Saturday, September 29, 2007

The Sub-Prime Crisis and the Hedge Fund Collapse

Here as we approach the 20th anniversary of the crash of October 19th, 1987, the academic world is starting to read the entrails of the hedge fund crash of 2007 as it relates to the sub-prime crisis.

In August, the financial world trembled as hedge funds involved in CDO's, most notably two funds of Bear Stearns, collapsed. Even this week, news of potential equity investments by Buffett or perhaps others have led to speculation in Bear Stearns stock (BSC).

What is sometimes missed is how verklempt the financial world got in August. A wave of deleveraging of hedge funds ensued which resulted in some very strange occurrences, namely cheap stocks, or value stocks, got pummeled, and expensive stocks, or popularly shorted stocks, rose. This caused a lot of pain on the street, especially among quantitative hedge funds, or quants.

In an academic article "What Happened to the Quants in August 2007?" by Andrew Lo, an MIT prof and a quant hedge fund manager, as well as a letter to clients by Cliff Asness, another well-respected hedgie, the conclusions are pretty much the same:

Here is a quote from Lo in an article in the International Herald Tribune: "Now that we have so many boats in the harbor, you can't whiz by at 50 knots without rocking a few boats." He is referring to the proliferation of hedge funds in equity neutral or long/short equity which ten years ago totaled about $10 billion. Today, that's a $160 billion figure. "In the middle of the ocean, your wake has no impact, but in a crowded harbor, a fast exit can cause quite a disruption."

Asness describes a similar viewpoint, "I have said before that 'there is a new risk factor in our world,' but it would have been more accurate if I had said 'there is a new risk factor in our world and it is us.' In his view, the gulf between cheap versus expensive got way too narrow in August, but has now become wide again. The problem was that too many boats were heading for the same exit.

The most highly shorted stocks showed a big uptick in trading volume. Worse yet, they beat the least shorted stocks by about twelve percentage points through the middle of August.

In Lo's paper he suggests that:

"The losses to quant funds during the second week of August 2007 were initiated by the temporary price impact resulting from a large and rapid unwinding" of one or more quantitative equity market-neutral portfolios. The speed and magnitude of the price impact suggests that the unwind was likely the result of a sudden liquidation of a multi-strategy fund or proprietary-trading desk, perhaps in response to margin calls from a deteriorating credit portfolio, a decision to cut risk in light of current market conditions, or a discrete change in business lines."
Forced mysterious liquidation is very reminiscent of those days in October of 1987, a reminder that an outbreak of fear and panic can occur at any time. Heightened risk sensitivity can often mask opportunity.

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Is Government Involvement in Energy Worth the Investment Risk?

Interesting how badly politicians can screw up supply-demand imbalances. As a Canadian who endured Canada's National Energy Policy of the early 1980's, it worries me to see the proposed royalty changes that the Alberta government panel has recommended. Our American friends who endured last year's Hallowe'en surprise are swearing to me (both in an affirmation sense as well as a profane sense) that they have had it with Canadian energy policy. Its not just individual investors who are incensed.

EnCana Corporation,(ECA) the Calgary based natural gas and oil sands producer was quoted yesterday as saying that if the panel's recommendations for draconian increases in royalties are implemented:

"EnCana plans to cut its 2008 capital investment in Alberta by about C$1 billion, or 30% to 40% of the C$2.5 billion to C$3 billion the company has planned for Alberta-based activity."
Furthermore, it would reallocate capital to investments outside Alberta.

Investors should remind themselves that the proposed royalty changes at this stage are recommendations with no certitude that they will be implemented.

Strange indeed to see a province that has enjoyed such wealth creation in this energy cycle and attracted capital largely because of a political culture that has favored capitalism finds itself seemingly breaking from that tradition.

My libertarian leanings are not directed just at my fellow Canadians. Witness the political interference that has created the mess in the ethanol markets in the U.S.

The long anticipated ethanol oversupply has arrived and will continue to put downward pressure on ethanol margins and crush spreads. The politics of bio-fuel triggered very strong emotions last year, for example,

" Perfect cannot be the enemy of the good. Corn ethanol is not perfect, but it is the best alternative. Our realistic options in the next decade are limited to oil or ethanol. Do we want to feed our farmers or Middle East terrorists?"
The New York Times (09/30 edition) features an article on the sudden surplus of ethanol. As the article highlights:
"But companies and farm cooperatives have built so many distilleries so quickly that the ethanol market is suddenly plagued by a glut, in part because the means to distribute it has not kept pace. The average national ethanol price on the spot market has plunged 30 percent since May, with the decline escalating sharply in the last few weeks."
Commodity based industries have no are as good as your worst competitor and price becomes the only differentiator. At the 2006 Berkshire Hathaway annual meeting, Charlie Munger made some negative comments about the economics of ethanol, in his imitable fashion right in front of Bill Gates, his fellow Berkshire director who had just announced some months earlier an $84 million investment in Pacific Ethanol (PEIX). Charlie also made the following statement:
"Running cars on corn is about the stupidest thing I ever heard of. Our government is under tremendous political pressure [to keep pushing and supporting corn ethanol] even though it makes no sense." He added, "More energy is used producing ethanol than it creates and that's without considering the damage to the topsoil producing fuel when we could be producing food." Munger further stated, "It's silly to drive up the price of food in order to provide an uneconomic fuel, as well as a dumb government policy. "

Believe me, I am a great supporter of going green, and I believe the long term returns may well be substantial. But getting there through ethanol is going to be a little ugly over the near term.

In a Goldman Sachs report earlier this week by their biofuel research team,estimates were reduced to reflect the new realities of ethanol. Aventine's (AVR) target price was cut to $11 from $17. There are $24 target estimates out there. Pacific Ethanol (PEIX) was trimmed to $9 from $11...the high target here is $17.60. Finally, VeraSun (VSE)was trimmed to $10 from $11 by Goldman...there is a $24 estimate out there.

I am an investor, not a "player" of commodities. I'm not being arrogant, I am merely avoiding an area where I have zero competency. The scatter in target prices and estimates and growth rates suggests that there will be an opportunity here, I can't decide whether its on the long or short side.

Goldman suggests that margins need to fall to incentivize a slowdown in future capacity growth and that utilization levels of 80% versus the current full utilization are need to bring ethanol into balance. Of course, 80% utilization spells weak margins in ethanol economics.

Here is a look at the GS charts on supply/demand as well as crush spreads for ethanol:
Ethanol Supply and Demand

It appears that according to GS, there is a 200 million gallon per month surplus of supply, roughly 40% of current capacity.

Ethanol prices are now trading at over a $0.40 per gallon discount to gasoline, the other side of the $0.50 premium that it traded for most of this decade. Based on a little bit of rusty physical chemistry, it should trade at a discount...there is less BTU value. As the GS report points out, and Charlie reasoned two years ago, there is no reason that the markets should not be rational about BTU content in the pricing of ethanol.

Here is a GS chart on the Ethanol spread:
Ethanol Spread to Gasoline has weakened considerably

The report argues that the new target prices suggested are based on replacement costs, what it costs to build a plant. Reasonable enough, but ultimately the value of any plant depends on the economics of the plant, not what it may cost to build it. If cash flows are poor, there is a high likelihood that the value is impaired, at least the sunk cost.

The National Energy Policy of Canada was introduced in 1980 to increase both Canadian control and Canadian ownership of the energy industry. It also sought to protect all Canadians from surging oil prices. The federal government would accomplish their goals through measures such as price controls and federal taxes on oil and gas production. These measures would increase federal government control in the oil and gas industry.

Similarly, since 1978, the United States government has granted a multitude of tax incentives and subsidies to promote the growth of a domestic ethanol industry. Taxpayers' repeated payments in the form of subsidies to corn growers, ethanol producers, and opportunity cost serve no other purpose than to artificially prop up the corn and ethanol industry.

Allowing government to choose winners and losers instead of the market has impeded investment in other alternative fuels which may make much more economic and even environmental sense. Equally stupid in my view, is the large handouts that go to conventional energy companies, another seemingly endless cycle.

From an investment standpoint, it still leaves me wondering about energy investments in North America, is government involvement here worth the investment risk?

Disclaimer: I, my family, or clients have a current position in Berkshire Hathaway. I, my family, and clients do not have a current position in any of the other securities mentioned.

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Nordson and High Quality Capital Goods Companies

Today's Barrons highlights Nordson Corporation (NDSN) as an attractive capital goods company. I agree that this is a wonderful business at a fairly attractive price.

The article describes the company's global positioning with some 70% of its sales from overseas, yet the gloom that many investors feel about a slowing in the U.S. economy is yet to be evident in Nordson's results. Here is a quote from their third quarter 10-Q:

"On a geographic basis, third quarter sales volume was up in all regions, influenced by acquisitions and higher Industrial Coating and Automotive Systems segment sales. Volume was up 32.1% in the Americas, 15.2% in Japan, 10.8% in the U.S., 9.9% in Asia Pacific and 8.6% in Europe."
In a recent Wall Street Transcript interview of June 11th (subscription required,) Charles Brady of BMO Capital is quite positive on the capital goods space:

"We are still fairly bullish for the industrial space for the remainder of 2007, as well as going into 2008, particularly for some of the smaller mid-cap companies. That is really our area of focus, as these companies often have a much nichier, growthier focus in some of their product lines and geographic areas. In addition, the acquisition pipeline for some of the small and mid-tier companies still remains robust, and there are a number of deals out there that are going to add to the organic growth rates."
Let's have a closer look at this business.

As per the 10-K, NDSN produces precision dispensing equipment that applies adhesives, sealants and coatings to a range of consumer and industrial products during manufacturing operations. The Company also produces technology-based systems for curing and surface treatment processes, as well as life sciences applications. Its products are used around the world in the appliance, automotive, bookbinding, container, converting, electronics, food and beverage, furniture, life sciences, medical, metal finishing, non-wovens, packaging, semiconductor and other industries. Nordson markets its products in the United States and 57 other countries. It operates in three business segments: adhesive dispensing systems, advanced technology systems, and finishing and coating systems.

Here is a spreadsheet the last decade of cash flows for Nordson.

As the Barrons article indicates, the operating cash flow has exceeded net income throughout the decade. From my analysis, about $880 million in CFFO was used to add only about $167 million in capex and about $350 million in acquisitions over this period. Shareholders also shared in the wealth with $172 million in dividends and buybacks (net of share issuance) of $73 million.The five year dividend growth rate is fairly low at 3.65%.

Looking at the financial ratios, NDSN has also demonstrated considerable improvement over the years. Here is some ratio analysis of NDSN per

As one can see, normalized ROIC has steadily improved to 20.8% from low to mid single digit levels. In fact, the last time ROIC peaked at 20%+ was in 2000. The business back in 2000 was still quite global with over 50% of revenues generated outside of the U.S. versus today's 70%. But productivity enhancements have also been established, the business has about 10% fewer employees with revenues up about 20% over that period. Clearly, growth has shifted to Asia-Pacific opportunities as well. And that dollar weakness! The euro has appreciated some 63% since the year 2000.

There are some competitors to Nordson that I believe should be considered as well. Actuant (ATU), Graco (GGG), and Donaldson (DCI) are all interesting niche businesses in miscellaneous capital goods.

Here is a spreadsheet comparison of these companies which looks at the operating profitability, and the cash flow characteristics of these businesses. It is based on their trailing twelve month statistics as provided by As you can see, the companies vary widely.

The real standout in terms of its profitability is Graco (GGG). Its operating margin of 27.24% compares exceeds those of NDSN at 15.38% and the others.Pre tax ROA of almost 44% dwarfs that of NDSN, at 13.35%.

Graco's core competency is manufacturing. Some 30% of its sales come from Europe and the Far East. As per the 10-K, the development of technologically superior, multiple-featured, reliable products is a key strategy of Graco with a particular emphasis on a goal of generating 30% of annual sales from products introduced in the prior three years.

Here are some of Charles Brady's thoughts on Graco per TWST:

"Last year, they (GGG) acquired a company called Lubriquip from IDEX Corporation (IEX) that they are in the process of integrating, and we believe the integration is ahead of schedule. It is a company that has margins well below the Graco average of the mid- to high 20s, so the overall corporate margins for Graco have been dragged down by this acquisition. As is typical for Graco, they will take costs out, make some manufacturing changes and get the margins back up to a much higher level. So we've probably got at least two quarters of continued negative impact from the acquisition, but once we get through that, we expect to see a fairly strong pickup in the overall margin, just from the improvement from that acquisition of Lubriquip."
I will be reviewing a number of these companies in the next several posts.

As always, I appreciate your readership.

Disclaimer: I, my family, and clients do not have a current position in any of the securities mentioned in this post.

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Sunday, September 16, 2007

Alan Greenspan's View of Housing

Alan Greenspan was interviewed by the Financial Times in today's paper.

Not surprisingly, he indicated that the decline in house prices is "going to be larger than most people realize." However, he also warned that the Fed should be careful not to ease rates too aggressively because the risk of "inflationary resurgence" was greater now than when he headed the Fed.

The former Fed chairman said the current turmoil in financial markets was “an accident waiting to happen”.

He also noted that the off-balance sheet investment vehicles that issued much of the asset-backed commercial paper represented a “savings and loans disaster waiting to happen” because of the mismatch between their assets and liabilities. Mr Greenspan thought the issuance of asset-backed commercial paper ”is probably not going to get back to where it was.”

He also observed that collateralised debt obligations – securities that slice up and repackage loans to meet the risk-appetite of different investors – “will never get back to the levels and structures that they were, because now everybody knows you cannot price them”.

Mr. Greenspan, always enigmatic as chairman of the Federal Reserve has watched the economic world flow past him and remains aloof. He has shown long-held caution that investors are too complacent and too confident that steady economic growth will somehow be managed. Yet, it seems somewhat disingenuous to be as oblivious to today's credit market disasters that were sown by the reckless interest rate reductions that he himself orchestrated.

Let me take you back to testimony he delivered to the House Banking Committee Hearing on the Financial Services Modernization Act back in 1999:

"Technologically driven proliferation of new financial products that enable risk unbundling have been increasingly combining the characteristics of banking, insurance, and securities products into single financial instruments. These changes, which are occurring all over the world, have also dramatically altered the way financial services -- financial services providers operate in the way they deliver their products."

"In the United States, our financial institutions have been required to take elaborate steps to develop and deliver new financial products and services in a manner that is consistent with our outdated laws. Costs of these efforts are becoming increasingly burdensome and serve no useful public purpose. Unless soon repealed, the archaic statutory barriers to efficiency could undermine the global dominance of American finance, as well as the continued competitiveness of our financial institutions and their ability to innovate and to provide the best and broadest possible services to U.S. consumers."

"Ad hoc administrative responses to these market forces lead to inefficiencies and inconsistencies, expansion of the federal safety net, potentially increased risk exposure to the Federal Deposit Insurance Funds and a system that will undermine the competitiveness and innovative edge of major segments of our financial services industry."

"Moreover, affiliation with banks need not, indeed should not, create bank-like regulation and affiliates of banks. This shift in supervisory mode, which is already underway, is market driven."

Here is another interesting Greenspan quote before a Senate Committee on Banking, Housing, and Urban Affairs in 2004:

"The key to developing secondary markets was securitization, and Fannie and Freddie played a critical role in developing and promoting mortgage securitization, the process whereby mortgages are bundled together into pools and then turned into securities that can be bought and sold alongside other debt securities. Securitization by Fannie and Freddie allows mortgage originators to separate themselves from almost all aspects of risk associated with mortgage lending."

"Asset-backed securities and the secondary markets in which they trade generally provide both households and businesses with excellent access to credit at an appropriate risk-adjusted interest rate. Moreover, credit supply is far more stable today than it was because it is now founded on a much broader base of potential sources of funds. The aspiring homeowner no longer depends on the willingness of the local commercial bank or savings and loan association to hold his or her mortgage."
As the newspaper, The Australian observed: Alan Greenspan's new book is called The Age of Turbulence but the former Federal Reserve chairman has so many critics these days it might appropriately be subtitled, The One That I Caused.

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Thursday, September 13, 2007

Warren Buffett Speaks

Janet Lowe has authored a completely revised version of her "Warren Buffett Speaks: Wit and Wisdom from the World's Greatest Investor." In order to provide complete disclosure, let me advise that John Wiley & Sons, the publisher, sent me a complimentary copy for which I am quite grateful.

There are many adoring fans of Buffett, myself included. I own and peruse regularly almost all of the writings about WEB as well as his own well-crafted annual reports. Of course, most of us who have been involved in value investing can recite almost verbatim, some of the quotations that are here. But many less familiar ones are here as well.

Ms. Lowe has completed a beautifully written and well organized book that provides a concise guide to investing as well as about life in general.There is no preaching or proselytizing here. The message is relaxed and provides excellent "thinking" in an easy read.

Some of the less familiar quotes provide great insight into how one should lead one's life. For some of my younger readers who aspire to being investment analysts or portfolio managers, there is valuable advice. Indeed, to those among us who are crotchety and old ( like yours truly and a few of my former co-workers) it provides a valuable reminder of certain principles.

Let me highlight a few:

The importance of cultivating good character: "Always hang around people better than you and you'll float up a little bit. Hang around with the other kind and you start sliding down the pole."

The importance of a mentor: "You're lucky in life if you have the right heroes. I advise all of you, to the extent that you can, pick out a few heroes. There's nothing like the right ones."

Understanding your place in the world (and this is a Munger quote): "If you're a duck on a pond, and it's rising due to a downpour, you start going up in the world. But you think it's you, not the pond."

Working with Good People: "I choose to work with every single person that I work with. That ends up being the most important factor. I don't interact with people I don't like or admire. That's the key. It's like marrying."

In addition on that same theme:

"Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if they don't have the first, the other two will kill you."

Having a Philosophy: "When proper temperament joins with proper intellectual framework, then you get rational behavior."

in addition, consider:

"If principles can become dated, they're not principles."

On investing: "The market is there only as a reference point to see if anybody is offering to do anything foolish. When we invest in stocks, we invest in businesses."

and an important one to consider in these volatile times:

"You can't get rich with a weather vane."

Buffett's philosophy and techniques have been a touchstone for me and many value investors for many years. The investment principles hewed by Benjamin Graham have stood the test of time, and hence truly are principles:

  1. Look at stocks as small pieces of the business.
  2. Look at market fluctuations as your friend rather than your enemy-profit from folly rather than participate in it.
  3. Margin of Safety

These truly are the cornerstones for successful investing.

Finally, one poignant quotation that I found truly touching about the definition of friendship:

"I remember asking that question of a woman who had survived Auschwitz. She said her test was, 'Would they hide me?'"

There have been some great, and some not so great books about WEB. There are some great ones on the way. This much revised and updated compact edition deserves a place on your bookshelf, if not your desk. Buy it, read it, live it!

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