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Volatility in 2012: Will It Linger Longer?
Tuesday, January 17 2012 | 10:18 AM
NEWOAK CAPITAL LLC
|While European woes have led to investors’ fears and market volatility, a host of other hazards pose potential dangers. Despite the US markets recent positive trends in GDP and employment, key uncertainties remain: housing market, foreclosures, budgetary political impasse, tougher regulations and legacy mortgage litigations. We should not forget that several trillion in planned budget cuts are still ahead. The impact of the slowdown in BRICs, jointly due to the European crisis and their own natural economic evolution, may not be compensated by the US economy and emerging markets.
The potential in rapidly expanding BRICs’ credit markets, particularly in China, should be watched. As an example, the first domestic AAA default in China had the potential to send shockwaves through the Chinese economy but was cured by the bond guarantor. The Arab Spring, Egypt’s election, and potential Iranian blockade of Strait of Hormuse are still looming.
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How Issuers can Increase Investor Interest in CMBS2 Mezz
Monday, January 09 2012 | 08:34 AM
|Why New Issue CMBS deals see little interest in Mezz classes and what Issuers can do about it.
A year ago around this time, the mood amongst CMBS market participants was quiet optimistic. Estimates of new issuance for 2011 from market participants generally ranged from $35 Bn to $70 Bn or more, on the way to $100 Bn in a few years. However, over the course of the year, the optimism has faded. New issuance totaled just $30 Bn in 2011, and forecasts are not much higher for 2012.
With more conservative underwriting, higher subordination levels from rating agencies, and wider spreads, new issue CMBS was expected to be attractive to investors. Yet, investors seem to have pulled back, and spreads have widened for both legacy and new issue deals. Macro level issues, especially uncertainty about Europe, are part of the reason. However, CMBS spreads have been far more volatile than other sectors including corporate and other ABS. As the table below shows, even new issue AAA CMBS spreads widened a lot more than other sectors. This spread volatility not only deters investors, but also loan originators from making new loans as they do not have a good hedge to protect them while aggregating loans for securitization. It also requires wider spreads for CMBS loans which makes them less attractive to borrowers.
One of the main reasons CMSB spreads widen quickly is that the sector has far fewer investors than other ABS sectors and corporate bonds. The reason there are fewer investors is that, with fewer loans, CMBS deals are lumpy and investors need the expertise to analyze collateral at the loan level. Not every investor has that expertise. So, they can feel comfortable analyzing RMBS, Credit card, Auto, Equipment, and Student Loan etc deals, but not CMBS. The creation of a super-senior AAA tranche helped bring more investors to AAAs by making the tranche safer needing less analysis. That is part of the reason AAA spreads have tightened.
Spreads for classes below AAA, however, continue to be very wide, as the mezz tranches have even fewer investors. Unfortunately, Insurance companies, which are perhaps the most knowledgeable commercial real estate investors and ones with resources to analyze the CMBS deals at loan level, tend to buy mostly senior tranches. Mezz tranches are left to a very small set of buyers. That means lower liquidity for these tranches, and less certainty about receiving a decent bid if needed. An additional issue is lack of transparency on pricing, as these are small tranches that do not trade frequently and each one is different depending on deal collateral. These factors make these classes even less attractive to buyers.
The table below shows the structure of a recently priced CMBS deal. The $674 mm deal has $118 mm of senior AAA, $55 mm of junior AAA, $104 mm of mezz tranches and $44 mm of B-Piece.
What makes Mezz tranches more difficult for investors is that they have lower credit enhancement than AAAs and they are generally very thin tranches representing about 3% to 4% of the deal. In other words, a 3% higher collateral loss could result in 100% loss on the tranche. That means investors require even more conviction and expertise to invest in these classes. The thin tranches are also more susceptible to rating downgrades if any collateral in the deal faces problems. This fear of ratings volatility is another big concern for investors.
One idea, that addresses both the spread volatility and the potential ratings volatility, is to do the opposite of what we did for the AAA – combine all the Mezz tranches into one single class. In this deal, instead of creating classes B, C, D, and E, there could be just one Mezz class. It will be a $104 mm class with average rating of around A-. At a thickness of 15% of the deal, this class will not be at risk of 100% loss if collateral loss increased by mere 3%, and so will be much less susceptible to spread and rating volatility. Also, with just one larger class, there will be more owners of that class and there is likely to be more trading and visibility on spreads, enhancing transparency and liquidity. If the combined Mezz tranche is priced around 640 over swaps or tighter, the issuer will have the same or better economics as with the tranched mezz structure. This will still be a significant pickup in spread for the same rating compared to other sectors and will probably bring in some new investors who were considering CMBS but were hesitant. At about 15%, the Mezz tranche is thicker, but still a small part of the deal. So, even a small number of new investors will make a difference.
And the issuers can try this structure without taking any risk at all. That is possible by using a structural feature that has been used in residential deals (which are also REMICs): Exchangeable Classes. The deal can be setup so that some investors can buy the tranched classes while others buy a single Mezz class. The structure allows owners of one form to exchange for the other form at any point in future using the proportions defined in the documents. This has been used for a long time. I used exchangeable classes extensively in $52 Bn of new CMOs when I was trading and structuring CMOs. Freddie, Fannie, and Ginnie deals regularly have them under the names MACR, RCR, and MX respectively.
There is no single magic bullet, but small changes can sometimes make a big difference. Some, like this one, are easy to try with a little extra work, no downside, and possibility of enlarging the pool of CMBS investors with all the benefits that come from it for investors, issuers, and people employed in the sector.
Note: A version of this article was published in Thoughts on Markets & Economy
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No Investment Sheep in Sight
Thursday, June 09 2011 | 11:27 AM
|If I had to pick one commodity that is still out of favour with investors it would be natural gas. When I study a long term chart of natural gas (monthly) I see a bear market low in September 2009 followed by a large 20 month symmetrical triangle. This in turn has printed a series of higher lows and is about to generate a positive 10-month ROC number.
We need to get into the natural gas space before the investment sheep arrive. In this case the investment sheep will likely be those trend following portfolio managers who are currently chasing the utilities, consumer staples and telecom stocks. Now when the sheep take note that natural gas prices have stopped declining (three higher lows since last October 2010) they may begin to accumulate the shares of the natural gas producers.
Some smaller names would be Celtic Explorations Ltd., Trilogy Energy Corp, Birchcliff Energy Ltd, Paramount Resources, Fairborne Energy Ltd., Perpetual Energy Inc, Corridor Resources Inc., Tethys Petroleum Ltd., Delphi Energy Corp. and Vero Energy, Inc. The big go to name is EnCana Corporation (ECA). The long term (monthly) chart of ECA displays the monthly cycle troughs of 2003, 2008 and 2009. Note the pending trough of May 2011 that is about to signal the end of the short 10-month ECA bear. This pending cycle trough is supported by an improving relative reform signal. On a P & F chart ECA needs to break above $35 to trigger a bullish stampede into the name.
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ABS CDO Commentary
Tuesday, May 10 2011 | 07:31 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT
Relying on NAV from outside sources (IDC/Mgr Marks etc.) can be a dangerous game as this can mislead investors. We strongly believe that Marks cannot be relied on. Spending additional time to independently mark the portfolio can help avoid potential pitfalls and can help investors spot significant misvaluation. This part of the analysis is especially important for cuspy and longer-WAL tranches. It is imperative that NAV is correct before asset-level assumptions can be used for deal-level cash flow analysis.
ABS/Multi-Sector CDO Opportunity: Buy Credit I/O ABS CDO's with Non-Agency Mezz. & Sub. Paper Underlying
The suspension of the foreclosure process has profound effects on non-agency credit I/O paper. By slowing down liquidations, cash flows to sub. and mezz. non-agency RMBS can continue for at least another 6 months which can have a profound effect on valuations of this underlying. Over the past few months, sub. and mezz. have been rallying (reflecting) longer timeline, but ABS CDO Credit I/O's (1st-pay '05-'07) ABS CDO's and 2nd-pay '04 and earlier paper haven't moved enough to reflect this improvement in cash flow.
ABS/Multi-Sector CDO Market Overview
The ABS CDO secondary market continues to trade up due to lack of supply and significant relative value. At this point, we are now seeing 1st-pay CDO risk-adjusted returns range from 7% (well-supported deals) to very low double digits (weaker deals). Investor interest for most of last year was mainly in older pre-2003 multi-sector deals, but we have seen this appetite change as of late. The lack of supply, rising forward rates, and foreclosure timeline extension have pushed many investors into "credit I/O" type investments. In terms of credit I/O bonds, these risk-adjusted returns did range from high teens to mid-20's but have now rallied to mid-teens returns (in general). Given the rising forward curve and lack of supply, we believe ABS CDO's will continue to outperform, especially at the credit I/O level.
Potential Supply & Basel III
Supply to date (secondary--no new issuance) has been relatively muted but this could change. On our trip to Europe, we spoke with several clients that have been beginning to talk about lightening up and having reluctance to buy ABS CDO's that are rated CCC. Basel III (although not in effect yet) is driving this decision-making. As most know, the big change in Basel III is treatment of CCC's for banks. Specifically, capital charges for banks will be a function of leverage. For example, if a bank is twelve times levered, the bank will have to hold 12 x 100%. Specifically, if the risk-adjusted return on the CCC ABS CDO is 12% and the bank has twelve times leverage, their effective return is negligible. This would make it prohibitively expensive to hold these types of assets. We need to monitor this trend very carefully since many European banks hold Legacy ABS CDO's and many European US banks have been a buyer of this paper.ABS/Multi-Sector CDO Opportunity: Buy 1st-Pay Seasoned Multi-Sector CDO's with Seasoned CMBS that are Cuspy
We mentioned this strategy in our last commentary, and it has performed significantly better than expected. At current levels, we still believe that the trade has more room.
The trade we mentioned in our last commentary involves the idiosyncratic loss surface/return profile of each one of these deals (ABS CDO's). To us, deals can fall into several camps. We have looked at deals that are very digital in nature (i.e. 25% return or 100% loss) and also deals that have a risk-adjusted yield of high single digits to low double digits with 5% to 0% downsides. However, there are deals that have a significant number of assets (ex. Seasoned CMBS) in them that are very option-like combined with other very solid assets. This mixture of assets is extremely hard to duplicate as most of these assets are difficult to find. The risk-adjusted return of this type of portfolio could be base case low double digits with a downside of 5%. The upside to this trade is in its optionality. On an optimistic scenario, potential upside could be over 20%.
We continue to encourage all investors to look for these types of deals. The way we uncover this is by running various scenarios and not just "base & stress" scenarios. This type of scenario analysis will help reveal "The Potential Optionality" of a trade.
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Finding Relative Value in CLOs
Tuesday, April 19 2011 | 10:07 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT
|Generally speaking, we remain bullish on AAA to BBB CLOs and negative on Equity, as mentioned in the last blog. However, not all CLOs are created equal. For this piece, we would like to explore some nuances that are involved in CLO investing.
As seen below, the general CLO market trend over the last 6-8 months has been positive.
Even after this positive trend, from an asset-liability arbitrage perspective, CLOs still remain cheap (overall) as loan prices are around $96 while the weighted average price of all of the liabilities and equity in the CLO structure are ~$90.5. We believe most of this value is locked into the AAA to A tranches with the best risk/reward in the AAA's and AA's. During the CLO rally in February to early March, the asset-liability arbitrage (see below) closed its gap to around 3.2 pts at its lowest, but has since widened back out to 5.5 pts post-Japan/Middle East.
CCC's Overvalued? Defaults Understated?
Recently Deutsche Bank released its annual default study, which analyzes CCCs on a historical default/risk adjusted basis. The study concludes that current CCC loan prices do not adequately compensate investors for risk. The risk we are referring to is associated with the next economic downturn. We believe, as does DB, that cycles are going to become significantly shorter (we are in the 3rd year of the current bull move) because the government no longer has the necessary ammunition, i.e. rates at 0% cannot go lower and budget deficits are bloated and unlikely to go higher. In the past the US government, specifically the Fed and Congress, and foreign cooperation (via no inflation) was able to prolong economic cycles and give us a “Goldilocks” economy. In our opinion, this Pollyanna situation is long gone and reality (risks) will set in with substantially lower growth and shorter economic cycles. Additionally, defaults have been understated due to many extensions and prepays. Although the default wall has been pushed back as companies have prepaid, defaults are still likely to rise. Remember the long-term high-yield default rate averages over 4%, NOT 1-2% as most are modeling.
Arbitrage in PiK Risk
Currently, we see the average Junior OC cushion around 2.5% in the US CLO universe, which has increased considerably over the last two years due partly to managers being able to build par but also increasing CCC prices. If CCCs are overvalued and understated, as we explored above, a price correction and ratings migration in this part of the curve would have a negative effect on CLOs’ OC tests, causing some deals to PiK. However, down the cap stack (where PiK risk matters), in our opinion the market has forgotten deal language and is not pricing accordingly. PiK risk is important and deals with lower PiK risk should trade better.
For those that are taking these binary risks, thorough reading and understanding of CLOs’ indentures is essential. While most CLOs take CCC haircuts for OC tests across all parts of the capital structure, there are some deals where these haircuts vary from the senior OC tests down to the junior and interest diversion tests. We have seen some deals in the universe where CCC haircuts are only used for the junior OC and interest diversion tests. These deals can offer extra cushion to the notes above these tests as they will more easily divert excess interest from the equity to delever the structure, while not PiKing the single As, BBBs, and BBs in some cases.
Prepays and WAL: Smart Investors Can Outperform but Document Work is Essential
Relative outperformance can be gained by taking advantage of the different non-modeled WALs (where the manager can/cannot extend the WAL of the deal) via reinvesting beyond the reinvestment period/OC trigger avoidance/extension language etc. A lot of research has recently come out from the bulges regarding prepays in CLOs as the headline numbers, on an annualized basis, have been in the mid-20s for the index and mid-30s for CLOs. Many of these analysts suggest that these high rates are generally good for AAA/AA post-reinvestment and equity pre-reinvestment, and bad for AAA/AA pre-reinvestment and equity post-reinvestment.
In general, we believe these statements to be true but want to caution investors on many of the nuances to this. We strongly believe that investors must read the indentures closely to determine the effect as many deals allow for prepays to be reinvested post-reinvestment date, as long as certain criteria are met, with some even allowing unrestricted reinvestment of prepays.
The following restrictions typically apply to the reinvestment of prepays: Sr. Notes must not be downgraded from their original ratings and Mezz./Jr. Notes must not be downgraded more than 1 notch from their original ratings. Some deal language use both Moody's & SP ratings, while others only use Moody's. Below, we explore the possible effects of the Moody's upgrades in relation to prepays and WAL.
The recently proposed Moody's methodology changes could also an effect on which deals are able to reinvest prepays post-reinvestment date. Its new proposal, if accepted, would upgrade Sr. Notes 0-2 notches and Mezz./Jr. Notes 0-5 notches. Performing a quick back-of-the-envelope analysis, we see 76% of the Sr. AAA universe currently within 2 notches of their original ratings and 30% of AA's within 2 notches. In the Mezz./Jr. area, we see 85% of A's within 5 notches of the one-notch downgrade limitation, followed by 63% of BBB's and 43% of BB's. Although many deals can be upgraded, as seen above, deal quality and indenture language should be monitored closely to determine the extent to which prepays can be reinvested post-reinvestment date. This is an ironic case where, if upgrades do occur, some of the AAAs from cleaner deals could actually underperform some of the dirtier AAAs as the cleaner deals will be able to continue to reinvest and extend the deal, negating the higher prepays and driving AAA WALs up and DMs down.
See below for Moody's rating transition table, showing the percentage of each part of the cap structure across the US CLO universe and how many notches are currently downgraded from their original ratings. For example in Sr. AAA's, 36.91% are currently rated Aaa (their original ratings), while 19.66% are rated Aa1 (1 notch downgraded), 19.66% are rated Aa2 (2 notches downgraded), and 12.2% Aa3 and below (3+ notches downgraded).
If all of these restrictions are passed, then typically after the reinvestment date the proceeds from the prepaid loan must still be reinvested in a loan that is inside the maturity and has the same or better rating of the prepaid loan. This could effectively cause deals to run at a 0% prepay post-reinvestment (all prepays would be required to be reinvested in similar loans, maturity-, spread-, and rating-wise, simulating a similar asset to that which prepaid as noted above), extending the deal and lowering DMs at the top of the cap structure, while increasing yields on the equity for these deals. Investors should pay careful attention to the language in deals in which they are buying AAA/AA and equity.
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Irrational Exuberance 2.0 - CLO Equity Edition
Wednesday, April 13 2011 | 08:44 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT
|CLO Equity Overvalued? Can Investors Earn 20's and 30's Cash on Cash Returns and Sell Before the Next Credit Cycle?
Credit Opp/Hedge Funds have been clamoring for CLO equity, attracted to the very high cash on cash returns seen so far. We are seeing cash on cash returns on many deals producing 20's%/30's% returns. This cash flow is enticing investors similarly to how the Sirens lured Odysseus (for those familiar with The Odyssey). Equity/BB's and some BBB's in our opinion have run their course and caution should be warranted (especially for long-term hold investors).
We believe that the I/O & P/O parts of equity/BB's are overvalued in general. In our opinion, the I/O part is overvalued due to the likeliness of excess spread to drop because of a combination of high prepays (empirical loan prepays 25-35% CPR vs. valuation 15% CPR in models); all resulting in lower leverage and lower WAS of future Libor floor loans which will be invested in. Real IRR on the I/O is likely to be substantially lower than the cash on cash returns received thus far.
In addition P/O valuations are extremely levered (at the bottom of the cap stack) to loan prices, defaults and CCC's loan prices and percentages. Small negative changes in these can have profound effects on sub tranche and equity prices by making a cash flow positive investment stop paying. The significant OC improvement throughout the past 1.5 years will begin to wane as this improvement was the product of discount purchases, CCC price appreciation, and low defaults. As mentioned previously in section II, we firmly believe that defaults have been artificially held at bay due to prepays and overly optimistic CCC loan prices. We believe that this is not a normal cycle (as we have seen in recent years) and can see a downturn sooner than most are assuming in their valuations.
Incentive Mgr. Fees (IRR Hurdles) Hurting CLO Equity Cash Flows?
In many deals, we've seen that future equity cash flows can be affected by incentive mgr fees beginning to kick in over the next few years. This is a common feature in CLO's that causes the manager to be paid an additional fee out of the excess interest once the IRR, since inception, has reached anywhere from 10-15%. Most only begin accruing once the hurdle is hit, while some deals have accrued this incentive fee since deal closing, accumulating fees between as much as $6-8mm that will be released once the hurdle is hit. With most deals now cash-flowing to equity and excess spread having increased, this issue is beginning to arise in cash flow and pricing analysis.
The higher quality deals that continued to pay throughout the cycle will be first to hit these targets, as expected. There are a few deals that are close to hitting their 1st IRR hurdles within the next 2 years. Babson 2006-2 and Stone Tower V are two deals we see kicking in as early as this year, with 7% of the universe observed by us with hurdles (20 deals) having hit their hurdles by 2013. We project many more will hit their hurdles over the next 3-4 years, 30% by 2014 and 50% by 2015, as cash flows begin to tail off because of the reinvestment period ending, exacerbating the drop in cash flow to equity.
Investors should run the prospective cash flows to determine if hurdles are being hit, how the fees are paid/accrued, and how that affects equity return. Deals that are currently cash-flowing robustly could drop off suddenly upon the passing of this IRR hurdle, especially on those deals that accrue since closing – which can divert 50-60% from equity to pay off this accrual. A simple back-of-the-envelope analysis of collateral, reinvestment, and current cash flow is no longer sufficient, and we suggest investors have a very strong grasp of the deal's indenture and all of its intricacies before purchasing.
US CLO Equity Analysis from BWICs dated 2/15-4/8
BWIC volume for CLO equity spiked in February and March (as seen below), giving the market more clarity on where different types of deals’ equity tranches are trading.
Using these prints, we compiled a datasheet below including a few relevant datapoints for each deal’s equity tranche that traded. Included below is the Bloomberg ticker for the equity that traded, color for where it traded (if at all), the reinvestment date, Junior OC cushion, underlying weighted average asset prices, and then yields at six different scenarios using generic reinvestment assumptions. This data should help investors find out where comparables have been trading when looking at CLO equity offers, BWICs, or current holdings.
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Monday, April 11 2011 | 03:46 PM
NEWOAK CAPITAL LLC
|There are several forces that might govern a bank’s behavior and keep it from taking reckless risks in lending and investing, possibly endangering the safety of its depositors and investors. First, there is the market: investors who don’t like lending policies can sell the bank’s stock and bonds, causing their prices to fall. Second, there is the oversight of the bank’s management. Third, there is the oversight of the bank’s Board of Directors. Fourth, bank regulators act as watchdogs, seeking to protect the interests of the depositors; this oversight is sometimes called “prudential supervision.”
In the wake of the recent worldwide financial crisis, it appears that the controls exerted on many banks by the market, by management, and by the board, were not enough to prevent gross excesses in bank lending, particularly in the real estate markets.
These problems quickly became those of the government and taxpayers, because of national systems of deposit insurance and the perception that some banks and financial institutions were “too big to fail.”
Consider our own country, where the federal government bailed out commercial banks such as Citibank, Wachovia, JP Morgan/Chase and Bank of America, as well as investment banks and other financial institutions, notably AIG. Similar dilemmas have faced the European Union, including Greece, Italy, Spain, Portugal and Ireland (and others, such as Iceland, which are seeking membership).
These shortcomings have led to calls for more stringent prudential supervision. In the United States, one aspect of the new environment is the far-reaching Dodd-Frank legislation. Internationally, the Basel Accords, promulgated by the Bank for International Settlements, are now entering a proposed third stage (Basel III).
The Dodd-Frank legislation is so far-reaching that banks are still scurrying around trying to understand how to comply. One striking aspect, as emerging in regulations under the 2010 Interagency Guidance Appraisal and Evaluation Guidelines, is that affected financial institutions will need to establish more objectively the value of their illiquid collateral, such as whole loans, real estate owned and derivatives, preferably by third party (arm’s length) evaluators ( disclosure: this is one area where my own firm consults). There has been militant talk by Republican Party spokesmen to roll back key provisions of the legislation, so the legal situation will remain in flux. Tea Party representatives particularly deplore the emerging Consumer Protection Agency.
As to Basel III, the proposed revisions are intended to increase the quantity of quality of banks’ required regulatory capital. More specifically, there will be greater clarity about eligible Tier I and Tier II capital, and the lowest quality category, Tier III, will be eliminated from eligibility. There will be required stress tests, which are hypothetical projections assuming adverse conditions such as economic recession and declines in real estate markets.
Of course, there are real questions about the ability of regulators to anticipate problematic lending, any more than stock investors, managers or boards. At the least, though, such regulators experience different economic incentives from the other players and may be more fearful of the inexpensive borrowing power that is available to depository institutions, multiplying the profit or loss from lending and investing activity.
Ron D'Vari CFA, CEO of NewOak Capital, and Andrew Szabo CFA, Managing Director of NewOak Solutions
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Black Swan Hype
Monday, March 21 2011 | 03:01 PM
|I don’t know about you but I grow weary of being regarded as stupid by these “Black Swan” guys who use scare tactics to influence normally sane investors.
A Black Swan is the latest buzz word which is a metaphor that encapsulates the event to be a surprise with major impact. In the “old” days we used the term “exogenous event”. An exogenous event in the capital markets is a one-off variable that is not resultant from any of the usual market drivers such as earning releases, employment data and industrial production numbers. The exogenous event (in this case Japan) is an external event that is large enough to affect markets and because it is change that comes from outside any model or analysis, there is no way to anticipate the event
The black swan buffoons tell us “this time it’s different, something is wrong.” The idea here is to have you believe that what ever worked in the past, won’t work anymore. We are to reject traditional stock analysis and to fear the current environment because it always the wrong time to invest.
They will tell you that buy-and-hold is dead because the equity markets have delivered zero returns over the past twelve years, just like the 1968 – 1980 period. What they don’t tell you is that during these long congestive periods there is great opportunity because “the next big thing” can emerge from these periods. The next big thing that emerged from the 1968 – 1980 zero return period was the new economy and the related components. To-day start-ups like Intel Corporation, Cisco Systems, Inc. Microsoft Corporation and Apple Inc. are household names.
The current 2000 – 2011 zero return period introduced the global economy and the related commodity boom. I do believe the Black Swans which is a large waterbird found mainly in the southeast and southwest regions of Australia missed this great investment opportunity.
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The Biggest Headache For Groupon And Facebook Investors
Friday, March 04 2011 | 10:02 AM
TAVAKOLI STRUCTURED FINANCE
|Groupon makes its money by selling coupons for goods and services. It partners with local merchants. When you buy a coupon for a merchant's discount on Groupon, it reportedly takes a 50% cut in the U.S.
Groupon has had a few embarrassments. On Valentine's Day, FTD's flowers were priced lower than Groupon's "deals" and the online discounter had to apologize to customers. Moreover, merchants often put conditions and restrictions on Groupon discounts that dilute the value of the deal, similar to restrictions on redeeming air miles. Even so Groupon's valuations have ranged from $1.2 billion to $6 billion to $15 billion all in the space of a year. What's it really worth? More on that later.
Facebook is free and "always will be." It makes its money from ads and revenues from games (if users don't block them), albeit phone apps so far do not display ads. Michael Arrington at Techcrunch reported that Facebook is secretly building its own phone to control its own operating system. He noted that Li Ka-Shing is a Facebook investor, and he is an investor in the rumored INQ and Spotify phone project. While Facebook may remain free, it would have to figure out a way to get users to pay their phone bills.
Facebook has tremendous potential to exploit its 500 million users. In fact, one of Facebook's fundraisers is a genius at exploitation. Goldman Sachs, the Great and Powerful Oz of Finance (just don't look behind the curtain), has already opined on Facebook's value. In January 2011, it valued Facebook at $50 billion when it sought to raise $1.5 billion in Facebook financing.
Rich Teitelbaum of Bloomberg News reminded the financial world that Goldman Sachs Asset Management's anemic track record suggests that Goldman may not be the best go-to source for putting a value on an asset. Despite Goldman's public relations hype that it employs the "best and brightest," it trailed the average return of its peer group in every category. Goldman has an incentive to dangle a high valuation on Facebook in front of clients:
Jim Clark of Netscape and Silicon Graphics fame was irritated that Goldman wanted to fee stuff its Facebook offering with a 4 percent placement fee, a half percent expense fee, and a snatch-back of 5 percent of investors' potential profits.
A few months earlier, Clark had invested in Facebook through another financial firm at a lower price, and the other firm wouldn't potentially gouge him with Goldman's 5 percent pleasure-of-your-company tax. "I don't think it's reasonable," Clark told Bloomberg. "It's just another way for [Goldman] to make money from their clients." The question remains whether Clark bought his stake at a reasonable price.
"Blankfein Flunks Asset Management as Clark Vows No More Goldman," by Richard Teitelbaum, Bloomberg News, January 24, 2011
In January 2011, SharesPost Inc. valued Facebook at $82.9 billion on the secondary exchange. Whatever price the market will pay today, one has to be concerned about what it will pay tomorrow. Even if the future value of Facebook is say, $4 billion, Goldman will rake in fees.
Both Facebook and Groupon became successes because they are web based networks that required few management skills, minimum capital to start, and there were no barriers to entry. That is also their biggest problem. The ugly truth is that no one can tell you what they are worth as businesses.
Groupon's successful-so-far revenue model is its curse. It's both trying to hold its position in "established" markets, and it's trying to expand. The problem is that web users in other countries have noticed Groupon's success and the fact that Groupon has been paying high premiums for local established discounting web sites just to get at the client distribution lists.
Groupon's competitors are both buying sites for the same reason as Groupon, and local entrepreneurs can easily copy Groupon's business model. It seems all it takes is a good web developer, a two-page merchant agreement, and an accounting firm that can handle the taxes as a site expands internationally. Groupon may have a head start, but it has no long-term competitive advantage. That puts its margins, its market share, and it's ability to expand and hold its position in new markets at risk.
Smart investors look for highly skilled managers in industries with a long-term competitive advantage in a stable industry run by decision makers with a "here-today, here-forever" mentality. Between Groupon and Facebook, it seems Facebook has the better chance of making a case, but it hasn't made one so far.
Facebook seems to be thinking of ways to create a loyal user base by penetrating deep within its user base. It certainly has a shot, but it is unclear whether it can maintain a competitive advantage.
Users are fickle, and young users will gravitate to the next exciting new thing. The rapid success of Catherine Cook's myyearbook.com has to give investors pause. She started the site 6 years ago as a 16-year old high school student with a $250,000 investment from her brother, and the site is valued at $20 million. While it's no threat to Facebook, it has a fresh look, is responsive to users, and offers new spins such as allowing users to buy each other gifts and "lunch money."
Investors may wonder when the next bright young kid will eat Facebook's lunch and make it look like a site for old fogies. Facebook may adapt, but it would do itself favors by disclosing its revenues, and how it plans to face up to potential competitors.
Note: This post originally appeared in the Huffington Post.
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Two Points For Investors
Tuesday, February 22 2011 | 02:46 PM
|If a picture is worth thousand words, the graph below is a valuable illustration of two very important points that investors would be better off to remember. This graphic focuses on the returns from various sectors in fixed income market, but the same concept generally applies to equities too.
The creators of the graphic intended to make the case for active management. I am assuming that anyone managing investments for themselves or others already believes in benefit of active management to some extent. The points I want to make go a little further.
The first point is that sector selection is much more important for generating superior returns than individual security selection. You could be very active in selecting securities, but if they are not in the right sector, the returns might suffer, no matter how much effort is put into picking the individual bonds or stocks.
The second point that this graphic makes to me is that, when I am picking funds, it makes sense to pick funds that have broader focus and a manager with expertise in multiple sectors. In other words, funds in which the manager has the expertise and ability to switch between different sectors may be able to do a better job than an investor trying to move between different funds. That thinking leads me to pick funds like PIMCO Total Return (PTTRX), Blackrock Global Allocation (MALOX), Vanguard Wellington Income (VWELX), and others.
Note: A version of this article was originally published on Seeking Alpha.
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