Author: subir

Commodity supercycles, Windup Girls and Family Farms

Commodity supercycles, Windup Girls and Family Farms

By |

In our SRI portfolios, we screen companies and industries for those actors who run sustainable businesses. Their usage of resources and fulfillment of broader responsibility counts as much as their financial prospects.  Ocassionally, we step back from our narrow interests in a specific company or industry to look at the broader picture.

We did that recently while reviewing the latest quarterly letter from Jeremy Grantham at GMO. In a note last year, Grantham had highlighted the impact that intensive conventional farming practices can have on the quality of soil. Healthy soil takes many, many decades to develop and the intensive use of pesticides and fertilizers can destroy microbial life in topsoil. Once that happens, it requires a continual regimen of fertilizers to make the land productive.  Intensive commercial farming techniques have killed life in the top soil, and this will have a long-term impact.

Those who’ve read Michael Pollan’s Omnivore’s Dilemma might remember the section on Polyface Farms. Pollan describes Salatin’s effort to rescue a ravaged industrially farmed tract using a complex crop and animal rotation regimen. It requires prodigious  knowledge of the local environment and intellectual rigor on the part of the farmer. The level of effort is a couple of magnitudes greater than that required to flood a field with fertilizers, pesticides and irrigation.

If intensive, fertilizer based farming permanently damages our agricultural production, this will have long-range impact for us. What does the steady depletion of our ability to produce food mean for the economy and our race? The first impact will be felt by the world’s poor, who will be priced out of food. This would lead to a rush to accumulate scarce resources and political unrest, possibly more revolutions like those we are seeing in the middle east.  Since the industrial revolution, the effort we have expended to raise crops and feed ourselves has steadily declined.  In the mid-1800s, fully three-quarters of all American workers lived and labored on farms, that number is under 3% today.  The story of progress in the 20th century has to a large extent been driven by the unshackling of vast numbers from the plough. A world where more human effort is required to raise the same amount of food would be one with lower growth, fewer advances and less comfort.

While, we’ve been thinking about these big trends, we’ve been following the Olympics, and the incessant ads reminding us that “luck” had no role to play in the success of any athlete. The truth, however, is that luck plays a large role. Most of the successful olympic athletes were lucky to be born into families or in nations where they were assured a consistently high caloric intake, access to a top-notch training program, and institutional support from their countries and employers. Meanwhile, many, many people in poorer parts of the world will never have that opportunity. The lottery of birth is truly amazing.

Life occasionally imitates art. For a dystopian vision of where intensive commercial farming and climate change might lead us we would recommend reading The Windup Girl, Paolo Bacigalupi’s richly imagined novel about a world ravaged by climate change, genetic modification and crop failures. Robert Heinlein’s book, The Moon is a Harsh Mistress tackles similar topics, from the standpoint of a colony on the moon. Of course, our salvation may lie in the exploration of our solar system, which is rich in resources. But the space program has been as underfunded as investment in training farmers to use organic practices.

 

2013 Q2 letter: Tapering off the rocket-fuel

2013 Q2 letter: Tapering off the rocket-fuel

By |

 We hope you are enjoying the summer thus far.

In the financial markets, things seem to be heating up as temperatures rise across the northern hemisphere. The events of the last few weeks of June seem to have triggered a wake-up call for many investors who may have been lulled into a false sense of security by a market that rose steadily throughout the winter. Many long term trends are starting to reverse course and risks we have been tracking for several quarters are beginning to materialize.

Space Shuttle lift-offIn a large part, the moves are being driven by two major players: the central banks of the US and China. In the US, various Fed board members have been travelling the country recently in an effort to warn investors that the enormous amount of bond purchases being undertaken monthly by the Fed will begin to “taper” off. In many ways, it is an attempt by the Fed to let all the party-goers know that the punch-bowl is about to be taken away. They aren’t saying it’s midnight and the party is over, but they have made it clear they are watching asset bubbles, have taken into account the improvement in housing and employment, and will be moving away from crisis tools. In other words, it’s Last Call.

The market has been discounting the probability of this happening for some time, but these recent public pronouncements have forced a rapid adjustment of expectations. The 10 year treasury rate has moved about 1% in a couple of months, wreaking havoc in any leveraged rate portfolio. The last time rates moved this rapidly was about 20 years ago. While this may be the beginning of a larger move that we believe will be spread over many months, the larger picture should be clear: the 30 year bull market in bonds is over. Bond investors should be prepared for potentially a five to six year period of rising yields and falling prices.

Meanwhile, on the other side of the world, China has executed a rather smooth transition of power, but the cost in terms of economic imbalances has been large. Like the US, the Chinese authorities have maintained an easy money policy since the onset of the global credit crisis. Along with looser credit, they have delivered large fiscal stimulus, by spending on investments, largely on infrastructure and other construction activity. Much of this spending has been financed with credit, and the borrowers are primarily local municipalities and governments. In many cases, projects are initiated and built to satisfy bureaucratic ambition, rather than commercial ends. Many of these projects will be unable to recoup their costs. In some ways, the outlook for Chinese regional governments is worse than it ever was for US municipal debt. The central Chinese authorities have begun to rein in excessive credit growth after voicing concerns over rising levels of indebtedness in late 2012 and early 2013. Overnight lending rates were raised unexpectedly in June, and this shocked Chinese banks and lenders. The local stock market promptly fell over 20%. We expect the re-adjustment in China to generate more pain for investors, and this will impact resource driven economies like Australia and Canada  who have been relatively immune to the malaise in the US and Europe, In our view, these recent monetary policy adjustments by the US and China will most adversely impact the future prospects of multinational banks. Banks that have positioned themselves for the move will benefit as the Fed withdraws from purchasing long-dated bonds. As the yield-curve steepens (long-term rates rise faster than short-period rates), the core lending franchise of most banks should become more profitable. While long-term rates rise faster than short-term rates, banks will profit since they generally borrow or take on deposits paying short-term rates and receive long-term rates on loans made. The problem is that in the aftermath of the financial crisis banks shrank the volume of general lending they were doing and began to load up on long-dated bonds of government and quasi-government entities instead in their search of low-risk investments. As rates rise, these bonds will drop in value, leading to painful losses which impact balance sheets and bank income statements. We see few banks/financials that have adequately prepared for the inevitable rise in interest rates, and we believe most financials will underperform over the next two years.

Another noticeable theme this year has been a steady profit-taking in various speculative momentum assets that have enjoyed outsized gains over the past few years. From Apple and Emerging Market stocks, to Gold ETFs, high-dividend stocks and High Yield Bonds, the speculative investments of choice have sold off over the past few months with breakneck speed. To us, this signals a loss of confidence in the late stages of a rally and is not a positive sign for equities (neither are rising interest rates). That said, the dramatic drops in certain stocks have created select opportunities for value investors like ourselves.

We have been re-positioning client portfolios to take advantage of some of these long anticipated moves. Most client bond portfolios have been heavily weighted towards short-term, low duration, and floating rate bonds and funds. We have continued this positioning and have attempted to reduce long term bond exposure. For more tactical portfolios, we have added a short-position on long-dated bonds (an investment which gains from drops in the value of long-dated bonds). We believe this leaves us well placed to take advantage of a rising yield environment. Where appropriate, we have been adding stock to client portfolios, generally high-quality, income-generating issues (rising dividends). We also added Japan exposure to many client portfolios late last year and very early this year. We think selected Japanese equities are a good, long-term holding and there is another opportunity to acquire them after the recent sell-off.

We have also been adding alternative energy exposure to client portfolios where appropriate. Alternative energy stocks sold off dramatically as the solar sector went through growing pains over the past few years. We believe the adjustments in the sector brought on by large-scale Chinese capacity build-out and the expiration of certain tax credits are largely complete and the industry is now poised for growth and value creation.

We expect markets to continue to be volatile this summer, and we aim to stay in touch with all clients, please feel free to call us if you have any questions.

Regards,

 

Louis Berger                                                                                        Subir Grewal

2013 Q1 Letter: Spanish Mortgages, Cypriot Banks & Earth Day

2013 Q1 Letter: Spanish Mortgages, Cypriot Banks & Earth Day

By |

We hope 2013 has gotten off to a good start for you.

We want to start off by wishing you a Happy Earth Day! We exhibited at the Green Festival in NYC over the weekend, and it was great to see so many friends there, and to make some new ones. We are always pleasantly surprised by the number of people who are eager to learn more about Socially Responsible Investing and how their portfolio can do good as it grows.

The first quarter of 2013 saw risk assets continue to rally. Despite continued concerns about the state of continental Europe, major US stock indices reached fresh all-time highs in March, six years after they last reached such elevated levels. The effects of inflation and dividends that have accrued to investors effectively cancel each other out, and so it is rather impressive that six years after the first warning signs of the impending credit crisis appeared, investors have regained most of the lost ground. Of course, the constitution of the indices have changed, many enterprises that were mainstays of the Dow and S&P have been expelled from them and new upstarts have taken their place. That, however, is the creative destruction of the market at work.

CyprusIn Europe, a low-grade fire continues to smolder and it seems as if the news continues to get gloomier. March brought news that overall unemployment in the Euro-zone reached 11%, a level not seen for over 50 years. Investors should not be sanguine; the economic crisis in Europe is severe and will take many years to recede. The roots of Europe’s problems lie in the excess of development, spending and borrowing that occurred in the Medittereanean states, most of it funded by loans from the North. It has been illuminating to see the difference in responses between crisis-stricken Northern European countries and those in the South, which appear to have played out like a parody of Max Weber.

The first casualties of the crisis were Iceland and Latvia. Both are small countries with financial sectors that had recently ballooned. Another was Ireland. In each instance, the general population seemed almost resigned to the effects of the bubble bursting. It was almost as if, as per the caricature, Northern Europeans were used to misfortune and hardship, taking it in stride. Draconian measures were taken in all three countries. Banks were liquidated, along with real-estate developers and many ordinary businesses caught in the indiscriminate downturn. Meanwhile, families adapted quickly to a far less comfortable lifestyle, embracing austerity with an almost welcome sense of Lutheran penance.

Meanwhile, similarly crisis-stricken countries in the South (Greece, Spain, Italy and now Cyprus) have seen wide-spread unrest as their citizenry have resisted austerity measures every step of the way. We empathize immensely with the ordinary people caught in economic events that are not of their making. In many cases, individuals with limited financial experience just happened to have made poorly timed decisions, with no understanding that there are good and bad times to extend oneself by taking on debt. For the past three years, Eurozone nations have been haggling over how to apportion the blame and cost of the cleanup.

This quarter saw two diverging answers appear. The first is from Spain and was not widely covered though it has far-reaching implications. The second is from Cyprus and was widely covered by the media due to its dramatic nature.

Spanish mortgages are very different from American mortgages in one key respect: a mortgage in Spain is both a secured debt and a personally guaranteed, recourse loan. Lenders can repossess the property securing the loan, and continue to pursue the borrower for any shortfall or costs resulting from the repossession, till the entire debt is repaid. A Spaniard who has his house repossessed and sold by the bank will continue to owe the bank any shortfall between the sale price and the amount of the mortgage. Personal bankruptcy is not an option for most, so it is almost impossible to start with a clean slate.

Many Spaniards discovered the nature of their mortgage debt after the crisis, and after home prices were halved. Thousands of ordinary Spaniards have been evicted from homes they owned due to delays in mortgage payments and subsequently find themselves owing the bank tens or hundreds of thousands of Euros since the property does not cover the entire debt. Scores of former homeowners have been driven to suicide to escape crushing debts. Meanwhile, unemployment in Spain hovers around 25%. These are truly depression-era conditions, and they have seen wide-scale protests similar to the depression.

Amidst all this turmoil, The European Court of Justice heard a case brought by an evicted home-owner, Mohammed Aziz, and decided the original terms of the mortgage agreement were unfair. Spanish courts can now overturn evictions and repossessions on the grounds of consumer protection.

Meanwhile in Cyprus, an event almost as remarkable was briefly averted. For a few days, it looked like deposit insurance was about to be over-ridden for all Cyprus bank customers. The largest Cyprus banks found themselves facing large losses on recent purchases of Greek sovereign debt. As part of a deal to provide rescue funds for them, Northern European finance ministries insisted that depositors bear some share of the burden. Late one Sunday, a plan was announced to levy a 5-7% charge against small depositors and a much larger one against those with deposits larger than 100,000 Euros. As one might expect, this led to pandemonium in the streets and in the Cyprus parliament.

In one way, this episode was a good reminder for us all that deposit guarantees are only as good as the political will that stands behind them. In the case of Cyprus, its Eurozone partners were politically unwilling to rescue the banking system of an offshore financial center widely reviled in the tabloids as a conduit for tax-evasion. Sweden’s politicians did not find it palatable to make whole Russian businessmen. We do agree that large depositors should face some losses during major bank failures. In recent years, many have forgotten that their deposits are liabilities of the banks and only as sound as the institution’s health. Indiscriminate bank rescues perpetuate moral hazard. That said, we believe it was a grave mistake even to suggest that smaller depositors would no longer enjoy full deposit coverage for their accounts. It doesn’t matter whether the levy is called a wealth tax or a deposit charge, imposing losses on small depositors weakens the banking system for everyone. What’s even more embarrassing than the sight of finance ministers making mistakes that Bagehot warned against 150 years ago is that the moment the plan saw clear light of day and they heard the uproar, all the decisions were reversed. So, the EU members have managed to look weak and incompetent while scaring small depositors and instigating a full-fledged bank run within the Eurozone.

So what does this mean for investors in the short and long-term? We believe the European crisis has yet to reach it’s denouement. We live in a interconnected world, and despite record profits for US corporations, any rapid deterioration in Europe or Asia could impact US stocks very quickly. We believe investors will be well-served to exercise caution in equities markets and consider taking profits selectively. Meanwhile, bond investors have to reconcile two competing concerns: any eventual removal of quantitative easing will hurt bond prices, especially since we are seeing record low yields and record highs for bonds. That said, a recession or crisis in Asia or Europe would lead to a flight to quality and likely support US bonds of all types.

Regards,

 

Louis Berger                                                                          Subir Grewal

2012 Q4 Letter

2012 Q4 Letter

By |

Dear Clients & Friends,

As the New Year begins, we’d like to wish you and your family a wonderful 2013.

2012 was quite an eventful year for the global economy. The Federal Reserve maintained exceptionally low rates, which prompted a number of reactions from investors and consumers alike. Home mortgage rates remained near historic lows, boosting the number of homes sold. That said, much of country still carries excess inventory and new home construction is a mere shadow of its 2006 peak. Household formation – the biggest driver of housing demand – remains low as unemployment in much of the country is still at recessionary levels.

The employment picture improved over 2012, with new unemployment claims down to 350,000 per week in December, a level consistent with moderate growth. However, a substantial number of workers remain unemployed or under-employed and many have been out of work for an extended period of time, making workforce reintegration more challenging. On a positive note, various factors are prompting resurgence in US manufacturing. Concerns about intellectual property theft, rising energy costs, the brittle nature of global supply chains, and higher labor costs in Asia have combined to force many industries to consider opening factories in the US. Employment expectations will have to be tempered as any new manufacturing facilities in the developed world shall be highly automated and employ far fewer workers than older facilities. In addition, workers will require higher level training as new factories will be more complex than past assembly lines.

Despite strong headwinds, most equity markets globally enjoyed double-digit returns in 2012.  The S&P 500 rose 13.4% on the year, and when dividends are factored in, the total return was 16%. Some foreign markets have done even better, despite relatively uneven news over the course of the year.

The US economy has seen 4 years of unbroken growth since Q1 2009. This makes the expansion comparatively long in the tooth since the average post-war expansion has lasted only 14 quarters. 2013 will pose a series of difficult questions for markets, many of them political in nature. The stalemate surrounding the 2001/2002 tax cuts has been resolved with rates staying level for all except the highest earners. However, a number of confrontations between Congress and the President over the debt ceiling, defense spending and troop withdrawals loom in the coming months. The US continues to run a deficit and by February, the Treasury will be unable to meet its monthly expenditure unless Congress raises the debt ceiling. The market is increasingly losing confidence in Congress’s ability to put aside ideology and act in the national interest. The wide ideological divide between very active right wing elements in the Republican party, and center-left elements in the Democratic party who believe not much was gained from compromise during the first Obama administration, guarantees the next couple of years will make for continuing political drama. To a large degree, this situation is an outcome of the US election in 2012. The election was expected to be a referendum on the Obama administration’s policies and a clear majority of voters opted to have the president continue to implement his policies.

Over in Europe, a similar dynamic is playing out. The political establishment is in stalemate while the broader European economy struggles towards a recovery. The French election this year has led to a Socialist far-left government of Francois Hollande possibly over-reaching by raising income tax rates to staggeringly high levels (over 75%) and inserting itself rather visibly into disputes with industry. Southern Europe continues to flounder, with Mario Morsi resigning as prime minister in Italy. Spain and Greece continue to be racked with widespread protests over austerity measures. Portugal and Ireland, meanwhile, seem to resigned to draconian austerity with characteristic acceptance of hardship. Perhaps most troubling of all is the suggestion amongst some circles that the United Kingdom may opt to withdraw from the political union while trying to maintain certain trading privileges. We do not expect any resolution to the European crisis till after the German elections in 2013.

In Asia, the Chinese economy continues to sputter, new car sales have dropped, along with energy demand and home prices in most cities. The politburo standing committee transition occurred in November after the US elections with an apparent loss for the Jiang Zemin faction that was closely associated with party elites. Meanwhile in India, it appears the Congress government faces a very difficult legislative session as the economy slows, inflation picks up and various necessary reforms are held up. The one bright spot in the East, surprisingly, is Japan. Japanese voters handed the LDP a resounding victory in the recent elections. The newly (re)elected government of Shinzo Abe seems to intend to use its super-majority to the fullest extent. It has been surprisingly assertive in demanding the Japanese Central Bank set an inflation target of 2%. The broader market has turned positive on Japan, perhaps relieved to finally see political will in action. We remain wary of investments in China, are more positive on India and relatively bullish on Japan.

In the final analysis, for much of the world, we return to the question of sovereign and household debt. This question is particularly acute for Japan, where total government debt is now over 200% of GDP. Meanwhile, in the US, consumers continue to pay down debt, deleveraging to a more sustainable level while the federal government will likely run deficits for another 2-3 years to compensate. We are now five years past the crisis of 2007, which was caused by a vast bubble in debt and spending. These cycles typically take seven years to resolve and we expect the current dynamic of restrained growth to continue for another two to three years, with significant risk of another recession in the near-term.

In terms of our 2013 investment outlook, we see a number of risks and opportunities. We believe bonds, particularly 20-30 year treasuries are ripe for a correction. Long-term bonds are priced for perfection and will face a severe sell-off when the market suspects the Fed is about to raise interest rates or end its QE program. This could present an opportunity for investors to increase medium-term bond holdings (3-5 years) and longer-dated bonds over time. We see value in international and emerging market equities and would look to add to positions over the course of the year. Portions of the US equity markets potentially look quite attractive if there is a significant correction (we believe a number of political and economic factors could trigger this). We think alternative energy and network-driven businesses would present a particularly interesting buying opportunity during a correction. These and other topics are explored in more detail in our Top Ten Themes for 2013.

Regards,

Louis Berger   Subir Grewal

2013: Top Ten Investment Themes

2013: Top Ten Investment Themes

By |

2013 Themes: Snakes and Ladders

 

  1. Europe lingers: The full-blown European crisis has been with us now for almost 4 years. It appears to morph into a different shape every few months. We believe political action and inaction in Europe will continue to drive global markets this year. Two important events will occur in 2013, a German election, and possibly a referendum in the UK on its relationship with Europe. In our view, the European Union will have to provide financial assistance to one or more peripheral countries in 2013, we believe this may be delayed till after the German elections to limit the impact on the Merkel government.
  2. Asia slowdown: The biggest Asian economy is showing some growing pains. 2013 may be the year when China backs away from a policy of growth at any cost and its institutions embrace a more holistic view of economic advance that includes environmental regulation and some liberalization of speech and rights. Though in the short term this might well lead to upheaval and a growth-shock, in the longer term, it will strengthen Chinese consumption. We believe China will underperform other emerging markets over the next year.
  3. Equities: Global Stocks are almost four years into an expansion that began in March 2009. On average, since the great depression, stocks have risen for just under four years before seeing a correction.  We have been skeptical of economic growth driven by monetary stimulus virtually since the beginning, and our view has not changed. We believe the prolonged monetary stimulus has built up imbalances in the system and as policy-makers remove the stimulus, there is a strong probability that stocks will be in for a very rough ride. Many companies have learned a lesson from the credit crisis and we believe stocks with strong balance sheets, robust business models and high-quality earnings will outperform.
  4. The myth of hyper-inflation: Certain observers have been trumpeting the risk of high inflation as a result of Fed easing. We do not believe this is a likely scenario. Whilst implementing staggering amounts of quantitative easing, the Federal Reserve has bought over two trillion dollars in Treasury and MBS debt over the past four years. This huge balance sheet gives the Fed an enormous arsenal to combat inflation. When it begins to sell its bond holdings, vast amounts will be taken out of the money supply, putting a damper on any inflation. This is why we find inflation protected bonds relatively unattractive.
  5. A rude awakening for bonds: The Fed has been providing price support for long-dated bonds with its large purchase program and low interest rates. When that price support stops and the market has to stand on its own, we expect bond prices to collapse and rates to rise. There is a chance the Fed halts its QE program and raises rates in 2013 if headline unemployment reaches 6.5%, which is within the realm of possibility given the current trends in jobless claims. As a result, we find long-dated bonds extremely risky and prefer floating rate, short-duration and international bonds.
  6. The Sun also rises in Japan: Japan has been mired in deflationary malaise for over 25 years. An entire generation of investors has lived through successive mirages of Japanese recovery. We have begun to believe that this time is different. The enormous growth in Japan’s Asian neighbors and its own robust legal institutions make it an attractive destination for investment, tourism and business partnership. Japanese businesses are taking advantage of these opportunities, and though China still possesses a cost advantage, the gap is closing as wages rise in China. We see Japan’s demographics stabilizing and a generational change underway in Japanese business creating an entrepreneurial surge. We believe this presents an attractive opportunity for equity investors.
  7. Gold: Our regular readers know that we are not enamored of gold. Fiat money has served the world relatively well and provides policy makers with some flexibility. Competing fiat currencies and the opportunity to invest in both real enterprises (via stocks) and geographic communities (via government bonds) provide the modern investors with a variety of options to store wealth. We continue to hold that the price of gold is elevated beyond fundamentals and not sustainable. We see demographic changes that are steadily eroding Asian demand for gold, removing this long ranged support. We expect gold prices to drop in 2013.
  8. The death of the PC has been greatly exaggerated: 2012 was the year when smartphones and tablets decisively pushed desktop computers from their perch as the primary electronic devices in most homes. Relatively low prices, accessible touch-screen interfaces, wireless internet access and rich functionality are making small devices the desirable option for more consumers. Despite being overshadowed by its cooler, touch-sensitive cousins, the traditional computer remains the one device capable of performing the whole range of computing functions. It will remain an essential business tool for years to come. We think it’s a little too early to call the death of the computer, and that certain PC-related stocks will outperform in 2013.
  9. Network everything: Though wide access to the Internet is well into its second decade, connected devices have yet to reach their ultimate potential. Over the course of the next decade, we expect to see more devices linked to the broader Internet for specialized and general function. This will include cars and household appliances, opening up new use cases and opportunities for businesses positioned to produce the right set of products and services. We believe the technology sector in general, and Internet infrastructure firms in particular, offer attractive growth potential over the next decade.
  10. Alternative Energy: Alternative energy businesses have suffered significant losses since 2009 due to a variety of reasons.  In the three years since, a couple of trends have converged to make their future look much brighter. Alternative energy at utility scale is approaching cost parity with conventional energy generation, and a nascent environmental movement is developing in the emerging world. These two trends are changing the equation for alternative energy and 2013 should see an increase in investment flows towards non-conventional sources of energy. We think prices are relatively depressed and the sector offers attractive value for long-term investors.
2012 Investment Themes Reviewed

2012 Investment Themes Reviewed

By |

2012 Themes: The More Things Change.

 

Since we’ve now closed the chapter on 2012, we’d like to review our “10 economic themes for 2012” from last January to see how well our ideas performed.

We’ve graded ourselves using these symbols: ? Right,  X Wrong, ? Not Exactly.

  1. ? Steady as she goes: We think it unlikely the Fed will raise rates in 2012, largely due to the presidential election… We were largely right here. The Fed held rates steady ahead of the presidential election. We will admit to being surprised at the robust extension of QE as we did not expect the Fed to make as controversial a decision only a few months ahead of an election.
  2. X Risk Off: We believe risk assets (stock, real-estate, long-dated and high-yield bonds) will have a difficult 2012. Stocks have benefited from a sharp rebound after the credit crisis and are now back to the higher end of the historical range. Bonds meanwhile, are trading at yields that are lower than any seen in two generations. During the course of 2012, we would expect both to correct towards the mean. This should provide some interesting buying opportunities, especially for dollar-based investors. We were flat out wrong here. Both stocks and bonds performed well in 2012. Stocks did well as vast amounts of monetary support helped lift demand from depressed levels. Bond prices were supported by the Fed’s steady purchases over the course of the year, and investors’ rediscovery of the appeals of fixed income.
  3. ? Break-Up or Make-Up, Brussels is good for both: 2012 should be the denouement for the European sovereign debt crisis… We believe a Greek default is extremely likely this year. Even if there is a pre-negotiated haircut with some lenders, the market will treat it with the seriousness that the first default by a “developed” economy in a generation should. In either case, Greek bondholders should be prepared for losses on the order of 60% of par value.  We are giving ourselves a half point here.  Greece did not default, even though private Greek bondholders will have to settle for 50 cents on the dollar.  However, by strong-arming creditors to accept the most draconian restructuring in recent history, Greece has managed to avoid the imprimatur of default. Greece continues to struggle and there is a another restructuring possible in 2013.
  4. ? Euro Trash: We expect the Euro to bear much of the burden of the European sovereign crisis, and the currency to weaken significantly against the dollar. When we discussed a Euro break-up last year, it seemed like an outlier scenario. We have been amazed at the speed with which events have moved and a potential Euro-exit for one or more peripheral economies is now being openly discussed. We were wrong here.  The Euro did indeed weaken by 10% over the summer, but by the end of the year it had made up the loss.
  5. ? Blue States/Red States: This is a two part theme. The presidential election cycle should be the major story in the US in 2012. In our view though, the more critical issue is the associated discussion about the US and individual state debt burdens. The charmed baby-boomer generation will have to decide how much of a cut in benefits is acceptable to ensure the burden of their entitlement programs in coming years does not doom the economic future of their children and grandchildren… Surprisingly the presidential election did not settle these issues. The topic remains hotly debated in Washington and the prime driver of US bond markets. Rating agencies continue to scrutinize every move in Congress with an eye towards the country’s AAA rating.
  6. ? Chinese Math: At the 18th Communist party congress, we expect power to be transferred to a new generation of Chinese political leaders. We have no doubt that the enormous state apparatus will be fully utilized to ensure economic stability during the transfer. However, we believe these efforts will ultimately be for naught. The structural shift required in China as it moves from an investment driven economy to a consumption driven one will make for a tumultuous year in Chinese markets. The stock market has been depressed for almost five years, and we expect Chinese real-estate is beginning to make the first moves in an unavoidable decline towards more reasonable levels. We give ourselves a qualified right on this one. There are signs that the Chinese economy is faltering, and real-estate prices have begun to fall.  But none of these has occurred to the extent we had anticipated.
  7. X Revolutionary Times: …We expect to see more political turmoil in Europe and the Middle East in 2012. This coupled with major elections and power-transfers in the US and China make for a very uncertain 2012 politically speaking. In our view, this will make for very jittery markets throughout the year. No doubt, 2012 was full of political upheaval and this was reflected in the markets with many sectors seeing large swings over the course of the year.
  8. ? Oil Slicks: The events in the middle-east will of course have an impact on energy prices. We expect political tensions to keep oil prices artificially inflated in 2012, but longer-term we think $100 oil is unsustainable as alternative energy sources approach cost-parity with conventional sources… Oil had a tough time rising despite extreme uncertainty in the Middle-East, it is still around $100. We give ourselves a draw on this one.
  9. ? Smart Homes: The past decade has seen the widespread adoption of computing and telecommunications technology touch virtually every aspect of human activity. We expect the markets to be enamored with a couple of very high-profile IPOs expected in 2012/2013 (Facebook and Twitter). We believe some of the higher profile IPOs of 2011 will perform poorly (GroupOn for instance)… We were largely right here, with some of the more questionable business models (like GroupOn) falling out of favor with investors. The most significant Internet IPO of the past five years (Facebook), was overpriced at issue and dropped significantly in the first few months.
  10. ? Housing: Still a buyer’s market: We expect the overall US housing market to remain stagnant in 2012 with pockets of strength, particularly in major urban areas (NYC, DC, San Francisco) and some suburban and rural areas that did not overbuild in the run-up to the credit crisis…  We were largely right here, the US housing market continues to languish at low levels of activity with prices not far from the lows in most markets.
Critical financial documents

Critical financial documents

By |

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!

By |

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

By |

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

By |

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

By |

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

By |

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 salesforce.com), 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.

By |

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.

An important notice

Washington Square Capital Management, LLC (“WSCM”) is an Investment Advisor registered with the Securities and Exchange Commission. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by WSCM in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption.

All written content on this site is for information purposes only. Opinions expressed herein are solely those of WSCM, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

Please review our ADV brochure and ADV part 3 for more information on our services, fees and conflicts.