Author: subir

Why Microsoft had to buy Skype, at virtually any price

Why Microsoft had to buy Skype, at virtually any price

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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

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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

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We held our first “webinar” earlier this month on the timely topic of municipal bonds. We have posted the narrated presentation at www.youtube.com/wsqcapital 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 blog.wsqcapital.com. 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.

 

Regards,

 

Louis Berger                                                                                        Subir Grewal

 

 

What the 1911 Triangle factory fire means for investors today

What the 1911 Triangle factory fire means for investors today

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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

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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.

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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.

Five things you didn’t know about IRAs.

Five things you didn’t know about IRAs.

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Image of Piggy Bank: www.flickr.com/photos/maedae/180440142/We’ve been fielding client questions about IRA contributions recently and thought a blog post would be in order.  Here are the top five things many people aren’t aware of when it comes to IRAs:

  1. Most people can make an IRA contribution for tax-year 2010 up till their tax-filing deadline (April 18 in most cases), and remember you need to file form IRS 8606 in many cases.
  2. You may be able to take a federal tax deduction for your traditional IRA contribution. Some people may even be eligible for a tax credit equal to their contribution.
  3. You can contribute to an IRA even if you are currently participating in a retirement plan at work (401k, 403b, etc.), but you may not be able to deduct the amount contributed.
  4. You may be able to make a contribution to your spouse’s IRA, even if your spouse does not have earned income for the year.
  5. The maximum amount you can contribute for 2010 to a traditional IRA is 5,000 for 2010 (6,000 if you’re over 50 years old).

For many people, Roth IRAs are attractive since distributions during retirement from Roth IRAs are not taxed. Distributions or withdrawals from traditional IRAs or retirement plans are subject to income tax in most instances.

In effect, you are saving more with a Roth IRA since you’re paying the taxes up-front. A $100 saved in a Roth IRA may mean lower income today than a $100 saved in a traditional IRA, but when it comes time to use the money, you will have more available since you pay no income taxes on regular withdrawals.

Here are five things people often don’t realize about Roth IRAs:

  • Income limits that govern who can contribute to a Roth IRA have risen slowly over the past few years, the 2010 limits are here.
  • Virtually anyone who has a traditional IRA can convert it to a Roth IRA (this started in 2010). The $100,000 income limit has been removed. You may have to pay taxes on part of the converted amount (typically contributions you claimed a deduction against and earnings).
  • Unlike traditional IRAs, there are no required minimum distribution rules for Roth RIAs, so you could leave your Roth IRA savings undisturbed after you turn 70 and a half.
  • Just like a traditional IRA, you could contribute to a Roth IRA for your spouse, but this is subject to income limits.
  • You may be eligible for a tax credit if you contribute to a Roth IRA, have income below certain thresholds and meet a couple of other criteria.

The IRS website on publication 590 provides the definitive overview on IRA plans (we’ve linked to many relevant sections of the document in the text above).

Of course, there are many other considerations when saving for retirement. We’re happy to answer questions you may have, just give us a call at 646-619-1157.

Datacenters, stock exchanges and jobs.

Datacenters, stock exchanges and jobs.

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We’ve been thinking about the potential for job creation in the current crew of technology companies, spurred along by some despondent Op-Eds. Felix Salmon wrote earlier this week:

Dorian Taylor sent me a thought-provoking email this morning which said that one of the reasons we’re seeing fewer companies tap the equity capital markets is that we’re in a phase where all of the buzz and excitement is in what he characterizes as “networked information services.”

“Relatively speaking,” writes Taylor, “these companies don’t really need a huge amount of capital at any given time because they aren’t buying stuff with it; they aren’t making or building or physically shipping anything.” (Yes, I know that datacenters are expensive, but this is broadly true).

The last line struck a chord. Back in 1997, I worked at a technology startup and it took an immense amount of effort and expense to reliably maintain networked machines for our high-traffic website. Times have changed a lot since. The typical new startup can now lease compute time and disk space on Amazon’s datacenters, which have significant excess capacity built to cope with demand during the holiday season. There are many competing service providers that offer a similar set of hosting services. On these platforms, individual virtual machines which include all the well-known open-source tools required to run or build a feature-rich website or app service can be deployed within minutes.

In most cases, you pay as you go for these services, and a simple website/app might end up paying a few dollars a month for enough capacity to serve thousands of users a day. Add a few Google ads and they might be cash flow positive on day one. Better still, you can scale up on-demand by adding more virtual machines. All of this has made building, deploying and expanding web-based services far simpler than it used to be. It’s a far cry from the dedicated hosting agreements and thousands of dollars a year it used to take to set up a website. As a friend remarked during a recent conversation, most web-based software/service startups now only require “sweat equity”. The point is that most startups, and many mid-sized firms, will not be building their own datacenters, nor should they. Only the largest of web-based services and sites with tens of millions of users need to maintain dedicated datacenters.

Felix Salmon kicked off this thread with a NYTimes op-ed titled Wall Street’s Dead End, which is worth a read simply because it’s so provocative. The op-ed was a comment on the NYSE-Duetsche Bourse merger. Felix thinks the stock market is largely irrelevant, partly because

the companies in which people most want to invest, technology stars like Facebook and Twitter, are managing to avoid the public markets entirely.

While we think the article is thought-provoking, it suffers from a number of blind spots. First, many major businesses through the years have been privately held for extended periods. Cargill, Mars and Ikea are just a few of the many examples where founding entrepreneurs have succeeded in retaining equity control over their companies for extended periods of time. Many investors would have been ecstatic to have the opportunity to be part-owners of these businesses, just as many are salivating at the prospect of investing in Twitter. Arguably, certain types of businesses simply shouldn’t be public, investment banks and commodity traders are the obvious examples.

Second,  many ordinary people do have exposure to private companies, generally through a pension fund that has a private equity or venture capital investment. Some ordinary folks are employees at the web darlings of today, and they have even more direct exposure to these companies.

Lastly, the IPO market is a poor measure of quality capital creation by the public capital markets. Ever since the South Sea Bubble, IPO crazes have signaled an unhealthy, manic capital markets. It is only during times of public mania that public market investors will gorge themselves on equity investments in unproven business models. In ordinary times, these companies have to raise capital from friends, family and astute private investors willing to finance ventures. There’s a good reason, for every Facebook, there is a Friendster, often a MySpace, and countless others that fail. In non-manic times, investor capital in the public equity and bond markets is rightfully allocated to companies with viable, sustainable business models. These companies are actively raising debt and equity capital today.

Which brings me to another NYTimes  op-ed, this one written by David Brooks titled The Experience Economy in which he writes:

As Cowen notes in his book, the automobile industry produced millions of jobs, but Facebook employs about 2,000, Twitter 300 and eBay about 17,000. It takes only 14,000 employees to make and sell iPods, but that device also eliminates jobs for those people who make and distribute CDs, potentially leading to net job losses.

In other words, as Cowen makes clear, many of this era’s technological breakthroughs produce enormous happiness gains, but surprisingly little additional economic activity.

The assertion Brooks’ is making will resonate with many, but is near-sighted. Technological progress has ever been about employing ideas to use resources more efficiently and open up possibilities. When the first farmer hitched up an ox to a plough he/she put more than a few people out of their regular jobs hoeing the fields. The successive rise of the steam, internal combustion and electric engines as the transport technologies of choice disrupted many, many existing businesses. Using fossil fuels, these new transport technologies spread and many buddy-whip makers, horse-handlers, stable-owners and carriage-drivers were undoubtedly put out of work. The specialized, advanced skills they had learned suddenly became less valuable. Yet few of us would clamor for a return to the days when city streets were over-run with horse manure, or when travel between New York and Philadelphia took a couple of days.

Just as the industrial revolution allowed us to make and move a far larger quantity of goods with less human effort, networks and computers are allowing us to move far greater and more varied bits of information around. Technological advances will always continue to disrupt many lives and livelihoods. For many these will be extremely painful experiences. Yet, in the end these advances will change the way we do things, and all of us will be led to them, as if by an invisible hand because the new ways are better, more convenient or more efficient.

Facebook’s existence and its 2,000 employees does not condemn the rest of us to lives of fruitless unemployment. Last week, a Search Engine Optimization company called me to ask whether we could use their services. This is a business that did not exist 15 years ago. What matters most is that Internet search is a lot better than trying to find a business or service in the yellow pages. The hoe has been replaced with the plough. And maybe, just maybe some of the folks who used to sell ad-space in the yellow pages will find work at SEO firms.

Webinar Invitation: Tax-free municipal bonds

Webinar Invitation: Tax-free municipal bonds

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Tax Free Municipal Bonds: Are They The Right Investment For You?

The past few months have been very eventful for the municipal bond market: the Bush era tax cuts have been extended, municipal governments are proposing massive budgets cuts, protests have broken out in states like Wisconsin and certain commentators have predicted widespread default. This uncertainty has provided an opportunity for those investors who know what to look for. In this webinar, we will provide an overview of municipal bonds, address many of the recent news events that have roiled these markets and share our approach to finding opportunities in this space.

This web-based presentation will run from 12:30-1:00 pm on Tuesday March 1st. It will include a 20 minute talk and 10 minutes for Q&A.

Please RSVP if you plan to attend as space is limited.

Presented by: Washington Square Capital Management

Speaker: Subir Grewal, CFA: Co-Founder and Principal

Date: Tuesday, March 1, 2011

Time: 12:30 pm, Eastern Standard Time (New York, GMT-05:00)

Discussion Topics:

  • Municipal bond market overview
  • The ramifications of recent legislative events
  • Our selection process and where we see opportunity

To register, please click here.

MA supreme court ruling on foreclosure only “apocalypse” for those who had a rosy outlook for residential real-estate.

MA supreme court ruling on foreclosure only “apocalypse” for those who had a rosy outlook for residential real-estate.

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Foreclosure signThe Massachusetts (MA) Supreme court upheld a ruling invalidating two foreclosures that were executed incorrectly.  The judgement is quite clear cut, and says banks need to ensure they are following the letter of the law when transferring, selling or assigning mortgage notes amongst themselves if they hope to have the court’s protection when they go to foreclose.  Nothing unusual here, and it is clear that documentation practices at many banking institutions and securitization firms were at best sloppy, and at worst fraudulent, heading into the real-estate crisis.  The plaintiffs (Wells Fargo and US Bank, attempting to foreclose on two delinquent mortgaged properties) argued that invalidating foreclosures where the borrower was clearly delinquent or had defaulted would create “widespread confusion” and impose “significant costs to innocent parties” (i.e. themselves).

We thought that what the MA attorney general had to say was interesting on this score:

Plaintiffs’ claims that the Land Court’s ruling will cause widespread confusion or significant cost to innocent parties are greatly exaggerated, and such reasoning does not warrant ignoring the plain requirements of the law designed to protect Massachusetts consumers.  Indeed, it is the foreclosing entities themselves who will bear the greatest cost of clearing title from their invalid foreclosures.  Having profited greatly from practices regarding the assignment and securitization of mortgages not grounded in the law, it is reasonable for them to bear the cost of failing to ensure that such practices conformed to Massachusetts law. (emphasis ours)

and further on:

Distressed homeowners often face challenges in the foreclosure process.  In certain cases, they may lack the technical knowledge and the financial resources to contest a wrongful foreclosure or otherwise ensure that the lender adheres to the obligation to serve the interests of the mortgagor in good faith.  Thus, plaintiffs’ implication that the borrowers have waived their right to challenge the legitimacy of the sale because they had “ample opportunity to challenge the foreclosure proceedings prior to the sales but failed to do so” is particularly troubling when the plaintiffs themselves have failed to comply with the statutory requirements to foreclose.

and further:

Thus, the plaintiffs profited from the risks they took, at the expense of each of the borrowers. Having reaped the benefits of their casual attitude toward ensuring they possessed valid assignments of the mortgages, it is not unjust that plaintiffs should now bear the costs of their errors.

The MA supreme court found that the plaintiffs who had foreclosed on the properties in question did not have valid assignments that gave them an interest in the mortgage at the time of foreclosure.  The documents they did have were either in incorrect form, or had been executed after the foreclosures. They also found that MA’s foreclosure notice requirement was not met because the mortgage holder was incorrectly identified in the notice (because the mortgages were never correctly assigned to the banks attempting to foreclose). In our view, there was really no other conceivable outcome for this case given the messy mortgage documentation.

Contrary to Felix Salmon’s view on the matter, we do not believe the court ruling is a housing-market catastrophe.  We do agree that it raises many questions about title to homes that may have been foreclosed on incorrectly (Judge Cordy in a concurring opinion made much the same note), and that many, many parties to real-estate transactions over the past few years may need to go back and confirm both their title-insurance and the documentation chain for mortgage assignment and transfer.  We also agree that banks who securitized mortgages will find that investors now have cause to question some of the representations made in the securities concerning transfer of mortgage documents.  However, the key fact preventing wholesale catastrophe in our our mind, is the court’s view on prospective remedies to any flaw in documentation.

In essence, the MA supreme court found that a party attempting to foreclose in Massachusetts had a strict responsibility to ensure their documentation was in order and that they had followed the letter of the law.  The court felt this was especially important since foreclosures in MA do not require judicial supervision, except for a couple of steps.  That said, the court writes concerning mortgage assignments:

We do not suggest that an assignment must be in recordable form at the time of the notice of sale or the subsequent foreclosure sale, although recording is likely the better practice. Where a pool of mortgages is assigned to a securitized trust, the executed agreement that assigns the pool of mortgages, with a schedule of the pooled mortgage loans that clearly and specifically identifies the mortgage at issue as among those assigned, may suffice to establish the trustee as the mortgage holder.  However, there must be proof that the assignment was made by a party that itself held the mortgage.

In one of the foreclosures, the bank failed to produce the schedule of loans and mortgages that comprised the trust.  In the other case, the bank provided a schedule, but that did not identify the mortgage with adequate specificity.  The court has, in our view, been very reasonable as to how this situation may be remedied:

A foreclosing entity may provide a complete chain of assignments linking it to the record holder of the mortgage, or a single assignment from the record holder of the mortgage.

and also:

where an assignment is confirmatory of an earlier, valid assignment made prior to the publication of notice and execution of the (foreclosure) sale, that confirmatory assignment may be executed and recorded after the foreclosure, and doing so will mot make the title defective.  A valid assignment of a mortgage gives the holder of that mortgage the statutory power to sell after a default regardless whether the assignment has been recorded.  Where the earlier assignment is not in recordable form or bears some defect, a written assignment executed after foreclosure that confirms the earlier assignment may be properly recorded.  A confirmatory assignment, however, cannot confirm an assignment that was not validly made earlier or backdate an assignment being made for the first time.

Creating new assignments with fresh dates, or  confirming a prior assignment so they are in correct form will be time-consuming, tedious and expensive.  As will restarting foreclosure proceedings once all documents required by state law are in correct form.  Ensuring staff who do this are competent and aware of the issues at stake will also be key, however, the problem is not insurmountable, nor is it prohibitively expensive. No doubt there will be cases where documents are in such poor shape that they cannot be remedied by banks or servicers alone.  But that is exactly the sort of situation the land transfer process is supposed to help fix.  In the two foreclosure cases covered by this ruling, the original mortgage was correctly executed and recorded, and the trustees may get an assignment from the holder of record (Option One, who was one of many mortgage originators supplying mortgages to banks for securitization).  No doubt there will be cases where the mortgage originators no longer exist, but with sufficient time and effort, successor entities can be identified.

The court’s ruling suggests it has no patience with mortgage-holders whose own sloppy practices got them into this mess:

The legal principles and requirements we set forth are well established in our case law and statutes.  All that has changed is the plaintiffs’ apparent failure to abide by those principles and requirements in the rush to sell mortgage-backed securities.

However, as we outlined above, it has left a route out for banks to cure problems with mortgage documentation, but is plainly unwilling to allow foreclosure proceedings when the process for real-property transfer has not been followed correctly.  We believe this is an important and correct ruling.  It clears the air for both consumers and mortgage-holders and should encourage banks to rectify errors in mortgage documentation.  We believe the banks and mortgage servicers will incur additional costs in rectifying these errors (of their own making), and that this will slow down the foreclosure process.

We do not believe this is an “apocalypse” scenario.  Rather, we believe the housing market will remain distressed for many years to come as these issues are sorted out and broader macroeconomic factors such as high unemployment fade.  For those who had been expecting a relatively quick rebound in housing, construction and real-estate price levels, this may well constitute an apocalypse.

10 themes for ’10 reviewed

10 themes for ’10 reviewed

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10 Economic Themes for 2010: Year-End Review

Since we’ve now closed the chapter on 2010, we’d like to review our “10 economic themes for 2010”  from last January, to see how well our ideas performed.

We’ve graded ourselves using these symbols:  Y Right  N Wrong  ? Not Exactly.

  1. ? We expect to see the US unemployment rate to peak at 11% in 2010: We were a bit aggressive with the numerical portion of this theme. While the US job market remains anemic, the headline unemployment rate stayed within the 9.5% to 9.9% range, ending the year at 9.8%[1]. Over 15.1 million American workers were unemployed and actively seeking work at the end of 2010, this is a larger number than at any time since WW-II (except for late 2009 when there were 15.6 million). Private sector job-creation continues to be very slow, and the broader measure of underemployment, U-6 has stayed between 16.5% and 17.1% all year, ending the year at 17.0%. U-6 counts those working part-time involuntarily and workers discouraged from looking for a job.
  2. Y Investors will continue to re-allocate towards less volatile investment classes, like bonds in 2010: This scenario played out almost entirely as we had outlined.  ICI[2] reports that investors withdrew a net $29.6 billion from stock mutual funds through Nov 2010.  Meanwhile, taxable and municipal bond funds saw net inflows of $266.4 billion.
  3. Y We expect a number of credit downgrades for developed nations as their persistent deficits come into focus.  The US Dollar will strengthen in any ensuing flight to safety: We were almost entirely right on this one. Throughout the year, we saw major credit downgrades affecting Greece, Portugal and Spain, as well as the creation of an unprecedented EU bailout plan for peripheral economies.  The US dollar started 2010 valued at 1.4323 per Euro, but strengthened as the situation in Europe deteriorated.  It reached a level of 1.1875 per Euro on June 6th and ended the year at 1.3373.
  4. N Interest rates will remain effectively at 0% until the 4th quarter of 2010, where we will expect to see the Fed raise rates to the 1-2% range: We were wrong on this one.  The Fed has continued to keep the fed funds rate at historically low levels and employed every form of monetary stimulus available to it.  We underestimated the dovish tone of the current Fed, and the Chairman’s commitment to maintain easy monetary policy while unemployment remains high.
  5. Y Continuing the trend from 2009, paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order: This was a major theme for consumers in 2010.  For Q2 2010, the personal savings rate was 10.5%, and it is likely that the full year personal savings rate will be above 5%, which is far higher than the 2006 full year rate of 0%.  Consumers continued to pay down credit card debt, the most recent data from the Fed[3] (for Oct 2008) shows revolving debt at $800 billion, which is down from $866 billion at the start of 2010 and $958 billion at the start of 2009.
  6. N The US economy will see almost negligible growth for 2010: We will not have final estimates on 2010 GDP growth till the end of 2011, but it is likely that GDP grew between 2.5% and 3.0% (as compared to 0.0% and -2.6% in 2008 and 2009).  The caveat, of course, is that this has been accomplished with record government stimulus.
  7. Y Corporations will increasingly turn to mergers and acquisitions to grow market share: We’ll take half a victory lap on this one.  The New York Times[4] estimates global M&A activity grew 23.1% (to USD 2.4 trillion) by value over 2010, though we are still nowhere near the $4 trillion level achieved in 2006 and 2007.  This is partly due to lower stock market values and corporate treasurers who, after being shell-shocked by the turmoil in the commercial paper market in 2008-09, are now hoarding cash.
  8. Y Growth in emerging markets will continue to outpace developed economies.  But this will not be enough to offset the stagnation in developed economies or lead to a robust global recovery: This trend appears to have held up well.  Though we have our doubts about certain large economies (see below), emerging market economies and financial markets performed well in 2010.  The MSCI emerging markets index[5] ended the year up 16.36% in dollar terms, while the S&P 500 ended the year up 12.78% (neither number includes dividends).
  9. ? We believe there is continued risk for a massive correction in China: While we have not yet seen a “massive” correction in China, the Shanghai composite index ended the year down 10.61% (one of the few major market indices down in 2010).  Residential real-estate prices have moderated in many markets and concerns about overbuilding continue to exist.
  10. N In 2010, certain commodities are poised for a sharp sell-off.  Top of our lists for a correction are gold and oil: We were flat out wrong on this one.  ICE’s Brent index rose from 77.85 to 93.49 over the course of 2010 and gold was up from 1096 to 1421 over the course of the year.

So the final tally is 5 themes right, wrong on 3, and not exactly on 2.

[1] http://data.bls.gov/cgi-bin/surveymost?ce

[2] The Investment Company Institute, http://ici.org/research/stats/trends/trends_11_10

[3] http://www.federalreserve.gov/releases/z1/Current/

[4] http://dealbook.nytimes.com/2011/01/03/confident-deal-makers-pulled-out-checkbooks-in-2010/

[5] http://www.mscibarra.com/products/indices/global_equity_indices/gimi/stdindex/performance_em.html

2011 Themes: These Go To Eleven

2011 Themes: These Go To Eleven

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2011 Themes: These Go To Eleven

  1. Raise ’em sort of high: We expect the Fed to raise short-term interest rates towards the end of the year, in response to slow but steady growth and a more hawkish group of voting members.  We expect rates to end the year in the 1% to 2% range. We think it is likely that the Fed raises rates to the 2% range this year because moves during the 2012 presidential election year would be politically toxic.  A rise in the short-term rate will result in a flatter yield curve (compared to the extremely steep levels today) and reduce bank earnings.
  2. Risk Off: We believe stock prices are quite a bit higher than underlying fundamentals support, at a trailing P/E of around 18.25[1], prices are at the upper end of historical range.  Governments across the world have provided immense demand support and a low rate environment over the past couple of years.  We also believe investor wariness and demographic changes (a large cohort of new retirees who will begin drawing down on savings) suggest much support for asset prices is weakening. We believe investors will continue to focus on fixed income investments, and rightfully should.
  3. United States of Europe: We expect the deterioration of sovereign credits in peripheral Europe to continue as these governments struggle with difficult but necessary financial decisions. We expect continued friction between fast-growing Northern European economies and Southern Europe.  This will doubtless further strain the Euro and all European establishments.  We believe the stresses created by the currency union existing outside of a strong federal structure will be resolved with a more federal Europe.  The alternate solution where certain states opt to leave the currency union is less likely, but not outside the realm of possibility.  In general, we believe European sovereigns will begin to be treated more like US states (which do not have the power to issue currency either) by the markets. Over time, we expect a move towards additional bond issuance at the European Union level, with each state having access to a certain amount of borrowing against the EU federal credit in exchange for heightened oversight and restrictions.
  4. Moody & Poor: We expect the US municipal bond market and state finances to continue as a topic of discussion.  We expect certain weaker revenue and real-estate project linked bonds to default, we also expect acrimonious budget debates on benefits for public sector employees and pensions in many states.  We think large scale defaults by major issuers (state GOs, water/sewer) are very unlikely, but investors will continue to discriminate between strong and weak credits and heavily discount informal support expectations and bond insurance.
  5. Running on Empty: The Chinese stock market did not fare well in 2010, and we expect the Chinese economy will experience lower growth in 2011.  Overbuilding and overinvestment in physical infrastructure during the past few years has left a glut of underutilized buildings and this could lead to a sharp downturn in Chinese property prices and construction activity.  Any such downturn would also impact Chinese banks, and potentially have a wider impact in the region, affecting commodity-driven economies like Australia and Canada.
  6. Consuming Confidence: We expect consumer de-leveraging to continue in the US as consumers pay down debt till it approaches historical averages.  This will make for a more difficult general retail environment and generally depress big-ticket discretionary spending.  The real-estate bubble has altered an entire generation’s perspective on housing, and we expect households and financial institutions both to be skeptical of high mortgage indebtedness and expectations of large capital gains in residential real-estate.  We expect similar deleveraging to occur in commodity-boom fueled economies like Australia and Canada. We do not believe US residential housing prices will rise in 2011, and may indeed fall further.
  7. Help Wanted?: We expect unemployment in the US to remain high, slowly falling below 9% towards the end of the year.  We also expect broader measures of unemployment and underemployment (the BLS’s U6) to stay above 15%.
  8. Arrested Development: Though it is notoriously capricious to forecast, we expect GDP growth in most emerging markets will continue at high single-digit rates, while slowing in the US and Europe to a sub-trend 2% rate till household and government deleveraging has run its course.
  9. Double Helix: We expect health-care technology related to genetic sequencing to increasingly take center stage in preventive and curative care as sequencers become cheaper and consumer testing becomes more prevalent.
  10. Feast and Famine: We expect 2011 to be a very volatile year for commodity prices.  We believe the environment is ripe for a sharp price correction in some commodities, gold and oil for example, and perhaps certain base metals as well.  Such a correction would be far more likely if China has a hard landing from the withdrawal of extreme stimulative fiscal policy and over-building over the past few years. We expect food prices to become a focus of attention in many parts of the developing world (as they were in 2008), and that governments will be forced to respond in whatever manner they can.  In the developed world we expect a resurgence of interest in agricultural and timber land investment.
  11. Death and Taxes, It’s all Politics: In the run-up to the US presidential election in 2012, we expect the political discussion to focus on debt and tax reform.  Corporate and higher-income tax-payer earnings will be the center of discussion and there is an off chance that the byzantine US tax code is simplified. In particular, trial balloons have been floated to withdraw the deductibility of mortgage interest, and tax life insurance benefits and municipal bond interest income.  Similarly, we have seen increasing discussion of doing away with the estate tax and replacing it with an income tax on proceeds received by heirs. Each of these deductions is supported by sizable vested interests and we think it is unlikely that they would all be swept aside and the tax code completely over-hauled.  Nevertheless, the possibility exists with a president and congress who are both eager to demonstrate their independence and fiscal sobriety to an irate electorate.
[1] http://www.econ.yale.edu/~shiller/data.htm

2010 Q4 letter

2010 Q4 letter

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Dear Client,

We hope you enjoyed a restful holiday season and have had a good start to the New Year.

We’ve attached two documents to this quarterly letter, one reviewing our economic themes for 2010, and another outlining our themes for 2011.

In the fourth quarter of 2010, risky assets (stocks, commodities) recovered sharply from mid-year lows, while safe-haven treasuries sold off dramatically in the last few weeks (the 10 Yr yield went from 2.81% to 3.30% in December).  The Federal Reserve continued to keep short-term interest rates at 0.00-0.25% and began a second round of extraordinary monetary easing (QE2). Unemployment continued to remain high and over 15 million Americans (9.7% of the labor force) were unemployed over the holiday season.  The mid-term election cycle was an expression of the electorate’s frustration with the lackluster recovery and increasing concerns about the national debt burden.

Our view remains that high levels of unemployment, household debt-reduction and relatively tight credit standards will continue to dampen growth in 2011. We believe stock market prices are higher than sustainable levels, and down-side risk has increased materially.  We continue to recommend holding substantial cash allocations while waiting for more attractive values to deploy cash.

We look forward to speaking with you during our quarterly review and wish you the best over the coming year.

Regards,

Subir Grewal                                                                           Louis Berger

2010 Q3 letter: Bonds and Bubbles, Breaking BRICs

2010 Q3 letter: Bonds and Bubbles, Breaking BRICs

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Bonds and Bubbles

Over the course of the summer, various market commentators have put forth the idea that we are in the midst of a “bond bubble”.  Since we advise substantial allocations to bond or fixed income investments, we thought it would be worthwhile to weigh in on this theory.  Since we are fully aware that bonds, like every investment, carry risk and have the potential to lose money for the investor, we think it’s important to review those risks and explain why we believe that in the current environment bonds continue to be a preferred investment option over stocks and other higher risk securities.

We believe talk of a “bond bubble” is over-stated because their limited return potential (maximum return is repayment of principal and interest) tempers speculative excess (unlike stocks, which are far more sensitive to cycles of euphoria and despair).  In general, we view bonds as less risky than stocks because bond-issuers have a contractual obligation to repay bond-holders, whereas holders of common stock are entitled to residual earnings.  Bond holders are creditors and thus rank higher in the capital structure than stockholders; this makes recoupment of bondholders’ principal more likely in the event of a bankruptcy or default.

Bonds drop in price due to three main factors, rising interest rates, credit or default risk, and inflation worries.  All these risks stem from the fact that a bondholder is essentially making a loan to an issuer who agrees to repay a fixed amount of principal, along with some interest.

In our view, the Federal Reserve cannot keep the fed funds rate at the extraordinarily low level of 0-0.25% for much longer.  Fed officials see the dangers in maintaining extremely low rates since we have just lived through a large scale credit crisis fueled in part by central-banks suppressing rates for far too long.  We expect spirited discussion after the mid-term elections on raising rates, and expect the Fed to raise short-term rates to 1.5-2% followed by a pause.  We believe interest rate risks for holders of medium and long-term bonds are substantial at this juncture.  That said, interest rate moves are typically measured and somewhat telegraphed by the Fed, and we expect any raise to be executed incrementally.

Bond prices also drop when investors are worried about default risk.  This has typically been a concern for investors in corporate or local government debt.  However, sovereign issues are not immune to default concerns, as demonstrated vividly by the collapse in Greek, Irish and Portuguese bonds this year.  This default risk exists for all issuers who do not control the repayment currency.  In the Euro-zone, monetary policy is controlled by the European Central Bank, not individual country’s governments or their central banks.  In this respect, individual Euro-zone countries are closer to individual US states than the United Kingdom, USA or Switzerland which control their own currencies.

US investors have begun to focus on default risk for municipal bonds after a rash of high profile defaults or near-defaults (Harrisburg PA, Vallejo CA, and Jefferson County AL).  Historically, municipal bond defaults have been lower and recovered amounts after default higher than those for corporate bonds.  However, numerous US states and localities are extremely stressed by the real-estate crisis and recession so historic comparisons may be unreliable.  Weak economic conditions, coupled with longer-range questions about pension obligations and eroding tax bases in certain regions have negatively impacted most US state and local finances.  We recognize these risks, but are reasonably confident that the political process in most states will tackle fiscal issues responsibly and issuers will honor pledges made to bondholders.  We do expect fundamental pension reform by states to control costs, and state workers will see retirement ages extended and rely on 401k-style retirement plans rather than defined pensions.  Both corporate and municipal bond markets have weak issuers and our role as investment advisors is to identify and avoid them.  Just as we analyze companies and industry conditions, when we invest in municipal bonds, we review regional economics, taxing ability, project viability and overall financials to gauge credit risk independent of ratings.  In 2009, we recommended purchases of corporate and municipal bonds as concerns about repayment were elevated and bonds were available at very attractive levels.  Over the past year and a half, these concerns have receded and prices for corporate and municipal bonds have risen to the point where we have considered taking gains by selling positions.

This brings us to the last risk to bonds: inflation. Inflation is the most difficult risk to manage because it’s unpredictably influenced by an array of macro-economic factors (commodity prices, money supply, interest rates, factory/labor under-utilization etc).  Its impact on the bond market is profound since it destroys confidence by undermining the real-value of future principal and interest payments.  Bond investors are justifiably fearful of inflation.

We recognize the risks in bonds, and our goal as investment advisors is to make intelligent decisions while balancing risks and potential rewards.  We know of no investment that carries zero risk.  The risk of any particular investment performing poorly rises if we pay too high a price to acquire it.  Even sound securities can be bad investments if we pay too much for them.  This is part of the reason we consider ourselves value investors – we like knowing what things are worth before we buy them, we like to buy when levels are cheap, and we generally intend to hold investments for the long term (for individual bonds, this usually means to maturity).  This applies equally to bonds and stocks, and it is undeniable that many bonds are currently above the price a prudent investor would pay.  As a result, we are looking for opportunities to sell bonds where we believe price appreciation has changed the risk-reward scenario.

If we do sell these bonds, we have to consider re-investment options.  We have discussed the possibility of purchasing stocks of high-quality, financially strong companies with cash on hand if the opportunity arises.  Since we will continue to hold some bonds for all clients, we have sought to limit interest rate and credit (repayment) risks by shifting investments towards financially stronger issuers and limiting bond maturities (i.e. focusing on shorter-term bonds or bond funds).  We believe inflation risk for US based investors are low, yet we have opted to limit inflation risk by keeping maturities short.  We are presently not recommending investments in long-dated bonds (over 7 year maturities).

Risk On, Risk Off

Over the past few months, we have seen an increase in the degree to which different markets move up and down together.  As various writers have noted, correlations between different stock markets have increased.  Surprisingly, this has been happening with equity market volumes at very low levels in developed countries.  Indiscriminate buying or selling can create opportunities for value investors and we are willing to take risk when rewarded well for it.  We are actively on the lookout for such opportunities.

Political Update

It’s a mid-term election year in the US and we have begun to see a lot of posturing and maneuvering by the political establishment to prepare for the November 2nd election.  The big story for this election will continue to be the state of the economy and persistent high unemployment levels.  The national mood is anti-incumbent, anti-Washington and we expect Democrats will lose House and Senate seats in this election cycle.

It is difficult for politicians to support free trade when unemployment is high, and these are certainly trying times for many workers in the US and Europe.  Every developed country would like to export its way out of this recession, but the entire world cannot do this at the same time.  High unemployment, low growth, large budget deficits and an impatient electorate can lead to irresistible pressures to enact protectionist policies in a short-sighted attempt to “keep jobs and industry at home”.  Rising trade barriers slows growth since it disrupts the global supply chains that virtually every industry relies on.  Only sustainable, balanced growth in both demand and supply can cure what ails developed economies, and we would be better served if elected representatives focused on encouraging sustainable global growth rather than protectionism.

Breaking BRICs

One of the great challenges confronting the world is how the rapidly developing economies of Brazil, China, Russia and India will be integrated into the broader global economy.  Thus far, they have been very successful as production centers of exportable goods and services.  However, as consuming and investing economies, their collective record is far more checkered.  China is a particular concern since many industries remain firmly under state control and consumption is a very small portion of GDP.  Capital and currency controls remain very rigid in China and most of the recent international tension has surrounded the floating peg maintained by Chinese authorities between the CNY and USD.  There are other fundamental institutional issues which affect China’s economic links to the world.  The Chinese legal system for one remains unpredictable and tightly under the administration’s control.  We have seen a number of instances where prosecution and arrest have been used to compel certain outcomes and actions from foreign businesses.  The recent wave of worker-led strikes and suicides at factories in China also betrays the fact that state-sponsored trade unions have not been representing workers’ interests.  Severe political repression of both workers and citizens leaves us concerned that discontent could quickly boil over into civil unrest provoking an unwelcome response from authoritarian regimes in both Russia and China.

In previous letters, we’ve written about the many imbalances and distortions we see in the Chinese economy.  We believe these concerns remain valid and we have begun to think about them and about the BRIC economies as a whole, in a slightly different way.  We now see a distinction between Brazil and India on one hand, and China and Russia on the other.  China and Russia remain heavily state-controlled, resource-intensive economies with repressive political environments, weak domestic consumption and a poor demographic outlook.  We believe future high growth in these two economies is not based on sustainable foundations.  In contrast, while growth in Brazil and India has been slower than in China and Russia, we believe it is more sustainable.  Political institutions in both countries are relatively democratic, state control of industry is limited and their legal systems, though notoriously slow and complex are not blatantly unfair.  Both Brazil and India have young populations with large numbers entering the workforce and this “demographic dividend” should lead to impressive growth over the next two decades.  This is not to say that Brazil and India do not face challenges; poor basic education and high inequality for instance are two issues that demand attention.  Still, it seems to us that these two countries are on a far more sustainable path than either China or Russia.  We will be taking a closer look at investments in India and Brazil, while our macro-view on China and Russia is more downbeat.  As always, we do not anticipate investing unless prices are attractive.

The Social Network

On the social media front, we wanted to let you know that you can now follow us through the following platforms online:

  • blog.wsqcapital.com – our blog.
  • facebook.com/wsqcapital – our page on Facebook
  • twitter.com/wsqcapital – our Twitter feed

We look forward to speaking with you during our quarterly review.

An important notice

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