC publishes forecasts for short term rates from each voting member. While they don’t link a name with each number, you can see what members expect short term rates will be at the end of this year, 2013, 2014 and over the long run (whose start is not defined).

In effect you can construct a crude yield curve incorporating their collective outlook. Comparing their yield curve with the market is fascinating, although market yields and implied rate forecasts have been steadily diverging from those issued by the Fed. In fact, the Fed’s own forecast has been remarkably stable even while ten year treasury yields have traversed a 1% range reaching 2.5% before falling recently to 1.5%. The chart below is derived from the average of all FOMC member’s rate forecasts at year-end. So there’s a clear discrepancy between the Fed’s statement that short term rates will remain low through the end of 2014 and the six FOMC members who expect rates to be higher (three of whom target hikes as soon as next year). At the same time that the Fed extended Operation Twist to the end of this year, they reaffirmed that the long run equilibrium short term rate is around 4%. Long term bonds continue to trade at yields that defy that forecast. The Long Run is still some ways off, but today’s bond buyers are fairly warned.

There is growing evidence that the “Fiscal Cliff”, looming in January 2013, will take a toll on the economy before its arrival. Although reports suggest that both parties are discussing a resolution to the sudden tax hikes and spending cuts that will take place under current law on January 1st next year, there’s little tangible evidence of such. There is growing evidence that companies are managing their businesses by incorporating this uncertainty into today’s spending decisions. It occurs to me that, while most economic forecasts project a substantial (3%+) GDP hit in 1Q13 IF no action is taken, few have considered that waiting until December’s lame-duck session of Congress to do the inevitable is quite likely to depress growth in the meantime. The non-partisan view surely blames both sides for placing the purity of their own political beliefs ahead of the pragmatism of removing at least one element of uncertainty.

The comments from many Congressmen that the planned tax hikes and spending cuts will assuredly be rolled back would be more credible if they didn’t insist on waiting until the last possible moment do do so.

For our part, we remain generally fully invested across our strategies. Owning steady, dividend paying stocks combined with a beta neutral hedge provides an uncorrelated source of return while markets are being buffeted around. Our most recent decisions have been to exit the last remaining shares of Family Dollar (FDO) which no longer provides compelling value given its recent increase in price. We have added modestly to Coeur d’Alene (CDE) which recently announced a share buyback given the large discount of its stock price to the estimated net asset value of its gold and silver reserves.

We have largely exited the short Euro position which has been held in our Fixed Income strategy as useful protection for the holdings of bank debt (given their equity sensitivity). It worked well for quite a while, but a few weeks ago I heard a reporter from the New York Times confidently announce on a radio interview that the Euro was going down and Greece would soon exit. Short Euro is probably too widely held, and isn’t that interesting any more.

Disclosure: Author is Long CDE

Last week I gave the second in a series of presentations I’ve been invited to make to the Tiger 21 group. Tiger 21 is an association of wealthy entrepreneurs that engage in “peer-to-peer” learning on issues that they have in common. Criteria for membership include a minimum investable assets of $30 million and payment of $30K in annual dues. Membership is by invitation only. The members have diverse backgrounds and sources of wealth, but one thing that brings them together is the search for unbiased investment advice. Most if not all members are regularly subject to marketing pitches from well-intentioned bankers seeking their investment in hedge funds, private equity and other illiquid, long-lived investments with their promise of recurring fee revenue for the banks over many years.

As I run through the basic Math of my book and explain why hedge fund investors in aggregate have not done that well, invariably an expression of understanding passes across the room as the audience grasps how one-sided the game can be. Generally groups like this have not made money in hedge funds, but they often blame poor manager selection and don’t focus on the structural disadvantages (fees, lack of transparency and illiquidity) that are stacked against them. They have an uneasy feeling that hedge funds haven’t been as good as is popularly believed, but the knowledge that the only group that’s made money is the managers is invariably met with much cynicism as countless meetings with hedge fund industry proponents are recalled.

Most of the Tiger 21 members I have met are self-made, and they well understand the profit motive and how to exploit a market opportunity. But even this unapologetically capitalist crowd is taken aback as the staggering imbalance between results for the clients compared with the managers sinks in. Perhaps never before in history has the inclusion of a diversified hedge fund portfolio been so challenged as an integral part of the ultra high net worth approach to investing.

The UK-based hedge fund lobbying group the Alternative Investment Manager’s Association (AIMA) was moved by my book to commission a defence of their paymasters by KPMG. It was somewhat misleading, in that its support of hedge funds was based on the 9% return that an investor starting in 1994 would have earned from an equally weighted portfolio, rebalanced every year. Of course no such investor plausibly exists, and holding an equally weighted portfolio isn’t possible for all investors (since hedge funds are not equally sized). And in 1994 although hedge fund investors did well there weren’t many of them. The industry was very small. If you’re going to recommend hedge funds why not consider how ALL the investors have done and not just a hypothetical one that was lucky enough to earn the good returns of the 90s (when hedge funds were a far better deal for clients). I posted my response shortly after KPMG’s report was published.

Meanwhile, where are all the happy clients who should be voicing their agreement with AIMA’s marketing brochure? Why is it that the only people advocating hedge funds are the people whose job it is to promote them in the first place? Has AIMA sensibly not sought endorsements from actual investors? Or have they tried and failed? Have they struggled to find any happy clients (although I could help them out as I know quite a few; it’s not that nobody made money, just the aggregate).

The Capital Asset Pricing Model (CAPM), that cornerstone of modern financial theory, teaches that a diversified portfolio is the best way to invest in any asset class since the market doesn’t reward idiosyncratic, or stock-specific risk. This is the most efficient way to achieve the systematic return of the asset class the investor is targeting. But it’s based on the not trivial assumption that the systematic return, or in other words the return on that particular market, is something worth having. Since the average $ invested in hedge funds would have been better in treasury bills, the thoughtful hedge fund investor might be advised to sprint away from anything that promises the average industry return. In my opinion the only way to justify hedge fund investments is if you’re good at selecting hedge fund managers.

You can invest in stocks and not be a stock picker; if you can’t pick hedge funds stay away. And the corollary is that IF you are skilled at picked hedge funds then diversification is not your friend. The more hedge funds you have the less likely you are to do any better than average. In my experience, the people who are happiest with their hedge fund investments only have a couple. The problem for the hedge fund industry is that two hedge funds should of course command a far smaller percentage of an investor’s portfolio than a more diverse selection. We wouldn’t need such a big hedge fund industry. That is how investors should use hedge funds. Will anyone else in the industry tell them?

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