Monthly Archives: June 2016

Second Hand Shoes

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Susanna Gibbons, CFA

I love second hand clothing stores. In large part, that is how you can spot a bond person: from their love of identifying marginal relative value in obscure, non-scalable ways. The corporate bond market itself is nothing but a big swap shop (see my post “Thrift Shop” from November 15, 2013). Even so, I have a few rules that I try to live by with respect to used goods, and the main one is this: Don’t buy second hand shoes.

I bought a pair of second hand shoes once. They were Stuart Weitzman, black, with a funky composite heel. They looked amazing, they fit perfectly. They were a bargain. I wore them to work the very next day, feeling pretty proud of myself for having scored such a find. As the day wore on, I started to notice small black chunks of what I thought was dirt start to accumulate under my desk. I ignored it. I went out for lunch, and those small black chunks became large black chunks, and I realized that the funky composite heels of these shoes were flying apart at an alarming rate. I arrived at Marshall’s, two blocks away, essentially barefoot as the shoes collapsed beneath me, and was forced to purchase a cheap replacement. I now understand that there is a complexity to footwear that makes second hand shoes especially risky. That risk is un-analyzable, so second hand shoes should not be included in one’s portfolio.

I try to apply that same rule to the corporate bond market. If you keep it simple, and focus on risks you can understand and analyze, I think you can do pretty well in either the primary or the secondary market. But the market also offers plenty of opportunity to purchase what I think falls into the category of second hand shoes. My favorite current example is bank capital securities.

The market has been through several iterations of bank capital securities. As the regulatory landscape and public opinion continues to evolve, so do capital securities. Some of these securities have done extremely well – they have relatively high coupons, and generate a fairly reliable stream of income. But the devil is in understanding the details. Reading through a typical prospectus on these instruments, one finds gems such as “Interest Payments Discretionary ….the Company shall have sole and absolute discretion at all times and for any reason to cancel an interest payment ….” Or another favorite – the company can redeem the notes at par if there is any regulatory change.  Also, if capital falls below a certain level – let’s say 7% — the security disappears entirely or becomes a different security, the terms of which might not even be known. What kind of bond doesn’t have to pay interest, and might or might not pay principal?

As an investor, I have owned these in the past, and I guess there are times when they make sense. But these securities are not exactly the classic pair of black pumps or mahogany penny loafers, and I don’t think they age especially well. Newly issued, there’s probably a nice window of regulatory clarity and attractive pricing that justifies their peculiarities.  Right now, though, investors seem downright complacent about the risks involved in owning these securities, layering them into portfolios in an effort to boost yield.

I made the mistake last week of buying another pair of second hand shoes. They didn’t fall apart entirely, but once again chunks of material started peeling off them, and I was reminded how important it is to heed life’s hard-earned lessons. If I get tempted to dip my toe into some bank capital securities, someone please remind me of how quickly the bottom can fall out of these things, leaving you barefoot on the street at the worst possible time.

Don’t buy second-hand shoes.

How Investors Should Navigate the Non-GAAP Earnings Confusion, Continued

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Adam Schwab, CFA, CFP

A Cheat Sheet for Common Non-GAAP Adjustments – Part I

I’ve tried to make the case that the legitimacy of non-GAAP measures is dependent on the individual company, the business model, the competitive environment, the management team, etc. There is no one-size-fits-all approach. While that will bother investors who want an easy answer, it’s reality. For those investors who want a quick guide to thinking and interpreting non-GAAP measures, I have compiled a quick guide of questions to ask on each topic.

Reorganization/Transition/Restructuring Expenses

Look for a continued history of these charges. The “serial restructuring” company should be obvious by the year after year disclosure of the same items. Again, the investor’s familiarity with the company and management team will drive the analysis. Restructuring charges were expenses that should have been realized all along in the past. Instead, companies get to kitchen sink these expenses as one-time items. Investors should normalize past profitability by blending the charge through past income statements to get a better gauge of historic profitability. This will lead investors to a better understanding of economic profitability, rather than just ignoring the charges.

Investors need to be realistic in their margin assumptions going forward. While most investors and management teams love to project a never-ending upward trajectory of margin expansion, reality and competition will dictate otherwise. Today, assume that the company you are looking at will likely have their “restructuring moment” sometime in the future, so adjust your understanding and valuation today to avoid getting blindsided in the future.

Options Expense

Why the options debate continues is beyond me. When you give away a claim or an option on company’s equity, that’s an expense. The argument for comparability has no merit in my mind. If one company is giving away more equity than another, the analysis/valuation should reflect that. Ignoring options expense only drives understanding further away from the truth. Because analysts want their models to be nice and clean, it leads to analysis that is borderline worthless.

Consider this example: if company A is paying its employee’s salaries at 2x the level of company B, should analysts back out the “extra” salary for comparability sake? I don’t think so. If a company chooses to pay more or issue more options, reflect that in their numbers.

Foreign Exchange

Companies with significant foreign operations (over 30% of revenue) should treat F/X movements as natural, recurring expenses/benefits. I understand the desire for comparability, but simply ignoring these movements is ignoring reality. Instead, use the company’s disclosures to set a framework for understanding the economic exposure. Given the rapid devaluation in Venezuela, Brazil, Russia, etc, it’s paramount to understand that these losses are more often than not real, economic expense, not just some accounting fiction.

In general, ignoring volatile f/x movements because they don’t model well will just create more unpleasant surprises for the investors in the future. What matters for investors are the long-term economic results, and if f/x movements are continually part of those results, then include them.

Amortization of Intangible Assets– Customer Relationships/Lists, Patents/Technology, Brands/Trademarks

Amortization of Intangibles is often a large component of non-GAAP earnings and the key is to separate and evaluate each intangible.

Patents and technology intangibles are typically always a true expense. The value of these assets declines as competing technologies render the current assets obsolete over time. Often, in a much quicker timeframe than the actual amortization period. Exercise extreme caution if a company claims their technology assets don’t depreciate or need reinvestment.

On the flipside, brands are almost always indefinite and don’t need separate reinvestment as ongoing marketing expense and normal reinvestment will support the intangible value into the future.

The same is true with customer relationships. A company will never have to have an annual budget item for customer relationships to maintain that asset. There is one caveat to ignoring brand and customer intangibles expense. Investors must ensure the business is adequately reinvesting in itself to make the case that brand and customer intangibles don’t need expensing. If the business is underinvesting, the intangibles will lose their value.

Look for Part 3 of this series next week on Freezing Assets.

Adam Schwab, CFA, CPA is a partner and portfolio manager at Elgethun Capital Management. Contact Adam at aschwab@elgethuncapital.com. Visit adamdschwab.com for more investing articles and podcasts.

A Letter From Our Society President

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Joshua M. Howard, CFA

Last month the Board of Directors of CFA Society Minnesota met to discuss the status of our current three to five-year strategic plan, which has been in place for two years now.  We took some time to reflect on what we have accomplished, debated whether any goals needed revising, and brainstormed ideas on what we hope to accomplish in the upcoming year. I was once again impressed by the commitment of your Board of Directors, as 18 board members spent three and a half hours at the end of a work day engaged in strategic planning, which isn’t every analyst’s idea of a good time.

CFA Society Minnesota’s Mission and Vision, which you can find on our website under the About Us tab, guided us in the creation of our current strategic plan and continues to guide our thinking about how we run the Society.  Our Mission is “To promote and advance the professional excellence, ethical behavior and fellowship of our members through quality programs, educational offerings, and volunteer opportunities.” Our vision states that “We envision a CFA Society of Minnesota that is highly valued, well respected, and widely recognized by investors, academia, and the business community in our region.” Both our mission and vision were updated in 2013. They align with and compliment the CFA Institute’s mission and vision, recognizing that each entity (Society and Institute) has different capabilities and goals.

Our current strategic plan has three main objectives. They are:

  1. Member Engagement: Expand participation and involvement among Society members
  2. Industry Awareness and Involvement: Increase awareness of and involvement in the Society among professionals and firms in our local investment industry
  3. Operational Excellence: Improve the effectiveness and sustainability of the Society’s business processes

Each of these objectives is supported by 2-3 specific, measurable goals. These include finding ways to assist our members as they grow in their careers (leadership training, writing and speaking groups, etc.), building a brand campaign and adopting policies and procedures that will aid in long-term financial and organizational stability. If you would like to see a detailed strategic plan, please contact the Society office at executivedirector@cfamn.org and they would be happy to provide the latest version.  If one of these objectives or goals is an area you would like to support please let our staff know that as well. We are always looking for thoughtful, energetic volunteers to help us accomplish our strategic plan.

Joshua M. Howard, CFA
President, CFA Society Minnesota

How Investors Should Navigate the Non-GAAP Earnings Confusion

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Adam Schwab, CFA, CFP

An Introduction and Three Guiding Principles

There has been a recent surge in the controversy surrounding non-GAAP earnings. While the debate continues on the proper use of non-GAAP metrics, investors can’t expect outside help and need to take control of their own understanding and interpretation of non-GAAP adjustments. Investors can’t rely on “guidance” from companies or regulators.

The problems run deeper than the GAAP vs. non-GAAP debate. The actual problem is investor’s lack of commitment to a thorough, fundamental understanding of the company. Without adequate understanding, investors will never be able to tell non-GAAP truth from fiction.  There is never a hard and fast set of rules to determine the validity of GAAP exceptions. Like any set of standards, there are exceptions and situations that don’t fit the model. The extreme doubters of GAAP or non-GAAP miss the point: no system is perfect. It’s the investor’s responsibility to determine the best representation of economic reality. Blind devotion to SEC guidance, FASB standards, or company management is a dangerous path.

This series of articles will help guide investors into asking the right questions involving non-GAAP metrics. This advice cannot replace actual analysis, but will give investors a better framework for thinking about these issues.

3 Rules to Remember

  1. Always reconcile each adjustment using the GAAP to non-GAAP reconciliation

Regardless of a company’s adjustments, investors should always reconcile to GAAP earnings. This figure, required by the SEC, allows investors to see a clean breakdown of non-GAAP adjustments. Unfortunately, that’s the easy part. The hard part is understanding what items are legitimate and which are not. Analyze every line item on an individual basis to determine its validity. One or two adjustments account for most of the deviations from GAAP. Unfortunately, there are no clear cut answers on which expenses are legitimate and which are egregious. Materiality depends on the company and industry dynamics. The only way to know is to dive deep into the business and financial statements.

  1. Pull up and compare reconciliations for the past 5 years

Don’t limit your analysis to the current year. Compare what “recurring”, non-recurring expenses have been consistent over many years. Repeated appearance is clear evidence that these charges are recurring in nature, even as management argues “one-off” or too volatile/unpredictable. In fact, a quick glance at successive reconciliations should show no yearly correlations between line items. Also, understand that the absence of repeated charges doesn’t mean one-time charges are legitimate. Evaluate every adjustment on its own merit.

  1. Match the reconciliation to the business model

Serial acquirers should not have their acquisition-related charges excluded. Acquisitions are part of their strategy and the associated expenses are legitimate and recurring. Major problems develop when analysts and management teams guide to high top and bottom line growth without the necessary acquisition spending to support that growth. It’s unfortunate that overconfident/aggressive companies and investors permit this mismatch to make valuation, free cash flow, and EPS more impressive. Some quick investor math on the implied ROICs would show an unsustainable level of ROIC into the future.

Look for Part 2 of this series next week on Freezing Assets.

Adam Schwab, CFA, CPA is a partner and portfolio manager at Elgethun Capital Management. Contact Adam at aschwab@elgethuncapital.com. Visit adamdschwab.com for more investing articles and podcasts.            

Too Big To Fail

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Susanna Gibbons, CFA

On May 16th, The Heller Hurwicz Economic Institute at the University of Minnesota hosted Neel Kashkari, President of the Minneapolis Federal Reserve, in a conversation on his Too-big-to-fail initiative. During the financial crisis, Mr. Kashkari ran the much-maligned TARP program, in which all banks in the US were infused with cash in an effort to “un-clog” the financial plumbing and allow markets to return to normal functioning. Mr. Kashkari was very clear that he felt the TARP program was necessary, that the Fed’s primary mistake in the crisis was that they were always reacting late, but that they were nonetheless very uncomfortable with the interventions which they felt were required. He was also very clear that the conversation he has started is intended to explore a wide range of transformational options with respect to the banking system, including breaking up the largest banks, or regulating them as public utilities, and that the Minneapolis Fed  is in the process of gathering information and opinions on this topic.

Mr. Kashkari was, however, resolute in his opinion that some action needed to be taken, and that the perhaps-majority opinion at the Fed that Dodd-Frank should be allowed to work before they shake things up was not an acceptable outcome. Something needs to be done, he believes, to put an end to too-big-to-fail forever. The basic philosophy, which on its face sounds quite reasonable, is that the public should not have to risk anything to support banks, that it is inherently unfair to use public funds to protect banks’ equity holders during a crisis since banks are private, for-profit institutions.

But does this philosophy actually makes sense? What we are really concerned about is having a banking system that is able to withstand a crisis, but we do not want to be forced to rely on systemically-focused tools like providing crisis-based market support. Instead, we are determined to identify a banking structure – whether through a better mix of businesses or a higher capital requirement – that has no negative impact on the public wallet.

The underlying philosophy, in my opinion, is illogical. Let’s just focus on the capital requirement. Many theoreticians would like us to believe that higher capital requirements are costless (or even beneficial), since they result in lower debt costs and greater capacity for risk-taking by banks. This is essentially a souped-up version of Miller-Modigliani, an application of that frictionless world of firm capital structure to the entire economy.  Most bankers are on the other side of this argument – they believe that higher capital requirements result in a higher overall cost of capital, which constrain a bank’s ability to lend, thereby limiting economic growth overall. A recent review of academic literature in a DNB Working paper titled Effect of bank capital requirements on economic growth: a survey, found that most empirical evidence suggests that an increase in capital costs of 100 basis points reduces lending by anywhere from 1.2 – 4.5%. While the paper was careful not to extrapolate from this to an expected impact on GDP overall, I would argue that a lending reduction of this amount spread across an entire economy would have a measurable impact on GDP. If the growth impact on our $18 trillion economy was just 10 basis points annually, over a ten year period this lower growth would cost the US Economy about $1 trillion in GDP – more than the 2008 bailout. And let us not forget that the entire amount lent under TARP was repaid, so the cost to the taxpayer is probably best summed up as the interest paid on funds borrowed.

I fully realize that in that last paragraph I am just making numbers up. My point is to simply place what seems like a modest growth impact in context with respect to the perceived unfairness of providing stability to the banking system during a crisis. There is no solution to this problem that is costless to the public, and it is entirely possible that the cost of building an unassailable fortress around the banking system is significantly greater than the cost of supporting the system in crisis.