Category Archives: Hot Topic Commentary

Numbers Geek

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John Boylan, CFA

What most lay people don’t know about people in our industry is what complete number geeks we really are. Geeky to the point where we have passionate feelings about our preferred calculator brand. For instance, we named our graduate school intramural football team “The HP 12Cs”, after our financial calculator of choice. Yes, we are numbers driven people and are passionate on how they are used in the investment process depending on where we are in the investment cycle.

One thing I am noticing talking with fellow investors is how the numbers, as measured in earnings-based valuations, are leading them to fewer potential buy candidates as the market continues to grind higher. There have been non-stop debates if the market is under/overvalued since the beginning of this rally. As usual, it depends upon the numbers you look at for your reference point. The Schiller P/E chart, for instance appears to show that the market is near the top end of its historical range.

 

Chart: Historic Shiller P/E Ratios

(click on image to enlarge graph)

Chart Historic Shiller PE Ratios_FABlog

Source: gurufocus.com

Additionally, looking at corporate profits as a percent of GDP can lead investors to wonder where the next leg of earnings growth may be.

 

Chart: Corporate Profits After Tax/Gross Domestic Product

(click on image to enlarge graph)

Chart Corporate Profits After TaxGross Domestic Product_FA Blog

Source: Federal Reserve Bank of St. Louis  

 

Sometimes, seemingly at least in part, at the expense of average household incomes.

 

Chart: Real Median Household Income in the United States

(click on image to enlarge graph)

Chart Real Median Household Income in the United States_FABlog

Source: Federal Reserve Bank of St. Louis  

 

Still others offer compelling evidence (along with several charts, see link) that the market can continue to rally. Recent positive GDP data along with good ISM data (57.1, arguably a healthy reading and up from last month) and a progressing jobs picture may support further market gains.

 

Chart: ISM Manufacturing: PMI Composite Index

(click on image to enlarge graph)

Chart ISM Manufacturing PMI Composite Index_FABlog

Source: Federal Reserve Bank of St. Louis  

 

Personal feelings on how the market will perform in the near/mid-term aside (I think we will do OK as long as the market has confidence in the Fed and its tactics and/or if it will come to the rescue every time the market has a hot lava burp), the question I normally ask myself when there is a lot of high valuation discussions is not what will the market do next, but what is the best valuation methodology to use with a given security at this stage of the cycle. Especially since so many of us need to be fully invested regardless of market conditions.

Why? Because usually when there is much debate about stock valuations being too high we investors sometimes can get caught up in earnings stories that will likely evolve beyond our investment horizon (if at all) to justify the current heightened valuation. This in my experience usually led me to two separate risks: getting led into a value trap hoping that a poorly run laggard would catch up to its peers over time or relying on earnings estimates two or even three fiscal years out.

Usually in these circumstances I tend to gravitate toward revenue based methodologies, such as price/sales and top line growth rates. I always thought that 50%+ of valuation work starts with revenues to begin with as so many estimates on all financial statements are driven by this line item. Additionally if the market continues to gravitate towards growth stocks I avoid value traps by only focusing on companies that can deliver on top line growth instead of focusing on margins and earnings that may never come. Conversely if the market begins to slip, if I focus on companies with a lower price to sales ratio, I don’t have to worry as much about discretionary actions a management team might do in a downturn such as delay or cut a stock buyback program, or what cuts they may make to “make the earnings number” in the short term but could harm future growth.

A Future Candidate’s Perspective: Ominous Trading Future Leaves Banks with Questions

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Each season CFA Society Minnesota invites finance students to learn about the CFA Program by interning with the local society. Students assist society committees with research for their projects, and are encouraged to take on tasks that broaden their skills and industry insight. Chris Roebber will be a junior this fall at the University of Minnesota Carlson School of Management. Chris wrote this commentary with the assistance of Freezing Assets contributors John Boylan, CFA and Lissa Rurik, CFA. If you’d like to work one-on-one with a future CFA Candidate this season, please contact us to volunteer!

Ominous Trading Future Leaves Banks with Questions

Large Wall Street banks have received a lot of flak in recent years. Whether it’s been the shady mortgage dealings or the seemingly obscene bonuses of bank executives, public scrutiny has been at an all-time high. But as banks are finally settling government lawsuits from the 2008 meltdown, a new challenge has presented itself, trading volume has fallen, the floors have gone silent, and trading revenue has seen double digit percentage drops. Large investment banks’ that rely heavily on trading revenue may want to consider changing their business model as the industry is becoming far less attractive due to economic, regulatory, and technological changes.

The falling trading volume and respective losses in revenue are telling signs that the current model is in danger. Global revenue from FICC (Fixed Income, Currencies, and Commodities) has fallen 16% since last year and 23% since 2010[i]. But it’s not just FICC revenue that has been in a slump, equity trading has fallen drastically as well. This past June’s trading volume was the lowest for the month since 2006 and last year’s average volume was 37% lower than its peak in 2009[ii]. In a volume driven industry, these dampened numbers are cause for great concern. Most traders point to a “boring” economy. Everyone from institutional investors to individuals is in a wait and see approach, rather than making big bets on the market. While traders may be partially right that some of the falling volume is due to this wait and see idea, regulatory and technological changes are cutting profitability, making this more than just a cyclical issue.

Rapidly changing regulations are making the industry far less profitable for the long term. Higher capital requirements have made it more costly to hold inventory and the Volcker rule has limited risk taking and could bring proprietary trading at large banks to a halt. These regulations have added up to a lower estimated return on equity than ever before. Sanford C. Bernstein bank analyst Brad Hintz estimates Goldman Sachs’ trading division to have an ROE of 7%, significantly lower than the firm’s theoretical cost of capital of 10%. If the golden child of Wall Street is struggling to produce the required return, their competitors cannot be far behind. Regulatory changes are not the only culprit though.

Changes in technology have shrunk spreads and hurt the long-term profitability of banks trading arms. High frequency trading is changing the industry outlook and not necessarily for the better. Advocates of HFT say it adds liquidity and decreases spreads. This is bad news for traditional market making traders. With small spreads, increased regulation on risk and an uncertain prop trading future, there is very little opportunity for traders to maintain margins. I would argue then that the increase in HFT is hurting big banks by decreasing profitability of market making traders. The margin contribution of high frequency trading businesses is dwarfed in comparison to the larger traditional trading platform. Banks would much rather have a healthy equity trading business making billions then a HFT arm generating hundreds of millions. The risks and ominous future of the industry has even brought the COO of Goldman, Gary Cohn to question the vitality of their dark pool, Sigma X, in a recent Wall Street Journal op-ed.

Clearly trading divisions are in turmoil right now, from both cyclical forces driven by a wait and see approach, to long-term regulatory and technological changes. Large investment banks with the heaviest focus on trading could suffer the most. These banks should sell off their high frequency trading arms and begin to transition away from depending so heavily on trading revenue. Investment banks can consider a more conservative approach like Wells Fargo, which has a smaller investment banking arm and instead focuses heavily on consumer lending. Another option is to focus more on traditional activities like M&A advisory. But at the end of the day, the status quo cannot stay for much longer.

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iBurne, Katy, Justin Baer, and Saabira Chaudhuri. “Empty Trading Floors Fray Nerves on Wall Street.” The Wall Street Journal. Dow Jones & Company, 13 July 2014. Web. 14 July 2014.

[ii]Strumpf, Dan. “U.S. Stock Trading Volume Slump Continues.” The Wall Street Journal. Dow Jones & Company, 1 July 2014. Web. 14 July 2014.

Firework

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As we headed into July 4th, 2013, Investment Grade Corporate Credit did not have a lot of friends. The fear of higher interest rates created all the fireworks, and spurred the market into a flurry of what today looks like a bout of panic selling, which ignited some rather unpleasant spread widening. IG Corps felt a little like a house of cards, one blow from caving in.

We find ourselves in a very different spot today. Spreads are about 50 basis points tighter than a year ago. With the threat of taper now behind us, and the reality of rate hikes somewhere in the future, volatility has remained low and risk-taking has been rewarded. Corporate credit has been one of the market’s star performers, with both spreads and rates rallying, pushing the benchmark up YTD by 5.7%. For us, it was the best July 4th in recent memory, since this was the first June since 2007 that spreads did not widen going into month-end.

The corporate bond market celebrated by taking most of the week off. There was about $18 billion in total new issue, and software provider Oracle was responsible for more than half of the volume, coming to market on the last day of the quarter with a $10 billion transaction spread across 6 tranches. The company will use the proceeds to pre-fund its $4.6 billion acquisition of Micros Systems, a provider of integrated software and hardware solutions for the hospitality and retail industries, as well as for share buybacks and general corporate purposes. Given the size of the transaction, ORCL pricing was attractive across the curve. The ORCL transaction again highlights current market trends around M&A. While we have not seen a significant pick-up in LBO activity, companies are increasingly turning to M&A to boost shareholder returns while taking advantage of attractive levels in the corporate bond market.

IG Corporate performance has so far won out over interest rate fears, M&A risk, slow economic growth – you name it. The sector has shown us all just what it’s worth. While it’s hard to imagine another six months as good as the last, for a brief moment we will just sit back and admire recent history with an ahh…ahh…ahh…

Inversion Layer

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John Boylan, CFA

The recent popularity of tax inversion strategies got me to thinking about what might be the toughest thing to do when analyzing a company. Namely determining what its optimal capital and tax structure could be. Most of the time, I tend to rely more on free cash flow analysis than trying to forecast capital structure or determine optimal tax considerations. I figure if I develop a reasonable and attainable cash flow forecast it would be easier to determine what the use of that cash might be. Even then I tended to be off in my cash use prediction because of the Curse of the Financial Analyst—we think tend to think every business decision is a financial decision. More often than not many other business and management considerations are of equal, if not higher, importance. We as analysts often forget that.

For example, why don’t more companies take advantage of tax inversion strategies? Management might feel uncomfortable having essentially two headquarters, one for executive management and one for day to day operations—some managements may feel uncomfortable managing crucial functions remotely. Some might feel that tax advantages and loopholes can shift over time for a variety of reasons, meaning a company may have to move its headquarters more than once to keep their tax saving strategy intact (e.g. Accenture moved to Ireland from Bermuda due to changes in tax considerations). Additionally some companies might see longer term opportunities for that cash that could offer a better return, even after taxes. This might include investments in research and development, marketing and distribution, new capacity, acquisitions, and the like. It also depends on where the cash resides and the opportunities, or lack thereof, there might be in that market.

Still as shareholders we often want as much cash returned to us from our investments as quickly as possible, and managements need to respect the will of its owners when it makes sense to do so over the long run. It really comes down in my view where the management and investors believe the company is in its growth cycle. If it is early on in the cycle I would rather see cash spent on growth, which also lowers a company’s tax bill without adding more managerial complexity to the organization. If the company is in a more mature industry I would rather see the company managed for cash flow and see that money returned to investors. Therefore in reality, I think that we need to take as close of a look at the personality and management style of its executive team and determine if their longer term goals match where we think the company is in its growth cycle as much as we do trying to determine what companies may be best suited for a change in capital or tax structure on a pure numbers basis.

Best Practices in Asset Manager Communications

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Tom Brakke, CFA

“The numbers speak for themselves.”

What asset manager with great numbers hasn’t wanted to toss a pitch book down on the table, utter those words, and wait for questions (only to return to the phrase over and over again in response to them)?

There are a few who have adopted that strategy (Bernard Madoff, for one, and some take-it-or-leave-it hedge fund managers), but for the most part it doesn’t fly for firms trying to win new institutional clients, even when the numbers are outstanding.

Therefore, an asset management firm must have a good communications strategy (and stick to it) if it is to succeed over time. The best practices for doing so were the topic of a recent presentation to CFA Society Minnesota by Judith McKinney and Gordon Dickinson of Callan Associates.

The presenters stressed the importance of a thorough communications strategy that is consistently applied. That’s a challenge, given that individuals have different styles and portfolio managers would prefer to be back at their desks evaluating ideas rather than answering questions about how they do what they do.

Large firms can marshal the brute force of their resources to hone such a strategy and to produce outstanding materials, but their presentations can lack the personality and display of camaraderie that are second nature for those at a small firm that are used to working closely together.

Each element of the communications chain needs attention, including requests for proposals, presentations for new business (and for review meetings), newsletters, white papers, websites, meetings with consultants, and whatever other opportunities exist to reinforce a firm’s message.

Through it all, there needs to be an ethos of quality, accuracy, integrity, and honesty. Superior materials and presentations provide a platform from which to convey the key messages that the manager wants to deliver.

The dynamics of a presentation for new business are critically important. The pitch book (whether in hard copy or on a screen) can be an effective vehicle through which the proper message is conveyed or a framework for failure, so the speakers from Callan spent a good deal of time reviewing its construction and delivery.

They said that “95% of the decks are pretty good” in following the four Ps – philosophy, people, process, and performance. A common problem is getting “bogged down in too many details” rather than concentrating on delivering a compelling narrative; they stress that “the appendix is your best friend.” Put the minutiae there.

In fact, “the best presenters don’t use the book very much.” They make eye contact, they connect with the audience, and they tell their story.

The flow of a presentation probably seems unimportant in the scheme of things, but several times the speakers from Callan talked about the quality of the transitions from one member of a presenting team to another. The little things matter, which is why practice is critical and thorough preparation often separates the managers that “show well” from those that don’t.

The most spirited interaction between members of the audience and the presenters from Callan revolved around the degree to which consulting firms are pro-cyclical in their approach to the recommendation of strategies and the selection of managers – going with recent winners rather than seeking out good managers who have been struggling. The discussion was prompted by a statement in the presentation deck that when meeting with consultants, managers should “focus on an investment product/strategy that is doing well; underperforming strategies may be non-actionable for the consultant.”

So, the numbers may not speak for themselves completely, but they speak very, very loudly. In the mutual fund world, “a five-star rating is the trigger for acceptance” (even though it is based upon past performance) and for an institutional mandate, “if you’re in the finals you don’t even have to talk about performance; you wouldn’t be there without performance.”

Therefore, the biggest hurdle to be jumped over in order to be hired is good performance. On the flip side, many good firms are fired because of a spot of poor performance. The representatives from Callan said that a big part of their job is trying to talk clients out of firing managers, but they stressed how behaviorally difficult it is for those clients – and for themselves – to go against the flow. They could cite just one situation where Callan recommended a firm that had subpar performance over the past few years but what they felt was the foundation for good performance going forward. (It turned out very well.)

The meeting featured much good information for asset managers looking to improve their communications practices – and I would not minimize the importance of the recommendations. But it is disheartening to be reminded that at its roots, this is a business of herding, and numbers, for the most part, speak louder than words, even if experience shows that they can be deceiving.