Saturday, July 26, 2014

Book review: "Rainmaker: The Saga of Jeff Beck" by Anthony Bianco

Jeff Beck was a successful deal-maker on Wall Street during the 1980s. He helped facilitate the leveraged buyout of RJR Nabisco, which made him a minor character in Barbarians at the Gate. Beck was known as "Mad Dog" because of his combat experience during the Vietnam War, and Barbarians depicts him living up to that nickname, eating a bag of Milk Bone dog biscuits that RJR Nabisco CEO Ross Johnson had given him as a joke.

Rainmaker makes it clear that the Milk Bone incident never happened. Neither did Beck's Vietnam exploits, which a front-page article in The Wall Street Journal revealed as fake, as it did with Beck's claims of significant inherited wealth. Ironically, although Beck was a compulsive liar about his background, he had better professional ethics than many of his contemporaries. He refused to do business with Ivan Boesky, being convinced that Boesky was a crook, and tried to get a couple of reporters to investigate the arbitrageur.

Beck was never one of Wall Street's richest people, but he was possibly its most entertaining. His antics included threatening to jump out an office window if he didn't get a deal fee, impersonating a Southern preacher, making a cameo in the movie Wall Street, and recalling his experiences in Vietnam over lunch with Oliver Stone, who had actually served in Vietnam. Stone was taken in.

Despite his successful career, Beck was cynical about deal-making. So is Bianco. He suggests that KKR's phenomenal early returns were a result of the low valuations that prevailed during the late '70s. (The RJR Nabisco buyout, done a decade later at a much higher valuation, produced extremely low returns, and several of KKR's smaller late-'80s buyouts went bust.)

One of Beck's biggest deals was KKR's buyout of Beatrice Foods. Beatrice had thrived in 1950s and '60s by acquiring lots of small, regional food companies. It kept these companies' founders in place to run them as part of a highly decentralized corporate structure. This strategy fared much worse in the '70s as the acquirees' founders retired and heavily-advertised national brands displaced Beatrice's regional brands-- contrary to what The Outsiders would suggest, decentralization wasn't an unalloyed good.

Beatrice's problems grew when a new CEO, James Dutt, took over. Dutt wasted tens of millions of dollars on a media campaign that advertised the company with the slogan "We're Beatrice" when the money would have been better spent on advertising the company's brands. Dutt also spent heavily to sponsor sports tournaments. He had little interest in operational details and reneged on an early pledge to centralize Beatrice's manufacturing and cut costs.

Dutt's tenure at Beatrice was similar to Ross Johnson's tenure at RJR Nabisco and its predecessor companies as described in Barbarians, although instead of merely being venal like Johnson, Dutt grew increasingly unbalanced. His erratic behavior eventually prompted Beatrice's board to fire him, which paved the way for KKR to buy the company.

As its title suggests, Rainmaker is mostly about Beck's career and personal life, but it contains a decent amount of detail about the buyout boom, including some LBOs that aren't well-known today. Bianco is a business journalist, and the book has its share of journalese, but it's still well-written. An interesting read but not essential.

Friday, July 25, 2014

Book review: "Selling America Short" by Richard Sauer

Richard Sauer worked for years as an SEC lawyer, left to join a corporate law firm, and later worked for a hedge fund that specialized in short-selling. Selling America Short is a chronicle of his varied career. The book recounts his experiences with a bunch of controversial companies, several of which went out of business following accounting scandals. Among the companies the books mentions are Lernout & Hauspie, Aremissoft, ACLN, Overstock, Novastar, and Fairfax Financial.

As a writer, Sauer is artfully deadpan. He doesn't indulge in hyperbolic descriptions the way business journalists often do. He also gives the impression of being objective and even-handed.

For instance, he mentions Sam Antar, the perpetrator of a major accounting fraud in the 1980s who later recast himself as corporate watchdog and fraud-fighter, claiming that he wanted to make up for his past sins. Although Sauer compliments Antar's analysis of Overstock, he implies that Antar's reformed-con persona was mainly a self-promotional gimmick.

The book's final chapter describes how the hedge fund Sauer joined was stabbed in the back by Goldman Sachs, its prime broker, after the Lehman crisis. Goldman forced the fund to cover its short sales at an inopportune time, saddling it with large losses when it had made a lot of money in the year to date and stood to make a lot more.

I was already familiar with all of the accounting frauds that the books describes, but I hadn't read a detailed account of the fund's demise before. It was eye-opening.

This is a quick read and worth checking out.

Thursday, July 24, 2014

Credit Acceptance and subprime auto lending

Credit Acceptance (CACC) is a subprime auto lender. Glenn Chan has written a series of posts in which he describes CACC's business model and how it has produced strong historical returns, calling it a wonderful business. He writes that CACC is good at underwriting and debt collection and has developed mutually beneficial partnerships with car dealers.

Chan is an astute investor - his articles about mining are essential reading for anyone who invests in that sector-- but I think that CACC is a bad investment for several reasons.


Business quality

CACC is a successful lender, but high-quality lenders differ from the typical high-quality business in a couple of important ways:
• Loans are essentially a commodity, and underwriting them has few barriers to entry. During a boom, it's easy for new companies to flood into the financial sector and depress margins, even if those companies can't match the high-quality lenders' returns over a full economic cycle.
• Even if a lender is structurally more efficient than its competitors, loan losses can still sink it. This happened to Golden West during the housing bubble, and it was far from being the bubble's most aggressive lender. Lenders face existential risks that the typical high-quality business doesn't face. (Edit: mitigating this, much of CACC's debt is non-recourse).


Macro issues

Although lower-income Americans' wages have stagnated or fallen since 2007, subprime auto loan volumes are close to reaching their 2006-07 peak. According to the CFO of America's Car-Mart, another subprime auto lender, "We believe that our customers have never been more stressed financially and, at the same time, have never been presented with more aggressive financing options for their vehicles."

This may be suppressing CACC's loan losses: if subprime borrowers can easily get a car loan despite being financially stressed, then many of CACC's borrowers who would normally default can find other, more aggressive lenders to refinance them.

Glenn Chan points out that the documentation for subprime loans is very stringent, as opposed to low-doc loans that were common during the housing bubble. I don't find this reassuring because 1) the housing bubble was so excessive that auto lending doesn't have to reach the same extremes to be a problem, and 2) subprime auto loans have their own dangers. They're typically issued at LTVs above 100%, in many cases above 120%, even though cars depreciate quickly. The high LTVs let lenders get around usury laws and trick borrowers into paying higher effective interest rates, but they also lead to huge losses on the loans that go bad.

Eric Falkenstein, in his application of Batesian mimicry to the business cycle, argues that investors always fight the last war: if a certain class of securities does well during a bust, this convinces investors that the securities are intrinsically low-risk or high-quality, which paves the way for a bubble to develop.

I think this has occurred with subprime auto loans. Used car prices were very strong during 2009, thanks in part to Cash for Clunkers, and the Fed's efforts to stimulate lending were particularly effective with auto loans since they have relatively short terms. These things kept loan losses relatively low, and that's given investors a false sense of security regarding how bad they'll get during the next downturn.


Valuation and margins

If CACC meets analysts' estimates, it will earn a ROE of 40% this year with relatively low leverage. This really isn't sustainable. Would-be competitors may not be able to match this ROE, but they don't need to match it to earn high returns.

CACC trades at 4x TBV. This also isn't sustainable IMO. Not a lot has to go wrong for the multiple to fall, and CACC is buying back stock, which is a waste of money at that valuation.

Tuesday, July 22, 2014

"China has a history of recurring and traumatic financial crises since liberalization"

A member of VIC dishes out some realtalk about China's financial system:

Although most China bulls may not be aware of this, China has a history of recurring and traumatic financial crises since liberalization, most of which have seen levels of loan losses that would make the worst fraud riddled S&Ls of the J.R. Ewing era blush (loss ratios >50% recovery ratios <20%).  This speaks to the problematic political incentives facing capital allocators in Chinese finance, and while there have have been some reforms and incremental professionalization since the last crisis, this incentive structure is still demonstrably visible in the lending preferences of the big state banks (still really the only game in town).  Given how enriching this has been for the Party, this is more of a feature than a flaw of Chinese finance.  This is still something that most Western observers fail to understand, who mostly seem to view China as being some sort of high-functioning, monolothic technoractic corporate state combining the best features of Western capitalism with an understanding of how to "get things done".  At least academics understand that property rights are important...  Anyways, returning to loss resolution:

The most recent example would be the post-Asian Financial Crisis GITIC blow-up in 1999.  GITIC's blow-up featured a lot of the same exotic trust and 'wealth management' products which have returned to popularity, and the bank was significant enough to have issued a lot of offshore debt.  The treatment of foreign creditors here is instructive - they were only allowed to see a list of claimants years later, they mostly never found out who got what, and the decision of the court was final.  Foreign creditors ended up receiving literally pennies on the dollar, despite generally having purchased debt 'guaranteed' by the government and initially receiving assurances that foreign creditors would be made whole.  This was more at the level of Cuba than Argentina given a ready ability to pay, as the financial system was of quite a manageable size at that time, and losses could have readily been made whole in one form or another.  I would wager that if more EM bond managers in the market today had a memory of GITIC, China wouldn't garner quite the same level of investor interest that it does today.

And yet, you have plenty of professional investors today talking about how the China bear thesis hasn't played out, China is different because of this or that, 'urbanization' will drive growth (and not the other way around), and that shares look 'cheap'.   I shudder to think of the well meaning investment professionals in this country allocating to funds raising capital to invest in distressed assets, credulously believing that this is a fair market system that respects the interests of private investors.  China was a one-way bet for a long time and I think a lot of current market participants have the idea that China=Growth hardwired into their heads.

Perhaps China's greater exposure to the global financial system will make them behave better this time, but they arguably needed the West much more back then then they do now (the old joke about the difference between owing the bank $100 and $100 million comes to mind).  Post GITIC there was something of a reform drive in order to prevent these problems from recurring, but reform was largely aborted as a buouyant global economy and the embrace of the 'BRICs' narrative ushered in the era of explosive growth which drowned out the pedantic voices of technocrat reformers within the PBOC and other regulators.  Will a resurgance of problems bring back desire for reform? 

Tuesday, July 15, 2014

Buffett odds and ends

Apart from Buffett's investing acumen, there are three reasons why he's so rich:
• Berkshire's insurance operations have given him cheap leverage without the risk of a margin call.
• He's had a much longer career than other talented investors. Buffett started his hedge fund when he was 26. By contrast, Soros was in his forties when he started his fund. Unlike many billionaires, Buffett hasn't retired to become a philanthropist or collect bad art.
• His career coincided with a multi-generational bull market. If the bull market hadn't produced a steady increase in asset values, he would have come up against the law of large numbers much sooner.

Berkshire is a bad investment right now. The Buffett's Alpha paper calculates that Buffett's private investments have historically done much worse than his public investments, and now, after a spate of acquisitions, private investments constitute the lion's share of Berkshire's total investments: "Berkshire’s reliance on private companies has been increasing steadily over time, from less than 20% in the early 1980s to more than 80% in 2011."

Most of the information by and about Buffett isn't very useful for understanding his success. Even Buffett's shareholder letters aren't useful-- they're propaganda pieces that offer a limited, misleading picture of how he thinks about investing and how he operates. Besides Buffett's Alpha, Alice Schroder's interviews are the only things I've read that get to the heart of why he's been successful.

Friday, July 11, 2014

Book review: "Conquer the Crash" by Robert Prechter

I bought a copy of Conquer the Crash after reading Credit Bubble Stocks's excellent review of the book. My opinions are broadly similar to CBS's, and I strongly recommend his review, especially his discussion of "investing ecosystems."

Prechter describes two big ideas in Conquer the Crash: Elliott Wave Theory and socionomics.

Elliott Wave Theory is a form of technical analysis. It postulates that securities move in patterns and that each pattern consists of five "waves." These patterns are self-similar in the sense that each wave can itself be considered a pattern and divided into five smaller waves. I'm not enthusiastic about technical analysis, and I think EWT is too subjective to have any predictive utility.

Socionomics is the idea that social mood determines the course of economics and finance. Conventional wisdom tends to assume the opposite, e.g. that a stock market crash would lead to a sustained decline in investor confidence. Socionomics is speculative but interesting-- at a minimum, I think the relationship between social mood and financial returns is more of a two-way street than investors generally assume.

Elsewhere, Prechter has written that "When social mood turns, the fundamentals will follow." The idea that fundamentals are a byproduct of more important underlying forces has influenced me greatly.

Many people dismiss Prechter because he's been prematurely bearish or becuase they think EWT is bogus, but that's a mistake. As CBS writes, "Lots of the ideas in Conquer the Crash stand on their own whether or not Elliot Wave theory is true."


New-era thinking

Writing in early 2002, Prechter argues against the idea of a "new economy." He compares the American economic boom of 1942-1966 with the boom of 1974-2000. The second boom had much much weaker economic growth than first, but that the stock market did much better during the second.

He finds the same phenomenon in 1920s America and 1980s Japan: economic growth was slower than during preceding booms, but the stock market rose much more amid talk of a new era.

All of these periods experienced rapid increases in debt. This, not the dawn of a new era, was what increased stock-market returns. Debt's benefits accrued unevenly, however. During late-'90s stock market, tech stocks and blue chips significantly outperformed other kinds of stocks. Stock-market breadth was similarly weak during the Roaring Twenties and Japan's asset bubble. As Prechter writes:

"During third waves, people focus on production to get rich. During fifth waves, they focus on finance to get rich. Manipulating money isn't very productive... In a finance-oriented economy, comparatively few entities benefit."


Parenthetically, higher economic growth doesn't lead to higher stock market returns, but Prechter doesn't claim that it does. Rather, he makes it clear that stories about a new economic era have no basis in reality. They're merely rationalizations created to justify a bubble.


Inflation and the Fed

Prechter argues that the effects of inflation, which he defines as an increase in the amount of money and credit relative to the amount of goods, vary with social mood:

"The inflation of the 1970s induced dramatic price rises in gold, silver, and commodities. The inflation of the 1980s and 1990 induced dramatic price rises in stock certificates and real estate."

He also argues that the Federal Reserve has less control over the markets than most people assume:

"Thus, regardless of assertions to the contrary, the Fed's purported 'control' of borrowing, lending and interest rates ultimately depends on an accommodating market psychology and cannot be set by decree."

"For the Fed, the mass of credit that it has nursed into the world is like having raised King Kong from babyhood as a pet. He might behave, but only if you can figure out what he wants and keep him satisfied."



Depressions

A deflationary depression can occur as a quick, sharp crash or prolonged period of stagnation and financial distress. The Great Depression is an example of the former. Japan is an example of the latter:

"Japan's retrenchment has been long and slow because most of the rest of the world's economies continued their investment manias and economic growth, allowing vigorous trade to provide support during the first decade of its economic decline."

Now that every major economy has high debt levels and is experiencing high credit growth, the next depression is likely to be a crash.

Prechter writes that "Short selling is a great idea at the onset of a deflationary depression, at least from a timing standpoint" but can backfire during major crises. If the financial system becomes so stressed that brokers fail, short sellers could be right and still lose.

This argument is even stronger for credit default swaps, for which large banks are the counterparties. CDS were great speculations when the subprime crisis began, but they became problematic when the crisis spread to the rest of the financial system.


Real estate

Prechter writes about various ways that banks can evade lending restrictions and loan-quality requirements, such as inflated appraisals. He also mentions that real estate doesn't clear quickly the way stocks do, so deflation casts a long shadow:

"Few know that many values associated with property-- such as rents-- continued to fall through most of the 1940s, even after stocks had recovered substantially."

Along those lines, Jim Grant, in his book Minding Mr. Market, writes about the Equitable Office Building Corp, which owned the Equitable Building in New York City during the Great Depression. Equitable had high-quality tenants and comfortably met its debt interest obligations during the most acute phase of the Depression, but its rental income steadily declined as leases came up for renewal. The company had to cut its dividend several times in the 1930s before omitting it and finally declaring bankruptcy in 1941.

Wednesday, July 2, 2014

Book review: "Barbarians at the Gate" by Burrough and Helyar

I stopped reading Barbarians at the Gate halfway through. Although it's considered a classic, it's really just a typical business book written by journalists. The writing is hyperbolic, and the authors emphasize the story's superficial aspects to make it more exciting to lay readers. Every chapter has descriptions like the following:

"J. Tomilson Hill III, Harvard College, Harvard Business School, was the warrior of the pair, a zealot for the Wall Street trenches. To enemies—and he had a few—Tom Hill came across as an oiled-back Gordon Gekko haircut atop five feet, ten inches of icy Protestant reserve. Hill was well tailored and proud of it; “the best-dressed man on Wall Street” a competitor called him, and Hill wore his dark Paul Stuart suits like armor. His office was all cool modern art and Lucite-encased tombstones commemorating past victories."

"A former Marine fighter pilot, at forty-nine Beattie had the sandy hair, baby-blue eyes, and soft voice of a kindly uncle, yet the steely gaze of an ex-Marine."


Despite the inflated prose, the book does offer some interesting descriptions.

Ross Johnson, the CEO of Nabisco and then RJR Nabisco, is portrayed as having been totally uninterested in the work of running the company. He main interest was using RJR's money to live lavishly: building a new headquarters in Atlanta because he found Winston-Salem too dull; overpaying movie stars and athletes to endorse the company's products so he could socialize with famous people; building the "air force," a fleet of ten corporate jets that he used for free; and many other abuses of company money. It's a chilling example of the agent-principal problem.

Johnson was able to take over successively larger companies despite doing badly for shareholders because he excelled at corporate politics. RJR had become increasingly dysfunctional in the years leading up to its merger with Nabisco, and that made it the perfect environment for Johnson to rise to the top. Once there, he bought off the board and other executives with freebies and favors. Good to Great lionizes Philip Morris's management, but Barbarians at the Gate gives the impression that their success was largely the result of having a dysfunctional competitor.

Before founding KKR, Henry Kravis and his partners were merchant bankers at Bear Stearns in the 1970s. Their record there was okay but not spectacular. After disagreements with Bear Stearns's leader, they left and started KKR. Their timing was good: 18 months later, legal rules were changed to make it easier for institutional investors to participate in buyouts, and a few years after that interest rates peaked. Kravis was always eager to do more and bigger deals, and that eagerness made him very successful in the 1980s bull market. He had the right personality for the time.