Category Archives: Hot Topic Commentary

MV=PQ

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John Boylan, CFA

Most people who read this column on a regular basis know I am not a big fan of reading too much into potential short-term Fed actions or other macroeconomic prognostications of the day. More often than not they are just transient noise. You do have to pay attention to the data behind those prognostications as sometimes you can see trends that could impact your investment thesis in the longer term.

One such current debate is how much longer the Fed will keep interest rates low, with one in the Fed (our own Minneapolis Fed President Kocherlakota) arguing we should continue the bond buying stimulus program as inflation is still too low.

However, are we investors focusing on the wrong longer term trend? It seems, at least to me, that there is only so much left the Fed can do. For me at least, it appears what we should be focusing on now is now what the Fed will do next but rather what will change the trajectory of money velocity in the longer term. Looking at the classic equation MV=PQ, where M is the money supply, V is velocity, P is the price level and Q is output, all seem to be doing OK except for velocity. Therefore I feel we will not reach full growth potential and acceptable levels of inflation until velocity changes. Consider the following charts:

The amount of money growth in the system is within normal ranges, and was relatively elevated in the not-so-distant past.

(click on image to enlarge)

M2 Money Stock

Additionally, productivity (output) seems to be holding in OK.

Labor Productivity

Source: Bureau of Labor Statistics

 

Inflation, as measured in CPI, likely isn’t optimal in the Fed’s view, but it doesn’t appear deflationary either and is still muddling along.

Consumer Price Index for All Urban Consumers

Money velocity is a different story however.

Velocity of M2 Money Stock

Therefore despite all this monetary pump priming and productivity and prices doing OK, money velocity has been in a notable downward trend. Therefore velocity seems to be an, if not the, anchor to growth.

Can the Fed control velocity? Well after trillions of dollars of stimulus later, one can plausibly argue no. While I agree with Friedman that inflation is always and everywhere a monetary phenomenon, there appears to be limited money turnover and demand, stunting the impact of increased monetary stimulus. That tells me that this is a fiscal policy, not a monetary policy, issue.

Therefore I am watching to see if there is a change in the fiscal environment as I feel that will move the needle macro economically long-term more than anything else. However this will require movement not from the Fed, which can only impact monetary policy—it will require movement from our federal and state legislatures and executives putting in place pro-growth fiscal policies.

Will it happen? One can only hope, and it bears watching closely as the New Year starts.

 

Knowledge Base: Aren’t Public Companies Required To Disclose SEC Investigations?

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Back in 2000 I pioneered using the Freedom of Information Act (FOIA) as a research tool with the SEC. Through the years we discovered countless undisclosed SEC probes and helped thousands of professional investors learn to interpret those that are disclosed. In fact, SEC comment letters are now posted now to the internet for free largely a result of my early efforts with the FOIA (This is the letter I sent to the SEC (link is external) in 2004 on that proposal.).

I’ve personally met with untold numbers of sophisticated investors and spoken at professional gatherings across the country about what we learned from our FOIA work and how SEC investigations really work.

This is my first in a series of articles I plan to post on things you as an investor need to know when it comes to SEC activity. If you like them, please let me know and I will gladly write more.

I leave you with kind wishes,

John P. Gavin, CFA
Founder and CEO
Probes Reporter, LLC
feedback@probesreporter.com
Or click here to use our online Contact Us form

Let’s start with some basic knowledge you need to have when it comes to SEC investigations —

  • Public companies are not technically required to disclose the existence of all SEC probes. Consistently, I hear investors say they thought otherwise.
     
  • When a public company discloses the existence of SEC activity of any kind it is likely because they felt the situation was serious enough it HAD to be disclosed.
     
  • Public companies hate talking about anything bad. Never forget that.

 

Public companies are not technically required to disclose the existence of all SEC probes.

Time and again, I am amazed to find out how few people actually know that public companies are not “required” to disclose when they have an SEC investigation. This is because public companies are only required to disclose matters that they deem “material”.

The consequences of undisclosed SEC investigations can be severe. We also know some SEC investigations go nowhere, so we are not necessarily critical of a company for not disclosing all the probes they have – or that we discover though our FOIA work.

Here’s the problem: Management, who could have self-serving reasons for not disclosing an investigation, gets to be the judge of what is and isn’t material. It’s not at all hard to imagine investors having a view that differs from management on these judgment calls.

The volume of undisclosed SEC activity we find, sometimes at just one company, is so high we find it hard to believe all of those management teams involved did not judge anything sufficiently material to warrant disclosure. But it happens.

Unless the SEC steps in and forces a company to disclose certain information (and that can take months or even years) the company gets to decide whether you need to know, what you need to know, and when you get to know it.

Feels a bit unbalanced, don’t you think? But that’s the way it is. So how do you protect yourself? Read on.

 

When a public company discloses the existence of SEC activity — of any kind — it is likely because they felt the situation was serious enough it HAD to be disclosed.

Trust that! Trust that they know this is a serious problem. That’s almost certainly why they disclosed.

Once, after speaking at a CFA breakfast meeting, a person who identified himself as an attorney experienced in such matters came up to me and said that management’s perception of the exposure being serious is the only reason a company will disclose an SEC probe. It was a strong view I couldn’t corroborate on my own. But I will tell you I wasn’t surprised.

In short, whenever a company discloses something bad, you can trust that the act of disclosure itself tells you that management judged the matter serious. This is true no matter how soothing the words or assurances are.

Also, keep in mind that Wall Street analysts are generally not a good source for helping you to interpret SEC probes that are disclosed.

Just as I’ve been amazed at how few people knew companies don’t have do disclose their SEC investigations, I’ve been equally surprised at just how misinformed even professional investors are when it comes to interpreting SEC matters.

For many reasons, they also tend to shy away from pressing a company too hard on an SEC exposure (though we would recommend otherwise).

 

Public companies hate talking about anything bad. Never forget that.

Public companies love happy talk. Wall Street analysts do too. As a result in our experience we’ve found that means most companies will not tell something bad that is impacting them until it becomes serious: Often too late for you to avoid losing money.

This often includes disclosure – or failure to disclose – SEC investigations. Even then, they may use spin and clever word choice to minimize the impact of the bad news. Never forget that.

 

Boom Clap

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Susanna Gibbons, CFA

The Corporate bond market just goes on and on and on. With almost $50 billion in supply, last week saw the biggest calendar since early September. And this was in spite of the fact that we’ve had a couple of months of spread widening. Investors still have plenty of appetite for investment grade bonds, and not just high quality — plenty of crossover bonds found a home. General Motors (Ba1/BBB-) was in the market with $2.5 billion of 5s, 10.5s, and 30s; Owens Corning, Discover Financial Services, and Omnicare also brought crossover deals totaling nearly $2 billion.

The deal of the week, though, was definitely Walgreens. The US drug retailer was in the market with $8 billion of bonds to finance its pending acquisition of British pharmacy Boots PLC. The US$ deal was followed by another $2 billion in Euros and Sterling today. Walgreens, now rated mid-BBB, had been a solid A-rated company until investing in Boots. In 2007, Boots PLC was the largest-ever LBO in Europe at 11.1 billion pounds, and was among the transactions the market was concerned about in the financial crisis. With LBO debt maturities looming, Walgreens took its initial 45% stake in Boots in 2012 for $6.7 billion. That first kiss must have been like a drug, because on August 6, 2014, Walgreens announced that it would purchase the remaining 55% ahead of schedule. This announcement came in spite of the fact that sales will be lower than expected, and it will not reap the benefit of a potential tax inversion. By purchasing the remainder, and agreeing to take on $7 billion in existing debt, Walgreens will have paid $22 billion for Boots, or 2x what the market thought was a pretty full price in 2007.

Walgreens shareholders have been none too happy about the transaction – the stock dropped nearly 20% on the August 6, 2014 announcement. The bond deal, though, went remarkably well, as the company brought 7 different tranches across the curve. The transaction came at relatively generous spreads (+145 on a 10 year is considered generous these days), and bonds have tightened about 7-10 basis points across the curve since pricing.

That is a pretty happy ending for KKR, to be sure. Whether it turns out to be magic for the company’s new bondholders remains to be seen.

Two Skeptics Debate the Role of CFA Institute

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Tom Brakke, CFA

In a recent column in Chief Investment Officer (“A Skeptic’s View of Today’s Religion”), Angelo Calvello calls out CFA Institute as “the Church of the Capital Asset Pricing Model,” accusing it of perpetuating groupthink about how markets work and not having “a demonstrable positive impact on the way we invest.”

As a CFA charterholder (one old enough to have a mere four digits in his charter number), you might expect that I would bristle at the characterization. While I think the charges are too sweeping and too focused on CFA Institute alone, I agree with most of what Calvello says about the asset management industry of today.

In fact, I’ve written in a similar vein over the years. I absolutely believe that there is a “paucity of genuine innovation.” When I ask investment professionals to rate their own industry and companies (after all, they are in the business of rating other ones), invariably they assign low marks.

Like Calvello, I “have criticized asset management’s business models, culture, and compensation structures; the academy’s lack of imaginative scholarship; and asset owners’ and managers’ behavioral biases” as key factors in the promise of the investment profession not being fulfilled.

And, as for the teaching of investment notions of the day as doctrine, I gave this advice in one of my Letters to a Young Analyst (in regard to the desirability of different credentials): “If you choose to pursue an MBA or a CFA, remember that they are built upon orthodoxy, by and large, which you need to learn and attack at the same time.”

Later in that book, I added, “We need to remind ourselves that modern finance is a very young discipline. Despite that, it is common to see historical asset class returns presented in a way that presumes them to be sound estimates of the future; asset allocation and risk management techniques being made to look scientific; and securities being described, classified, and recommended using relatively few years of evidence as if they were definitive.”

There is so much that we don’t know – and, despite that, the teaching of finance in universities and by CFA Institute and other credentialing organizations is entirely too focused on answers rather than questions. It may not be surprising, then, that the same tack is usually taken when investment professionals talk to asset owners. Narrow perspectives are honed and reinforced; unfortunately, good questions tend to get in the way of pat answers.

One of the best things about the CFA exam process is the need for candidates to study a broad body of investment knowledge in order to pass the tests. However, as with other disciplines, it is easy for a test-taker to perceive that body of knowledge as fixed and foundational, even when it’s not fixed and may only be foundational for a limited period of time.

Soon enough, however, the diversity of the CFA curriculum fades away for most charterholders, at least those that find their way into asset management. Specialists rule, and the mission for most is playing the game of relative performance.

Has it worked for asset owners? Hardly.

Is CFA Institute responsible for the current state of affairs? No, although it’s complicit. In that, it has plenty of company, although it also has a lot more leverage to change the status quo than most of us.

I’m not sure how I would alter the exam process if it was mine to do, other than by stressing the transient nature of the current body of knowledge and the persistent failure of the investment industry to translate the reigning theory into successful practice. I want candidates to learn most everything that they are currently being asked to learn, just not to think of it as scripture.

And it would be nice for there to be a greater focus on the softer skills that matter just as much, from communicating effectively (yes, that means listening as well as speaking/writing), to understanding the broader context of investment decision making, to designing and managing organizations that can meet the real needs of clients. But, should the CFA curriculum be modified in some way to do that? I’m not so sure.

No doubt, we need different kinds of people in the industry, whether they are mathematicians and artists (as Ashby Monk wants to see in a new generation of asset owners) or polymaths (the subject of a previous Calvello column). Training more and more people in the same way isn’t an answer to the current shortcomings. Variant perspectives are required.

Which gets us back to CFA Institute and the tens of thousands of us that have earned our CFA charters.

The organization has always stressed the need for ethical behavior by charterholders, but, despite that emphasis and its Future of Finance initiative, it hasn’t been the force for change in industry behaviors that it should be. As I wrote in a previous posting on this site, CFA Institute “needs to engage and mobilize the large asset owners and asset managers that wield the economic power in the markets.” And change how business is done. That it apparently hasn’t done so to any degree is a greater problem right now than any tendency to cling to a particular theoretical doctrine.

In fact, charterholders are all over the map on many of the concepts that Calvello bemoans. And CFA Institute provides forums in which they are vigorously debated. While I might be an agitator and as skeptical by nature as Calvello, I’m not banned as a heretic. To the contrary, CFA Institute has invited me to share my views in various ways and I’ve had the opportunity to speak to many local CFA societies.

So, while I agree with much of what Calvello has to say, the first priority for CFA Institute should not be to rip up the current body of candidate knowledge. Instead, it should be more aggressive in trying to improve the industry. As with a portfolio manager who becomes a closet indexer to avoid career risk, professional organizations can get too focused on protecting the position they are in rather than advancing the cause.

For CFA Institute, it is time to intensify the battle. It can’t be a bystander and it can’t be thought of as merely a credentialing agency. If that’s all it does, it is providing troops for the industry, not for the profession. That’s the last thing we need.

One of These Things Is a Lot Like the Others

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John Boylan, CFA

Oddly enough, I remember the first ever Sesame Street way back in 1969. My kindergarten teacher sent a note with us home telling us about a wonderful new PBS educational TV show specifically for us rug rats. Back in those days Oscar the Grouch was orange and they used to play a game on that show called “One of These Things Is Not Like the Others.”

This taught me a lot about relationships. Some things are indeed like the others, while others are not. Frequently us on Wall Street forget that and classify things where things are surely not where they should be.

One thing that drives me nuts about this industry is the monolithic thinking it often gets itself into. Staples analyst are staples analysts. Health Care analysts would never understand tech and so on. In reality sector boundaries are completely artificial and ignore business realities on how managers run their organizations.

In my opinion analysts don’t follow companies, or even sectors. What we really strive to do as analysts is discern superior business models and business structures (i.e. how are they set up financially to support the business model) and invest in those that offer intrinsic value compared to their current stock price. Sector membership in reality is immaterial to how investors should view a company.

Therefore I find more investment cycle commonality among companies with similar business models than ones that are reside in similar business sectors—much like managers view their own businesses. Certain models are influenced more by consumer sentiment ebbs and flows, others by recurring revenues, and still others by fluctuations in the business investment cycle—things that transcend belonging in a particular sector. Investors can take advantage of those commonalities as each business model has similar investment cycles. There are many more types of models but many companies fall in to one of those three buckets—let’s use the Information Technology sector as one such example.

For instance most semiconductor companies have heavy cyclical components based on a predictable business investment cycle, not unlike most late-stage industrials—the semi cycle is just faster and tougher to time. You usually want to purchase those companies the same way you would with a stock like CAT; when absolutely no one believes anyone will ever buy one of their products for a long time. Software companies are essentially recurring revenue companies and can often be valued on those razor-razor blade revenue streams, e.g. not unlike some medical product companies. However, with the advent of cloud delivery of software, we can see a day when software companies become more cyclically driven like their semi brethren. Finally, some tech companies are primarily driven by consumer sentiment, usually driven by a product introduction cycle, as they are essentially consumer discretionary items—media content delivery and consumption devices. Herein lies Apple.

For example, I sometimes think one of Apple’s best comp companies in terms of the way it is structured, and the mind-set of the company as a whole is Nike. Both are highly innovative companies that have rabid followings in an oligopoly market structure. Distribution channels are crucial for both companies and their products are vitally important for their retailers to carry, but both Nike and Apple also utilize their own storefronts to satisfy the information needs of their “power users” and for promotional purposes. Both offer products that are performance driven, yet can be used as fashion accessories. Both companies have significant opportunities in emerging markets as newly formed middle classes strive for high quality western goods and brands. Finally, this is why new product releases are so crucial to both Nike and Apple—both companies need product refreshes or new product categories to satisfy changing trends with consumers and counter other product releases from competitors.

Would it not make more sense to organize a research division based upon business models? To an outside entrepreneur, I think it would. It certainly would force us to focus on those items that truly drive the business as opposed to simply the S&P sector it resides.

So perhaps one of these things is not like the others, at least the way Wall Street defines it.