Thursday, December 23, 2010

Discussing SURW on “The Contrarian” (Episode 1)

Posted by Michael Rog on 12/23 at 10:30 AM

(0) CommentsPermalink

Monday, March 22, 2010

Emerging and Frontier Markets: Where the Money Will Flow

There is a tidal wave of money, and over the next 100 years it will flow to every Emerging (EEM, VWO, EEB, BKF) and Frontier (FRN, GAF) market on earth which practices prudent economic policies and provides a stable business and political environment.

There are five main reasons why money will continue to flow to these markets.

  1. Cost advantages.

  2. Natural resources.

  3. Debt payments.

  4. Currency undervaluation.

  5. Interest rate differentials (Carry trades).

As the kind reader has already observed, the first four points are rather obvious. A lot of ink has been spilled over cheap labor, abundant supplies of oil/natural gas, the creditor status, and currency undervaluation in Emerging and Frontier countries. This has only been equaled by the inversely proportional legislative response in Developed nations (nothing has been done).

The carry trade has been given a lot less attention. The problem with humans is that we find it very hard to comprehend, and more importantly accept, that largely impersonal forces shape our everyday existence, the fabric of our lives, and the fate of nations. The carry trade is precisely such an impersonal force. Capital goes where it is treated best, like customers for fine dining. When meal sizes are anemic and interest rates are low, customers leave and head for more hospitable, higher yielding environs, or commodities.

A strong argument can be made that in some (but not all) Emerging and Frontier countries, higher interest rates are accompanied by lower risk.

In retrospect, it is quite obvious to many economic observers that the Yen carry trade supplied huge amounts of cheap capital to American markets in the mid to the late 90s, super-charging the bull market and the tech bubble. Decades from now, it will be obvious that our own low interest rate environment fueled a bull market in Emerging and Frontier markets which will go down in the history books as fueling global development far more than any intentional government handout.

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like "pushing on a string." There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world's carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

I concluded the article by saying:

Americans may finally realize that there is a free lunch after all--we will be supplying it as speculators borrow in our low-yielding currency to invest elsewhere.

A high level view of geopolitical situation in the next 100 years will be Convergence. Really, the Ultimate Convergence Trade. Political convergence, as Francis Fukuyama and Daniel Yergin/Joseph Stanislaw have argued, has occurred. There is a global consensus that free markets work. There is a global convergence of mass culture (if you disagree, just ask the French. For years, they have bemoaned “Americanization” before anyone else did). There is a global convergence of values—Democracy is good, “Theocrazy” is bad, etc.

The two convergences that we have yet to see are wage rate convergence and interest rate convergence. Of course, countries at equal levels of development will have slightly different wage rates and interest rates tied to differing tax rates, regulatory regimes, labor law, political/civic virtue, economic policy sophistication, central bank policy, etc. But these disparities are minimal compared to the disparities in wage rates and interest rates between Emerging, Frontier, and Developed nations.

A good rule of thumb is that the meat of interest rate differentials will be eliminated only when Emerging and Frontier countries develop to the point that their wage rates converge with Developed nations (in other words, only when they are fully developed). That could take over 100 years, even in a nation such as China (FXI, GXC, HAO). In the meantime, there will be a lot of money to be made by borrowing in dollars and investing in Frontier and Emerging markets.

But, you may say, that's crazy. In 2008, the dollar strengthened, proving that even if investing in Emerging and Frontier markets is prudent during times of political stability, that periodic instability in financial markets makes such investment stance implicitly short gamma, or short volatility. That is probably a fair criticism. Therefore, the rational investor may want to keep leverage fairly low (if it is used at all) and have strict criterion for moving to cash.

However, the U.S. government has made it very clear that it wishes to devalue the dollar. Recent events have made this quite obvious. The recent Federal probe into hedge funds betting against the Euro has been totally misinterpreted by the public and the media. The real story, of course, is that when the Euro drops, the dollar rises. In essence, the government is pressuring these funds to not bet on the dollar and to not allow it to strengthen. Unfortunately, in the future, we may see more of that.

The flow of money adheres to largely impersonal forces such as interest rate differentials. In Global Macro, the sound advice is not to fight it.

If, however, we wish to improve public policy in the developed world, we have to fight the challenges of uncompetitive cost structures, high natural resource prices, a debt-laden economy, and a weak dollar head on.

Disclosure: Long FXI, GXC, no other positions in securities mentioned. Positions may change at any time.

 

Posted by Michael Rog on 03/22 at 02:39 PM

(0) CommentsPermalink

Monday, March 15, 2010

Time for Google to Show Some Backbone

Much has been made of the fatuous notion that the Chinese government is hesitant to kick Google (GOOG) out of the country. Nothing could be further from the truth. Indeed, the notion that the Chinese absolutely need American search technology is an ethnocentric bias which says more about our own arrogance than it does about Chinese motivations.

The number one thing to understand about the Chinese is that they look out for their own. Indeed, as has often been said, there is nothing free about free trade. They sell us T-shirts and pirate our software. When they cannot pirate something, such as Visa (V) or Mastercard (MA) services, they seek to set up their own domestic monopolies, such as China UnionPay.

The same thing is happening with search. Baidu (BIDU) could become, in essence, a Chinese search monopoly free from serious foreign competition. That has been the goal all along. Like Japan with their national champions, Honda (HMC) and Toyota (TM), the Chinese seek to help their companies in any way they can (underhanded or not), rather than tear them down, as we do in the U.S.

Which brings us to the second major dynamic in China's national strategy. The Chinese remember something very primal about capitalism that we have forgotten in the U.S. For them, the goal is not to compete. Their goal is to win. As basic as it sounds, in the U.S., for too long, we have believed the fairy tale that we can have perpetual competition without winners or losers. The Chinese have no such illusions. Unless we embrace reality, we will go the way of the British Empire and collapse from the soft decadence of low expectations.

What should we do? Google should fight to the bitter end. That means forcing China's hand and making the government forcibly shut down Google in China. For too long (as Google itself might admit), Google has showed no backbone when it came to complying with the censorship dictates of the Communist Party. Google should engage in a three step plan which would show solidarity with the Chinese people, while maintaining management's fiduciary duty to shareholders to maximize long term profits.

I. Rather than using non-compliance as an excuse to gracefully pull out of China, Google should be openly defiant.

II. Second, if the Chinese did forcibly shut down the site, Google and the U.S. should use such an action to demonstrate to the WTO that China is using censorship, and in effect, human rights violations, to hinder free trade.

III. Third, the WTO would be pressured to tie the issues of human rights violations to free trade, since Google would be able to show that since it didn't comply with human rights violations, that it wasn't allowed to compete.

Google's situation in China highlights a very basic question. Can countries use human rights violations as a pretext to constrain free trade? If the WTO rules that they cannot, it will set a very important precedent which ties the privileges of free trade to responsibilities as a full member of the international community. But first, Google must show some backbone and force the issue. Doing so is the only way they can make up for past complicity with Chinese Communist Party oppression.

Disclosure: Long BIDU

Posted by Michael Rog on 03/15 at 02:43 PM

(0) CommentsPermalink

Sunday, March 07, 2010

China’s Currency / Commodity Strategy

Commodity prices and yuan appreciation are inextricably linked. While foreign governments can pressure China to allow the yuan to strengthen, most policy makers overestimate the influence that they have over foreign governments. Indeed, the number one influence on the yuan exchange rate is the price and the availability of industrial commodities.

Traditionally, countries with weak currencies have paid proportionally higher prices for commodities. China has escaped this fate by attempting a global commodity grab aimed at directly sourcing raw materials for its voracious manufacturing, construction, and energy industries. This is vertical integration at the national, as opposed to simply company, level.

Why is vertical integration so important to China strategically? Because in order to gain the full advantage of low-cost leader status through a weak currency, China cannot afford to pay higher commodity prices, which would lead to inflation and to higher prices for finished products, eroding the very cost advantage that a weak currency confers. Indeed, if commodity prices, denominated in yuan, spun out of control, China would be forced to allow its yuan to appreciate in order to secure commodities at economic rates.

Therefore, on a very real level, it is China's access to plentiful and cheap supplies of commodities that is allowing it to maintain a relatively weak yuan. Indeed, American policy makers would do well to take a page of out China's playbook and to secure cheap supplies of energy around the world if we wish to stave off inflation while continuing to debase the dollar.

During the Cold War, we had Mutually Assured Destruction. In our own time, if all nations imitated China, it would be a policy of Mutually Assured Devaluation. We can see it now in Europe, where the monetary debate has concluded with a consensus that the European Central Bank's conservatism has lead the Euro to appreciate against the dollar to such an extent that it has damaged European manufacturing.

The Chinese are not, contrary to popular opinion, practicing neo-Mercantilism at all. In Mercantilism, according to Adam Smith, countries equated Gold bullion, or hard currency, with wealth. The Chinese are under no such illusions. They correctly equate plentiful supplies of industrial commodities with wealth when paired with their manufacturing base.

The distinction is important, because a cheap supply of industrial commodities represents a long term cost advantage for Chinese industry independent of currency manipulation. The Chinese have learned from the Japanese experience and are intent upon securing commodity supplies to build upon their advantage of cheap labor with cheap input prices. Indeed, even the yen eventually strengthened. What were the Japanese able to source for cheap raw materials? The lumber from bonsai trees?

If we agree that China's access to cheap commodities lies at the heart of its ability to keep its currency weak—indeed, to have its cake and eat it too—we then must agree that China doesn't need to change. We do. The United States must also vertically integrate in order to better compete.

How can the U.S. successfully vertically integrate and maintain such integration?:

  1. We can aggressively develop domestic sources of fossil fuels and minerals.

  2. We can use military force to prevent foreign governments from nationalizing American assets.

  3. We can develop renewable energy sources at home.

  4. We can make high-impact/low-probability bets on fusion.

  5. We can out-bid the Chinese when they attempt to acquire foreign commodity supplies.

  6. We can build hundreds of new nuclear power plants.

However, doing nothing is economic suicide. U.S. policy makers are attempting to beat the Chinese at their own game and to engage in Mutually Assured Devaluation. If policy makers do succeed, the U.S. dollar will depreciate, commodities priced in dollars will sky-rocket, and interest rates will go sky-high.

Unlike China, which has an additional cost advantage of plentiful capital from its high savings rate, the U.S. has no such cushion. Therefore, in any Mutually Assured Devaluation, China would have comparatively lower real interest rates, further increasing its cost advantage, to say nothing of the fact that it would dramatically curtail its purchases of U.S. government bonds, further driving up U.S. interest rates.

I propose that the iron law of modern economics is that countries can be a net importer of capital, commodities, or goods, but not all three simultaneously if they want to achieve sustainable economic growth. The examples are numerous. Just examine Western Europe vs. Saudi Arabia, Brazil, and Asia.

Currently, the U.S. is a net importer of energy and a net importer of manufactured products. Ridiculously, the U.S. also imports (borrows) some of the capital to pay for them. Never have so few produced so little to consume so much. There is an old saying in Economics. “If something cannot continue forever, it generally doesn't.” With its global hunt for cheap commodity supplies, high savings rate, and cheap labor, China can keep its currency cheap almost indefinitely. We will have no such luxury, as the pain from a dollar devaluation will swamp any benefits. We no longer have the option to do nothing, nor to engage in a policy of devaluation. We literally have no policy flexibility—at least no policy option surrounding currency or interest rate manipulation which will work well in the long run.

We should be careful what we wish for. A dollar devaluation in relation to the yuan will not help us. Becoming a vertically integrated nation, with a plentiful supply of cheap commodities, will. Unfortunately, we will never have cheaper labor prices than China. However, we can have cheaper input prices. If we wish to compete, cheaper input prices are not optional—they are a requirement for maintaining our way of life and competing effectively in the global markets.

Disclosure: No positions

Posted by Michael Rog on 03/07 at 02:44 PM

(0) CommentsPermalink

Tuesday, February 02, 2010

U.S. Antitrust Policy: The Myth of Monopoly

Few have done more than Robert Bork and Richard Posner to elucidate the central problem with antitrust policy in the U.S.--namely that, contrary to its objectives, inefficient firms are protected from competition, and as a result, consumers are hurt by higher prices.

Recent events have proven that assessment to be wildly optimistic. I would argue that, overwhelmingly, U.S. antitrust policy which prevents M&A shields foreign firms from strong U.S. competition, hobbles our companies from successfully challenging foreign competitors for market dominance, is a leading cause of our trade deficit, and leads to widespread U.S. unemployment

In effect, our companies compete, but they do not compete to win, since they are not allowed to grow to a size which would allow them to crush foreign competition. Foreign firms are under no illusions. They are conceived, designed, managed, and grown to win in the battle place of global markets and are often regulated by governments which recognize that in any human endeavor, superior human ingenuity, discipline, and execution leads to a winner of that competition.

Our firms are competing to compete. They are not playing to win. Like little league parents who coddle their children, our government, in its effort to promote competition, is ensuring that our firms are wholly unprepared for victory in global markets.

The U.S. government needs to think globally. Even a company which is dominant domestically, might pale in comparison to the size of the global market and the foreign competition. It is naive to think that gnats can compete effectively against giants and win. U.S. firms must be allowed to freely merge in order to compete.

Some recent examples:

  1. The Big Three (at risk of becoming The Three Dwarfs). Ten or twenty years ago, could you have imagined the U.S. government allowing all three to merge in order to better compete with Toyota (TM) and Honda (HMC)? The country would have screamed monopoly, but what do we have now? Three inefficient companies with higher prices than Japan's national champions, massive unemployment, and layoffs. Wasn't antitrust law supposed to protect consumers with lower prices? Instead, it has left us unable to compete with an onslaught of lower-priced competitors, from Japan, Korea (Hyundau/KIA, etc), and soon China.

  1. Google (GOOG) vs. Baidu (BIDU). Google may be dominant in the U.S., but even before it contemplated pulling out of China, Baidu had over two-thirds of search engine market share in China. Search depends upon mobilizing vast amounts of human capital and spreading out those costs over billions of tiny transactions. If we do not allow companies such as Google to grow (by acquisition or otherwise), they will lose dominance to countries that put no such restrictions on their national champions, who will soon be knocking on the door of our domestic markets.

  1. eBay (EBAY) vs. Alibaba's Tabao. Alibaba's Jack Ma has already crushed eBay in his fight for China's internet auction market. Now he has vowed to now take on Amazon and eBay on their home turf. Given his record, why shouldn't we believe him? What's the unconventional conclusion? In a bid to make us competitive, the U.S. government should not put up barriers to companies such as eBay, Amazon (AMZN), Google, or Apple (AAPL) merging or buying up smaller competitors. By allowing these companies to merge, the government would be allowing them to better compete. Losing our manufacturing base has been bad enough. We cannot afford to lose our superiority in hi-tech.

Now for the unpopular ones...

  1. Big Oil” is “Tiny Oil.” 95% of the world's oil and natural gas reserves are controlled by foreign state-owned oil companies. Like high-tech companies, but more so, energy exploration depends upon mobilizing vast amounts of financial capital and technical expertise to explore and to develop new fields. Moreover, if companies such as Exxon Mobil (XOM), Chevron (CVX), and ConocoPhillips (COP) were allowed to merge, they could have much more leverage against erratic foreign governments, such as Hugo Chavez's regime in Venezuela, which seek to unilaterally seize the assets of U.S. Companies. If we do not want to import so much foreign oil, we have to allow American companies and American ingenuity to compete. Currently, the share of all U.S. energy companies combined is not enough to make a dent in global energy supply, which will require the exploration and development of vast super fields far offshore, the development of more efficient means to extract energy from shale and tar sands, or even massive nuclear, hydroelectric, wind, and solar projects.

  1. Steel. Shrewd operators such as ArcelorMittal now dominate the global steel industry. U.S. Steel is an also-ran. No American firm can currently challenge Lakshmi Mittal and his son Aditya Mittal (MT) for dominance of the global steel industry. It is rather like trying to fight Mike Tyson with both hands tied behind one's back. It would take dozens of mega-mergers of U.S. firms in order to even mount a credible challenger. Unfortunately, long before a U.S. competitor would become viable, I expect that the antitrust authorities would put a stop to it.

Conclusion

American ingenuity needs a chance to compete More efficient foreign firms are mauling us in global markets, leading to the widespread failure of U.S. Companies, such as GM's recent near-death experience.

When our companies cannot effectively compete, neither can labor. Unemployment goes sky-high. Rational public policy, which would create an environment essential for U.S. success, has been replaced by irrational policies which result in subsidies for industry.

We pay three times—first, with higher prices for consumers; second, when public policy failure leads to bankruptcies and layoffs; and third, when we put companies on life support which we never allowed to effectively compete.

As Americans, we have never been afraid of foreign competition until we have been prohibited from successfully meeting it by severely misguided government policies. Current antitrust policy protects neither consumers, nor labor, nor companies, nor our trade deficit. The competition experiment hasn't resulted in greater competition. It has resulted in higher prices, layoffs, and the dominance of foreign firms. When will the U.S. government make it legal for American firms to compete again?

Unfortunately, U.S. companies such as GE have learned that the European Union can be even more capricious when it tried to merge with Honeywell in 2000-2001. Perhaps the developed world as a whole needs a new approach to allowing M&A. Emerging countries already recognize that only strong companies can compete. The only alternative to robust M&A is slow, but perpetual decline leading to the loss of our standard of living and the loss of our way of life.

Disclosure: Author holds long positions in BIDU, AAPL and EBAY

Posted by Michael Rog on 02/02 at 02:45 PM

(0) CommentsPermalink

Monday, January 11, 2010

Cheap Is No Longer Good Enough

by Toby Shute, Fool.com


After a recent college reunion/homecoming, I had a chance to connect with fund manager Harry Long, the managing partner of Contrarian Industries. Long's company specializes in alternative asset management, algorithmic system research and development, and strategic consulting. Harry and I had a wide-ranging conversation about fundamental and systematic approaches to investing. Here's an edited portion of our exchange.

Toby Shute: You've described your investing approach as an attempt to marry the qualitative with the systematic. This reminds me of Warren Buffett's description of his investment strategy as 85% Benjamin Graham and 15% Philip Fisher. Let's start with Graham. What was his most important contribution to the investment field?

Harry Long: Graham's most important contribution to investing was the brilliant way he went about systematizing it. He gave very clear, mechanical rules, which outperform most discretionary human investors, even today.

If you look at services like Validea.com, the American Institute for Individual Investors, and countless other services, they have taken his dictates from The Intelligent Investor and put them into a screen, which beats the pants off just about everything else developed since.

I think Joel Greenblatt is trying to follow in that tradition. We'll see how he stacks up to Graham. It's a noble pursuit.

Shute: Phil Fisher is known for focusing on the characteristics of a great growth franchise, some of which are impossible to quantify. Importantly, though, he weeded out potential investments using a 15-point checklist that he applied pretty strictly. Are checklists an effective way of systematizing a qualitatively oriented investment process?

Long: When it comes to checklists, I've seen many, but very few good ones. It's really multiple simple rules, when applied in combination, that get you performance. For instance, if investors automatically sold, or had a rule against investing in, any company with earnings decreases of greater than 14% in any quarter, they should have sold almost all bank stocks in 2008.

In practice, you'll find that a well-designed system, using objective data, will often key in on companies that Fisher would have appreciated qualitatively. You have to do both, but I would encourage your readers to find businesses with great metrics and then ask "why?" rather than trying to find great stories which may or may not be executing.

Shute: What else can investors learn from Phil Fisher?

Long: Most investors would do best to stick to Fisher's basic tenet -- buy businesses with strong competitive positions. As Fisher pointed out, if you avoid companies with unhealthy profit margins, you save yourself a lot of money, sleep, and heartache. On the other hand, there are occasionally companies such as Wal-Mart (NYSE: WMT  ) that have low margins on purpose.

As for his focus on R&D, it's pretty hit-or-miss. Apple (Nasdaq: AAPL  ) and Google (Nasdaq: GOOG  ) would be examples of great success stories. However, while the Intels (Nasdaq: INTC  ) of the world had great runs, they are still plowing billions into R&D and hitting a growth wall.

Investors should have a diversified portfolio of quality. Cheap is no longer good enough -- investors need to search for cheap and excellent. Competition is simply too brutal, unless you are in a position to take control of ailing firms.

Shute: Can you apply this advice to a particular sector?

Long: In the financial sector, rather than owning banks, which risk capital through lending and have infinite competition, [investors] could own something like MSCI, which gets fee income from its MSCI indices. It doesn't risk capital. Simple business -- you hand me money, I hand you information -- and it has very little strong competition in the index business. MasterCard (NYSE: MA  ) and Visa (NYSE: V  ) also don't have the same balance-sheet risk as an issuer like American Express.

I could go on and on. Just because you're investing in the financial sector, you don't have to be conventional.

[Michael] Bloomberg understood that the way to be successful is to sell the miners their picks and shovels. Why does everyone spend time studying banks, rather than his example? Why aren't people obsessed with studying FactSet Research Systems (NYSE: FDS  ) ? Maybe it's a tabloid phenomenon where success is simply too boring.

You've heard Harry's approach to tackling these two threats to your wealth. How do you deal with them? Have you systematized your approach to picking great companies? Sound off in the comments section below.

Harry Long's comments are purely his personal opinions and should not be construed as financial or investment advice.

Posted by Michael Rog on 01/11 at 02:50 PM

(0) CommentsPermalink

Sunday, January 10, 2010

Tackling 2 Threats to Your Portfolio

By Toby Shute, Fool.com (Reprinted with permission.)


Harry Long is the managing partner of Contrarian Industries, which specializes in alternative asset management, algorithmic system research and development, and strategic consulting. Continuing our previous conversation on smart stock selection, Harry and I also discussed two great challenges for today's investors: dealing with global competitiveness and surviving bear markets.

Toby Shute: Before an investor even gets to the point of evaluating an individual security, he or she needs to decide which ones are worth looking at. For Buffett, the answer is to "start with the A's" -- i.e. look at everything -- but that's hardly practical for most humans. And as Seth Klarman has written, investors following this approach "will spend virtually all their time reviewing fairly priced securities that are of no special interest." How do you resolve this issue?

Harry Long: I love the question. It highlights my own struggle. When I was younger, I went through every non-bank SEC reporting company in the U.S. below $100 million in market cap. I barely slept, and it nearly killed me, but I found companies like Crown Crafts that returned around 6.5 times my money.

There was a lot of low-hanging fruit to pick from in Warren Buffett's youth. There is almost none today in the U.S.

Shute: I know that one of the primary criteria you seek in a business is a strong competitive position. Some Fool favorites, including Best Stock for 2010 nominees Intuitive Surgical (Nasdaq: ISRG  ) and Intel (Nasdaq: INTC  ) , certainly fit the bill here. Why is this attribute so important?

Long: The world has changed. Up until the mid 1980s, you could pick a group of mediocre companies that were cheap and heavily diversified and make 17% a year before foreign competition destroyed every smokestack industry, as Buffett famously prophesied.

The public is slowly beginning to understand that the process of brutal foreign competition is only accelerating. GM might think Toyota (NYSE: TM  ) is brutal, but I assure you, Toyota will look like a fuzzy teddy bear compared to what the Chinese are going to do to the auto industry. The margins in every single industry will be destroyed. Absolutely decimated. The equivalent of the $5,000 car will be introduced in every heavy industry, and it will destroy companies which lack protection from competition, or aren't low-cost leaders.

If you really want a nightmare, think of the coming competitive progression in autos from Japanese and Korean to Chinese and maybe eventually Vietnamese competition. It will never end. That process will probably continue for well over 100 years, until world wage rates begin to converge with free trade and unfettered competition.

The public thinks that recession is the problem, but that's totally backward. The problem is prosperity. Aggregate demand will increase over time, but each individual firm, if it lacks protection from competition, will see the individual demand for its products decrease, as the number of competitors explodes.

Shute: How might our readers uncover such competitively advantaged companies using a stock screener like the one we offer over at Motley Fool CAPS? Contrarily, what might cause a screen to miss such great businesses?

Long: Your readers should ask themselves, "What makes a great company?" Then they should tinker with every screener they can get their hands on. Ideally, not only would they ask normative questions, but they would also backtest, or find people who have. Then they should ask themselves what would change the relationship between variables going forward.

No database is complete, or 100% accurate, so you have false positives and false negatives. Also, there are certain wrinkles in accounting that can lead to errors as well. So optimally, you're using multiple databases to plug as many holes as possible.

Shute: Would the market be significantly more efficient if someone like Google (Nasdaq: GOOG  ) or Morningstar (Nasdaq: MORN  ) made publicly available all the financial data and screening tools that institutional investors have access to?

Long: Yes, undoubtedly, but only to the extent that the public became well informed about the most predictive factors and actually used them, as opposed to gambling.

Shute: Garry Kasparov lost to IBM's (NYSE: IBM  ) Deep Blue in 1997, which rocked the chess world. Do purely mechanical investment systems have a shot at beating active fund managers like Legg Mason's (NYSE: LM  ) Bill Miller over a multidecade time frame, or will they merely augment human judgment?

Long: My sense is that, over time, good systems will beat most discretionary traders, but there are always a few extraordinary individuals out there who challenge one's notions about human potential. Over a multidecade time frame, I believe people will do best when they combine human judgment with systems.

Shute: Thus far we've talked about systematizing the process of security selection. You've also implemented a system to automatically take positions, long or short, based on an algorithm that evaluates long-term market direction. Is this a big leap, philosophically or in practice, from using quantitative methods to pick stocks?

Long: It is a huge leap. Most quantitative equity managers screen for P/E ratios and P/B ratios and call it a day. That did not save them from the carnage of 2008. An accurate system for market direction is key.

Why should today's investor be content to be ignorant about market direction? Market direction is an entirely worthy subject of intellectual inquiry. It is a mistake not to study it systematically. Investors cannot afford to be closed-minded, unless they can afford to periodically see their portfolio cut in half, or worse.

Just imagine how terrifying it would have been to be a Japanese equity investor for the past 20 years. They lost more than two-thirds of their money. Does the same thing need to happen here before people are willing to rigorously explore serious questions about markets?

Shute: One clear advantage of having a system to identify market direction is that it frees up one's time to stop worrying about the macro and just focus on security analysis. What are the other potential benefits of
this approach?

Long: Our understanding is that it has the potential to lower drawdowns. However, while drawdowns can be reduced, they never, ever, go away. The wonderful thing about a system is that unlike a human, it doesn't care which direction the market moves -- it just cares about movement. You can take a year like last year, which devastated most investors, and a system could do very well. The most important thing for people to remember is that people's behavior does not have to be rational in order to deal with it systematically -- it can be highly irrational, as long as it repeats in a statistically measurable way.

In addition, the same method which picks markets direction can be used systematically to enter and to exit stocks that have been chosen by more traditional fundamental algorithms.

Shute: Any last words?

Long: Trust no received wisdom, test everything, and build something useful that lasts. Has it ever worked any other way?

Posted by Michael Rog on 01/10 at 02:47 PM

(0) CommentsPermalink

Thursday, November 12, 2009

Congress and the Fed: An Epic Game of Chicken

With the Federal Reserve worried about its independence, it has a Faustian bargain to make: keep its independence, or keep interest rates low.

Essentially, many in Congress would like to see the Fed keep interest rates lower for longer than it might if left to its own devices, in order to stimulate employment. It is a frightening prospect that pressure is being brought to bear on Chairman Ben Bernanke to keep monetary policy loose—the same Chairman who once wrote that the Fed could drop money from helicopters, if necessary, to prevent a severe deflation.

If the purpose of Fed independence is to keep monetary policy independent from politicians, who always prefer inflationary policies, it is essential that Ron Paul’s bill, which seeks to audit the Fed (a necessity) is not used as a backdoor method by Congress to gain control over monetary policy.

Bernanke is in a tough position. He wants to maintain the Fed’s prerogatives to set monetary policy. However, to do so, he may be tempted to bend to the will of Congress and keep interest rates lower than he might otherwise in the absence of external pressure.

If power is the ability to influence, then Congress, in practice, has huge power over the Fed if it’s Chairman allows himself to be tempted to make the Faustian bargain of keeping interest rates low, in return for the maintenance of Fed independence. If Bernanke does not show backbone, Congress would not even have to pass a bill giving itself more power over monetary policy. It would simply have to threaten to do so every time it was unhappy, holding the Fed hostage to political whims. To his credit, Ronald Reagan supported Paul Volcker’s inflation fighting stance, however unpopular with Congress. Chairman Bernanke should be similarly supported by President Obama in the area of monetary policy independence.

Distrubingly, the New York Times’ Edmund Adrews noted on November 11.

Voters had become suspicious and unnerved by the Fed because of its trillion-dollar efforts to bail out the financial system, Mr. Frank warned. If the Fed really wanted to survive the disgruntlement in both parties, he continued, Mr. Bernanke would have to step back and let him devise a compromise.

Reluctantly, the Fed chairman agreed to reduce his own visibility on the issue and let Mr. Frank take the lead.

This is exactly the wrong approach for Chairman Bernanke to pursue. Rep. Frank is a shrewd politician. The scenario which is unfolding should be a familiar one to Chairman Bernanke if he has ever been pulled over for a questionable “traffic violation.” It’s good cop-bad cop. “We’ll help you, just stop fighting us.” Congress does not want to help the Fed. Like any institution, it wants to expand the sphere of its own authority. Can anyone guess who will have more power under any compromise bill? House Financial Services Committee Chairman Barney Frank.

Compromise on monetary policy is a fool’s errand.  Instead, the Chairman Bernanke should take a hard line, conceding that the Fed over-stepped the bounds of prudence in supporting problem banks and agreeing to tighter strictures in that area, while vehemently fighting to protect the Fed’s prerogatives in setting interest rates. If the Chairman does not, long-term inflation, and indeed, hyperinflation could result.

Otherwise, if Bernanke succumbs to the temptation of appeasing Congress by keeping interest rates artificially low (which is what most members of Congress really want), he will have given up his power without a fight, and more importantly, compromised the integrity of the very currency whose value he is mandated to protect.

Bureaucracies have a bad record when its comes to a question of the public interest vs. the perpetuation of the bureaucracy. Unfortunately, it looks like Bernanke may have already made his choice. Earlier this week, multiple Federal Reserve officials gave speeches around the country, openly stating that the need to spur jobs was worth the risk of inflation. This is a clear message to Congress: “We’ll do what you want, just leave us alone.” It’s also a clear message to investors. More inflation is coming.

The Fed needs to educate Congress and to fight for prudence. Higher prices hurt ordinary citizens when their dollars don’t go as far. When citizens can afford less, it hurts demand for good and services, reducing GDP growth and employment. It’s a simple argument, and it’s the right argument. The Fed should make it.

Disclosure: Author holds a long position in GLD

Posted by Harry Long on 11/12 at 03:13 PM

(0) CommentsPermalink

Tuesday, October 27, 2009

The Witch of Inflation

In the folk tale Hansel and Gretel, the children’s stepmother convinces their father the woodcutter to abandon them deep in the forest so they cannot find their way back home.

Hansel can only leave a trail of breadcrumbs from the bread he has for lunch. Unfortunately, the birds of the forest eat his trail of breadcrumbs, causing Hansel and Gretel to become lost and eventually at the mercy of an evil witch who plans to fatten up the children, then eat them.

Unfortunately, U.S. politicians have left the citizenry in a similar predicament. In the folk tale, the stepmother wants to abandon the children, because she fears starvation. In the past year, low equity to asset ratios at U.S. banks have caused bankers to fear insolvency.

Bankers’ response to insolvency has been to lobby for policies which increase the money supply and impoverish ordinary Americans. Quite literally, much of the public has been abandoned in an economic sense by the very elected representatives who are supposed to look out for their interests.

The breadcrumbs are a basic knowledge of economics, and the birds of the forest are the forces of ignorance and propaganda. Like Hansel, perhaps we can plant a trail in stone.

The classic Monetarist view is that all inflation is a monetary phenomenon, related to increases or decreases in the quantity of money.

Intuitively, this makes sense. For instance, in a simple example, if we have a family with a budget constraint (income) of $50,000 and a spike in energy prices causes expenditures related to energy to go from $3,000 to $6,000 a year over a period of 2 years:

In year 1, the family had $47,000 to spend on all goods other than energy ($50,000 - $3,000).

In year 2, the family only has $44,000 to spend on all goods other than energy ($50,000 - $6,000).

It is impossible for the average price level of all goods other than energy to increase, when there is less money to spend on such goods. Therefore, the average price level of all goods must stay the same. The energy price spike is actually deflationary to the prices and quantity demanded of goods other than energy. We can see this in retail sales figures, etc during energy price spikes.

Therefore, the only real way to get the average price level for all goods to increase is to increase the supply of money.

——-

A simplified economic Monetarist framework is:

M x V = P x Q

M is the quantity of money
V is the velocity of money (which is assumed to be constant).
P is the price level during the period.
Q is real output (which is assumed to be constant).

With some simple math, we see that:

P = M x V / Q

Since Velocity and Real Output are assumed to be constant, when the government increases the money supply, it only leads to an increase in prices.

In other words, the government can seriously affect prices, but it cannot affect output by increasing the money supply.

Q = M x V / P

Since Velocity stays constant, Money Supply (M) and Prices (P) increase together, so Q (Real Output) does not change.

What are we left with? Not economic growth, or increases in Real Output (Q), but instead, inflation.

——-

Of course, like Hansel and Gretel being fattened for slaughter by the witch, the rapid in increase in money supply initially looks like a demand increase to business people of all stripes. But then, as input costs rise, the reality that prices are increasing (rather then real demand increasing) eventually sets in. Input prices increase, and profits do not.

Of course, the above is a coarse, simplified equation, with many built in assumptions. However, the stagflation of the 1970’s has empirically proven the point that many of the equation’s assumptions are roughly accurate. As Lord Keynes said, “It is better to be roughly right, than precisely wrong.”

Indeed, the 1970’s proved furthermore, that in the real world, when prices increase, people (especially the unemployed) can afford less quantity of goods and services, and the economy is actually dramatically hurt.

When the Fed increases the asset side of its balance sheet by buying up toxic debt, the liability side of its balance sheet automatically increases. What are these liabilities? Dollars. However, without a gold standard, there is effectively no true liability, per se, merely an automatic increase in the money supply of dollars.

Intuitively, if the amount of real goods and services stays constant in the short term, there are now more dollars “chasing” the same goods and services and prices rise. Since there are more dollars, each dollar is less valuable. No new value has been created in the real economy of supply and demand for real goods and services.. The price level has merely risen.

Why do bankers like inflation? What are they thinking (I use the term liberally)? First, they needed more capital. What’s the abstract (for most people) promise of higher inflation in the future next to their need for capital now? Remember, the government basically handed the banks capital. Who cares if the creation of more money hurts everyone else’s savings, increases the general price level, and hurts the standard of living of those on fixed incomes? Second, accounting in the U.S., unlike in some South American countries such as Chile, is done in nominal terms, not adjusted for inflation. If house prices reflate, bankers do not have to write-off as many loans. Inflation covers all manner of banking sins.

But what we have, make no mistake, is the phenomenon of replacing financial expertise with political “expertise”. The average bank may not have diligent banking practices, but it does have the ability to buy votes. Since most Americans’ wealth is held in dollars, banks are quite literally lobbying (in effect) to make the average taxpayer’s dollars, and hence wealth, decrease in value.

Why are we socializing the cost of stupidity with affirmative action for the formerly rich and stupid? Why are we putting our society at the mercy of the witch of inflation? Why have we given politicians the power to dramatically affect the value of money—a power which recent events have proven they are prone to abuse under the influence of banking lobbyists?

If the goal of certain less competent market actors (Bank of America, Citigroup, etc) is to gain access to the public purse in order to secure their prosperity, the answer is to shrink the public purse, moving the scope of government action to the private domain.

Without government handouts, banks would be forced to raise capital in the private markets, or get taken over by the FDIC and have their deposits moved to less leveraged, more responsible banks.

Banking lobbyists have painted the false choice as one between governments bailouts to shore up equity capital and financial collapse. Multiple firms, such as Indymac, have had their deposits sold off to more responsible banks under the auspices of the FDIC, without any loss of depositor funds. The FDIC did lose almost $11 billion on insuring Indymac’s deposits, but this pales in comparison to the cost the government would have incurred to increase Indymac’s equity capital. Even large FDIC-led solutions are possible. Washington Mutual, with over $307 billion in assets was acquired by J.P Morgan Chase, in the year’s largest deal arranged by the FDIC. These transactions have a clear track record of success vs. government handouts which keep problem banks in business.

The government can still accomplish the essential function of safeguarding depositor funds, without handouts to problem banks. These handouts don’t safeguard our financial system—they safeguard bankers’ jobs and hurt the rest of us with the resulting inflation. There is no net gain to society from these bailout. There is a net loss to society as the incompetent are rewarded with taxpayer funds, inflation takes hold, and deficits increase the interest paid to foreigners on ballooning government debt.

Nothing good will come of it. If we continue to prosper, it will be in spite of dumb decisions surrounding the money supply, not because of them.

DIsclosure:
No positions in any companies mentioned. That may change at any time.

Posted by Michael Rog on 10/27 at 03:35 PM

(0) CommentsPermalink

Wednesday, October 07, 2009

The Dogma of Low Interest Rates Is Wrong

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like "pushing on a string." There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world's carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

I concluded the article by saying:

Americans may finally realize that there is a free lunch after all--we will be supplying it as speculators borrow in our low-yielding currency to invest elsewhere.

Yesterday that debate was conclusively laid to rest with the latest numbers from the NSX on net flows into ETFs.

  • YTD, $25.264 billion has flowed out of U.S. Equity Long ETFs.
  • YTD, over $13 billion has flowed into U.S. Short and Short Leveraged ETFs.

Conversely,

  • YTD, over $17 billion has flowed into Global Equity Long ETFs and less than $1billion has flowed into Short and Short Leveraged Global Equity ETFs.
  • YTD, over $24 billion has flowed into Commodity ETFs and less than $0.5 billion has flowed into Short Commodity ETFs.

Capital goes where it is treated best, like customers for fine dining. When meal sizes are anemic and interest rates are low, customers leave and head for more hospitable, higher yielding environs, or commodities.

Economists take it as unquestioned dogma that low interest rates are stimulative. Of course, ultra low interest rates are not stimulative to the real economy, they just increase asset prices. Rather than accept conventional arguments using faith based reasoning, a far more scientific approach is to examine the evidence.

I would argue that extremely low interest rates suck investment funds and liquidity out of nations. You heard it here first, and the evidence is clear. Money has flowed out of U.S Equity ETFs and into Global ETFs.

Many argue that the U.S. could never share Japan's experience of a quarter century bear market in which stocks dropped over 75% with interest rates at or near 0%.

If we do not wish to share such an experience, why are we repeating the same policies which led to such results? What policies did Japan pursue? Near zero interest rates, the propping up of zombie banks, and the arbitrage of replacing of managerial competence at financial institutions with political competence aimed at securing taxpayer charity.

Does this sound familiar? Money flowed out of Japan starting in the early 90's and into economies such as ours. The tech boom was supercharged by a massive Japan-funded carry trade. We may be funding such a boom in emerging markets and commodities right now to our detriment. Liquidity and investment funds will continue to flow out of the U.S., as they have, if we do not change policies which are contradicted by logic and clear evidence.

The public needs to understand that good policies are not about slogans, or personalities--they are about sound quantitative practices based upon clear arithmetic. As Keynes said of inflation, less than 1 person in 100 may understand it, but turning the dollar into a carry trade currency is unsound, procyclical, and will suck liquidity and investment funds out of the U.S. to our long term detriment.

For the investor, global macro is about understanding the global flows of capital and the drivers behind them. Sound advice is to follow the money.

Disclosure: Long EEM, FXI, PGJ, FCHI, HAO, EWZ, GXC, GLD. Positions may change at any time.

Posted by Harry Long on 10/07 at 05:11 PM

(0) CommentsPermalink

Challenging the Low Interest Rate Religion

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like “pushing on a string.” There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world’s carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.

The test of such a statement would be a country which is raising interest rates, while the rest of the world keeps them low. This week, Australia has provided us with such a test. Their central bank has raised interest rates, and so far, Australian equity markets have moved higher

I would argue that their central bank’s decision to raise rates will incentivize capital to move from countries with anemic interest rates to Australia, which will (everything else being equal) benefit their economy and equity markets. Currently, central banks around the world operate under the erroneous assumption that anemic interest rates are stimulative. I have argued that ultra low interest rates increase asset prices rather than stimulate the real economy. Australia should benefit from its rate increase. Of course, only time will prove the point.

Hopefully, the world’s central bankers and economists are taking note.

Disclosure: Long EFA. Positions may change at any time.

Posted by Harry Long on 10/07 at 05:10 PM

(0) CommentsPermalink

Thursday, September 17, 2009

It’s Not Just the Carry Trade

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

"[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like "pushing on a string." There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world's carry trade currency of choice. Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical."

I concluded the article by saying:

"Americans may finally realize that there is a free lunch after all--we will be supplying it as speculators borrow in our low-yielding currency to invest elsewhere."

We are living in truly interesting times. If Warren Buffett was correct in saying that the 19th century was the British Century, the 20th Century was the American Century, and the 21st Century will be the Chinese Century, there are multiple factors at work on seven different levels creating the boom in emerging markets.
I. The carry trade. Our interest rates are anemically low. Emerging market interest rates are higher. Capital goes where it is treated best.
II. Emerging market GDP growth rates. In March, everything was cheap. When you have compressed valuations, the smart money goes with the highest growth rate.
III. Emerging market competitive advantages: low cost labor, light regulation, and governments which want to help industry and job creation.
IV. Conversely, America seems hell-bent on destroying its economy: huge government deficits, the breaking of the social pact of property rights with the mal-treatment of GM debt holders, an inability to show backbone in demanding true free trade (foreign countries trade mostly freely with us, we are not allowed full access to foreign markets), the government demand for position limits on the commodity exchanges (forcing the very transactions off-exchange which the government would rationally want centrally cleared), horribly complex and ineffective regulation, the rise of zombie banks.
V. A turn towards the very socialist ideologies which successful emerging countries such as China have rejected (affirmative action for the formerly rich and stupid, bank investors, bank executives, etc).
VI. A rejection of our unique "Americaness": the values of self reliance, property rights, and rugged individualism which made us a great and prosperous nation.
VII. An increasingly crushing tax burden on those who produce and save in order to subsidize those who do not produce and spend(insolvent banks, California, etc).
The end effect of all of these factors has been to make emerging market equities even more attractive than emerging market debt. It's not just the carry trade at work. It is the combination of the carry trade with very attractive economic fundamentals. Indeed, countries such as China are seeing GDP growth rates that we have not seen in the U.S. for generations.
Disclosure: Long EEM, FXI, PGJ, FCHI, HAO and EWZ. Positions may change at any time.
Posted by Michael Rog on 09/17 at 02:46 PM

(0) CommentsPermalink

The Decline of the Empire Will be Cheered

In The Unintended Effects of Bad Policy (May 18th), I wrote that:

”[L]ow interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like “pushing on a string.” There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world’s carry trade currency of choice.  Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.”
 
I concluded the article by saying:
 
“Americans may finally realize that there is a free lunch after all—
we will be supplying it as speculators borrow in our low-yielding
currency to invest elsewhere.”
 
We are living in truly interesting times. If Warren Buffett was correct in saying that the 19th century was the British Century, the 20th Century was the American Century, and the 21st Century will be the Chinese Century, there are multiple factors at work on seven different levels creating the boom in emerging markets.
 
I. The carry trade. Our interest rates are anemically low. Emerging market interest rates are higher. Capital goes where it is treated best.
II. Emerging market GDP growth rates. In March, everything was cheap. When you have compressed valuations, the smart money goes with the highest growth rate.
III. Emerging market competitive advantages: low cost labor, light regulation, and governments which want to help industry and job creation.
IV. Conversely, America seems hell-bent on destroying its economy: huge government deficits, the breaking of the social pact of property rights with the mal-treatment of GM debt holders, an inability to show backbone in demanding true free trade (foreign countries trade mostly freely with us, we are not allowed full access to foreign markets), the government demand for position limits on the commodity exchanges (forcing the very transactions off-exchange which the government would rationally want centrally cleared), horribly complex and ineffective regulation, the rise of zombie banks.
V. A turn towards the very socialist ideologies which successful emerging countries such as China have rejected (affirmative action for the formerly rich and stupid, bank investors, bank executives, etc).
VI. A rejection of our unique “Americaness”: the values of self reliance, property rights, and rugged individualism which made us a great and prosperous nation.
VII. An increasingly crushing tax burden on those who produce and save in order to subsidize those who do not produce and spend(insolvent banks, California, etc).

The end effect of all of these factors has been to make emerging market equities even more attractive than emerging market debt. It’s not just the carry trade at work. It is the combination of the carry trade with very attractive economic fundamentals. Indeed, countries such as China are seeing GDP growth rates that we have not seen in the U.S. for generations.

Disclosure:
Long EEM, FXI, PGJ, FCHI, HAO, EWZ.
Positions may change at any time.

 

Posted by Harry Long on 09/17 at 10:43 AM

(0) CommentsPermalink

Wednesday, July 29, 2009

Seize the Moment and Fight for America

Once more unto the breach, dear friends, once more

—William Shakespeare, Henry V

American business is at the cusp of the greatest potential reform in the history of our nation. While many are looking to Washington for answers*, the only lasting reform which can lead to growth must come from the owners of public corporations. Who else has the pure incentive to fix our problems?

Unfettered proxy access (sans takeover restrictions), the elimination of staggered boards, and the legal abolition of poison pills are key structural reforms which will be key to economic prosperity and meeting the competitive gorilla of China.

However, even without these reforms, populism and shareholder-led capitalism have never before been so totally aligned. We must seize this moment. Saving companies is about saving America and American jobs. Saving companies is about preserving the tradition of American ingenuity and innovation. Saving companies is about preserving everything that was once great about this nation and can be great again. This is a fight for our American way of life and for our values—values which some executives have forgotten.

What is the nature of the enemy and what tactics work? This is trench warfare, and the enemies are greed, hubris, illogic, pride, vanity, stupidity, and incompetence. The main thrust of all reform must be to shed light on these negative values which hurt our country and our companies. Light has a cleansing quality, to use the oft-quoted cliché. And it’s true—from Watergate, to the Pentagon Papers, to the scandal in your local government, to Enron. This is not a battle of personalities—this is a battle about values. In life, people with stronger frames of reality win against those with weaker frames of reality. Think rational John Paulson shorting subprime vs. idiot banks making subprime loans.

Good values, if they are advocated for strongly, are always stronger frames than bad values. Bad values fear transparency, openness, investigation, exposure, debate and censure—think Enron, communism, and corrupt politicians. Good values shine with exposure—think Warren Buffett, Charlie Munger, Walter and Edwin Schloss.

Which tactics work? I prefer to do things in the old-fashioned, gentlemanly way. I call executives privately, express my concerns, and start a dialogue. Often, it works. However, sometimes it does not. Some executives suffer from bad breeding and do not return phone calls. What do you do then? People may not like to admit it, but the old-fashioned public flogging in the town square is fantastic for behavioral modification of problem executives. It plays upon the sad psychological phenomenon that most people refuse to change bad behavior until they are shamed into it (we have all seen this with politicians). If you have done your homework, know the facts (sometimes they are so glaring and scandalous as to be obvious), and have good ideas for improving your company, here are some next steps:

  1. Start a blog! (executives, employees, competitors, customers, and suppliers read them obsessively, it freaks them out, and it gets their attention—trust me, I know from experience (www.buildfremont.com). It works even better if you email/snail mail the web address to investor relations, company directors, other investors, and post it on message boards.
  2. Make sure your facts are unimpeachably accurate. This is what gives you credibility and the ethical high ground (along with being right in your analysis and suggestions).
  3. Criticize people responsible for bad behavior or performance by name.
  4. Be fair and even handed—praise people in the organization who are doing good things by name as well.
  5. Be specific about what is going wrong.
  6. Use numbers. They can all be found at www.SEC.gov
  7. Write a clear narrative.
  8. Propose practical solutions.
  9. Publish on www.blogger.com for free and keep costs low.
  10. Write articles for sites like SeekingAlpha.

Get to know intelligent people in the activist investor community and start a movement. Tap into The Official Activist Investing Blog (activistinvesting.blogspot.com) and The Icahn Report (www.IcahnReport.com). Read David Einhorn’s Fooling Some of the People All of the Time. Study Daniel Loeb.

There is a good chance that if you do items 1-10, you will get a call from the management team that was ignoring your concerns. This may seem like a victory, but remember—at this point (you already tried it the old-fashioned, gentlemanly way) you are dealing with low quality people who respond to strength, not manners—just like the school bully. Chances are they think a call or meeting will appease you. But what you want is substantive change--not a pompous feeling of importance. If the meeting or call leads to reform, great, your story ends here. But if it doesn’t, what are the next steps?

  1. Go to the press. Corporate governance is a hot topic. Seize the moment. Be creative.
  2. Ask questions on the company’s conference call. Sometimes it is closed to everyone but sell-side analysts, but often, anyone can ask questions. This is one way Jim Chanos famously exposed Enron.
  3. If you think the company is doing something illegal, contact the SEC and state securities regulators in writing.
  4. Nominate yourself or someone else to the company’s board. It is surprisingly easy to do.
  5. Call and write to institutional investors such as CALPERS with your concerns. Pension funds have been at the forefront of corporate governance reform. These institutions have the clout to get your issues a fair hearing.
  6. Present your case to activist hedge funds.
  7. Write and call board members directly. Some will remember that their job is to represent shareholder interests. Some will fear for their director’s fees if management hears they are speaking with you and will hang up on you. All of them will be surprised you are reaching out to them.
  8. Get to know the field. This past year, many traditional activist funds have had awful performance. Some have closed down. There is a vacuum of interest among the hedge funds, especially in the microcap space, where individual investors need to stick up for themselves and push for reform. Transparency, good corporate governance practices, and operational performance are the pillars of shareholder value at any public company. Focus on these, and you will be doing your part to improve our country. The Founders often noted that the prosperity of the nation was rooted in the virtue of the republic. We cannot have prosperous companies without virtuous owners who demand the same of management.

Fortunately, there are many wonderful American businesses. Success is a choice and failure is a choice. If you encounter greed, hubris, illogic, pride, vanity, stupidity, and incompetence at firms in which you invest, show them no quarter. Make no mistake—you are fighting for the soul of our country. Why should executives get rich while investors suffer and workers suffer after the inevitable layoffs? Companies which successfully implement values, philosophies, policies, risk control systems, and actions geared towards transparency, strong corporate governance, and sustainable growth will not only see profits increase, but will also gain the support of the investment community and will be able to create jobs.

At companies, as in America, either we all win together, or we all ultimately lose.

 


*It must rather be akin to banging one’s head against a wall after the “success” of government regulation at Fannie and Freddie, the Community Reinvestment Act, the cronyism of the bailouts, the upending of our property rights, and the blatant European-style socialism coming from Washington, D.C. every day

Disclosure: Harry Long owns FMMH shares directly, through partnerships, and through trusts. To the best of his knowledge, certain of his family members own FMMH shares through partnerships and trusts. Such ownership may change at any time.

Posted by Michael Rog on 07/29 at 02:38 PM

(0) CommentsPermalink

Sunday, July 19, 2009

A Roadmap to Turn Around Problem Banks

The key to financial stability and reform at major banks is simple. The President, through his force of stature, could go to the nation’s most successful and conservative banks, such as Hudson City Bancorp (HCBK) and request that some of these banks’ executives and loan officers be placed in leadership positions at problem financial institutions. Of course, the incompetent executives they replace would have to be fired.

Most well run banks would naturally view losing talented executives as a raiding of their ranks, and rightly, as a penalty, rather than a reward, for their excellent performance. The government could issue to these well-run banks modest amounts of stock options in problem banks where their former executives have been placed as partial recompense for the loss of talented executives and the strengthening of competitors.

In addition, as Carl Icahn rightly points out, retention bonuses should only be paid to executives that a rational business enterprise would want to retain. This rules out the vast majority current of executives at many major financial institutions (let them find work elsewhere after they have destroyed their current employer!). However, few would object to paying performance-based bonuses to executives who have left healthy, thriving banks and insurers for those in need of their managerial expertise, as a public service to the country. The debate about compensation at financial institutions in which the government has a stake could then become rational.

Reckless managements must be replaced by those with a proven track record for performance. The current strategy of many incumbent CEOs is to engage in an arbitrage, whereby intelligent and conservative risk control is replaced by political lobbying aimed at keeping their jobs and getting access to government coffers when they fail in their fiduciary duties. This must stop. Getting the best managers to work for the worst banks and insurers is the key to real turnarounds and lasting financial stability.

Posted by Harry Long on 07/19 at 12:16 PM

(0) CommentsPermalink