The California Public Employee Retirement System (CalPERS) recently announced they were closing down their $4.1 billion hedge fund program. I don’t know if they read The Hedge Fund Mirage. It might have saved them some time.
The New York Times has an interesting perspective.
CalPERS’ $4 billion hedge fund portfolio will cause barely a ripple in the $2.5 trillion hedge fund industry as it’s redeemed over the next several quarters. Some speculate that their decision will cause other public pension funds to re-examine their commitment to hedge funds, although you’re unlikely to find a public pension trustee who will admit to being a follower.
What struck me most about this news though was the fees CalPERS paid. They disclosed a 7.1% net return on their $4 billion portfolio during their last fiscal year, as well as $135 million in fees. In recent years there’s been some anecdotal evidence that the ubiquitous “2 & 20” (2% management fee and 20% profit share) was coming down. That may be so, but you wouldn’t know it from CalPERS’ experience.
They don’t disclose their actual fee structure, but an educated guess is possible. Given the information provided (investment size, net return and fee expense) 1.9 and 19 (i.e. a 1.9% management fee and 19% incentive fee) would make the numbers add up. 2 and 18.5 also works. Given that CalPERS has a reputation as one of the most aggressive negotiators of investment terms, it’s surprising that their realized fees during their last fiscal year were so close to the traditional 2 & 20.
Now, it’s possible that some of their funds lost money, which doesn’t alter their effective fee but could mean that they’d negotiated lower incentive fees but had failed to benefit. There are no negative incentive fees. And CalPERS does include funds of hedge funds in their portfolio so that again may understate the fee savings they negotiated with individual managers.
Nonetheless, it still adds up to $1 of fees for every $2 in investment return. Nice business for some.
The Economist is my favorite magazine. Since I joined the 21st century and started downloading it on my Samsung tablet, I can now read it on Thursday nights when it’s published instead of waiting for my physical copy to arrive by mail, on Saturday (if I’m lucky). The writing is invariably high quality and typically well researched. I don’t always agree with their opinions though. They recently suggested that the resignation for personal reasons of Mark Frissora, former CEO of Hertz (HTZ), somehow reflected his prescient forecast that the car rental business is in for hard times. The article relies heavily on Morgan Stanley who are bearish on HTZ.
Of course it’s possible Frissora could be so farsighted. But there are a few problems with this theory. First, the car rental business is great right now. Avis (CAR), HTZ’s main competitor, is enjoying record business. Its stock recently made an all-time high. HTZ business and stock have both been struggling. They still haven’t reported 2013 financials, and in their most recent quarter attributed weak revenues to unexpectedly strong demand from business clients whose advance booking left insufficient cars to meet short term, more profitable leisure customers. Neither one of these issues sound like industry-specific as much as the result of poor management at HTZ.
My guess is that the increasing role of activist investors looked likely to make Frissora’s life miserable. The company is relocating to Estero, in SW Florida and no doubt the Naples golf courses looked increasingly appealing compared with battling Mark Tannenbaum of Fir Tree Partners, a HTZ investor who recently said Frissora, “has completely lost credibility.” Yesterday Carl Icahn reached an agreement with HTZ to replace three existing board members with his own slate.
We thought Frissora would soon be leaving. His departure is good for HTZ investors. We remain one of them.
Sometimes being invested in a stock can feel like being trapped while the enemy takes shots at you from all sides. You were expecting reinforcements to arrive at this exact spot, and while you know you can hang on it sure would be nice to not be fighting this battle alone.
Then, out of nowhere arrives the U.S. Cavalry and although the fight’s not over, you finally believe that victory might be at hand. The stock in question is Hertz (HTZ), which we own, and right now Carl Icahn looks a lot like the U.S. Cavalry.
When an industry has two big publicly traded competitors, comparing their performance is an obvious element of researching their investment potential. HTZ and Avis (CAR), along with privately held Enterprise, dominate the North American car rental market. Consolidation has dramatically improved the prospects for the surviving firms, by reducing competition and thereby allowing price hikes. Rental firms are also making better use of their biggest asset, which is cars. HTZ for example owns Dollar Thrifty and can recycle cars from the Hertz brand whose customers expect a newer car downstream to a lower price point, thereby getting more use out of their cars before selling them. HTZ and Avis are also experimenting with hourly rentals which turn out to be complimentary to their traditional business (business travelers rent for days during the week while hourly renters are typically on weekends). In short, the fundamentals for the business are great.
To examine the periodic public comments from HTZ and Avis you would think they operate in completely different environments. Avis introduced their 2Q results with the following summary, “Our strong second quarter results were driven by our continued growth in both volume and pricing in North America and our relentless focus on accelerating growth in our most profitable channels,” said Ronald L. Nelson, Avis Budget Group Chairman and Chief Executive Officer. “Summer volume and pricing have continued the trends we saw in the first half of the year, and we expect to post record results in our third quarter.”
Meanwhile HTZ, which hasn’t filed a comprehensive financial report this year due to accounting software issues, recently said, “The Company now expects to be well below the low end of its 2014 guidance due to operational challenges in the rental car and equipment segments…”
The operational challenges in the rental market are self-inflicted. The company has been wrong-footed by higher than expected demand combined with recalls on some of their models, with the odd result that, as noted in their recent 8-K filing “Fulfilling advance reservations and contracted business consumed the majority of available fleet. This left the company without inventory to capture more of the higher-rate leisure close-in rentals, which typically generate greater ancillary sales.”
HTZ is a company begging for new leadership. They’re shooting themselves in the foot when their biggest competitor is growing its EBITDA by 19% and expecting a record 3Q. As well as performing poorly, HTZ keeps requesting more time to produce restated financials for 2011-13. It increasingly looks to be just a matter of time before some adult supervision gets involved.
That’s the beauty of investing in public companies. You’re not alone. Carl Icahn has a wonderful quote on his blog from comments he made at a 1988 Texaco annual meeting: “A lot of people died fighting tyranny. The least I can do is vote against it.”
Icahn doesn’t appear to have lost any appetite for a fight during the subsequent 26 years. In the 13D disclosing his 8.7% holding in HTZ, “… lack of confidence in management” was listed as one of the reasons. We share that view. Other notable investors include Glenview (run by Larry Robbins) and Fir Tree (run by Jeffrey Tannenbaum). They’re also fed up with the ongoing mistakes. Tannenbaum recently said that HTZ CEO Mark Frissora, “has completely lost credibility.” We look forward to some fireworks, and to Mark Frissora devoting more time to his golf game.
IBM must be one of the least liked large cap stocks around. The criticisms are easy and familiar: they haven’t grown revenues in years, they are involved in financial engineering to prop up earnings, they are taking on lots of debt to support cashflows. Recently, Barron’s Roundtable noted that Fred Hickey had IBM as a short recommendation.
It’s true IBM has been a poor performer against the S&P500 over the past year. However, it has less volatility than the market with a trailing Beta of 0.66 so all other things being equal you would expect it to lag somewhat when prices are rising. And it’s true that revenue growth for years has been non-existent, hovering frustratingly around the $100BN annual level. However, earnings have grown nicely over the past ten years aided by improving margins and a reduced share count. So although revenues are flat since 2004, over that time EPS has more than tripled from $4.93 to an estimated $17.90 consensus forecast. The sharecount has dropped from 1.7 billion to around 1 billion as they relentlessly return cash to shareholders through buybacks.
As for debt, it’s true that it’s risen although IBM is hardly a leveraged company. They’re expected to finish the year with $48BN of long term obligations less Cash of $17BN for $31 BN of net debt, supporting pre-tax operating income of $21BN. This hardly seems like reckless leverage. Meanwhile, they still look to be on track to hit their target of $20 in operating EPS next year. At $194 a share it just doesn’t seem ridiculously expensive.
As for innovation, in 2013 IBM inventors received 6,809 patents, the 21st consecutive year of being the most prolific recipient of such awards.
So IBM isn’t that exciting on a daily basis, but it does look like a fairly compelling place to invest some of your money if you’re not one of those people who requires daily gratification on your stock picks. Fred Hickey’s price objective on his short IBM was $150 in the abovementioned article. At the time of his interview it was trading at $182 but has since risen $12, over a third of Hickey’s sought after gain. Shorting isn’t easy, and don’t imagine we’re claiming victory because we still own IBM and anything can happen. But there must be better ways to make money than trying to short IBM. They just keep generating cash, $18.1 BN in Cash from Operations (less change in Financing receivables) over the past 12 months, or about $18 per share.
For excitement, watch Amazon (AMZN) as they continue to break records for the most inefficient converter of revenues into profits. In ten years sales have increased sevenfold while EPS has halved. In their most recent quarter over $19BN in revenues, up 23% year on year, generated a small operating loss. The best investment you can make in Amazon is to sign up for Amazon Prime. Being a customer is far more likely to be satisfying than being an owner.
In reading the July/August edition of the CFA Institute’s magazine, an article called “Fragile Trust” by Susan Trammell caught my attention. There’s no doubt that popular confidence in financial services firms was sorely shaken by the 2008 crisis. But it’s still sobering to consider the results of a 2013 survey by Edelman Trust showing that only 46% of respondents expect financial services firms to do the right thing, dead last out of 18 industries considered.
A survey by the Economist Intelligence Unit last year asked financial services executives about the benefits of improving ethical conduct at their firms, and the most popular choice was that it would improve their ability to “withstand unexpected and dramatic risks”. People who work in Finance recognize the value of high ethical standards, and yet the public doesn’t perceive that the industry operates in this way.
Part of it relates to confusion or simply misunderstanding of the difference between brokers-dealers versus investment advisors, or “sell-side” versus “buy-side” in Wall Street parlance. And indeed, why should non-institutional investors even need to know the difference? The structure of U.S. financial regulatory oversight need not be a concern of those outside it. Most investors simply want to invest their money through people whom they can trust. And while that does qualify a pretty healthy majority of finance professionals, the lower standard applied to broker-dealers (sell-side firms) versus investment advisors (buy-side) can expose unwitting investors to abuse.
Broker-dealers don’t have a fiduciary obligation to their clients, simply a requirement to meet a lower standard of suitability and disclosure. Their clients are regarded as being responsible for their own decisions, so while a broker can offer advice (“I think this is a good investment”) he’s not under the fiduciary obligation of an advisor to put the client’s interests before his own.
Many investors find this subtle distinction meaningless or are unaware of it. But it’s what enables, for example, unlisted registered REITs (Real Estate Investment Trusts) to be sold to clients in spite of underwriting fees that can reach 15% of the invested amount. I wrote about just such an example, of Inland American Realty and its underwriter Ameriprise, last year. The fees were in the prospectus so deemed to be disclosed, although it’s expecting a lot to think people will wade through 100+ pages of a legal document. And the regulators were not totally absent as subsequently Massachusetts settled civil claims with Ameriprise on just this security, complaining of high fees and conflicts of interest. The conflict of course comes from the fact that the broker recommending (i.e. selling) the security to their client is receiving the egregious underwriting fees. A fiduciary standard would disallow such a transaction. Such applies to investment advisors but not to broker-dealers.
It seems to me that for the financial services industry to raise itself from being 18th out of 18 industries in surveys of public trust, more and more individuals will need to willingly behave as if the fiduciary standard applies to them even if it does not. Every profession needs to retain the trust of its clients, and Finance needs to as much as any other. The CFA Institute’s Future of Finance Initiative is a good place to start, and professionals on both the sell-side as well as the buy-side can choose to conform to its principles voluntarily. Many already do – the rest ought to.
Recently the Financial Times (FT) noted that the number of U.S. companies raising their dividends had hit the highest level since 1979. Much research has been done on the merits of companies that pay out a large percentage of their profits in dividends (high payout ratio) and those that retain most of their earnings so as to reinvest in their business. Payout ratios have been falling steadily for decades and currently the FT notes that S&P500 companies pay out only 36% of their profits. However, share buybacks have increased over that period so one can’t conclude that the total cash returned to shareholders as a percentage of profits has fallen.
Buybacks are a more efficient way of returning cash because they create a return (through a reduced share count and therefore a higher stock price) without forcing each investor to pay tax on the cash distributed (as is the case with a dividend). Theoretically, publicly listed companies need never issue dividends since any shareholder desiring, say, a 2.5% dividend can always sell 2.5% of his holdings.
One might think that companies with low payout ratios are retaining more of their earnings so as to invest in the high return opportunities they see in their business. This ought to lead to faster dividend growth in the future as the projects provide their payoff. I’m currently reading Successful Investing is a Process by Jacques Lussier, PhD, CFA. The author kindly sent me a copy as I’ll be speaking at a CFA event in Montreal he’s organizing later this year. Mr. Lussier notes some interesting research by Arnott and Asness in 2003 that sought to compare low dividend payout ratios with faster subsequent growth.
In fact, they found just the opposite, that low dividends don’t lead to higher dividends later on. In too many cases it seems that managements are overly optimistic about the opportunities to deploy capital either internally or on acquisitions. And in fact this is the real power of stable dividends with a high payout ratio. Rather than suggesting the company has few interesting projects and therefore nothing better to do than return capital to owners, it imposes a level of capital discipline on management that ultimately leads to higher returns. Companies that return more cash to shareholders have less to squander on ill-judged investments, and the shareholders ultimately benefit.
Incidentally, Master Limited Partnerships (MLPs) represent an extreme case of this. Since they routinely distribute around 90% of eligible cashflows they have very little retained earnings and therefore have to raise new debt and equity capital for any project. This imposes a wonderful discipline on MLP managements in that they’re always having to explain to underwriters and investors what exactly they’re planning to do with the proceeds of a debt or equity offering. It’s one of the reasons MLPs have had such consistently strong performance; so many of their management really focus on return on capital.
It’s all part of the Low Beta Anomaly, the concept that low volatility (or low Beta) stocks outperform on a risk-adjusted basis and even on a nominal basis. So far this year the returns to low volatility investing have been good (for example, the S&P500 Low Volatility ETF, SPLV, is +8.6% through June) as many of the high-flying momentum names crashed during the first quarter. Slow and steady dividends with growth may not appear that exciting, but boring is often better where you’re money’s concerned.
Denis Kessler, CEO of Scor, a large reinsurer, is the most recent critic of today’s low interest rate environment. It’s not only the stereotypical retiree clipping bond coupons that is suffering from current interest rate policy. Insurance companies typically hold substantial amounts of their investment portfolios in bonds, both because of regulatory requirements as well as the need to respond to claims whose timing is often unpredictable. Kessler claimed that central banks were “ruining” the insurance industry, and claimed that insurers were the unwitting victims of the aftermath of the financial crisis even though they didn’t create it (AIG and its credit derivatives portfolio presumably notwithstanding).
Warren Buffett has described an insurance company’s “float”, that is, the premiums they receive in return for making payments in the future, as akin to being paid to borrow money. This is true to the extent that insurance companies can operate with a Combined Ratio below 100% (that is, the sum of underwriting losses plus operating expense as a % of net earned premiums). If they spend more than their premiums then of course the float costs money and the difference needs to be made up on the investment side.
Most insurance companies either through poor underwriting or competitive pressure slipped into just this model, whereby positive investment results were needed to cover a Combined Ratio above 100%. One of the capital disciplines practiced by Warren Buffett’s Berkshire Hathaway (BRK) in its insurance business is to separate out the management of the float from the underwriting, so as to prevent success at the former from compensating for poor execution of the latter. BRK’s insurance businesses have generated a net underwriting profit for eleven straight years. One clear benefit of separating underwriting from investing is that the insurance executives at BRK have little incentive to grow via unprofitable business expecting to rely on strong investment results as support.
However, for many insurers persistently low interest rates have heaped pressure on one side of this equation. One might have expected the market to adapt, through a “hardening” market (insurance-speak for rising premiums) given lower investment returns, and while this has happened to a degree pricing hasn’t adjusted as much as needed. This is why so many insurance companies trade at a discount top book value – because while profitable, they’re not yet earning an appropriate return on equity.
Aspen Insurance (AHL) is one that we have liked in the past because of their well regarded management but it still trades at only 87% of book value (we don’t currently own AHL). Another name we have owned in the past but don’t at present is CNA also at 87% of book value. We continue to own AIG which is valued at 83% of book value excluding unrealized investment gains (or only 76% of book value if you include such mark-to-market gains, which isn’t an unreasonable approach). And we also own BRK, which trades at around 140% of book value but is of course a diverse conglomerate with large operating businesses and a substantial investment portfolio. You don’t often hear them complaining about low interest rates, either.
Our Hedged Dividend Capture Strategy is designed to extract dividend income from equities while mitigating equity market risk through hedging. It’s designed for investors used to better returns from high grade bonds.
The chart above doesn’t look like much, but it represents a snapshot of the thinking of the Federal Open Market Committee (FOMC) on interest rates. Their communication has come a long way since the days of cigar-chomping Paul Volcker in the 1970s, when they went out of their way to disguise their intentions. Alan Greenspan inherited this culture and while in his early years he clearly relished confounding Senators with his unintelligible responses during Congressional testimony, over time he initiated a move towards greater transparency around the Fed’s decision making process and objectives. Ben Bernanke continued this and no doubt the trend will be maintained under Janet Yellen.
On the chart above (reproduced from the Fed’s website), each dot represents the view of a single FOMC member on the year-end level for short term interest rates (specifically, the Fed Funds rate). There are 16 voting members and each provides a forecast for the end of this year, 2015, 2016 and the long term. I’ve been watching these releases for nearly three years because over time they provide a fascinating picture of their evolving interest rate views.
The first three annual forecasts (2014-2016) can almost be used to construct a yield curve. Indeed, interest rate futures contracts are now often described as priced above or below the Fed’s forecast. Of course, their rate forecast can be wrong, just as the economic forecasts on which it’s based can be. Circumstances change, and there’s nothing intended to be inflexible about these figures. But it does allow us to see more clearly whether economic events alter their view. For example, U.S. GDP growth in the first quarter was quite weak at -1.5%, due largely to the harsh winter those of us in the north east endured. However, the FOMC has a reasonably positive view of growth for the remainder of the year (2.1%-2.3% for all of 2014 which implies around 3.4% on average for the remaining three quarters). As a result, they very modestly tweaked their rate forecasts higher over 2015-2016 (by about 0.07%-0.10%).
More significantly in my view, their long run forecast of interest rates fell from 4.0% to 3.75%. This is the equilibrium rate at which they think rates should settle assuming they had no bias to run monetary policy with either an accomodative bias (as it is now) or a restrictive one. 3.75% is neutral. It takes account of their long run estimate of inflation and of GDP growth.
Back in early 2012, their median long run forecast for rates was 4% and they raised it to 4.25%. They brought it back down to 4% last Summer and then 3.75% yesterday. If their forecast is right (and their forecasts are more important than anybody else’s) it means the fair value yield for, say, a ten year treasury security is a little lower. An investor now ought to be willing to hold it at a somewhat lower yield than before since in theory a ten year bond represents roughly the average short term yield over that period of time.
Steve Liesman from CNBC picked up on this and asked Janet Yellen in her press conference yesterday what was behind this shift. She noted that the composition of the FOMC had changed since the last forecast in March which might make the comparison less meaningful (two voting members were replaced according to a rotating schedule). But she conceded that it also probably reflected a more modest view of long term GDP potential in the U.S. economy.
For investors, it confirms what we’ve long felt, which is that interest rates are likely to stay relatively low for a long time. The Fed’s not about to make bonds more attractive by pushing rates sharply higher, so they will remain a fairly unattractive investment choice. And while you can’t infer too much about equities from the Fed’s interest rate view, it still seems likely that stocks will provide superior long term returns compared with bonds over the medium term.
Earlier this week I was at the 67th CFA Institute Annual Conference in Seattle. It enjoyed a record attendance of over 1,800 and I have to say was one of the better organized events I’ve been at, situated in the cavernous Washington State Convention Center. One thing I particularly liked was that the networking doesn’t involve people trying to sell you something, and the fact that delegates are overwhelmingly CFA charter holders results in a good probability of an interesting conversation.
Sheila Blair, former head of the FDIC, gave a very good talk on the regulatory landscape and improvements she would like to see. Canada avoided any sort of financial crisis and in response to a question she concurred that being “a little more Canadian” would be a good thing in the U.S., pointing to campaign finance reform as one area that could reduce the ability of Wall St to influence the legislative process.
I also like the CFA’s new initiative, The Future of Finance which includes as one theme Putting the Investor First. The CFA is a great organization to be taking a leadership role in the debate about the financial services industry and how well it is meeting the needs of clients. As long as unlisted registered REITs, with their egregious underwriting fees, and closed end fund IPOs (which invariably trade to an immediate discount) are part of the landscape there is much room for improvement.
I gave a presentation titled, “The Fallacy of Hedge Funds” which relied on my book, The Hedge Fund Mirage. The audience was very generous with their attention and questions.
Afterwards I did a couple of interviews with the FT, one on hedge funds and the other on High Frequency Trading. HFT was the major topic of conversation at the conference.