Author: subir

Critical financial documents

Critical financial documents

An article in the New York Time today reminds us all how important it is to have our financial act in order before a life-changing event occurs. We always advise clients to prepare a will, health care proxy and medical directive as part of our initial conversations with them. We’ve worked with numerous legal and estate professionals to tackle these tasks for clients. Without these documents, families can find themselves facing a morass of complex legal issues at the worst possible time.

In most cases, for young families, term life insurance and good disability insurance are cost-effective ways to ease the financial stresses of losing an income. We always evaluate these options as part of our comprehensive financial planning process with each client. Our regularly updated financial plan also contains a consolidated balance sheet to provide a view of all your financial assets and accounts in a single place. Such an accounting can make re-organzing your finances after a disaster much easier.

2012 Q3 Letter: Quantitative Easing – To Infinity and Beyond!

2012 Q3 Letter: Quantitative Easing – To Infinity and Beyond!

We hope all of you in the north-east made it through Hurricane Sandy safe and sound. For many of us, it was a reminder of the awesome power of mother nature, the interconnectedness of our modern lives and the fragility of our beautiful planet. US stock markets were closed for two days straight, and our offices in lower Manhattan will be without power till the weekend. We have been working remotely, and it has been a good test of our disaster readiness procedures.

The big economic news of the third quarter was the Federal Reserve’s decision to take the unprecedented step of intervening in the capital markets during the home stretch of a presidential election campaign. We’ve noted in previous letters that as a non-partisan institution, the Federal Reserve prefers to avoid any appearance of political favoritism, often going to great lengths to maintain this reputation. By intervening in the capital markets at the height of election season, the Fed risks the appearance of favoritism towards the incumbent party. Expansionary monetary intervention can drive stock market rallies and boosts investor confidence, benefiting the party in power – in this case, the Obama administration. Using this logic, our thinking was the Fed would abstain from announcing any new stimulus plans until after the election. It turns out we were wrong.

On Thursday September 13th, by a vote of 11-1, the Federal Reserve board voted to launch QE3, their latest and greatest stimulus plan effort. Unlike past plans, this one is unique in that it is open-ended, there isn’t a set expiration date or monetary cap. And instead of purchasing US Treasuries, which the Fed has done in the past, QE3 involves a $40 billion monthly purchase program of agency mortgage-backed securities. In addition to QE3, the Fed also announced that it expects to keep interest rates close to 0% through the end of 2015 (having previously stated that rates would remain at this level through 2014).

These policy announcements come on the heels of the Fed’s June 20th decision to extend Operation Twist through the end of 2012 and the European Central Bank’s Sept 6th decision to initiate their own open-ended “no limit” bond buying program to purchase European sovereign debt as and when needed. Four years after Lehman Brothers’ failure, the Fed and ECB continue to reload their monetary “bazookas”.
So why is the Fed stepping in now with such a bold plan given the upcoming election and their recent action in June? Well, with a muddled employment picture and a relatively stagnant housing market, the Fed sees monetary stimulus as a necessary crutch to keep the economic recovery moving forward, especially since the current Congress has no interest in passing any further economic stimulus. By purchasing these bonds, the Fed hopes to lower rates and encourage companies to borrow and expand operations (hire more people), and nudge individuals to buy large ticket items (spend more money) and take on mortgages (buy homes).

Sounds good, right? What could be wrong with encouraging corporate hiring and consumer spending? Well, several things, actually:

  1. Inflation: If the economy recovers sooner than expected, food, materials and energy costs may rise much faster than the economy.
  2. Weak dollar: A weaker currency makes imports more expensive and can drive inflation further. The flip side of this is that a weaker dollar makes US exports more competitive.
  3. Encourages speculation: Low interest rates imply cheap credit, so speculative investors – the kind whose actions led to the credit crisis — can afford to take on more risk through leverage and loans. And as high-risk assets outperform, these speculators are financially rewarded.
  4. Punishes savers: Conservative investors – the ones who were fiscally responsible during the housing mess – are punished. These investors (often retirees) who normally keep their money parked in savings accounts, short term CDs or Treasuries are being forced into riskier asset classes because interest rates are so paltry. More money heading into riskier or longer-dated bonds drives those rates even lower, so savers have to be even more aggressive than ever to generate decent returns.
  5. Using all their bullets: Now that the Fed has given the market what it wants – a virtually unlimited supply of stimulus, QE to infinity – how will they ever top this? If things turn south in the global economy, what can the Fed do to calm nervous investors?
  6. Sets the housing market up for a fall: Real-Estate prices are extremely sensitive to interest rates since most buyers borrow some portion of the purchase price of their home. Higher interest rates lead to higher monthly payments, which in turn drives home prices down. At the moment, low rates are propping up home prices, when they begin to rise, this support will disappear and home prices may well stagnate or fall.

We also see the election and the forthcoming budgetary debate having an impact on municipal bonds and US state finances. Over the next few months, one of the major ratings agencies will revise the way it accounts for the long-term pension liabilities incurred by municipalities. Many state budgets and finances are still in a weak state after the crisis, and this revision may lead to some ratings downgrades. In addition, we expect the US federal deficit to take center stage after the election. Regardless of which party controls congress or the presidency, we expect to see federal support to states weaken further. This means states will have to fend for themselves, implying weaker municipal credits, absent a very strong recovery.

So how should investors respond to these new policies? We prefer a conservative balanced portfolio of stocks and bonds for most investors. We are reluctant holders of interest-rate sensitive or cyclical stocks and longer-term bonds, recognizing that the Fed’s policies are driving prices up in those sectors. We retain a preference for high quality, dividend-paying stocks and utilities. In the bond market we continue to limit holdings to high-quality corporate, municipal and international emerging market debt, keeping maturities short. We realize this is not a recipe for outsized returns, but we would rather be safe than sorry.

As we approach the holiday season, we recommend all clients consider the following year-end planning items:

  • Review your 401K contributions (you have until Dec 31 to use the 2012 limits), and IRA contributions.
  • Consider re-allocating between securities as the Bush tax cuts sunset and capital gains rates may go up.
  • For those with taxable estates, it is worth reviewing the special gifting opportunities available in 2012.

As most of these items involve tax-planning, and since we do not provide tax-advice, we do recommend consulting you tax professional prior to taking any action. We are, as always, happy to assist.

2012 Q2 Letter: Banking on a Financial Scandal

2012 Q2 Letter: Banking on a Financial Scandal

We hope you’re enjoying your summer and are staying cool.

In our previous letter, we noted that the gaudy first quarter returns for risk assets (namely US stocks) were on an unsustainable trajectory and unlikely to continue upwards indefinitely. As we anticipated, the second quarter saw a steep selloff in risk assets as problems in Europe continued to deteriorate and US economic data disappointed. In June, equity markets rallied back a bit on the news that the Federal Reserve will be extending its Operation Twist policy through the end of 2012. However, this commitment fell short of what many risk investors were hoping to see in response to a global slowdown. As a result, risk assets have begun to sell off again as we enter the third quarter. So long as central banks continue to intervene in the financial markets (and investors anticipate these moves), we expect equity and bond markets will continue to respond in volatile fashion.

From a valuation standpoint, we believe US stocks appear to be near cyclical highs. The S&P 500 currently trades at a Price-Earnings (P/E) ratio above 16, which is above the historical average. The cyclically adjusted P/E ratio or CAPE, (a longer-term measure that averages 10 years of earnings) is at an even greater extreme of 22. Over the past century, US stocks have reached cyclical peaks with a CAPE over 22 on five occasions, in 1929 (at 32.5), in 1966 (at 24.1), in 2000 (at 44.2), in 2007 (at 27.5) and in 2011 (at 23.48).  While stock prices could certainly continue to march higher, we don’t view these valuations as a bargain.

In our view, Europe continues to be the main driver of movements in most major markets, including bonds and foreign-exchange. The Euro has weakened substantially against most major currencies as it becomes clear that European institutions have no conclusive solution to the peripheral crisis (instead, they favor a “kick the can down the road” approach of providing emergency bailout funds to temporarily stem insolvency in countries like Greece and Spain). European equities have weakened substantially in response. In both the US and China, manufacturing activity has slowed over the past few months as uncertainty over the health of European consumers and companies mounts.

Back in the financial markets, it seems as if large banks can’t go a few of months without embroiling themselves in a major controversy. This quarter saw two banks — which had emerged largely unscathed from the financial crisis — fall flat on their faces, and one infant institution in Spain cry out for state assistance. At JP Morgan, a trading unit in the chief investment office was given a great deal of discretion and used it to develop an infatuation with a trading model that turned out to be a poor reflection of reality. The result was a loss of a few billion dollars, a number of ruined careers, and the surprising prospect of Jamie Dimon (JP Morgan Chase CEO) apologizing in public. The final cost of the trading losses has not been tallied as yet, but the episode has become exhibit A for the camp advocating strict implementation of the “Volcker rule” which prohibits banks from engaging in proprietary trading. We believe clear and consistent enforcement of the Volcker rule would go a long way towards preventing future financial crises.

Across the pond, Barclays found itself the first major casualty in a developing scandal surrounding the process used to set a key benchmark rate, LIBOR (London Interbank Offered Rate). LIBOR is used to price many financial instruments, including loans and derivatives amounting to hundreds of trillions of dollars. Many adjustable rate mortgages, and most interest rates swaps are based on some form of LIBOR. The rate, however, is determined based on a process developed in the 1980s. Treasury departments at major money-center banks in London submit an estimate of their borrowing rate. The outliers are discarded and an average of the remaining is published. It appears that at least at Barclays, proprietary traders who are supposed to play no part in the process were able to influence the teams providing Barclay’s submissions. Traders whose portfolios were impacted by the rate were able to persuade colleagues into altering Barclays’ submissions in their favor. To add insult to injury, senior managers claimed that regulators had encouraged them to lower the reported rate during the financial crisis so as not to appear weak. The end result: both the chairman and the CEO are on their way out and several other banks are rumored to have been guilty of similar manipulation schemes.

In Spain, Bankia the conglomerate formed by a merger of seven politically important cajas (savings banks) discovered that 2 + 2 = 4 when it comes to bank balance sheets. The large book of real-estate loans it had inherited from its predecessor banks continued to deteriorate and in May Bankia came clean, took a 4 billion Euro loss and asked for a 20 billion Euro capital injection from the Spanish government. Investors fled Spanish government debt once they saw the size of the hole in Bankia’s balance sheet and knew Spanish leaders had no choice but to extend it an open credit line. Seeing Spain’s borrowing costs rise to unsustainable levels, European leaders reached a tentative agreement to create a “banking union” and have European institutions, rather than individual nations serve as a back-stop for failing banks. Predictably, right after this “summit to save Europe” ended, dissenting opinions amongst the 26 Euro member nations made an unwelcome appearance. Markets seem to have gotten the message and the resumed the sell-off.

Meanwhile, the worm continues to turn, oblivious to the effectiveness of monetary or fiscal policy, but perhaps not to the relentless summer heat. An intense heat-wave across the US is being mirrored in the great granaries of Eurasia as well. Both Ukraine and Russia have experienced unusually high temperatures coupled with a long dry spell. The same conditions extend across the great plains of North America. This has begun to impact yield estimates for the corn, wheat and soybean crops, with many fields weakened by the unrelenting heat. Prices have surged, and a continued dry spell could see food prices rise. The sudden price hike in 2008 played a very large role in the global unrest that year.

We continue to advise clients to maintain a defensive allocation and limit exposure to risky assets like long-dated or high-yield bonds, low-quality stocks and commodities.

Here at Washington Square Capital Management, we quietly celebrated a happier anniversary this quarter. April marked three years in our existence as independent investment advisors and financial planners committed to furthering our client’s interests. We would like to thank all our clients and friends for your support and encouragement.


Subir Grewal                                                                           Louis Berger

Google vs. Yahoo : Machine vs. Man

Google vs. Yahoo : Machine vs. Man

In our minds, the difference between Google and Yahoo! has always been the degree to which their core product relies on automation.

Google wins whenever the best solution is a highly automated, machine-solvable one. Yahoo! has the upper hand when the solution requires some level of human interaction and editing.

This is a distinction that goes back to the founding myths of the two companies. Yahoo! came to life as a curated index of internet resources managed by Jerry and Dave. Google, as envisioned by Sergei and Larry, was a mechanism to make all the internet’s information accessible and useful, and it had to be done by machines because the task was so enormous.

This is why Search was the natural model for Google and remains it’s core offering. Meanwhile, Yahoo has had to effectively give up on search, but still does a better job with segments that require some curation, news, finance and sports, in particular.

A few years ago, the default assumption would have been that a people heavy information gathering system (Yahoo!) would never survive the competitive onslaught of a heavily automated solution (Google).  Hand-crafted websites with good editorial values are still in many ways a notch above those built purely by algorithm (not to mention the constant battle with spammers who try to game search results). The evolution of the web has made us question that assumption. It seems to us that there is a role for curated/edited content and this can be quite valuable territory. We can easily see a large-scale curated search service having value. We also think the original Yahoo list could find a following amongst older users who may not adapt as easily to the free-flowing trial and error approach required to effectively use a search engine. Similarly, we can see the hierarchical list model having value for non-native English speakers, who may be more comfortable browsing through a tree than trying to recall unfamiliar words.  Yahoo’s initial list managed to create a sense of discovery. You could actually browse the web using it, much like you might library stacks or a department store. That element has almost entirely been lost on the modern Internet.

So, maybe Yahoo! does have a future, if it can go back to its roots and become the curated guide to all the Internet content that is worth your while.


As of this article’s publication date, Washington Square Capital Management and its clients do not hold positions in either company, this may be subject to change. We  may in the future acquire positions in other companies mentioned in this post. This article is not a recommendation to buy, sell or hold any securities mentioned.

Why Entrepreneurs Should Take A Look Inside Pandora’s Boombox

Why Entrepreneurs Should Take A Look Inside Pandora’s Boombox

The true tragedy at Pandora Media is not that the stock traded below its IPO price within 24 hours (though investors who bought shares in the secondary market on the first day may disagree).  Rather,  it’s that the founder (who was one of three co-founders) holds only 2.25% of the outstanding shares.  Meanwhile, two venture capitalists, both of whom are former Wall-Streeters, individually own over 20% each. Pandora is not making its founder, or the people who work there, wealthy. But it has turned out to be a very lucrative investment for the venture capitalists who took the company public.

Aren’t startups that make real products/services supposed to make their founders wealthy, not their financiers? What happened here?

Pandora launched in 2000, during the height of the tech boom, and has followed a long and circuitous path to becoming the $2 billion plus $1.75 billion company it is today. The business required a lot of outside capital, necessary to negotiate and acquire rights to music content and to build out its streaming capability. In addition, they have a large team of music analysts on staff to catalog tracks as part of the Music Genome project. Two of the co-founders (Will Glaser and Jon Kraft), left Pandora after the tech-wreck and the company required many successive rounds of financing to stay afloat. Pandora had a number of near-death experiences as the business model changed from subscription to advertising, and their focus shifted from serving music retailers to subscribers. It would have been easy to write them off about a dozen times over the years, but they managed to survive and go public in the end. It is a remarkable testament to their perseverance that they are now a business that has built a service offering a unique blend of algorithmic and curated content, combining both crowd-sourcing and expert analysis. And they have a devoted subscriber base that is growing.

How then, to explain the fact that a co-founder who has been at the company for twelve years, through numerous ups and downs, ends up with a minute share of the firm, while the financial sponsors walk away with many multiples of their investment?

As many entrepreneurs in the tech space already know, capital infusions almost always require giving up equity.  And when a company requires several capital infusions, it means that equity is spread even thinner.  But when a company is in danger of folding, lifeline capital infusions require deals that, in retrospect, may seem horribly one-sided (rarely in the founders’ favor).

There are mitigating circumstances, of course, and we’re not saying that Pandora’s founders are guilty of making horrendous deals – they likely did what they had to in order do keep the company afloat.  Nor are we saying nice guys finish last (even though we think Tim Westergren is one of the nicest founders we’ve ever had the pleasure of meeting). We also recognize that Pandora’s trajectory is not one that other startups will necessarily follow. It’s just an illustration of one particular outcome, one which was spectacularly unfavorable to the founders monetarily.

So what should founders do?

The first thing is to understand the value and cost of venture capital financing. As a startup founder, you want your idea and work to reward you. If your business is as good as you believe it is, equity capital may turn out to be very expensive. Debt, could easily make more financial sense and leave you with more control of your company. It’s also important to understand the parameters of the deal you’re offered. Learn to read term sheets and, as always, get more than one quote. For instance, aggressive deal terms can dilute founders to a surprising extent. A few years of 8% coupons on compounding cumulative preferred can quickly add up. That said, there are certain advantages to working with a good VC. Some of the best can help you develop your business by providing good advice, and if they have a large following, help launch your product or service. A good VC’s experience and timely assistance can be invaluable. For example, it’s the VCs who suggested Pandora switch to a advertising model and get out of the subscription radio game.

As a founder, it’s important to understand that venture capital firms are not your friends. In fact, some of the more aggressive outfits will not balk at taking advantage of founders who don’t have a strong grasp on how to structure a capital deal.  Pandora’s story underscores the need for entrepreneurs to have expert legal and financial advice in place early on in the game, so they can protect their personal interests when VC firms come calling.  Ideally, this should come from an independent advisory firm that does not have a brokerage or investment banking arm which may be more interested in maintaining a continuing relationship with VCs.

Shameless plug: We can’t pass up the opportunity to say that Washington Square Capital Management was founded precisely so we could provide unbiased advice on investments and financial planning to our clients. As an added kicker, we enjoy working with entrepreneurs and technologists so much, we waive our minimum investment requirements. To get a flavor, read our post on Personal Finance 101 for Aspiring and Successful Entrepreneurs. To learn more, reach out to us via e-mail (info at wsqcapital dot com) or call us at +1-646-619-1156.

Image credit: F.S. Church


As of this article’s publication date, Washington Square Capital Management and its clients do not hold positions in either company, this may be subject to change. We  may in the future acquire positions in other companies mentioned in this post. This article is not a recommendation to buy, sell or hold any securities mentioned.

Facebook, Cypherpunk and Psychohistory

Facebook, Cypherpunk and Psychohistory

One of the more notable financial news stories of the year so far is the decision of social media heavyweight Facebook to go public (an event we alluded to in our top 10 themes for 2012). The question on everyone’s mind is whether a potential $100 billion market valuation is appropriate for a company that had roughly $1 billion in net income last year. It wouldn’t be the first tech company to trade at a three digit P/E (we’re looking at you, but it would be the largest. We are going to leave the valuation question aside for a moment and think in broader terms.

In our view, there are a few factors to keep in mind when considering the lofty growth expectations that surround Facebook.

Fewer, poorer, new users: At 845 million relatively regular users, Facebook already has the cream of the crop when it comes to potential consumers. The economic elite — by far the most attractive consumers — are, for the most part, already on Facebook. The next billion users will have less spending power, and will not consume as many of the digital goods Facebook wants to sell them, nor will advertisers pay as much for access to them.

With the exception of China (where Facebook is banned), the network has no other large upper-middle class markets it can tap into. Since the next billion Facebook users will have more modest means and this could be a tricky cultural and business shift. Facebook initially set itself apart by limiting usage to select colleges. Over time it has successfully expanded availability to new demographics (older users and international users) . But its user base has always been the more affluent segment of each market.

By highlighting this, we’re not trying to diminish the broader value of an open social network and its ability to connect people and create opportunities for them. We hope Facebook continues to be another powerful Internet tool available to a person of modest means to foster deeper connections, expand their horizons and develop themselves. But we do recognize that social networks by definition will mirror divisions in societies, and certain virtual spaces will be more attractive than others to specific groups.

User disengagement: There’s a chance Facebook jumps the shark and usage drops. Despite its meteoric rise in recent years, Facebook operates in the notoriously fickle world of social media, where users may tire of a particular platform and seek out the next hottest thing (let’s not forget Friendster or Myspace, once robust social networking communities before Facebook came along).  While Facebook has done a phenomenal job building its user base and cornering the social media market, there are other platforms out there waiting to swoop in should there be a misstep (Google+), or capitalize if users ultimately decide they prefer to segregate their status updates (Twitter) from their picture sharing (Instagram) and location data (Foursquare).

In addition to the possibility of competitors poaching away market share, there is also a question as to how users will interact with the platform going forward.  We already see a divergence in the frequency with which men and women use Facebook. Women use Facebook much more regularly than men do. Over time, we could see photo-sharing and instant updates lose their novelty value for certain users who then disengage from Facebook.

Advertising could be ineffective on Facebook: It’s tough for an advertiser to grab a Facebook user’s attention when they are competing with photos and updates from their nearest and dearest. Ads on Google search are powerful revenue generators primarily because the user is searching for something and the ad is related to the search. A Facebook user, on the other hand, is visiting the site because they wish to see photos or updates of their family and friends. An ad on Facebook generally disrupts the user-experience.

Of course, Facebook could use the reams of data it has on each user to suggest a gift for your wife or girlfriend based on browsing or comment history; but this could easily mis-fire and be considered intrusive. Similarly, word of mouth recommendations are very powerful drivers of product sales, and Facebook is an effective medium for friends to share these; but advertisers tamper with word of mouth at their own risk. Our sense is that Facebook has become a virtual family gathering or a dinner party, and overt advertising or sponsorship will always feel slightly out of place at such an event.

On Facebook everyone knows who you really are, even if you’re a dog. All that said, there is one aspect of Facebook that sets it apart from virtually every other website and could end up being extremely valuable. From the very beginning, Facebook has insisted on “real names” and worked to keep anonymous or fraudulent identities off the platform. The result is that Facebook can tie virtually each of its 845 million users to a real-world identity. They have also built an authentication framework on their platform which other sites can use in lieu of asking users to pick new passwords or user ids. Since Facebook has photographs of all your friends, they can be used as a challenge if unauthorized activity is detected. Your ability to recognize your friends, along with Facebook’s knowledge of who they are, combined with a large photo database, makes it very difficult for an unknown attacker to try to hijack your profile. This has meant an enormous shift in the previously anonymous world that the Internet was, and it remains a rare and valuable commodity. It is a service Facebook could charge other sites for down the road. For Facebook, it may be the next big thing. Perhaps bigger than targeted ads.

Further Reading:

The genesis for this post came as a result of a wide-ranging conversation we had recently, and which led us to think about two of our favorite books…

The first is Neal Stephenson’s Snowcrash, a 20 year old book that predicted much of the impact the Internet would have on human society. No one who has ever read that book can underestimate what anonymity can lead to and what power accrues to an entity that can definitively identify 20% of humanity.

The second book is Asimov’s Foundation series, which is what got one of us interested in Economics and reinforced the constancy of human behavior.  Some of the conversation about 3-D printing and replicators also brought to mind Asimov’s gem, The Last Question.


Photo credit: Flohuels

History as enshrined in law: Another lesson to remember from the credit-crisis.

History as enshrined in law: Another lesson to remember from the credit-crisis.

We recently re-read a very good piece on Risk management lessons to remember from the credit-crisis 2007-2009 published by BlackRock. The document is well worth a read, and we recommend it highly for all professional investors.

There are, however, a couple of things we wish the authors had added to the note. Particularly with regard to understanding the institutional and legal context within which investments are made.

Portfolio managers must understand what happens when the market fails and a security enters liquidation: Investors should examine a potential investment through the eyes of a distressed investor prior to committing capital. Investing in distressed securities is a very specialized field that requires a lot of specific expertise. However, that should not dissuade the average investor from subjecting the investment to a  simple smell test. What happens to this security if the issuer becomes financially distressed?Who will they choose to pay first, and whom will the courts force them to pay and in which order. Part of our investment process focuses on what would happen in a distress or liquidation scenario (and what conditions would bring the issuer to that point). This occurs naturally to us because we invest in debt instruments, where return of principal is the paramount concern. We always evaluate both bonds and stock whenever we consider an investment in a company, i.e. look at the entire capital structure. We try to understand how decisions would be made in a liquidation, who would have authority to make decisions, and who would receive what portion of the liquidation proceeds in which order. We are generally wary of anything that has been through multiple layers of securitization. Understanding issuer and obligor motivation in a complex securitization requires peeling many layers of control. This is generally not worth the effort unless the returns being offered are extraordinary.

Investors should understand the financial history of the jurisdiction they are operating in, and how that impacts both law and convention: This usually falls under the rubric of operational risk, and is often an after-thought, but we believe portfolio managers must understand this. Many supposedly astute investors found themselves on the wrong side of the pond when Lehman Brothers failed (see NYTimes and DealBook). Hedge Funds with assets held within Lehman Brother’s UK prime brokerage operation found themselves facing an uncertain claim on securities they had believed were in segregated accounts. In marked contrast, the experience of the ’29 crash led to very different rules and conventions in the US, and this limited the impact on US prime brokerage clients. The lesson here is larger than a simple admonition to read custody and brokerage agreements carefully. You really do need to understand the cultural environment within which the law of the land came to be formed, and the environment in which it will be interpreted. This is part of the reason investments in China always give us pause. We’re simply not sure what underpins property rights in a jurisdiction where the collective memory of private ownership goes back half a generation at best. For that matter, we have similar concerns about Russia.

This brings up a much larger, third issue. As many ivory towers exist on Wall Street and the City of London as in Cambridge and Oxford. Many portfolio and risk managers in the institutional investment management world operate in the rarefied, highly specialized world of large corporations with armies of highly paid professionals in each division. The rough and tumble world of actual business, where businesses fail, frauds exist and people go bankrupt, is often as alien as Titan’s toxic atmosphere.

Silver Dominoes, or a Tale of the Merchant of Margin.

Silver Dominoes, or a Tale of the Merchant of Margin.

The sharp drop in silver last week made us think of price-support in different markets and how that depends on the constitution of market participants. When a significant percentage of a market is composed of financial buyers and speculators, many of them leveraged, it is prone to sharp, steep drops. It doesn’t matter whether the underlying object is “safe as houses” or “worth their weight in gold”. When a speculator buys an asset with borrowed money, the lender (typically a bank or brokerage) will seek additional security if the asset’s market price moves in the wrong direction (a margin call), and when the speculator can’t provide additional security to hold on to the position, the lender will move to sell the asset. If a significant number of buyers are speculating with borrowed money, or on margin, small downward moves snowball as waves of margin calls  trigger liquidation, which trigger further margin calls.

This is a lesson that was dearly learned during the crash of ’29 and led to the simple and strict margin limits in the US equities markets. The lesson was unlearned over time. High loan-to-value mortgages were used by large numbers of people seduced by stories of millionaire flippers to speculate in real-estate. High levels of leverage are what trigger quick unwinds in the carry-trade as well. IN 2008-2009, all this frenzied activity triggered the recent real-estate bubble and ensuing crisis.

What a lot of US-based “investors” in commodities fail to understand is that the financial markets for commodities operate with a degree of leverage that is simply unattainable for the average investor in equities (the market people are most familiar with). To take an initial position in a 5,000 oz. silver future on the CME (worth about $187,500) requires posting $18,900 in margin. That’s 10:1 leverage, or 10% down, and this is after the exchange recently raised the margin requirement. A 10% move can wipe out the margin posted, and a 2% move can require the speculator to post additional margin. Seasoned participants in commodities know this, but we fear the vast masses who have been drawn to investment products linked to gold, silver, copper etc. do not appreciate how much borrowed money fuels the market they’ve recently entered.

Why Microsoft had to buy Skype, at virtually any price

Why Microsoft had to buy Skype, at virtually any price

People are scratching their heads about Microsoft’s acquisition of Skype and the price they paid. They shouldn’t be. Microsoft had to purchase Skype and in our view they would have paid even more to do it. It was a must-have strategic acquisition.

Google is running circles around Microsoft in cloud-based office-productivity and communications tool adoption by small-businesses. If you’re starting a company (or have a small company), Google will provide, at no cost:

  • E-mail (for up to 10 users) on GMail (used to be 50 up until yesterday)
  • Basic word-processing, spreadsheet apps
  • Chat, messaging, video-conferencing via Google Chat
  • Mobile computing via Android
  • Telephone services via Google Voice

It’s free as long as you’re willing to accept some advertising and you can pay $50 a year per person to remove the advertising. All of this takes about 15 minutes to set up for 5 people. Why would anyone want to deal with their telephone company again, or buy and set up a Microsoft-Exchange server, or buy and install Microsoft Office on 5 PCs. All you need is a PC or an Android phone and some form of internet connectivity.

There’s a race underway between Microsoft and Google to attract small and medium sized businesses and provide a full-range of office productivity and communication tools. The company that wins will generate the same sort of network-effect revenues that Microsoft has enjoyed for decades from the wide-spread adoption of Windows and Office by businesses of all sizes. Once individuals begin to use a set of tools it’s tough to make them switch to an equivalent unless the new features are compelling.

24 months from now, 20% of all US businesses, and 80% of new startups will be paying either Microsoft or Google $50-$100 a year per employee to provide the basic suite of office-productivity and communication tools.

Microsoft killed ResponsePoint last year, that was their small-business/VoIP offering, but it wasn’t really successful. They had to acquire Skype because if they didn’t they would be missing the last piece of the puzzle. Adoption rates for Hotmail and Micorosoft Office in the cloud would be minimal. Microsoft AdCenter would remain an also-ran to Google AdWords.

With Skype, they’ve got a recognizable brand for the next few years in Internet telephony, and the infrastructure and user base to build on.

For the moment though, Skype is a cheap way for consumers and road-warriors to make calls. Microsoft will have to extend Skype’s features and re-align its brand to appeal to a wider array of businesses and increase adoption in the office.

Google Voice already has a rich feature set, I’ll point out just two that people love:

  • Google Voice will transcribe voice-mails into text, so you can read voice-mails without having to listen to the message (you have to use it just once to understand how much quicker it is)
  • Google Voice will ring all your phones, in sequence or simultaneously when someone calls your Google Voice number if you want it to.

Google doesn’t really need anything Skype has to offer, they’re already on their way. The reason Google bid for Skype is on the off-chance they could buy it, migrate everyone to Google Voice and shut Skype down. If they’d succeeded, Microsoft would have had to build the VoIP in the cloud offering from scratch, which would have meant a two year lag.

Following the standard M.O., Google is offering all these services to colleges and schools for free. So the next generation will already be comfortable using them when they arrive at their first job.

The folks who should be really worried are telephone companies because their value-added phone-based services for businesses are going to be radically disrupted by VoIP combined with cloud-based features. PBX manufacturers and vendors should be worried as well, because all the switching technology and features they’ve spent decades developing into customized physical equipment and offering to small businesses via large sales-forces is going to become largely obsolete. What’s worse for the telcos is that this competition is coming from the two software companies with the deepest pockets and biggest cash-generation engines out there. Lawyering up or Lobbying up won’t work.

As of this article’s publication date, Washington Square Capital Management and its clients currently hold positions in Microsoft which may be subject to change. We  may in the future acquire positions in other companies mentioned in this post. This article is not an recommendation to buy, sell or hold any securities mentioned.

Personal Finance 101 for Aspiring and Successful Entrepreneurs

Personal Finance 101 for Aspiring and Successful Entrepreneurs

We read a number of startup, entrepreneur and venture blogs with great interest, and since many of our clients are entrepreneurs we have an interest in matters that touch on personal finance issues specific to them. We were struck by Fred Wilson’s blog post on his own experience recycling capital earned from investments in startups and how this has sometimes led to difficult times with his personal finances. He writes about how very early, concept-stage companies are financed in the US by angel investors and why that has been difficult to replicate elsewhere (i.e. not venture capital firms). His post is worth a read, and it got us thinking.

One thing that sets the US apart from most other parts of the world is a willing group of investors who are prepared to fund concept-stage companies, and who rely largely on their own experience founding similar companies in the past.

The second reason we think this happens in the US more than in other countries is far more tenuous and abstract. It’s trust. In many other parts of the world, legal systems and societies are not mature and trusting enough to permit someone to invest as an angel and not be branded a fool or worse if things go wrong. We also suspect that the number of charlatans masquerading as “entrepreneurs” is higher in other parts of the world than it is in the US.

Fred is focused on startup financing and advocates angel investing for successful entrepreneurs. Our view is a little different: we think successful entrepreneurs should capitalize on their unique hard-won insight into their industry and opportunities to judiciously fund startups, but we also believe there is a role for opportunistic investments in the public market  (stocks, bonds) in a successful entrepreneur’s portfolio. We also firmly believe successful entrepreneurs should set aside an income generating, ring-fenced portfolio that is robust enough to support them and their families if their angel investments fail spectacularly.

Some successful entrepreneurs may also need help controlling their urge to spend on expensive toys, but that is a different discussion.

The challenges faced by an aspiring entrepreneur are of a different cast.

Based on our own experience founding a business from scratch, and from working with clients who have done similar things, we’ve created a short check-list aspiring entrepreneurs should at least consider before diving head-first into a startup. Most of them relate to personal finance, some of them delve into the realm of personal fulfillment, a necessary discussion since starting a business can be such an emotional and stressful exercise.

  1. Evaluate yourself: are you ready for everything the world and your startup are going to throw at you? Will you be able to work outside your comfort zone, sell when all you’ve done is analyze (or vice-versa)? Will you be able to view your friends who remain in the corporate world in the right perspective as they fly around business class and wield expense accounts? When the romance of being an Entrepreneur/Business-Owner/CEO dies and you’re fixing the thirty-eighth thing to go wrong this week or reliving the latest deal that fell apart, where will the reserve to keep going come from?
  2. Evaluate the business you’re entering: particularly what the relative value of sweat and capital are in the business. This will tell you a lot about what you need to bring to the table and how you should treat partner’s contributions (in both sweat and capital).
  3. Get buy-in from your family and friends: They are along for the ride. Whether you acknowledge it or not, you are going to cause them financial and emotional stress as your business gets going. Make sure they know that.
  4. Be Cheap: You will have to become an arch conservative, make sure you are ready to cut expenses to the bone. Figure out what’s essential to retain your sanity and keep that.
  5. Be fair to your partners: Your ultimate success will depend on this more than anything else. Joel Spolsky has a great post on how to allocate founder’s equity, you should read it.
  6. Know when to quit (in advance): There’s a point where it makes sense to quit. Or regroup to fight another day. Think about what that point is for you along emotional, temporal and financial axes.
  7. Protect your fortress of solitude: Keep a reserve of both emotion and money, so you can, if necessary, exit gracefully to stage right.


2011 Q1 Letter & upcoming webinars

2011 Q1 Letter & upcoming webinars

We held our first “webinar” earlier this month on the timely topic of municipal bonds. We have posted the narrated presentation at for the benefit of those who were unable to attend. We plan to host three webinars this quarter:

To register for any of these webinars, please visit We will continue to add recordings of future presentations to our page on youtube. Feel free to pass along an invitation to anyone in your circle interested in learning more about these topics.

IRA contributions, Roth IRA conversions

Most taxpayers can make IRA contributions for the 2010 tax year up until the individual tax-filing deadline, which is April 18, 2011 this year.

Roth IRA conversion rules have changed and virtually anyone can now convert a traditional IRA into a Roth IRA. Partial conversions of an IRA account are also permitted. Please contact us if you’d like to discuss specific issues surrounding your circumstances.

Interest Rates & QE2

In prior letters, we have discussed the extraordinary measures the Federal Reserve and other central banks around the world have taken to keep interest rates at historic lows. Short-term rates in the US remain below current inflation levels, which means savers are being penalized for holding cash. This is no doubt due to the actions of the Fed which continues to purchase the bulk of newly issued US Treasuries under its Quantitative Easing program. We estimate short and medium-term rates are 1.5% to 2.0% below where they would otherwise be.

Meanwhile, the flames of inflation have begun to flicker. A combination of increased demand and easy money policies has driven up food and commodity prices. If this trend continues, maneuvering through the obstacle course of rising inflation will take a toll on the global recovery. And as is usually the case, the burden will be heaviest for the world’s poorest who spend a higher percentage of their income on necessities. We are beginning to see some policy action and rate hikes in developing markets. Unless inflation levels stabilize quickly, this will begin to impact global trade. We caution bond investors that future returns are likely to be lower than those in recent years past. We continue to recommend high-quality bonds with 3-5 year maturities.

Budgets and Bluster

The issues facing most developed-market governments are remarkably similar whether we are talking about Greece, Ireland and Spain, or the US, California and Illinois. The long-term challenge involves tackling unfavorable demographics and enacting the painful policy reforms required to tackle the cost of social programs. In the short term, the double-whammy of a real-estate/financial crisis requiring an immense expenditure of government support, followed by a great recession driving down tax revenues have created huge deficits. The exact mix differs: in Ireland the cost of a bank bail-out has supercharged the national debt, whereas in Greece the crisis is compounded by a culture of tax-evasion and protectionism. In the US, the core problem is reforming Medicare and a health-care system that takes in more revenue per person and results in lower levels of health than those in other developed countries.

The imminent congressional debates over the federal budget and the national debt ceiling will bring fiscal issues front and center in the US. As the 2012 election campaign kicks off over this summer, we expect fiscal issues will be key in every race. In Europe, meanwhile, the moment of reckoning for Greece, Ireland and Portugal fast approaches. European institutions will either have to come up with a plan for debt-restructuring or direct support to assist struggling governments in the short-term. Meaningful progress towards the longer term demographic and policy challenges will also need to be made.


Nature, Energy and Politics

The March 11 earthquake and tsunami took a terrible toll on the people of Japan. The economic damage is also enormous as a significant percentage of the area’s power generation and distribution capacity has been offline for weeks, impacting businesses and residences across the main island of Honshu. Rolling blackouts have affected many areas, including Tokyo. Two nuclear power generation facilities (Fukushima I and II), with a total of ten operational reactors between them, suffered severe damage. It is now clear that all the reactors at Fukushima I will need to be scrapped. A large amount of fuel from the operating reactors and spent fuel stored at the facility has been damaged and released into the environment. The situation remains critical and the full extent of the crisis is still unknown.

Nuclear power generation requires operational and design expertise far more specialized than other forms of energy production. In general, the industry has recognized this and a great deal of thought and effort has been put into improving design and procedures. We should also not forget that most other forms of energy generation carry their own risks, and often a higher carbon footprint. For instance, the production and burning of coal costs numerous miners their lives every year, and damages the respiratory systems of populations globally. Hydro-electric dams have failed due to design faults or natural disasters causing a large number of casualties. We firmly believe renewable energy must be at the core of any long-term solution to global energy needs. Nevertheless, replacing our current energy infrastructure is a multi-decade project and represents an enormous investment. One step towards that process would be to accurately account for the true health and environmental costs of all forms of energy production. As things currently stand, the conventional energy industry derives numerous economic benefits from tax-breaks, favorable industrial policy and political gridlock in assessing the true environmental cost of greenhouse gas emissions.

With all this in mind, we believe certain modern nuclear plant designs can play a role as a crucial bridge technology. In many fast-growing economies, nuclear power is the only viable alternative to coal and gas for large scale power generation. It is clear though, that the nuclear industry will face tough public scrutiny and a risk re-assessment is underway. We are particularly concerned about the operational safety of nuclear power in countries without a strong tradition of accountability, independent oversight and open public discourse (see China). Some of these concerns are acute for certain developed nations such as Japan, which has few energy resources of its own and relies on nuclear power for 24% of its electricity needs. As a result, we continue to view long-term investments in renewable energy favorably.

Upheaval in the Middle East

Mass protests in the Arab world have captured the world’s imagination since the sudden, largely peaceful overthrow of Ben-Ali in Tunisia. We certainly do not believe every group engaged in protest has benign intentions and recognize that in some countries one repressive regime may be replaced by another. That said, we are hopeful the power of public protest and increasing civic engagement by ordinary citizens will transform the moribund political and economic regimes in the region. For the time being, we expect this part of the world will continue to experience upheaval over the next decade or more. In many of these societies, oil wealth has distorted economies and politics. A demographic bulge is now bringing about rapid change. Investors should remain aware that demographic and political change may cause certain markets to be disrupted over the next decade.

We are positive on emerging markets in the long-term, but advise caution for the present since asset prices have risen very rapidly. Further rises in oil prices could accelerate inflation and lead to a slow-down in global growth, which would impact emerging markets negatively.




Louis Berger                                                                                        Subir Grewal



What the 1911 Triangle factory fire means for investors today

What the 1911 Triangle factory fire means for investors today

There’s a spate of coverage for the 100 year anniversary of the fire at New York’s Triangle shirtwaist factory. The tragedy led to the death of 146 workers and a national discussion about workplace safety rules and labor rights. Various news organizations have coverage, some of the more interesting articles are:

The fire is being remembered as a seminal moment in the history of labor rights in the USA.  It should also remind entrepreneurs and businesses of the value in a common set of effective standards and regulations. Everyone who engages in commercial activity knows that there are a hundred things competing for your attention every day. It is not always possible for a small concern to draft and apply safety rules for every operation it conducts. It is also difficult to operate a commercially viable enterprise if competitors can undercut prices by playing fast and loose with safety and standards.

Perceptive business owners (a category that includes investors) know that their capital can be permanently impaired by lax safety standards. This is sometimes true even if the lax standards are a competitors, since in the eyes of the consumer there is guilt by association. Owners and investors who are interested in creating long-term value (and exhibit some level of common decency) should advocate for the fair treatment of workers, clear and uniformly applied safety standards, and independent regulators. This is true whether you are invested in a bank, a coal mining firm, or a company making blouses.

Recording of our Municipal Bonds webinar

Recording of our Municipal Bonds webinar

We held a webinar earlier this month on municipal bonds. We provided a basic overview of the municipal bond market and discussed recent events. We’ve now posted a replay on youtube, the links are below:

Geographic risk in municipal bond portfolios.

Geographic risk in municipal bond portfolios.

We always recommend national portfolios when managing a substantial allocation to municipal bonds.  Clients often ask about losing the state tax income benefits by buying out of state municipal bonds. Our answer has always been that we believe it is crucial to control geographic risk and concentration, particularly since these can be idiosyncratic, tail-event type risks.

In past discussions with clients, we’ve focused on how certain states and municipalities can have an over-reliance on one or two industries and be impacted by a cyclical or secular downturn. We’ve also pointed out that certain natural disasters can impact a geographic area so severely that a short-term recovery becomes difficult or even impractical. Many disasters can erode the tax base and asset values to such an extent that creditors may suffer substantial losses in default.

For instance, environmental devastation during the dust-bowl era wreaked immense damage on agricultural production in many states and this impacted state and local finances significantly. The tragic events unfolding at present in Japan should remind investors that natural and environment disasters can devastate communities for extended periods of time. When these disasters come in the form of a dam failure or nuclear accident, they can make a large area inhabitable.

Such events are inherently unpredictable, and highlight the need for geographic diversification in investment portfolios of all types. Humans are fallible creatures, in investing as in many other things. Geographic diversification is a way to limit the impact of that fallibility.