Sunday, April 22, 2018

Wapner, When the Wolves Bite

The title of Scott Wapner’s book, When the Wolves Bite: Two Billionaires, One Company, and Wall Street’s Most Epic Battle (Public Affairs/Hachette Book Group, 2018), comes from an article in the Yale Law Journal: “Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System.” That’s as academic as the book gets, which is fine, because, even if you know most of the story, it’s still a page-turning account of what became a vituperative personal battle over Herbalife. Is Herbalife in effect a Ponzi scheme that the government should shut down (Bill Ackman’s position) or is it a legitimate company on which investors can make money, especially in the event of a short squeeze (Carl Icahn’s view)?

Scott Wapner was the obvious person to write this book since he hosted “the brawl” between Ackman and Icahn on CNBC’s Halftime Report (January 25, 2013) in which Icahn, despite his Princeton philosophy degree, sounded eerily like his friend Donald Trump, with claims such as “as far as I’m concerned the guy [Ackman] is a major loser.” Unfortunately for Ackman, Icahn would be right in one sense—Ackman would take a major loss on his short Herbalife position and Icahn would profit handsomely from his investment in the company.

Herbalife is a multilevel marketing (MLM) company in which distributors are compensated for what they sell as well as for how many new recruits they bring in. In its swashbuckling early days it often seemed to cross the line of legality, and, even as the shorts and longs battled it out, the FTC fined Herbalife $200 million and put in place regulations to ensure that it had real customers and didn’t misrepresent how much money its distributors could make.

Wapner delves into the early research that eventually prompted Ackman to short the company’s stock and explores the role of activist investors. But at its heart When the Wolves Bite is a tale of outsize egos going to battle using the money of investors in their funds. Ackman came out bloodied, his reputation tarnished (not only by his Herbalife position but also by his forays into Valeant and ADP), and his assets under management now half their 2015 peak. Carl Icahn, in the meantime, stepped down as President Trump’s special adviser on deregulation amid controversy and is smarting from three straight years of either outright losses or massive underperformance in his investment fund.

Is there a moral to the story? I could suggest several, but I’m sure my readers could think of even more. So I’ll leave it to your imagination. In the meantime, if you want an engaging, fast read, When the Wolves Bite may be just the ticket.

Wednesday, April 18, 2018

Schilit, Financial Shenanigans, 4th ed.

It has been 25 years since Howard M. Schilit first published Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports. And it has been eight years since I reviewed the third edition of the book, starting, and hopelessly dating, my post with the words: “with Jeff Skilling (and now Richard Scrushy) back in the news….” It seems like a lifetime ago. But, alas, financial shenanigans never go out of style. And investors must keep an eye out for them.

In this fourth, fully revised and updated edition (McGraw-Hill, 2018), Howard Schilit, with the help of co-authors Jeremy Perler and Yoni Engelhart, delves deep into ways in which companies, even reputable companies, cook their books and corporate management teams fool investors. The book is a must read for every active investor. And, of course, a bonanza for short sellers.

So, what kinds of ruses do companies use? They manipulate earnings, cash flows, and key metrics, and they employ “creative” acquisition accounting. Schilit explains these ploys in easily understandable prose and illustrates them with case studies.

Let’s look at a single case study, new to this edition, and one of my personal favorites: Valeant. In 2007 Valeant hired McKinsey & Company to help jump-start its growth. The team, led by Michael Pearson, “advised a radical strategy—cutting internal R&D and pursuing growth through acquisitions and price increases.” The following year Valeant recruited Pearson to become its CEO, and he set out on an acquisition spree.

In 2010 Valeant and Canadian-based Biovail agreed to merge and, for tax purposes, to locate the headquarters of the combined company in Quebec. Biovail had had a sordid accounting history, but Valeant overlooked such “trivial details.” Two years later Valeant acquired another company with a well-known history of accounting problems, Medicis. In 2013 Valeant paid a steep premium for the financially troubled Bausch & Lomb. Then, in the widely reported and followed “unorthodox” partnership with Bill Ackman, the company set its sights on Allergan but was rebuffed. In 2015 Valeant acquired Salix Pharmaceuticals, another troubled company “just working its way through a major accounting scandal.”

With each acquisition investors cheered and Valeant’s stock price jumped. When Pearson became CEO its stock price was $13.24. Soon after the Salix acquisition it hit its all-time high of $262.52. Expensive acquisitions of tainted or troubled companies caused Valeant’s GAAP-based losses to intensify, “but the profitability metric that management focused on, ‘cash earnings,’ grew and compounded.” This was accounting gimmickry. “Acute investors understood that while it was impossible to know the exact catalyst that would spark the unraveling, they knew the downfall would be inevitable, no matter how big the balloon inflated.”

A Hillary Clinton tweet about price gouging dinged the stock, but it was the expos√© of Valeant’s fraudulent relationship with Philidor Rx, a mail-order pharmacy, that sent its stock into free fall. Pearson was ousted as CEO, the SEC began investing the company for fraud, and all the debt raised to finance acquisitions came back to haunt it. “By April 2017, … Valeant’s share price crash-landed below $9, an incredible decline of 96 percent from its summer 2015 peak.”

Analysis in hindsight, of course, is much easier than analysis in real time, but with the proper tools investors can avoid companies poised to crash and burn—or short them. Financial Shenanigans is a great place to start learning the ropes.

Sunday, April 15, 2018

Brodie and Harnack, The Trust Mandate

The Trust Mandate: The behavioural science behind how asset managers really win and keep clients by Herman Brodie and Klaus Harnack (Harriman House, 2018) is a short book (about 130 pages of text). It starts by looking at some seeming anomalies regarding which managers attract the most asset inflows—notably, not necessarily the best performers. A lot of “soft factors” go into the decision to hire (and fire) an asset manager. People search for “personal character traits to help them make predictions about the manager’s future behaviour or, at least, to reassure them that the positive impressions they have gained elsewhere are justified.” They want an asset manager who is trustworthy, who is both willing and able to act in their interests.

Trust, the authors explain, is “inseparable from risk or vulnerability. There is no need for trust in the absence of risk. … So, in a risk-oriented business, like asset management, trust is a genuine asset—a form of social capital.”

The authors cite a curious finding regarding the relationship between trust and market efficiency. In an efficient market, as we know, prices should respond fully and swiftly to the arrival of firm-specific news. And yet, prior to Sarbanes-Oxley, “this rapid adjustment tended to occur only if the firm was incorporated in a high-trust region. If the firm happened to be based in a lower-trust region, investors were less likely to take the information at face-value. Their hesitation caused the initial stock price reaction to be more sluggish.” Think, for instance, of post-earnings-announcement drift. The region of the U.S. with the highest level of trust was the Northwest; with the lowest, East South Central (Kentucky, Tennessee, Mississippi, Alabama). Following the introduction of the Sarbanes-Oxley Act, “the effect was eliminated. Regulation, it appears, has the possibility to raise the minimum level of trust in all firms—even in a sophisticated and well-developed capital market like in the US.”

How does an asset manager inspire a potential client to trust him? The authors offer a range of suggestions, from the fragrance of hand cleansers in the washrooms of the asset manager’s offices to the trade-off between warmth and competence where “one additional unit of warmth, so to speak, will bring providers closer to a high-trust relationship than one additional unit of competence.”

The authors have struggled mightily to tease out the many strands in a trusting client-manager relationship. Ideally, we want to deal with someone who is, let’s say, talented, diligent, shares our values, and isn’t a jerk. But how do we rate these attributes? Are we willing to hire a less talented investment manager who isn’t a jerk over the jerk who is extremely talented? Probably. I assume that most asset management firms have already figured this out and keep their talented jerks hidden from public view. Or make them CEOs. (And, no, I won’t name names.)

Wednesday, April 11, 2018

Fraser, Class Matters

“Class matters in America precisely because the country has labored so hard to pretend it doesn’t.” This is the defining premise of Steve Fraser’s latest book, Class Matters: The Strange Career of an American Delusion (Yale University Press, 2018).

Fraser chose six icons of American history, none of which at first glance seems to have much to do with class, to frame his narrative: the settlements at Plymouth and Jamestown, the U.S. Constitution, the Statue of Liberty, the cowboy, the “Kitchen Debate” between Richard Nixon and Nikita Khrushchev, and the March on Washington and Martin Luther King’s “I Have a Dream” speech.

Here I’ll look briefly at the utopian view underlying the “Kitchen Debate.” At the American National Exhibition in Moscow in 1959, in the kitchen of a six-room suburban ranch house at the center of the exhibit that, it was claimed, “everyone in the United States could afford,” Vice President Nixon and Soviet Premier Khrushchev argued over “which society was likely to produce the best stoves, washing machines, televisions, electrical appliances, and other consumer delights.” The American Tomorrowland kitchen on display that year “promised to level the playing field between haves and have-nots.”

The notion of leveling was a common cultural theme at the time. One American magazine after the other touted the demise of social and economic classes. House Beautiful, for instance, wrote: “Our houses are all on one level, like our class structure.”

Admittedly, the post-war U.S. economy boomed, as did the country’s standard of living. A dominant view at the time was that “the modern corporation together with the welfare state worked to efface class. … Neither capitalist nor socialist, this new social species fused free-market liberalism with social democracy.”

But, even then, material well-being and social security were not universally available. “[A] whole phalanx of government housing programs, private-sector financing, local zoning protocols, and state and federal tax subsidies and shelters guaranteed that those options were really only practicable for families of more than modest means and of the right complexion. The suburban dream, like the American Dream more generally, turned out to be part real, part hallucination: class (and race) matter, no matter the efforts to make it go away.”

Sunday, April 8, 2018

Yardeni, Predicting the Markets

In one way or another every investor and trader predicts markets, even though some claim they’re not doing it and others decry the very attempt. Warren Buffett, for instance, famously said that “the only value of stock forecasters is to make fortune tellers look good.”

The economist Edward Yardeni, president of Yardeni Research, is a proud, self-described prognosticator. He calls his newly released, 600-page professional autobiography Predicting the Markets.

The book, which spans the author’s 40 years on Wall Street, ranges over geographies, socio-economic and business phenomena (technology and productivity, inflation, business cycles, consumers, demography), and markets (real estate, bonds, commodities, currencies, corporate earnings, valuation, stocks). The book itself contains no charts, a decision I applaud. Instead, the charts, and updated versions of them, are available on a companion website and are downloadable as .pdf files.

Yardeni has always grounded his prognostications in current analysis, which Ben Bernanke described as “getting an accurate assessment of the current economic situation, requiring a deep knowledge of the data mixed with a goodly dose of economic theory and economic judgment.” Throughout the book Yardeni explains the theory and judgment he brought to bear on relevant data to inform his predictions.

Yardeni is an old-school economist who claims never to have run a regression since his graduate school days. As a result, his book, though occasionally dense, is eminently readable by anyone with an interest in the interplay between economics and the financial markets over the years. No math background required.

Although Yardeni’s charts and the book’s final chapter bring his story up to date, one of the greatest contributions of this book is the historical context it provides to those economists and Wall Streeters who haven’t had such lengthy careers as the author. Perhaps even more important is the insight it offers into current analysis and the interplay among economic and market variables. In an obvious case, as Yardeni writes, “Predicting the stock market shouldn’t be all that difficult since only two variables drive it … -- earnings and the valuation of those earnings. But it’s tougher than it sounds, because both of those variables are driven by so many others.” Predicting the Markets connects a lot of dots.

Wednesday, April 4, 2018

Town, Invested

Danielle Town’s “12-month plan to financial freedom,” Invested: How Warren Buffett and Charlie Munger Taught Me to Master My Mind, My Emotions, and My Money (William Morrow, 2018), written with help from her bestselling author father Phil Town, is much better than the search-tag-filled subtitle would lead one to believe.

The setup is this: Danielle Town, a young lawyer, had always tuned out when her father, author of Rule #1 and a motivational speaker, had tried to get her to invest. But she eventually realized that, without investing, she would end up a wage slave for her entire life. And so, she finally decided to become her father’s student—and, having some of the entrepreneurial instincts of her father, to do a podcast of their conversations, and then to write a book based on these podcasts.

Danielle Town had two hurdles to overcome in order to become an active investor. First, she “was never one for numbers.” Second, and more devastating, she was terrified of investing. The first month in her 12-month plan thus dealt with “becoming brave.” Describing her fear, she writes: “I feel like I’m entering a dimly lit parking garage through an enclosed concrete stairwell with heavy doors at both ends, and I didn’t pack my pepper spray because it didn’t fit in my clutch and also I was afraid I would accidentally set it off in the crowded bar, and yes I had a few generously poured aged bourbons and still my radar is going off, saying, ‘Girl, don’t go into that concrete stairwell.’ … There are two types of people in the world—those who look at the Enclosed Concrete Stairwell and think nothing, and those who look at the Enclosed Concrete Stairwell and think, There’s a good possibility that this won’t end well for me. The first type is, more often than not, men; the second type is generally women. … [M]y instinctual reaction to the idea of investing in the stock market was GET THE HELL OUT OF THAT ENCLOSED CONCRETE STAIRWELL AND CALL AN UBER, IT’S WORTH THE SURGE PRICING.”

Even though Warren Buffett would probably have told her to put her money in an index fund, her father wanted her to get returns closer to Buffett’s than to the S&P 500. And she wanted to invest in companies whose mission and values she could support. So, in months two through twelve, she learned about value investing √† la Buffett and Munger, how to compile an antifragile portfolio, when to sell, and living thankfulness.

Invested is an inspirational book for the unwilling investor. Even though many people who read it will get only as far as buying an index mutual fund, it might speak to a new generation of potentially active investors as well. But those who are galvanized to invest on their own should understand that one book doth not a successful investor make. Nor, as Town points out, does one year. “There’s still a lot to practice.” And to learn.

Wednesday, March 28, 2018

Jensen, The End of Indexing

Niels Jensen’s The End of Indexing: Six structural mega-trends that will threaten passive investment (Harriman House, 2018) is a wonderfully thought-provoking book. It tackles macro issues that threaten not only passive investment but much active investment as well. Whether you agree with Jensen or not, and on most points it is hard not to, he will inspire you to rethink your long-term investing strategy.

The six mega-trends that Jensen analyzes are: the end of the debt super-cycle, the retirement of the baby boomers, the declining spending of the middle classes, the rise of the East, the death of fossil fuels, and mean reversion of wealth-to-GDP. No, he didn’t ignore automation; he just didn’t want to include it as a mega-trend because he wasn’t sure of its economic ramifications. And so it remains an important thread throughout the book but one with more questions than answers.

Jensen is a Dane based in London, the chief investment officer of Absolute Return Partners, which he founded in 2002. Although many of the charts he uses are based on U.S. data, he draws on trends from across the globe, contending that “all the structural trends in this book are global (or near global) in nature.”

Here I’ll take a quick peek at the last mega-trend, mean reversion of wealth-to-GDP. Jensen’s thesis is that “certain ratios have well established mean values, and the long-term mean value for US household wealth-to-GDP is about 3.8 times. In other words, if wealth-to-GDP is much different (as it is now), it will probably revert to the mean over time.” In recent history, the ratio hit 4.8 in 2000, fell back to 3.6 after the bear market of 2001-02, then went back up to 4.7 before getting decimated during the Great Recession, and as of the end of 2017 reached a whopping 4.9.

The wealth-to-GDP ratio can be understood as a capital-to-output (or capital efficiency) ratio, with wealth as capital and GDP as output. The lower the ratio, the more efficiently a country utilizes the capital at its disposal. So right now the U.S. isn’t using capital efficiently.

Total U.S. household wealth stands at $96.9 trillion; as of the end of 2017 U.S. GDP was $19.7 trillion. A return to the long-term mean of 3.8, assuming no significant change in GDP, would shave about $22 trillion off of household wealth. (In December 2008 U.S. household wealth troughed at $56 trillion, $41 trillion below the current figure.)

How should an investor structure her portfolio if she believes Jensen’s analysis? Jensen is a long-term investor, so he is not prescribing a short-term fix. In fact, he says, “if my recommendations work well in the near term, it will be down to luck more than anything else.” But, after reviewing four types of risk—beta, alpha, credit, and gamma—he is most inclined to focus on gamma risk. Examples of gamma risks are the factors (e.g., volatility, momentum, income, value, and size) in factor-based investing. The gamma risk factor offering the most attractive risk premium at the moment, he believes, is illiquidity risk, such as investing in music royalties.

I’ve barely skimmed the surface of Jensen’s book in this review. It merits reading and re-reading. And trying to take the other side of his arguments.