The Crisis of 2008: Lessons learned, unlearned and reinforced

The one thing I can say about 2008 was this it was not boring. I know that there will be a flood of books coming out over the next few months telling us what happened, why it happened and most important of all, who to blame. I don't think that they will tell us much that we don't know already.  I have a different book in mind and this is what I want to do. I want to look inward and ask myself what I have learned from these last few weeks that I can incorporate into my "view of the world" looking forward. I The market collapse and investor reaction has been a humbling experience and has revealed how much I do not know or fully understand about finance.  Here is my initial list:

Things that I know now that I did not know on September 12....

1. Nominal interest rates can become negative.
   
2. There is no riskfree asset.
   
3. Equity risk premiums can change dramatically even in mature markets.

Things that I thought I knew on September 12, that I am not so sure about now...

1. Large companies in developed markets can always raise new capital.
   
2. Bank runs are things of the past, with the regulatory oversight, accounting rules (mark to market) and risk management tools that we have today.
   
3. Value investing (investing in low PE , high dividend yield and low PBV stocks) is less risky than growth investing.
4. Dividends are sticky.
5. Diversification across asset classes provides protection.

Things that I kind of knew on September 12 that have been reinforced since....

1. Debt is a double edged sword. (The costs and likelihood of distress can be much higher than I thought...)
2. A large cash balance is not just a wasting asset but protection against danger.
3. The line between hedging and speculation is a very fine one... and easy to cross...
4. Main Street and Wall Street are co-dependent. One cannot be healthy, if the other is not.
5. We are in a global economy.
6. Ignore illiquidity at your own peril.... Its cost can vary across time and across markets
7. Risk is not just a number.
8. Stocks don't always win in the long term.
9. Smart money is not that smart!!! 
10. Even great investors make mistakes! 

In fact, I have been collecting ammunition for each of these points, by scouring news stories from the the last three months. Sometime over the next year, I will sit down and start putting it down on paper. All I need is a good title!

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Sticky dividends!

When we look at how companies have set dividends in most markets, the word that comes to mind is "sticky". Put another way, most companies set absolute dividends and stick with those dividends through good times and bad. A few even have a policy of consistently raising dividends and continue to do so, even in the worst of times. This has been true for decades in the United States, but I was curious about whether the last three months of market turmoil have made significant inroads into changing the policy. The answer seems to be yes, but with caveats...

1. S & P keeps track of how many companies in the S&P 500 index increase, decrease and suspend dividends, by month. In the last quarter of 2008, 32 firms increased dividends, 17 firms cut dividends and 10 suspended dividends. No firm initiated dividends during the period. If you are surprised that more firms increased dividends than cut or suspended dividends, here are the statistics for the previous three quarters.

• First quarter, 2008: 93 increases, 7 decreases, 4 suspensions
• Second quarter, 2008: 65 increases, 9 decreases, no suspensions
• Third quarter, 2008: 45 increases, 6 decreases, 8 suspensions
• Just as a further contrast, in all of 2007, there were 299 dividend increases, 7 decreases and 3 suspensions.

2. Some companies did deviate from long-standing dividend behavior in these last three months. To provide an illustration, Pfizer did not increase its dividends in 2008, for the first time in 42 years, evoking an article in the Wall Street journal wondering why they decided to do so...

I think 2009 will lead to even more conservative behavior, at least when it comes to dividend policy. After all, one reason that companies felt comfortable maintaining dividend payments, even in the face of declining earnings or losses, was the belief that they could raise funds from capital markets, if they needed them. If the last quarter of 2008 has taught them a lesson, it is that capital markets can shut down even for the largest companies in the most developed markets. There is a new found respect for large cash balances at companies, though I am not sure how long it will last.

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Hard wired to deceive?

As the Madoff story runs its course and investors express surprise and shock that they were taken to the cleaners, it may be worth noting that research in the social sciences suggests that this may be par for the course, given our genetic make-up. Here is the evidence:

1. Brain size and potential for deceit are correlated: Studies of primates have uncovered an interesting finding. The larger the brain of a primate, the more likely it is that it will indulge in deceitful behavior. The great apes, for instance, are masterful deceivers but as the primates with the largest brains (arguably), human beings are at the top of this deceitful heap... And smart human beings are much better at deceiving others than dumb human beings!!
Bottom line for investing: You are at greatest risk of being lied to, when you invest with the smartest portfolio managers (hedge funds?)...

2. We lie and we do so habitually: A study that tracked students (by inviting them to keep track of their lies in a journal) uncovered the fact that they typically lied about two times a day.
Bottom line for investing: The standard investment sales pitch contains more than its share of half truths.

3. We do feel guilty when we lie, but that does not stop us from lying again: The same study that uncovered the fact that students lie two times a day, on average, also found that while they felt guilt at doing it, the fact that they were able to get away with it reinforced the behavior. Put another way, if you get away with lying once, you will will try it again...

Bottom line for investing: All the ethics classes in the world and forcing everyone to attend religious services every week won't stop the next big fraud or even reduce its likelihood.

4. We often want to be lied to: Here was the most interesting conclusion. The researchers who have looked at this phenomenon and noted that it has been going on for as long as we have been on earth have determined that, deep down, we want to be lied to. In some cases, this is because the truth will hurt too much (That dress does really make you look fat) and in other cases, because the lie makes us feel better (You are brilliant!!!)..

Bottom line for investing: Every fraud has two players - the fraudster and the victim. While we tend to think of the former as the villain and the latter as the victim, they need each other for it to work.

So, take the talk that you hear about this being the fraud to end all frauds with a grain of salt. This has happened before and will happen again... why? .. because we are human!!

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To zero..and beyond...

Day before yesterday, the Fed announced that is was cutting the Fed Funds rate close to zero. In the weeks preceding, the three-month US treasury bill rate has flirted with negative yields... Both phenomena raise a question: Can nominal interest rates become negative?

Let us start off by accepting the fact that real interest rates can become negative and have, for extended periods in the past. Real interest rates can happen when expected inflation is high but central banks decide to flood the market with enough funds to keep nominal interest rates below the expected inflation rate. However, a negative nominal interest rate is not only unusual but difficult to grapple with. As my sixteen-year old put it, why would someone put their money into an investment to get less in three months than they invest today? Why not stick the money in a checking account or even under the mattress for that period?

For small amounts of money, nominal interest rates should never fall below zero, because either the checking account option and the mattress option is viable. But what if you are a portfolio manager or a corporation with $ 3 billion in cash? Holding the cash balance as currency in your corporate headquarters is an invitation for the heist of the century (Think Oceans 11, 12 or 13..) Putting the cash into a bank account is not completely secure, because the FDIC protection works only up to $250,000.... If the bank goes under, your principal is at risk. In normal times, we would not consider this a likely scenario but we are not in normal times.

Both the Fed move to cut the Fed funds rate close to zero and the short term treasury bill rate dropping below zero are indications of how much investors have lost faith in the banking system. Large investors are in effect saying that they would rather accept an -0.5% nominal interest rate than risk leaving large amounts of cash in a bank. That is not only astounding but scary.

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To Madoff or not to Madoff?

By now, everyone has heard the story of Bernhard Madoff, the New York city based investment advisor, who was just arrested for perpetrating a fraud estimated in the billions ($55 billions?) As we look at list of prominent people who have been snared in this web of deceit, including Mortimer Zuckerman and Elie Wiesel, we have another opportunity to examine the consequences of greed, hubris and eventual downfall.

The facts of the story seem fairly clear. Madoff made his initial reputation as a broker/dealer, and he built a business based upon computerization and quick trades for his customers. Somewhere along the way, he also became an investment advisor, though he did not file to officially become one until 2006. He moved in the highest circles of society, and wealthy investors clamored to be his clients. He made himself even more desirable to these investors by turning away several. His allure was not that he delivered super high returns but that he delivered stable and solid returns year in and year out. In effect, he seemed to have found a way to take little or no risk and deliver about 5-8% more than the treasury bond rate. Last week,. he gave away his secret. He had been operating a Ponzi scheme, i.e, using money raised from new investors to deliver returns to old ones. Like all Ponzi schemes, it was dependent on new money coming in. The market collapse of the last few months essentially cut off that inflow, leaving Madoff exposed.

Rather than make this a treatise about bad investment advisors and unquestioning investors, I would like to make a general point about investing in general and professional investors in particular. There are two questions that we can ask about these investors:

a. How much money (returns) did a particular investor make over a period or periods?

b. Why did they make the returns that they did?

As individuals, we are drawn to the first question and there are services that report these numbers in mind-numbing detail. Morningstar, for instance, has returns on every mutual fund in the US, going back in time. Others then build on these numbers: the funds themselves advertise with evidence of superior returns and ranking and reputations are built on past returns. The second question, however, is viewed as intellectual and in some cases, as academic, and seldom gets answered seriously. If we want to entrust our money to a professional, though, we need both questions answered well. In other words, I not only need to know how much you (as a professional money manager) have made over time but also why you made this return: was it superior information, your analytical ability or your trading skills? Using the language of corporate strategy, I would like to know what your competitive edge is and how you plan to maintain it.

 Any investor asking the second question about Madoff would have uncovered red flags. The man was not (and never claimed) to be a sophisticated number cruncher and he clearly did not enunciate an innovative investment strategy. The only potential advantage that he might have had came from his access to the trading data of investors (through his broker/dealer firm) and front running (trading ahead of) his brokerage clients. That, of course, is illegal and would eventually be uncovered. In other words, there was no basis for his solid, stable returns. He was either lucky (but that is tough to pull off over 30 years) or committing fraud. Last week we found out the answer.

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Enterprise value is negative... Is that possible?

There are three measures that can be used to capture the market value in a business. We can measure the market value of equity, i.e., the market capitalization of the equity in the firm. We can add the market value of equity to the market value of debt to get the total market value of the entire firm: think of this as the market value of all of the assets of the firm. We can add the market value of equity to the market value of debt and subtract out cash and marketable securities to get to the enterprise value: this, in effect, is the market value of the operating assets of the firm.
We see the first number in equity multiples; the PE ratio and the Price to book equity are computed using the market value of equity. We see the last number in multiples of EBITDA and revenues; the rationale for netting out cash is that the income from cash is not part of either EBITDA or revenues.
All of this leads me to a curious phenomenon that has occurred at some large firms, where the enterprise value has become negative. Here, for instance, is a Bloomberg article on the topic:
http://www.bloomberg.com/apps/news?pid=20601087&sid=ahiVT6vmGNEA&refer=home
In other words, the cash and marketable securities exceed the cumulated market values of debt and equity. In theory, at least, this seems to be an easy arbitrage opportunity, where you can buy all of the debt and equity in a firm and use its cash balance to cover your investment costs and keep the difference. Here are some reasons why you should be cautious:
1. The computed enterprise value may not have captured all of the debt outstanding in the firm. With a retail firm, for instance, enterprise value should include the present value of lease commitments as debt. What you see reported as enterprise values for WalMart, Target and Best Buy is understated because of this failure. In the Bloomberg list, for instance, there are a preponderance of banks and financial service firms. I have always had a tough time defining debt and enterprise value at these firms and am dubious about most of these firms.
2,. The cash that is netted out to get to enterprise value is usually from the most recent financial statement (rather than the current date used for market cap). Given how quickly firms burn through cash, what you see on the balance sheet may not reflect what the firm currently has as a cash balance.
3. Some services are sloppy about their definition of market value and seem to mix up market value of equity with market value of the firm.
The core of the article, though, is that stocks are cheap on a historical basis but history also tells us that there are no slam dunk investment profits. There is a many a slip between the cup and the lip when it comes to arbitrage profits.

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Corporate Hedging: Answers to questions

A couple of posts ago, I presented six examples of risk hedging/ taking that I would like to take through my three bucket test - risk to pass through, risk to avoid/hedge and risk to exploit.

1. Southwest has always hedged against oil price risk, using futures contracts. Is what they are doing make sense? Given that Southwest's core competence (see, I can speak like a corporate strategist) is running an airline (not forecasting fuel prices), that fuel prices are such a large portion of total costs, and Southwest has done this through high and low oil prices (and are thus not trying to time the oil market) , I think it makes sense.
   
2. In the last two years, other airlines that had never hedged against oil price risk decided to start because oil prices had gone up so much. Is what they are doing make sense? I am much more suspicious of this activity. The very fact that they are hedging only after oil prices have run up, suggests to me that there is an element of market timing here. Not surprisiingly, firms that do this end up with the worst of both worlds. They hedge against oil prices after they have run up and stop doing it after oil prices have gone down.
   
3. A publicly traded soccer team buys insurance against it's leading player getting injured. Does that make sense? I think this does, since investors in the firm would have a difficult time doing this on their own. The team also has information on the player's physical status that an investor would have no access to.
   
4. As the Brazilian Real increased in value against the US dollar, Aracruz decided to make a bet of tens of millions on the continued strengthening of the Real. Good idea, bad idea? This is plain dumb. Aracruz is a paper and pulp company. As an investor in the company, the last thing I want them to try and do is time exchange rate movements (and I would have said the same thing even if they had made money)
   
5. A trader at an investment bank decides to bet, with proprietary capital, that interest rates in the US will rise over the next year. Makes sense? I have always been skeptical about propreitary trading profits reported at investment banks, since I see little that they bring to the table as competitive advantages. They trade with each other, using the same information base and often the same traders (who move from bank to bank). I see no reason to believe that a trader at an investment bank (and the economists at the bank) have any special insight into the future direction of rates.
   
6. Barrick Resources, a gold mining company, decides to sell futures contracts to lock in the price of golf for the next five years. What do you think? I invest in gold mining stocks because I am optimistic about gold prices going up. If Barrick goes out and hedges against gold price movements in the future, it is undercutting my rationale for investing.

The bottom line, though, is that we should not judge any of these firms by the outcomes of their actions, but by whether their actions make sense. (Aracruz could have made hundreds of millions on its currency bets and Southwest is probably losing money, now that oil prices are declining)

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