The Jaded Consumer hopes to outline a few salient health care finance issues in a series of issue-focused posts. There may be many solutions to some issues, and the Jaded Consumer does not pretend to offer ideal solutions. However, a policy piece finding fault with the status quo should offer proposed interventions, or it is a mere gripe session. Other nations, with different national predilections, would doubtless steer a different course likely to be recommended here. However, The Jaded Consumer intends offering practical solutions that might be accepted in the United States.
This first article addresses risk segmentation as a barrier to affordable universal coverage. Universal coverage is not addressed as a right, though there are states in which legislatures sought to make it a right before encountering federal barriers to achieving the goals of their constituents. Universal coverage for health risks is addressed here as a national aspiration.
The barrier raised by risk segmentation is escalating marginal cost. The idea is something like this:
0) The risk of health care expenses is distributed unequally across the population
(This point is a huge deal and is numbered zero as a sort of emphasis.)
1) Most easy-to-cover people get covered easily through private funding. (This is in part a result of the tax-advantaged status of employee benefit plan contributions under statutes designed to enshrine compensation practices dating from the time of World War II wage freezes, when non-cash benefits seemed to employers a plausible way to compete for scarce labor. Today, anyone sufficiently healthy and socially stable enough to hold down a permanent full-time job is advantaged in accessing externally subsidized health care. The subsidy isn't, as often thought, the subsidy of employers -- they will never pay more than they can afford for labor -- but the subsidy of the federal government, which has chosen to push people into employee benefit plans by electing to tax this form of compensation at zero percent.)
2) People who argue most forcefully that they need coverage, and those whom advocacy groups most urge should be covered, are drawn overwhelmingly from a subset of the population far from the left tail of the health care expense curve; these people are, on the whole, less likely to be cheap risks to cover. (Think about impoverished, permanently disabled Medicaid enrollees and the elderly, who are already in high-cost federally-supported safety net systems precisely because the risks posed by these persons has led to government intervention.)
3) Uncovered and safety-net populations experience increasing concentrations of high-risk individuals. This one takes a little explanation, and is critical to the problem of incremental establishment of universal coverage. The cherry-picking of "good" risks by for-profit coverage schemes (like mandatory coverage participation at some level for young full-time employees who've never been ill a day in their working lives) cause the population of already-covered people to have a lower cost of coverage than the groups described by (2) above, making the "high expense" of covering those easy-to-cover people seem to be chump change by comparison to the cost to cover the concentrated risks in the remaining population. As the cost of coverage increases, the benefit of the tax breaks in (1) will push more people into available private schemes because of the amplified after-tax cost advantage, despite legal uncertainty regarding enforceability of rights under employee benefit plans (compared to non-employment-related insurance coverage).
How Insurance Works
You don't hope to crash your car.
However, for only a few hundred bucks, you can get months of protection (by a licensed insurer, regulated by the state for its solvency in the face of its insurance obligations) against the risk that you cause a wreck that crumples someone else's fender -- protection that includes sending someone to inspect the claimed damage, haggling on the phone or by mail with the other driver about the cost of his repairs, and even defending you against his law suit -- hiring lawyers, conducting depositions, running a trial -- if he doesn't like what your insurance company is telling him about the value of his rusting jalopy.
All things considered, this coverage is a deal.
As it happens, you don't have a choice about this coverage; every state in the Union has a vehicular financial responsibility law, and when last I checked forty-eight of them specifically required insurance as the way this financial responsibility must be demonstrated. In order to evade this coverage, there are people who work all kinds of scams -- paying one month on a six-month policy and then ceasing payment, printing false insurance cards, you name it -- but if you want to renew your driver's license and keep your car registered so you're not pulled over and ticketed every week, you either have the coverage or you work very hard to evade the requirement. The reason this coverage is so cheap is part of the secret of how insurance works, and why it works so well when the covered population is (almost) the whole population at risk. Only scam artists escape the pool; all the responsible people like yourself are in the covered pool, and are sharing the cost of the risk. The legal minimum insurance is cheap not because law suits aren't costly and not because people don't get into wrecks in this country and because there aren't tens of thousands killed every year on U.S. roads and many more injured -- the insurance is cheap instead because the burden of all this cost is allocated across an enormous pool of covered risks. (Okay; it's also cheap because the legal minimum caps out at a cost well below the cost of a human life. Most fender-benders aren't million-dollar claims. The outlier risks are left where they started, in the hands of individual motorists, because the many state legislatures creating the mandatory coverage laws have reached a compromise between the premium-paying public and the premium-hungry insurers, and have drawn a line where the mandate ceases, and private choice to obtain more coverage steps in. Tweaking local coverage requirements isn't rare.) In short, since the whole population contributes to mandatory coverage, the per-member burden is comparatively modest.
The coverage you elect, the one that protects you against the risk of someone totaling your car and fleeing into the night, is more expensive. It's above the point the mandatory coverage, above the point risks are spread population-wide, that risks are concentrated among a subset of willing buyers -- and this is the point at which it starts to become expensive. If you don't owe a bank money secured by a car (banks require more-than-minimum insurance to protect their loans' collateral), and you aren't frightened by these risks (fearful people often overinsure, to the delight of insurers), then you need not pay for them. You can opt out of the extra coverage.
Adverse Selection and The Problem Of Personal Choice
Insurers like to talk about moral hazard -- the tendency of the insured to conduct themselves so as to experience losses at a greater rate or severity than the non-insured -- and they like to allege that the world is full of insurance fraud. The world is as equally full of insurers trying to shirk their contract obligations in the face of loss. It's probably a wash, each side diligently working to cheat the other.
The real reason insurers hate the individual coverage market is adverse selection.
Adverse selection is the reason that when insurers price a lifetime annuity (a bet the covered life will last forever) and life insurance (a bet the covered life will end tomorrow), they don't use the same mortality tables. When you shop for an annuity, insurers use a mortality table that assumes you are healthy and going to live an awfully long time. When you shop for life insurance, they use a table that assumes you are hiding anything that can't be picked up on their screening tests, and will drop dead without a great deal of provocation. In short, the insurers assume when you shop for insurance that you know you need the coverage.
While some folks can be convinced by an insurance agent to buy anything, there are others who are particularly keen to get life insurance because they know all their near relatives died young, or they just learned they have a lethal illness and have been approached by a viatical settlement buyer, or the like. Prospective insureds who fear losses can be in a much better position than an insurer to appreciate the risks facing them. In this world -- where paper medical records can lay unnoticed by searching insurers, where billing codes are manipulated to ensure payment rather than accuracy -- insurers fear the information gap in underwriting important risks like health (which can quickly run into six or seven figures on a bad risk) is stacked against them. In a market in which members can opt out of sharing the population's risk, insurers fear the worst and charge accordingly.
Mandatory Coverage Is Coverage For Insurers
This is why full-time employees "get" health coverage in most companies whether they like it or not. Without the choice to opt out, employees are powerless to exercise adverse selection, and insurers can rest easier, unworried that new applicants are seeking coverage to run a scam; they are seeking coverage because they want a job. People with genuine work qualifications are probably less likely to be running a scam than the general population, besides. Moreover, insuring a whole pool of covered risks is a more attractive enterprise; there's little wonder insurers who deal with employee benefit plans structure their offerings so as to yield this result.
With very few employers failing to insure health risks at some level, and none to my knowledge processing claims directly, it's clear that the preference of insurers in structuring their offerings directly drives benefit plan coverage decisions. Insurers don't want to have to insure loners who turn up begging for coverage (what does he know that we don't?), but they are happy to write policies on whole populations who can't say "no" when their employers are looking for a way to pay valuable compensation that isn't subject to employer taxes.
Covering The Uninsured
So let's look at a common solution: we'll take the people who we're worried about -- the uncovered folks we want to stop choking emergency departments to death by allowing neglect of primary care to mature into a succession of expensive minor emergencies, the chronically ill who don't seem to qualify for stingy government programs, and so on -- and we'll cover them all in a special program to stem the tide of uninsurance. Because this population is selected for its high costs, coverage of it will be through the roof.
Think about it: if these people's claims weren't breaking local hospitals' ER budgets and didn't swamp county hospitals' funding and weren't killing everyone with an inclination to provide charity care, nobody would be clamoring for their coverage. If the claims weren't significant, the whole problem would be written off as not-a-big-deal. The county would cover it, or teaching hospitals, or charities. But that's the problem: the cost of this care dwarfs the resources people want to use to address it.
Covering these folks will cost a fortune.
Enter the High Risk Pool
The idea of creating government-established high-risk pools and offering group coverage to everyone in the pool surely sounds like a great idea at first: it's group coverage and not individual coverage; everyone in the group must paricipate; there should be a group discount -- right?
Ha, ha.
Americans like to think you get a deal buying products in bulk, but this is insurance, not a sack of yams. You get a discount by spreading risk, sure. But a high-risk pool isn't a place risk is spread: it's a place risk is concentrated. Insurers don't want any part of it at typical prices. Unless the premium is so high that there's a safe bet on the large concentration of risks, all bets are off. Insurers required to play this game would sooner leave the market. (Mind you, you don't need zillions of insurers to have a competitive market; two or three are enough, if there is no price collusion.)
The usual fix for this is to have government subsidize the high-risk pool. This, in effect, is the very thing the pool was to avoid: soaking the public fisc with the cost of the uncovered care. Taxpayers don't want to do this, since they are themselves (ask them) already paying for their own care. The only folks they see covered by a scheme like this are folks who don't have a job and don't pay taxes. Not exactly an easy sell, is it?
The Newest High-Risk Pool Proposal
President Obama -- I say President Obama because it's sure he will win, so why bother dreaming up silly terms like "hopeful" and "prospective" to term what's already a fait accompli? -- will urge a payroll tax to cover the cost of covering everyone not already covered by an employer plan. He spells it out right here. (In it he also spells out some funny things like how he'll save money for the health care system with tort reform, which is ironic considering the biggest estimates ever calculated for the annual financial cost attributable to malpractice claims and so-called "defensive medicine" don't amount to a tenth of a percent of the national health care budget. This, from a man who has claimed earmarks aren't a material expense!)
President Obama's plan expressly exempts from the payroll tax any employer already providing "adequate" coverage. This means that every employee will have a choice: whether it is cheaper to pay the payroll tax, or to maintain the existing plan. In other words, covered populations that are cheaper than the payroll tax will be able to avoid shouldering any of the risk-shifting associated with the incremental coverage. Once the price of the new plan is known -- that is, once the employer tax is spelled out in a statute -- employers will have even greater incentive to game their benefit plans for tax purposes. Employers with young, healthy populations will pay insurers to keep them out of the employer tax, and employers with older or less healthy populations will cheer, throw their health plan out the window, tell employees they have joined the new federal program created by Congress, and save all those extra health care dollars. After all, the payroll tax will be a tax-free benefit and fully deductible, it'll just be cheaper.
This market behavior will ensure that only populations that cost more than the payroll tax are in the federal risk pool. By spelling out the alternative in a statute, the payroll tax will enable insurers to conduct their ordinary cherry-picking operations even more effectively. Employers will be beseiged by cut-rate plans offering to "cover" for less than the cost of the payroll tax mostly-healthy populations with plans designed to scrape through the payroll-exemption language in the post-Obama tax code.
Spreading Risk For Real
To spread the risk of the whole population -- including the population of covered lives cherry-picked by insurers from an applicable risk pool -- it is necessary to tax not payroll but premiums. A premium tax of the sort states ordinarily collect on insurance premiums can be used to conduct risk allocation by funding the overpayments caused by the risk pool. A premium tax ensures that insurers price all their products -- to any market segment -- so as to cover the demands of the high-risk pool. The premium tax structure can thus be designed to make cherry-picking futile, ensuring more coverage and less coverage-avoidance.
Federal Health Services Funding Monopsony? Not The Cure!
In the law of the sale of goods, every state in the Union has the same substantive law. (Louisiana does not have common law, so the Uniform Commercial Code Article 2 language that depends on the existence of the common law cannot be used there; however, a local analog containing the same substance has been enacted to achieve the same result with different words.) Congress didn't need to create federal law on the sale of goods; the utility of uniform law was itself enough to inspire coordination and uniformity. State-law insurance insolvency statutes are the same way: federal law does not govern them (due to the McCarran-Ferguson Act), but there is nevertheless uniform law nationwide. Automotice drivers' responsibility has worked the same way. The argument that federal law is needed to create uniformity is a canard.
Federal law is in fact the major obstacle to universal care in this country, and has been so since the late 1970s when employers used federal law to enjoin a payroll tax funding Hawaii's health plan. Oregon had a radically different plan -- one with distinct and innovative cost-containment measures from which the nation could have learned valuable lessons for health plan design -- but the lessons brave Oregon would have taught us have been lost to federal preemption. Tentative movements of other states toward universal coverage have been slowed by the lack of freedom to experiment in this regulatory arena.
Experimenting on a state-by-state basis to provide data points on coverage features that are effective -- and which are ineffective -- is not a strength a single federal plan can possibly offer America. Once in place, the plan will be pulled about not by data or the lessons of neighbors' differing lessons, but by pure politics. Health care providers who have been terrorized by their powerlessness before federal payors and their ruthless watchdog agents' hungry zeal to threaten fee recoupment will understand immediately why a federal monopsony in health care finance is a danger to the field. Hospitals and physicians familiar with federal funding games will understand why giving the federal government an even larger fraction of the covered population will work against health care workers and their desire to provide quality care.
The worst obstacle to the development and innovation in health care policy in the last thirty years has been federal law preventing state experimentation in funding policy, plan enforcement, and quality assurance. The last thing America needs for the improvement of health care policy is more involvement by Congress. A new federal uninsurance pool funded by an opt-out payroll tax will accelerate risk segmentation, escalate the cost-shifting of the cost of health coverage onto government, and will prevent local efforts to innovate -- as Oregon heroically tried to do before it was stabbed in the throat for its efforts -- in ways that will result in genuine efficiency gains.
Saturday, October 11, 2008
Friday, October 10, 2008
Berkshire On Sale?
While on hold with my broker trying to get a options rollout trade placed, I noticed an interesting thing: Berkshire Hathaway, which isn't especially liquid in good times, was on sale. The bid/ask at one point on the B shares was less than a thousand against some six-figure sum apparently designed to catch people who thought they were looking at an A-share quote. As an enterprising investor, I opened an account window where I had money and started entering an order.
While I was entering the order, I saw the bid/ask go to a range close enough to look like trades might occur, and the range went below $3,000.
I feverishly tried entering an order near $3000. By the time I'd clocked to confirm, you'd think this crazy pricing had solved itself. No. The pricing was still reportedly low, but the online trading platform gave me a "not available" error.
Crazy. I kept getting messages like this until the price returned to $3750. At $3750 there is still a good long-term buy in BRK.B, but if day-open prices are going to do this, I'm going to wait for desperate-to-get-liquid sellers at the next open with another order. I want to catch them by surprise.
With Berkshire Hathaway reportedly actually trading some B shares at $3000, I'm unsurprised to see poorly-understood companies like American Capital trading at less than half the last-published net asset value, and offering a dividend about 8% per quarter. The deals are hot!
While I was entering the order, I saw the bid/ask go to a range close enough to look like trades might occur, and the range went below $3,000.
I feverishly tried entering an order near $3000. By the time I'd clocked to confirm, you'd think this crazy pricing had solved itself. No. The pricing was still reportedly low, but the online trading platform gave me a "not available" error.
Crazy. I kept getting messages like this until the price returned to $3750. At $3750 there is still a good long-term buy in BRK.B, but if day-open prices are going to do this, I'm going to wait for desperate-to-get-liquid sellers at the next open with another order. I want to catch them by surprise.
With Berkshire Hathaway reportedly actually trading some B shares at $3000, I'm unsurprised to see poorly-understood companies like American Capital trading at less than half the last-published net asset value, and offering a dividend about 8% per quarter. The deals are hot!
Thursday, October 9, 2008
On the Analysis of American Capital
This morning opened with heavy volume in American Capital. I was curious whether the volume portended anything interesting (volume spikes don't seem uncommon when one looks at a chart with ten-minute volume measurements, and this volume was less than other recent spikes and cooled). While trolling through my brokers' site for information on ACAS, I ended up looking at a recent spate of reports on the company. In case anyone thinks there's something like agreement on what ACAS' business will deliver investors, I thought I'd share this gem:
Seriously, can views of a company's prospects as an investment get any more scattered across the map?
So I looked at some of the reports.
The bullish report, from MarketEdge, was thin on analysis but offered a whole table of which chart metrics were "bullish" or "bearish". The analysis that did appear said, for example that moving average convergence/divergence (which the authors did not describe) portended a bullish future, and that "Relative Strength is Bullish." Capital letters were in the original. (Some of the comments in the "report" remind me of the output one can obtain from fnord.pl -- you can reload that page for more fnord.pl output, at the top of the page in bold.) This opinion was listed as effective for the week ending October 3, 2008, and the opinion was listed as having been formed when the share price was $25.75.
Since that time, I was able to make a purchase for a relative at $14.50 per share. Just how good are pictures on stock charts for predicting the next chart the ticker will print?
Since I've already lambasted vacuous analysis of ACAS offered by Jim Cramer, I opened TheStreet.com's report on ACAS with some anticipation. I enjoy Jim Cramer, don't get me wrong; he is entertaining. He may even be right on his call that SHLD and GS are one-stock retirement funds in the model of Berkshire Hathaway and serve as a workingman's hedge fund, though the fact he later said SHLD was a short tends to make me think he's had a change of heart. I haven't followed up his call on GS, made near 190, but I think the way to buy GS is to be Warren Buffett and to get a sweetheart deal not offered to retail investors.
Looking at the report, I noticed there was some interesting reasoning going on in The Street.com's October 5, 2008 analysis of American Capital:
I don't think 2005 was a typo, though. They probably meant what they said, and intended to refer to 2005. I've seen vastly-obsolete predictions in reports like this before, and I don't think the authors pay enough attention to notice the reports' content so as to realize they should update the text. I can't work out why the national derivatives exposure is an ACAS-specific concern, unless TheStreet.com believes that ACAS has a dangerous derivatives exposure -- which the report does not suggest in the slightest. TheStreet.com opined that the economy is growing, and if ACAS hasn't got some identifiable exposure to dangerous-looking derivative instruments, the story on the economy should stop there. (Maybe TheStreet.com doesn't think the economy is growing, just that it "will" grow in 2005; the authors should pick up a newspaper from this year, and relate that to the expected future instead of the prognosticated past.)
Other reasoning TheStreet.com applied to ACAS involved the earnings metric (rather than the taxable profit metric, which drives dividends) and FAS-157-compliant valuations reporting. At a time that the mark-to-market rules are being examined as a culprit in financial firm failures, one wonders what unrealized but supposed 'losses' mean, exactly, on investments that are performing as expected. One also wonders whether the rules that require performing investments to be written down due to factors other than their actual performance -- such as the resale market for the investment -- will survive much past the close of the study period.
The difficulty of valuing complex derivative instruments certainly gives rise to a host of evils. Warren Buffett explained how two firms could both lawfully claim to have a profit on a hard-to-price derivatives transaction, and how employee bonus structures created incentives to overstate valuations of these instruments. The incentive of parties to create difficul-to-value instruments to carry on the books for a period of time longer than any worker's whole career is clear: they want to cheat. Especially with contracts that aren't due for many years, and whose performance cannot be ascertained, there is risk of deception in valuation.
However, the lack of existence of a secondary market for fully performing loans hasn't caused federal regualtors to cease allowing banks to claim the nominal value of the loan. Performing loans on the books of other financial institutions are arguably much more accurately valued on a similar basis, or on the basis of a present value model for the future payment stream represented by the performing loan, than they are at fire-sale liquidation value in the face of a market characterized by liquidity crisis. Mark-to-market might make a great deal of sense for investments for which a liquid market exists (at least, if control blocks are not at issue), but it has some non-trivial drawbacks in the case of investments that cannot be readily sold (whether due to covenants, or regulations). An investor (as opposed to a trader) is much more interested in the fact that an underpriced mortgage instrument pays millions per quarter as promised (and the knowledge that it need not be liquidated) than in what one might obtain in a fire sale involving commercial mortgage instruments.
I don't pretend that American Capital's price drop to half its last-published net asset value has been enjoyable to watch, but I can tell you that on the dividend payment date next week I hope it's even lower. I hope that it remains low while American Capital reaches a date in which its compliance officer informs management it is not barred from trading in the firm's securities, and can exercise the remaining amounts in ACAS' $500 million share buyback authorization.
At current prices, ACAS is in a position to retire about a sixth of its outstanding shares with the remains of its authorized buyback. ACAS' fairly consistent operating earnings would benefit from a boost like that, and ACAS' concentration of realized investment gains across fewer shares would be a big benefit to shareholders going forward. In the past, ACAS hasnt' had many days in the quarter in which it wasn't barred from making share purchases, however. ACAS' ability to time its buyback may be poor. On the other hand, participants in the DRIP will be able to benefit substantially if the current pricing continues, as ACAS' $1.05 dividend is approaching 8% of the share price -- for one quarter.
Assuming my hypothesis about people misunderstanding ACAS is right, and that ACAS is as sound as I expect, then the outlook for the future is tremendous. In that case, this is a great time to be in the DRIP -- and a very interesting problem for ACAS' management, weighing the benefits of existing investment opportunities against the benefits or a share buyback. If the opportunities in the market involve mispricing as severe as appears the case in ACAS, then perhaps ACAS has other opportunities that make it hesitant to not to invest.
At current price levels, ACAS could take a substantial write-down in asset values and reduce its dividend and still provide an outstanding return. There is no reason known so far that ACAS' capacity to continue dividends should be impaired, however; ACAS has been consistently liquid throughout the recent economic situation, and has been managing its leverage with a prescience that has kept it far from its regulated limits. ACAS seems well-positioned to survive the downturn, and looks to provide excellent returns for anyone with the financial strength to remain invested.
Seriously, can views of a company's prospects as an investment get any more scattered across the map?
So I looked at some of the reports.
The bullish report, from MarketEdge, was thin on analysis but offered a whole table of which chart metrics were "bullish" or "bearish". The analysis that did appear said, for example that moving average convergence/divergence (which the authors did not describe) portended a bullish future, and that "Relative Strength is Bullish." Capital letters were in the original. (Some of the comments in the "report" remind me of the output one can obtain from fnord.pl -- you can reload that page for more fnord.pl output, at the top of the page in bold.) This opinion was listed as effective for the week ending October 3, 2008, and the opinion was listed as having been formed when the share price was $25.75.
Since that time, I was able to make a purchase for a relative at $14.50 per share. Just how good are pictures on stock charts for predicting the next chart the ticker will print?
Since I've already lambasted vacuous analysis of ACAS offered by Jim Cramer, I opened TheStreet.com's report on ACAS with some anticipation. I enjoy Jim Cramer, don't get me wrong; he is entertaining. He may even be right on his call that SHLD and GS are one-stock retirement funds in the model of Berkshire Hathaway and serve as a workingman's hedge fund, though the fact he later said SHLD was a short tends to make me think he's had a change of heart. I haven't followed up his call on GS, made near 190, but I think the way to buy GS is to be Warren Buffett and to get a sweetheart deal not offered to retail investors.
Looking at the report, I noticed there was some interesting reasoning going on in The Street.com's October 5, 2008 analysis of American Capital:
Notional derivatives exposure is a subject of concern for the Federal Reserve since, in aggregate, these companies are holding a notional value of more than $70 trillion in exposure. While firms are reporting improving profitability, there is also a trend of higher risk appetite. We expect the economy to continue to expand in 2005, with the Federal Reserve maintaining a policy of interest rate increases. Ultimately, the presence of tighter regulatory oversight coupled with a growing economy should bolster capital market activity going forward, and the industry’s prospects for increased profitability should remain favorable.If the authors of the report thought what happened in 2005 was material to likely 2008 or 2009 performance, the authors of the report could be bothered to look up what happened in 2005 rather than talk about "expect[ing] the economy to continue to expand in 2005, with the Federal Reserve maintaining a policy of interest rate increases." Yesterday, the whole planet seemed to reduce government bank rates half a percent. If "2005" were a typo, and they'd meant 2008, I'd say they got it wrong.
I don't think 2005 was a typo, though. They probably meant what they said, and intended to refer to 2005. I've seen vastly-obsolete predictions in reports like this before, and I don't think the authors pay enough attention to notice the reports' content so as to realize they should update the text. I can't work out why the national derivatives exposure is an ACAS-specific concern, unless TheStreet.com believes that ACAS has a dangerous derivatives exposure -- which the report does not suggest in the slightest. TheStreet.com opined that the economy is growing, and if ACAS hasn't got some identifiable exposure to dangerous-looking derivative instruments, the story on the economy should stop there. (Maybe TheStreet.com doesn't think the economy is growing, just that it "will" grow in 2005; the authors should pick up a newspaper from this year, and relate that to the expected future instead of the prognosticated past.)
Other reasoning TheStreet.com applied to ACAS involved the earnings metric (rather than the taxable profit metric, which drives dividends) and FAS-157-compliant valuations reporting. At a time that the mark-to-market rules are being examined as a culprit in financial firm failures, one wonders what unrealized but supposed 'losses' mean, exactly, on investments that are performing as expected. One also wonders whether the rules that require performing investments to be written down due to factors other than their actual performance -- such as the resale market for the investment -- will survive much past the close of the study period.
The difficulty of valuing complex derivative instruments certainly gives rise to a host of evils. Warren Buffett explained how two firms could both lawfully claim to have a profit on a hard-to-price derivatives transaction, and how employee bonus structures created incentives to overstate valuations of these instruments. The incentive of parties to create difficul-to-value instruments to carry on the books for a period of time longer than any worker's whole career is clear: they want to cheat. Especially with contracts that aren't due for many years, and whose performance cannot be ascertained, there is risk of deception in valuation.
However, the lack of existence of a secondary market for fully performing loans hasn't caused federal regualtors to cease allowing banks to claim the nominal value of the loan. Performing loans on the books of other financial institutions are arguably much more accurately valued on a similar basis, or on the basis of a present value model for the future payment stream represented by the performing loan, than they are at fire-sale liquidation value in the face of a market characterized by liquidity crisis. Mark-to-market might make a great deal of sense for investments for which a liquid market exists (at least, if control blocks are not at issue), but it has some non-trivial drawbacks in the case of investments that cannot be readily sold (whether due to covenants, or regulations). An investor (as opposed to a trader) is much more interested in the fact that an underpriced mortgage instrument pays millions per quarter as promised (and the knowledge that it need not be liquidated) than in what one might obtain in a fire sale involving commercial mortgage instruments.
I don't pretend that American Capital's price drop to half its last-published net asset value has been enjoyable to watch, but I can tell you that on the dividend payment date next week I hope it's even lower. I hope that it remains low while American Capital reaches a date in which its compliance officer informs management it is not barred from trading in the firm's securities, and can exercise the remaining amounts in ACAS' $500 million share buyback authorization.
At current prices, ACAS is in a position to retire about a sixth of its outstanding shares with the remains of its authorized buyback. ACAS' fairly consistent operating earnings would benefit from a boost like that, and ACAS' concentration of realized investment gains across fewer shares would be a big benefit to shareholders going forward. In the past, ACAS hasnt' had many days in the quarter in which it wasn't barred from making share purchases, however. ACAS' ability to time its buyback may be poor. On the other hand, participants in the DRIP will be able to benefit substantially if the current pricing continues, as ACAS' $1.05 dividend is approaching 8% of the share price -- for one quarter.
Assuming my hypothesis about people misunderstanding ACAS is right, and that ACAS is as sound as I expect, then the outlook for the future is tremendous. In that case, this is a great time to be in the DRIP -- and a very interesting problem for ACAS' management, weighing the benefits of existing investment opportunities against the benefits or a share buyback. If the opportunities in the market involve mispricing as severe as appears the case in ACAS, then perhaps ACAS has other opportunities that make it hesitant to not to invest.
At current price levels, ACAS could take a substantial write-down in asset values and reduce its dividend and still provide an outstanding return. There is no reason known so far that ACAS' capacity to continue dividends should be impaired, however; ACAS has been consistently liquid throughout the recent economic situation, and has been managing its leverage with a prescience that has kept it far from its regulated limits. ACAS seems well-positioned to survive the downturn, and looks to provide excellent returns for anyone with the financial strength to remain invested.
Tuesday, October 7, 2008
A Short Update
In keeping with my observation that the folks in charge of keeping the markets safe for investors have decided it's unimportant that sellers actually deliver anything to buyers, I thought I'd point out the current short interest in a few issues I watch:
Short
Interest
as
% of
Float_____Symbol and Name of Issue______Market Cap
===== ___===================_____=========
56.81%____SHLD - Sears Holdings Corp.___$11 Billion
27.34%____CDS - China Direct Inc._______$0.1175 Billion
19.16%____ACAS - American Capital Ltd.___$4.6 Billion
14.66%____AGNC - American Capital Agency $0.238 Billion
10.94%____AINV - Apollo Investment Corp. $2.0 Billion
_3.50%____GS - Goldman Sachs Group Inc. $47.5 Billion
_2.92%____AAPL - Apple Inc.__________$93.2 Billion
_2.80%____GOOG - Google Inc._________$119.8 Billion
_2.38%____MKL - Markel Corp._________$3.2 Billion
_1.09%____IBM - Int'l Business Machines Corp. $155.1 Billion
_0.78%____MSFT - Microsoft Corp._______$228.3 Billion
_0.24%____BRK.A - Berkshire Hathaway Inc. $207.3 Billion
First: The meme that has shorts descending like locusts on innocent companies and crushing them for the marrow of their bones needs some elaboration. Crushing high-fliers seems to work best when share overhanging the market are modest enough in size that shorts can create enough near-term impact to inspire real investors to notice the selling and respond (or, have their good-'till-cancelled stop-loss orders respond). Moving the share price of a hundred-billion-dollar behemoth with sizeable trading activity is much harder than attacking a thinly traded issue, or an issue with an enormous market capitalization.
Second: In a company with over five or ten percent of its entire outstanding float short, what's the chance most of that short interest has actually delivered the shares? A look at the Regulation SHO lists confirms that the heavily shorted issues are also failed-to-deliver issues. A requirement for actual delivery of securities would offer some meaningful limitation of short activity -- by creating demand among shorts for possession of borrowable certificates, and thus adding value back to the market shorts artificially depress by expanding supply -- and limit the opportunity of shorts to manipulate the market by effectively issuing new shares from which the issuer derives no benefit (only detriment).
Under the SEC's who-cares attitide toward share delivery, I've begun to wonder whether I'm in the wrong business. Imagine you could sell goods all day long from an empty inventory and never get caught? I mean ... who wouldn't play this for all it was worth?
This means that if you went to all the people who thought they owned shares of Sears, and you bought their interest (nevermind that Eddie Lampert wouldn't part with his without charging a pretty penny; he'd wait until you've bid up the shares, then he'll want a control premium), they'd purport to sell you 156.81% of the outstanding shares of SHLD. Of course, that's impossible to own, as the most you can own of any corporation is 100% of its outstanding stock. That is, you know, part of what it means for stock to be outstanding. If it's not part of that 100% oustanding, it hasn't been issued. And that's what non-delivering sellers are peddling: "shares" that haven't been issued. Interestingly, the extra 56.81% created by shorts is enough to mess up the voting and control of a corporation pretty badly. To whom to you send materials in a proxy fight? Not to the guys who didn't get delivery, I imagine -- and if that's you, you've been deprived of your right as a shareholder to have your say on shareholder matters. Given that shareholders haven't a statutory right to profits or dividends, but only to vote their shares, this is basically a complete deprivation of one's rights as a shareholder.
Normally as you short shares, you expect to have to borrow the shares from someone. This way, you owe someone the shares, and you have something to deliver a buyer. The buyer doesn't know about your lending arrangement with the shares, and he doesn't care: he has the certificate and he's taken care of. As shares are accumulated by someone who isn't lending them out, it becomes harder to find shares to borrow. As certificate-lenders sell their shares they require their borrowers to replace them -- to cover the short -- and as buyers do things like request certificates to be delivered and enroll in company-run DRIPs that don't lend shares, the shares get harder to borrow. If short interest is especially vigorous in a security, it might also get hard to borrow the shares, making short positions hard to establish during a collapse.
The interesting thing is that, because sellers aren't required to deliver the shares, there's no-one to force shorts to cover as the certificates of owners are requested for delivery and stop being available to borrow for short sales. This means that as you buy up shares from people who have certificates, you eventually have two kinds of people: you (who hold the share certificates) and dupes who think they hold securities that they paid for but were never delivered, because the seller never figured out who's certificate he was going to deliver.
One thing I notice is that companies with lower market capitalizations (SHLD has $11Billion in market cap at present, and ACAS $4.6Billion) seem easier to drive down with high short interest than companies that have larger market caps, like Berkshire Hathaway. But have I got it wrong? But for the extra shares created by shorts -- the marginal 56+% -- might SHLD have a rather different market cap? The principles of supply and demand certainly suggest it.
Short
Interest
as
% of
Float_____Symbol and Name of Issue______Market Cap
===== ___===================_____=========
56.81%____SHLD - Sears Holdings Corp.___$11 Billion
27.34%____CDS - China Direct Inc._______$0.1175 Billion
19.16%____ACAS - American Capital Ltd.___$4.6 Billion
14.66%____AGNC - American Capital Agency $0.238 Billion
10.94%____AINV - Apollo Investment Corp. $2.0 Billion
_3.50%____GS - Goldman Sachs Group Inc. $47.5 Billion
_2.92%____AAPL - Apple Inc.__________$93.2 Billion
_2.80%____GOOG - Google Inc._________$119.8 Billion
_2.38%____MKL - Markel Corp._________$3.2 Billion
_1.09%____IBM - Int'l Business Machines Corp. $155.1 Billion
_0.78%____MSFT - Microsoft Corp._______$228.3 Billion
_0.24%____BRK.A - Berkshire Hathaway Inc. $207.3 Billion
First: The meme that has shorts descending like locusts on innocent companies and crushing them for the marrow of their bones needs some elaboration. Crushing high-fliers seems to work best when share overhanging the market are modest enough in size that shorts can create enough near-term impact to inspire real investors to notice the selling and respond (or, have their good-'till-cancelled stop-loss orders respond). Moving the share price of a hundred-billion-dollar behemoth with sizeable trading activity is much harder than attacking a thinly traded issue, or an issue with an enormous market capitalization.
Second: In a company with over five or ten percent of its entire outstanding float short, what's the chance most of that short interest has actually delivered the shares? A look at the Regulation SHO lists confirms that the heavily shorted issues are also failed-to-deliver issues. A requirement for actual delivery of securities would offer some meaningful limitation of short activity -- by creating demand among shorts for possession of borrowable certificates, and thus adding value back to the market shorts artificially depress by expanding supply -- and limit the opportunity of shorts to manipulate the market by effectively issuing new shares from which the issuer derives no benefit (only detriment).
Under the SEC's who-cares attitide toward share delivery, I've begun to wonder whether I'm in the wrong business. Imagine you could sell goods all day long from an empty inventory and never get caught? I mean ... who wouldn't play this for all it was worth?
This means that if you went to all the people who thought they owned shares of Sears, and you bought their interest (nevermind that Eddie Lampert wouldn't part with his without charging a pretty penny; he'd wait until you've bid up the shares, then he'll want a control premium), they'd purport to sell you 156.81% of the outstanding shares of SHLD. Of course, that's impossible to own, as the most you can own of any corporation is 100% of its outstanding stock. That is, you know, part of what it means for stock to be outstanding. If it's not part of that 100% oustanding, it hasn't been issued. And that's what non-delivering sellers are peddling: "shares" that haven't been issued. Interestingly, the extra 56.81% created by shorts is enough to mess up the voting and control of a corporation pretty badly. To whom to you send materials in a proxy fight? Not to the guys who didn't get delivery, I imagine -- and if that's you, you've been deprived of your right as a shareholder to have your say on shareholder matters. Given that shareholders haven't a statutory right to profits or dividends, but only to vote their shares, this is basically a complete deprivation of one's rights as a shareholder.
Normally as you short shares, you expect to have to borrow the shares from someone. This way, you owe someone the shares, and you have something to deliver a buyer. The buyer doesn't know about your lending arrangement with the shares, and he doesn't care: he has the certificate and he's taken care of. As shares are accumulated by someone who isn't lending them out, it becomes harder to find shares to borrow. As certificate-lenders sell their shares they require their borrowers to replace them -- to cover the short -- and as buyers do things like request certificates to be delivered and enroll in company-run DRIPs that don't lend shares, the shares get harder to borrow. If short interest is especially vigorous in a security, it might also get hard to borrow the shares, making short positions hard to establish during a collapse.
The interesting thing is that, because sellers aren't required to deliver the shares, there's no-one to force shorts to cover as the certificates of owners are requested for delivery and stop being available to borrow for short sales. This means that as you buy up shares from people who have certificates, you eventually have two kinds of people: you (who hold the share certificates) and dupes who think they hold securities that they paid for but were never delivered, because the seller never figured out who's certificate he was going to deliver.
One thing I notice is that companies with lower market capitalizations (SHLD has $11Billion in market cap at present, and ACAS $4.6Billion) seem easier to drive down with high short interest than companies that have larger market caps, like Berkshire Hathaway. But have I got it wrong? But for the extra shares created by shorts -- the marginal 56+% -- might SHLD have a rather different market cap? The principles of supply and demand certainly suggest it.
The Next Ten Years
In the ongoing effort to keep my eye on the ball, I thought I'd have a look at the ten-year chart printed by some companies that have interested me for various reasons. Here is the ten-year chart for Apple (AAPL), Microsoft (MSFT), and American Capital (ACAS):
We've all read the boilerplate investor warning that past performance cannot guarantee future results, but there is something about past performance we can learn about a company with consistent management. Microsoft is still run by Ballmer, Apple is still run by Jobs, and American Capital is still run by Malon Wilkus. What we can ask, therefore, is what conditions have changed that might make each of these management teams perform differently over the next ten years.
Apple
The company with the most change over the last ten years is arguably Apple. Apple had just returned to profitability from the long-suspected brink of death, and proceeded to grow sales so that its fixed investments were no longer consuming its revenues, and expanded margins by an order of magnitude. Apple introduced highly-successful new products that showed Apple could provide a worldwide online market place, and could deploy its operating system on bomile devices. While it's possible to deploy further new products, becoming recognized as a plausible going concern and growing gross margins to thirty percent are just not stunts one can repeat. Apple is pulling in substantial cash each quarter and has accumulated nearly $24 per share in liquid assets, but since Apple doesn't distribute these to shareholders and hasn't a history of making particularly productive use of cash not invested strategically. Akamai, ARM Holdings, Earthlink, and Samsung come to mind as investments that either materially aided Apple's opportunities or produced an attractive financial return, or both; but managing cash not deployed in Apple's own business has never appeared to be a particular strength of Apple.
Apple approaches the next ten years with a stronger balance sheet and with a product array that reaches a much larger addressable global market. Although it is regionally strong in the United
States in sales share of music players, there is considerable global growth yet to capture. In the computer segment -- where Apple derives most of its revenue -- Apple shows continued growth and is nowhere near reaching global market saturation. Moreover, Apple has been able to maintain product distinctiveness, and has resisted being turned into a commodity vendor as it's grown.
As discussed here, Apple may have a lot of things going for it, and it may have even better growth in some segments (like mobile phones, for which manufactured quantities have been projected from hardware ID numbers) than predicted. Given the significant number of unknowns in Apple, it may be hard to pick a price at which Apple's future earnings stream has been mispriced and offers a "deal". However, Apple has long been subject to wild speculation and -- bargain or no -- it's likely that Apple will again one day be mispriced on the high side. The question, of course, is whether Apple's future makes mispricing on the high side down the road a very reassuring exit strategy. The answer there, of course, depends how bullish one is on 3G iPhones in China and Russia and elsewhere, and whether Apple will eventually offer mainstream enterprise tools to expand its footprint beyond the consumer and creative markets it has traditionally targeted.
Microsoft
Microsoft is arguably the company with the least different over the last ten years. Even as its competitors' products become recognized as legitimate alternatives in the operating system and application markets, Microsoft has maintained both dominant share in these markets and tight control of the APIs and file formats that prevent customers from easily discarding Microsoft as a supplier. The one place it seems significant losses exist -- dwindling browser share -- isn't even a revenue generator for Microsoft. Microsoft continues to bring substantial cash every quarter, and there's no end in sight.
Unfortunately, the stability of this revenue hasn't resulted in a catapulting share price: the shares are priced in expectation of the revenues, and of the $0.13 dividend MSFT pays shareholders (from after-tax profits; MSFT has no special tax status). The 2% or so dividend doesn't move the needle much on the chart of stock-price returns given above.
Microsoft's efforts to grow its business into new segments may have resulted in unit sales, but so far the lifelong financial impact of efforts like the XBox are negative, and the Zune is thinly-enough sold that even if it would be a commercial success for a different company, it's economic impact on Microsoft isn't material and likely won't be. Microsoft knows in principle what it needs to do to grow shareholder value -- produce new highly-desirable products in high-margin product segments -- but Microsoft hasn't executed. There is a difference between knowing the path, and walking the path.
Microsoft's inability to shut off its obsolete products to force upgrades into customers' computers suggests that its control over its customers is less complete than it was in 1995, while raising the embarrassing possibility that Microsoft's new products just aren't worth using. Microsoft is still making money from these customers, as they must buy (or rent) operating systems for new machines at Microsoft's current prices even if they "downgrade". Microsoft's substantial revenues from operating system sales are likely to continue showing growth as the market for computers as a whole grows, even if Microsoft's share of the pie does slip a bit. Microsoft's position hasn't changed that much in ten years.
Based on the chart, that might not be a good thing.
American Capital
American Capital has grown its global reach and expanded its funds under management and has demonstraded to an occasionally skeptical market that it can keep paying -- and raising -- its regular quarterly dividends. At today's price below $17, and in light of the 2008 dividend of $4.19, American Capital has a dividend yield of over 24%. Interestingly, although ACAS pays a dividend on the basis of taxable income in order to maintain its tax status and thus in theory might pay a fluctuating dividend, ACAS has never lowered a quarterly dividend. Moreover, the deal flow facing ACAS during an economic downturn offers fire-sale opportunities of a sort that should provide tremendous returns down the road as the economy inevitably recovers (whether next year, or a few years out). Given that ACAS historically trades at about 1.4x NAV, one would need to more than double ACAS' price to bring the price in line with historic norms.
Unlike the previous two companies, whose liquidation value isn't of much use in valuing their shares, ACAS as a BDC must routinely state the current market value of its assets, and thus can be more readily identified as a bargain. Currently, ACAS trades at a discount of over $10 to its last-published NAV. ACAS' last few years of sales have shown that ACAS' valuations are fair, as specific sales and even whole-portfolio cross-sections have been sold -- and each time within a few percent of the last-published valuation.
Whether looking at the fact that ACAS shares would yield a 58% gain just to reach NAV, or that ACAS has shown the ability to pay substantial dividends in the past and forecasts rolling $500 million of taxable 2008 income into 2009 to cover future dividends that look to yield about 25% on the current price (which as I write is under $16 per share), it seems ACAS is the screaming deal in this line-up. ACAS may not have a track record of exploding by orders of magnitude, but it has a business model that enables consistent returns without fear of market saturation. One need not hypothesize un-annuonced future products to understand where ACAS will make its profit.
With most of the $500 million authorized for share buybacks still available for share purchases during periods the company isn't barred by its compliance officer from purchasing shares off the market, prices this far below net asset value are extremely attractive. With shorts -- who have added an extra 20% of the outstanding shares to the float by selling shares they don't own -- having driven down the price of the shares by reducing the scarcity of available shares, ACAS has an opportunity to retire more than 10% of its outstanding shares from the market. This would serve to magnify future returns. For example, the $0.04/sh/q ACAS gets from its investment in AGNC won't shrink merely because ACAS has fewer shares or less cash. Portfolio companies controlled by ACAS, whose profits flow to ACAS' bottom line due to balance sheet consolidation, aren't going to start earning less because of a changed share count. Even if the recession drives down operating earnings at portfolio companies below the 80¢/q ACAS once enjoyed, these businesses stand to benefit from a recovery like other businesses; the application of those profits to a smaller base of shareholders will have a magnifying effect on long-term ACAS returns.
Unlike AAPL or MSFT, at which share issuance has been dilutive, ACAS has made a point of issuing shares only when it can raise greater-than-NAV funds and thus increase the net value per share. Management has made a point of avoiding bad deals, even when criticized for it or when it causes a quarterly number to be blown. Because ACAS manages permanent capital and is in the habit of looking at the long term rather than the quarter, management's interests are much better aligned with long-term shareholders than management at many companies.
ACAS distributes most of its taxable income to shareholders in the form of dividends as a requirement of its tx status. ACAS' shareholder distributions are at present $4.19/share per year, which is greater than the pretax profit (per share, per year) at Microsoft. To sustain a dividend like ACAS', Microsoft would need a profit per share of something over $6/share per year. Microsoft's recently-closed fiscal year raked up less than $2 per share in earnings after its tax expense.
Conclusion
Microsoft may have a float far too big to be easily manipulated by non-delivering short-sellers, which is some protection against marketplace lunacy, and it may have more predictable earnings than Apple, which offers some protection against Apple's wild speculation-driven volatility. However, Microsoft hasn't got the potential for growth of either company, as its new products don't seem to be moving the needle at all. Moreover, the total returns offered by Apple and American Capital over the last ten years easily outpace the sideways slide of Microsoft's shares. Microsoft may have had a fat one-time dividend not captured in the above chart, but it's dwarfed by Apple's returns and easily eclipsed by the steady quarterly dividend churned out by American Capital.
American Capital had great success deploying assets in quality investments in the last downturn, and there's no reason to believe its solid management won't continue to do the same. American Capital's growth has an excellent outlook, and while it may not be as stratospheric as that one might fantasize at Apple, it has the benefit of being easier to understand as a source of growing recurring revenue.
For the next ten years, The Jaded Consumer sees Apple as the safer bet for high risk-adjusted returns. For stratospheric returns, one can speculate on the next revolution Apple may deliver to the world; but for people who would like Treasury-bill returns without the federal guarantee, there's always Microsoft.
We've all read the boilerplate investor warning that past performance cannot guarantee future results, but there is something about past performance we can learn about a company with consistent management. Microsoft is still run by Ballmer, Apple is still run by Jobs, and American Capital is still run by Malon Wilkus. What we can ask, therefore, is what conditions have changed that might make each of these management teams perform differently over the next ten years.Apple
The company with the most change over the last ten years is arguably Apple. Apple had just returned to profitability from the long-suspected brink of death, and proceeded to grow sales so that its fixed investments were no longer consuming its revenues, and expanded margins by an order of magnitude. Apple introduced highly-successful new products that showed Apple could provide a worldwide online market place, and could deploy its operating system on bomile devices. While it's possible to deploy further new products, becoming recognized as a plausible going concern and growing gross margins to thirty percent are just not stunts one can repeat. Apple is pulling in substantial cash each quarter and has accumulated nearly $24 per share in liquid assets, but since Apple doesn't distribute these to shareholders and hasn't a history of making particularly productive use of cash not invested strategically. Akamai, ARM Holdings, Earthlink, and Samsung come to mind as investments that either materially aided Apple's opportunities or produced an attractive financial return, or both; but managing cash not deployed in Apple's own business has never appeared to be a particular strength of Apple.
Apple approaches the next ten years with a stronger balance sheet and with a product array that reaches a much larger addressable global market. Although it is regionally strong in the United
States in sales share of music players, there is considerable global growth yet to capture. In the computer segment -- where Apple derives most of its revenue -- Apple shows continued growth and is nowhere near reaching global market saturation. Moreover, Apple has been able to maintain product distinctiveness, and has resisted being turned into a commodity vendor as it's grown.
As discussed here, Apple may have a lot of things going for it, and it may have even better growth in some segments (like mobile phones, for which manufactured quantities have been projected from hardware ID numbers) than predicted. Given the significant number of unknowns in Apple, it may be hard to pick a price at which Apple's future earnings stream has been mispriced and offers a "deal". However, Apple has long been subject to wild speculation and -- bargain or no -- it's likely that Apple will again one day be mispriced on the high side. The question, of course, is whether Apple's future makes mispricing on the high side down the road a very reassuring exit strategy. The answer there, of course, depends how bullish one is on 3G iPhones in China and Russia and elsewhere, and whether Apple will eventually offer mainstream enterprise tools to expand its footprint beyond the consumer and creative markets it has traditionally targeted.
Microsoft
Microsoft is arguably the company with the least different over the last ten years. Even as its competitors' products become recognized as legitimate alternatives in the operating system and application markets, Microsoft has maintained both dominant share in these markets and tight control of the APIs and file formats that prevent customers from easily discarding Microsoft as a supplier. The one place it seems significant losses exist -- dwindling browser share -- isn't even a revenue generator for Microsoft. Microsoft continues to bring substantial cash every quarter, and there's no end in sight.
Unfortunately, the stability of this revenue hasn't resulted in a catapulting share price: the shares are priced in expectation of the revenues, and of the $0.13 dividend MSFT pays shareholders (from after-tax profits; MSFT has no special tax status). The 2% or so dividend doesn't move the needle much on the chart of stock-price returns given above.
Microsoft's efforts to grow its business into new segments may have resulted in unit sales, but so far the lifelong financial impact of efforts like the XBox are negative, and the Zune is thinly-enough sold that even if it would be a commercial success for a different company, it's economic impact on Microsoft isn't material and likely won't be. Microsoft knows in principle what it needs to do to grow shareholder value -- produce new highly-desirable products in high-margin product segments -- but Microsoft hasn't executed. There is a difference between knowing the path, and walking the path.
Microsoft's inability to shut off its obsolete products to force upgrades into customers' computers suggests that its control over its customers is less complete than it was in 1995, while raising the embarrassing possibility that Microsoft's new products just aren't worth using. Microsoft is still making money from these customers, as they must buy (or rent) operating systems for new machines at Microsoft's current prices even if they "downgrade". Microsoft's substantial revenues from operating system sales are likely to continue showing growth as the market for computers as a whole grows, even if Microsoft's share of the pie does slip a bit. Microsoft's position hasn't changed that much in ten years.
Based on the chart, that might not be a good thing.
American Capital
American Capital has grown its global reach and expanded its funds under management and has demonstraded to an occasionally skeptical market that it can keep paying -- and raising -- its regular quarterly dividends. At today's price below $17, and in light of the 2008 dividend of $4.19, American Capital has a dividend yield of over 24%. Interestingly, although ACAS pays a dividend on the basis of taxable income in order to maintain its tax status and thus in theory might pay a fluctuating dividend, ACAS has never lowered a quarterly dividend. Moreover, the deal flow facing ACAS during an economic downturn offers fire-sale opportunities of a sort that should provide tremendous returns down the road as the economy inevitably recovers (whether next year, or a few years out). Given that ACAS historically trades at about 1.4x NAV, one would need to more than double ACAS' price to bring the price in line with historic norms.
Unlike the previous two companies, whose liquidation value isn't of much use in valuing their shares, ACAS as a BDC must routinely state the current market value of its assets, and thus can be more readily identified as a bargain. Currently, ACAS trades at a discount of over $10 to its last-published NAV. ACAS' last few years of sales have shown that ACAS' valuations are fair, as specific sales and even whole-portfolio cross-sections have been sold -- and each time within a few percent of the last-published valuation.
Whether looking at the fact that ACAS shares would yield a 58% gain just to reach NAV, or that ACAS has shown the ability to pay substantial dividends in the past and forecasts rolling $500 million of taxable 2008 income into 2009 to cover future dividends that look to yield about 25% on the current price (which as I write is under $16 per share), it seems ACAS is the screaming deal in this line-up. ACAS may not have a track record of exploding by orders of magnitude, but it has a business model that enables consistent returns without fear of market saturation. One need not hypothesize un-annuonced future products to understand where ACAS will make its profit.
With most of the $500 million authorized for share buybacks still available for share purchases during periods the company isn't barred by its compliance officer from purchasing shares off the market, prices this far below net asset value are extremely attractive. With shorts -- who have added an extra 20% of the outstanding shares to the float by selling shares they don't own -- having driven down the price of the shares by reducing the scarcity of available shares, ACAS has an opportunity to retire more than 10% of its outstanding shares from the market. This would serve to magnify future returns. For example, the $0.04/sh/q ACAS gets from its investment in AGNC won't shrink merely because ACAS has fewer shares or less cash. Portfolio companies controlled by ACAS, whose profits flow to ACAS' bottom line due to balance sheet consolidation, aren't going to start earning less because of a changed share count. Even if the recession drives down operating earnings at portfolio companies below the 80¢/q ACAS once enjoyed, these businesses stand to benefit from a recovery like other businesses; the application of those profits to a smaller base of shareholders will have a magnifying effect on long-term ACAS returns.
Unlike AAPL or MSFT, at which share issuance has been dilutive, ACAS has made a point of issuing shares only when it can raise greater-than-NAV funds and thus increase the net value per share. Management has made a point of avoiding bad deals, even when criticized for it or when it causes a quarterly number to be blown. Because ACAS manages permanent capital and is in the habit of looking at the long term rather than the quarter, management's interests are much better aligned with long-term shareholders than management at many companies.
ACAS distributes most of its taxable income to shareholders in the form of dividends as a requirement of its tx status. ACAS' shareholder distributions are at present $4.19/share per year, which is greater than the pretax profit (per share, per year) at Microsoft. To sustain a dividend like ACAS', Microsoft would need a profit per share of something over $6/share per year. Microsoft's recently-closed fiscal year raked up less than $2 per share in earnings after its tax expense.
Conclusion
Microsoft may have a float far too big to be easily manipulated by non-delivering short-sellers, which is some protection against marketplace lunacy, and it may have more predictable earnings than Apple, which offers some protection against Apple's wild speculation-driven volatility. However, Microsoft hasn't got the potential for growth of either company, as its new products don't seem to be moving the needle at all. Moreover, the total returns offered by Apple and American Capital over the last ten years easily outpace the sideways slide of Microsoft's shares. Microsoft may have had a fat one-time dividend not captured in the above chart, but it's dwarfed by Apple's returns and easily eclipsed by the steady quarterly dividend churned out by American Capital.
American Capital had great success deploying assets in quality investments in the last downturn, and there's no reason to believe its solid management won't continue to do the same. American Capital's growth has an excellent outlook, and while it may not be as stratospheric as that one might fantasize at Apple, it has the benefit of being easier to understand as a source of growing recurring revenue.
For the next ten years, The Jaded Consumer sees Apple as the safer bet for high risk-adjusted returns. For stratospheric returns, one can speculate on the next revolution Apple may deliver to the world; but for people who would like Treasury-bill returns without the federal guarantee, there's always Microsoft.
Monday, October 6, 2008
Winning In Afghanistan
Developments in Obama's war the United States must win took an interesting turn, as Talibanis sat down with representatives of President Karzai's elected government in Saudi Arabia. This seems to be a development from earlier use of King Saud as an intermediary in discussions between the Taliban and the Afghan government led by President Karzai.
Now that the word is out that the Taliban have parted company with Osama, the theory of winning has become interesting. Is the conflict in Afghanistan about the ascendancy of Islamist militancy (a fight in which the U.S. has a dog), or is it now a conflict about which Afghan factions will collect taxes, in which case presumably Obama's thesis has weakened?
This piece suggests that Obama's position on Afghanistan isn't based on a theory of how to achieve victory, but on the recognition that in the post-9/11 United States one needs to claim to win a war to get elected.
The pessimistic view that U.S. soldiers can't attain victory in Afghanistan at any force size may be misplaced. If the Taliban have sworn off the export of terrorism and will talk terms with the legitimate government of Afghanistan, there may be peace without surrender on the horizon -- a peace that we didn't win with bullets, but which was made possible by refusing to allow the elected government to be overrun by bandits.
In the end, didn't we all know the only way for freedom to exist anywhere is for people to demand it? If Afghani or Iraqi people aren't willing to draw a line in the parched earth and refuse to be bullied beyond it, they will be bullied into the sea the moment we pull up our tent stakes and there's nothing we can do about it regardless how much blood we spill before we come home. Freedom is a condition that persists in the face of oppression only when enough people refuse to live on their knees, and make it clear they will die before being pushed aside. Oppression faces the Middle East from would-be Islamofascist governors in Iran, nameless apparent anarchists bent on blowing up progress where elections give women rights, and long-time autocrats carefully tending police states all over the region.
The question is whether the Middle East has enough good people left after all these years to do what's right for their children. The United States can't offer fee-free police protection across the globe forever. The whole mission was predicated on the notion that locals preferred liberty to oppression.
Now it's time to find out if that belief was warranted.
Now that the word is out that the Taliban have parted company with Osama, the theory of winning has become interesting. Is the conflict in Afghanistan about the ascendancy of Islamist militancy (a fight in which the U.S. has a dog), or is it now a conflict about which Afghan factions will collect taxes, in which case presumably Obama's thesis has weakened?
This piece suggests that Obama's position on Afghanistan isn't based on a theory of how to achieve victory, but on the recognition that in the post-9/11 United States one needs to claim to win a war to get elected.
The pessimistic view that U.S. soldiers can't attain victory in Afghanistan at any force size may be misplaced. If the Taliban have sworn off the export of terrorism and will talk terms with the legitimate government of Afghanistan, there may be peace without surrender on the horizon -- a peace that we didn't win with bullets, but which was made possible by refusing to allow the elected government to be overrun by bandits.
In the end, didn't we all know the only way for freedom to exist anywhere is for people to demand it? If Afghani or Iraqi people aren't willing to draw a line in the parched earth and refuse to be bullied beyond it, they will be bullied into the sea the moment we pull up our tent stakes and there's nothing we can do about it regardless how much blood we spill before we come home. Freedom is a condition that persists in the face of oppression only when enough people refuse to live on their knees, and make it clear they will die before being pushed aside. Oppression faces the Middle East from would-be Islamofascist governors in Iran, nameless apparent anarchists bent on blowing up progress where elections give women rights, and long-time autocrats carefully tending police states all over the region.
The question is whether the Middle East has enough good people left after all these years to do what's right for their children. The United States can't offer fee-free police protection across the globe forever. The whole mission was predicated on the notion that locals preferred liberty to oppression.
Now it's time to find out if that belief was warranted.
Election FUD on U.S. Economy
I noticed that in the vice-presidential debate, Joe Biden tried to take McCain to task for making bullish statements about the U.S. economy. Maybe he should give the same lecture to Warren Buffett. Buffett has spoken about the need for a bailout, and about the housing inventory, and about the effect of leverage against mispriced mortgages on the balance sheets of banks that were more worried about their quarter than about the future. Throughout, however, Buffett's statements about the economy -- not the balance sheets of lenders, but the U.S. economy -- have been long-term bullish. (Example: "It has not paid to sell American short since 1776, and the time to start is not 2008." This, in August 2008.)
Buffett likened the U.S. economy facing the current mortgage crisis to "a great athlete" needing resuscitation following an unexpected heart attack. Rather than point fingers and discuss whether the patient ought to have trained or eaten differently, Buffett stated the important thing was to get out the rescussitating equipment and start working. The athlete needs to be put back in shape for competition. Buffett didn't say the patient needed to be retired, or that the patient was no athlete at all and shouldn't be outdoors exercising.
Speaking on the housing oversupply, Buffett stated that the United States creates several million households per year, and that the surplus will simply be worked off, though not overnight. He doesn't sugar-coat that it's a problem, but he emphasizes that the characteristics of the United States' economy create reasonable confidence in recovery -- and that the things we do now to mitigate the current liquidity issues brought on by subprime mortgages can accelerate the recovery that would occur if the market participants were allowed to crash and burn as a result of the subprime-related excesses of banks.
Buffett isn't alone in thinking the U.S. economy is a place of opportunity. A manager of a much smaller pool of money, American Capital's Malon Wilkus, stated that the financial problems currently observed remain quite specific to the home mortgage market, and those who levered against it. Wilkus gave the commercial real estate market as an example of a near industry that simply wasn't showing defaults or other significant problems. But for exposure to the suddenly-illiquid subprime mortgage market, participants in the U.S. market seem healthy.
The subprime problem is a problem of home mortgages and the institutions that mispriced the risks these mortgages offered their balance sheets as they levered their balance sheets against what proved to be an unmarketable asset. The problem -- the reason that the ripples are so large, and are creating problems for people who never thought they were investing in risky mortgages -- has to do with the economic relationships of the entities in the subprime mess.
A writer at Seeking Alpha claims that with AIG alone requiring $85 billion to keep afloat, the market is doomed because the recently-passed bailout $700 billion bill won't be nearly enough to halt the tsunami. This kind of sloppy thinking from a pessimist is exactly how sloppy optimists got it wrong to create the current mess. A little attention to the substance of the transactions will save embarrassment later. AIG didn't just consume a $85 bailout. The Federal Reserve Bank just opened AIG a two-year line of secured credit bearing a loanshark-like cost, giving AIG a little while to straighten out its balance sheet so it doesn't become insolvent in a quarter or so. The Federal Reserve Bank now holds warrants on 79.9% of AIG's shares, so that if AIG pulls out of its subprime-caused nosedive, Uncle Sam will be its new business partner.
The reason $700 billion in illiquid assets clogging a financial institution's balance sheets is a disaster is because the reason financial institutions are able to impact financial markets in the normous way that they do (Buffett recently stated Americans' participation in the public markets amounts to something like $20 trillion, and banks move this market all the time) is that most financial institutions use enormous leverage when they operate. Assuming an institution is levered at a relatively modest (for a bank) 10:1 (debt:equity), $100 billion in assets becoming so illiquid that no-one will take them as collateral effectively wipes out $1 trillion in assets the institution can borrow to make available for ordinary (that is, fiscally sound) financial transactions. At this level of leverage, a $700 billion investment in currently-unlendable assets in exchange for cash would replace $7 trillion in currently-missing market liquidity. That's more than a third of Americans' stock ownership, using Buffett's numbers. That's nothing to sneeze at.
The federal government is planning to get paid pretty well for this investment. Buffett said that if the purchases are made at current market prices, he'd like to invest his own money alongside the Treasury. Moreover, the Treasury will be taking equity stakes from institutions who want to drink deeply from the well. Anyone Treasury saves from that big a gaffe has a new partner in business.
But back to the candidates: if McCain says the U.S. ecomony -- which creates millions of new households per year and despite record oil prices has managed to narrow trade deficits through increased exports -- is fundamentally strong, one would expect some argument why he's wrong.
Biden offers no argument, he just points and laughs. Biden is trading on economic panic to persuade the fearful that his opponent is out of touch. It's possible that, by contrast, Biden himself has no idea what's going on or why, and hopes you don't, either. McCain appears simply to take the fairly unremarkable view Buffett has long endorsed, which is that the U.S. economy is a long-term bull play and remains so. This is in no way inconsistent with the view -- also endorsed by Buffett -- that quick action is needed to speed recovery from the financial sector's Kool-Aid-splashed subprime home mortgage orgy.
Biden's observation -- that McCain professed confidence in the U.S. economy and then called for immediate action to protect it from the subprime meltdown -- doesn't prove his thesis. Biden is just pushing election-season FUD, when constituents might like to hear substance.
Because Obama didn't answer in the first debate what specific platform planks he'd sacrifice in light of fiscal pressure brought on by the subprime mortgage crisis, we don't know if he intends imposing his new payroll tax immediately, or in eight years. Biden, who was busy laughing at McCain's confidence in the United States economy, didn't care to share his view, either.
Buffett likened the U.S. economy facing the current mortgage crisis to "a great athlete" needing resuscitation following an unexpected heart attack. Rather than point fingers and discuss whether the patient ought to have trained or eaten differently, Buffett stated the important thing was to get out the rescussitating equipment and start working. The athlete needs to be put back in shape for competition. Buffett didn't say the patient needed to be retired, or that the patient was no athlete at all and shouldn't be outdoors exercising.
Speaking on the housing oversupply, Buffett stated that the United States creates several million households per year, and that the surplus will simply be worked off, though not overnight. He doesn't sugar-coat that it's a problem, but he emphasizes that the characteristics of the United States' economy create reasonable confidence in recovery -- and that the things we do now to mitigate the current liquidity issues brought on by subprime mortgages can accelerate the recovery that would occur if the market participants were allowed to crash and burn as a result of the subprime-related excesses of banks.
Buffett isn't alone in thinking the U.S. economy is a place of opportunity. A manager of a much smaller pool of money, American Capital's Malon Wilkus, stated that the financial problems currently observed remain quite specific to the home mortgage market, and those who levered against it. Wilkus gave the commercial real estate market as an example of a near industry that simply wasn't showing defaults or other significant problems. But for exposure to the suddenly-illiquid subprime mortgage market, participants in the U.S. market seem healthy.
The subprime problem is a problem of home mortgages and the institutions that mispriced the risks these mortgages offered their balance sheets as they levered their balance sheets against what proved to be an unmarketable asset. The problem -- the reason that the ripples are so large, and are creating problems for people who never thought they were investing in risky mortgages -- has to do with the economic relationships of the entities in the subprime mess.
A writer at Seeking Alpha claims that with AIG alone requiring $85 billion to keep afloat, the market is doomed because the recently-passed bailout $700 billion bill won't be nearly enough to halt the tsunami. This kind of sloppy thinking from a pessimist is exactly how sloppy optimists got it wrong to create the current mess. A little attention to the substance of the transactions will save embarrassment later. AIG didn't just consume a $85 bailout. The Federal Reserve Bank just opened AIG a two-year line of secured credit bearing a loanshark-like cost, giving AIG a little while to straighten out its balance sheet so it doesn't become insolvent in a quarter or so. The Federal Reserve Bank now holds warrants on 79.9% of AIG's shares, so that if AIG pulls out of its subprime-caused nosedive, Uncle Sam will be its new business partner.
The reason $700 billion in illiquid assets clogging a financial institution's balance sheets is a disaster is because the reason financial institutions are able to impact financial markets in the normous way that they do (Buffett recently stated Americans' participation in the public markets amounts to something like $20 trillion, and banks move this market all the time) is that most financial institutions use enormous leverage when they operate. Assuming an institution is levered at a relatively modest (for a bank) 10:1 (debt:equity), $100 billion in assets becoming so illiquid that no-one will take them as collateral effectively wipes out $1 trillion in assets the institution can borrow to make available for ordinary (that is, fiscally sound) financial transactions. At this level of leverage, a $700 billion investment in currently-unlendable assets in exchange for cash would replace $7 trillion in currently-missing market liquidity. That's more than a third of Americans' stock ownership, using Buffett's numbers. That's nothing to sneeze at.
The federal government is planning to get paid pretty well for this investment. Buffett said that if the purchases are made at current market prices, he'd like to invest his own money alongside the Treasury. Moreover, the Treasury will be taking equity stakes from institutions who want to drink deeply from the well. Anyone Treasury saves from that big a gaffe has a new partner in business.
But back to the candidates: if McCain says the U.S. ecomony -- which creates millions of new households per year and despite record oil prices has managed to narrow trade deficits through increased exports -- is fundamentally strong, one would expect some argument why he's wrong.
Biden offers no argument, he just points and laughs. Biden is trading on economic panic to persuade the fearful that his opponent is out of touch. It's possible that, by contrast, Biden himself has no idea what's going on or why, and hopes you don't, either. McCain appears simply to take the fairly unremarkable view Buffett has long endorsed, which is that the U.S. economy is a long-term bull play and remains so. This is in no way inconsistent with the view -- also endorsed by Buffett -- that quick action is needed to speed recovery from the financial sector's Kool-Aid-splashed subprime home mortgage orgy.
Biden's observation -- that McCain professed confidence in the U.S. economy and then called for immediate action to protect it from the subprime meltdown -- doesn't prove his thesis. Biden is just pushing election-season FUD, when constituents might like to hear substance.
Because Obama didn't answer in the first debate what specific platform planks he'd sacrifice in light of fiscal pressure brought on by the subprime mortgage crisis, we don't know if he intends imposing his new payroll tax immediately, or in eight years. Biden, who was busy laughing at McCain's confidence in the United States economy, didn't care to share his view, either.
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