Tuesday, January 25, 2011

Exploiting Economic Illiteracy

“I think it’s important for people to understand the ideas of scarcity and decision making in every day life so that they won’t be ripped off by politicians”,

“Politicians exploit economic illiteracy”

- Dr. Walter Williams.

Those were the comments that resonated with me in the recent WSJ Op-Ed,The State against Blacks; Then I got to thinking, yah, not only politicians pal!

In the article, Dr Williams, a George Mason Economics Professor, discusses how the welfare state has done more harm to African-Americans than slavery did. And that “black people cannot make great progress until  they understand the economic system, until they know something about economics”

Not to take away from Dr. Williams’ message, but I believe his statement holds true for more than just the African-American population.  I believe its imperative for investors - of all stripes - to have a basic knowledge of economics. With the cacophony of noise emanating from Wall Street and politicians pushing their agendas, many investors are tearing down the rapids sans a guide and indeed some without a paddle.

A proper understanding of the true state of the global economy is vital for investors to avoid investment land mines.

Yesterday, Mark Cuban (who incidentally made his fortune in the stock market; during the Tech bubble nonetheless), blogged in Wall Street’s new lie to Main Street - Asset Allocation:

Today, your investment advisors want you invest in things you have absolutely no fricking clue about and have pretty much absolutely no fricking ability to learn about”.

Although I agree with one half of his proclamation, I do not agree with the other. With this one sentence, I believe he highlighted one of many myths and misconceptions under which current investors toil, that 
you can’t possibly, under any circumstances possibly learn this stuff!
Nothing ensures the longevity of myths and misconceptions like a modicum of half-truth.

The misconception that economics and finance is indecipherable, is one that is perpetuated admittedly, by many in finance for selfish reasons.  While the profession may not be seen as academically rigorous as the legal or medical, it does take hard work and study to gain insight. And even then, success is not guaranteed.  

Investing is NOT a real science like physics although, the reams of academic papers with unintellligible equations, talk of Chaos Theory, Brownian Motion and Levy Flight would probably convince you otherwise.  Although many professional investors have used these theories successfully, it didn’t happen overnight and it did require some serious study and application of brain usage on their part.

Too many investors want a magic elixir that guarantees outrageous profit with no risk, either to their pocket or their brain cells. Should you invest in a 1 year 8.10% Callable Yield Note linked to the performance of the Ishares MSCI Brazil Index Fund and SPDR S&P Metals and Mining ETF? Well for starters, it would help if you knew where Brazil was. Then maybe what’s in the index and the ETF before thinking about the possible 8.1% yield.

While, I agree there is a lot of scuttlebutt floating about, as highlighted in my post, ETF Mania or: A Study in Herd Behavior, I think everyone should be investing at their comfort and education level. In The stock market is for suckers, MIT professor Andrew Lo proposes to: “license retail investors to educate and protect them”.

I’ll leave you with two quotes i keep very much in the front of my mind:

There is nothing more frightening than active ignorance.-- Goethe

There are two ways to be fooled: One is to believe what isn't so; the other is to refuse to believe what is so. --Soren Kierkegaard

Happy Trading

Thursday, January 20, 2011

Merger Arbitrage Candidates: Interesting Reads

Following up on Risk Arbitrage Back On?, today Morningstar (MORN) and its unit Footnoted published their respective 2011 M&A outlooks, along with a list of top takeover candidates:
CHICAGO, Jan. 20, 2011 /PRNewswire/ -- Morningstar, Inc. (Nasdaq: MORN), a leading provider of independent investment research, today published its Merger & Acquisition Outlook for 2011, a comprehensive research report that outlines merger and acquisition trends by sector, identifies the 100 most likely takeover candidates across Morningstar's equity coverage universe, highlights the likely acquirers, and examines the implications of merger and acquisition activity for bondholders.
"While global merger and acquisition activity has been on the decline over the last few years, we observed the inklings of a revival in 2010 and expect both the number and size of deals to substantially increase in 2011," said RJ Hottovy, director of equity research for consumer stocks and editor of the report. "We expect some of the key M&A themes to include interest in emerging markets, companies that have mastered a unique niche in their respective industries, and the ability to generate free cash flow."  

Interesting reads:

Morning Star M&A Report


ETF Mania, or: A Study of Herd Behavior

Nestled on page B11, in this weekend’s Wall Street Journal was an article, “Social” Funds Embrace Emerging Markets.

One of the fads that’s irked me for some time is Socially Responsible Investing.  
Surely, that must go against the whole capitalist ethos, no?
What does Socially Responsible Investing even mean? And I don’t mean the wikipedia definition. I mean,  you’ve got 30 secs to explain it to me........... go!

Uh huh, thats what I figured. Sounds good though, right? All you need is a prospectus plastered with an image of giggling children frollicking in a field of daisies, under a sun filled sky et voila.
This whole ETF and theme-based fund frenzy is really getting out of control.

This one fund in particular, the MMA Praxis International Fund(MPIAX), aims for 20% Emerging Markets exposure, screening for companies that produce alcohol, tobacco and weapons. Therefore, mining and sweatshops that employ cheap efficient labor have a free pass.

Talk about coming to the party late and with nary so much as a cheap bottle of plonk. While procrastinating over how the write researching this post, along comes the WSJ with Here Comes The Dumb Money (hat tip stonestreetadvisors). Gee, I wish i’d thunk o’ that title.  

Because over the last year, the MSCI Emerging Markets Index has risen over 35%:

And since 2008 over 142% - Not to also mention that HUMONGOUS Volume spike during Sept of last year:

And inflows for the week ending Jan 14th 2011 show that the leading Emerging Markets ETF, Vanguard’s Emerging Markets ETF (VWO) was once again among the ETFs with the highest inflows ($840mn).  Admittedly, the iShares MSCI Emerging Markets Index (EEM) was among the ETFs with the highest outflows (-$1.1bn).   

However, I believe the outflows from EEM has more to do with cost of VWO (ubercheap), and EEM lagging the MSCI Emerging Markets Index. Perhaps, lately a third reason - How EEM is structured.

VWO uses a replication strategy (it seeks to own as many of the underlying stocks in the index as possible),  holding as many as 800 stocks. EEM on the other hand uses a sampling strategy designed to deliver the index’s returns without owning all the securities in it and “optimizes” - a not-so-clever euphemism for backing the truck up on derivatives.  

Understanding ETF methodologies is an important criteria that is often overlooked by both professional and retail investors.  Of the roughly 1200+( numbers change frequently with additions and closures) ETF and ETNs that can be traded, maybe 75 are truly understood and should be traded.   
The rest are an exercise in futility, pandering to the masses desire for an investing elixir.
This is all part of the greater trend of investors missing out on a rally, and getting into the latest fad/innovation to jump start gains. Ordinarily, you would chuckle at the "dumb money", but plenty "smart" money gets in on the act too. 
You’ll know we hit bottom when there is an art mutual fund/ETF or worse an ETF that allows investors to Put Money on Lawsuits to Get Payouts.  Look carefully before you leap. 
Happy Trading

Friday, January 14, 2011

Risk Arbitrage back on?

A NYtimes DealBook article, Return of the Risk Arbs, declared betting on mergers is back from the dead in November 2010:

We're seeing people dip their toe back in the water and participate, said Keith M. Moore, a managing director at MKM Partners in Stamford, Conn.

Many investment banks echo'd that sentiment in their 2011 outlooks, proclaiming mergers will return with a vengeance in 2011, with the rationales being:

  • Healthy corporate balance sheets with access to accommodative financing and reasonable or some might say cheap valuations.
  • The need to buy growth.
  • Product and or geographic extension.
  • Cost rationalization.
I would, however be remiss in not including the improving swagger of CEOs with an appetite for destruction, deal making.

With mergers being back in fashion, we might see the re-emergence of risk arbitrage or merger arbitrage, one of the most popular hedge fund strategies. So time to brush up on the strategy, review any new FTC guidelines and crank up "ye olde arb spreadsheet".

So, what is risk arbitrage? I can tell you it is not buying stock in a company because uncle Vito said “something’s gonna happen, so get stuck in”. Although, it would probably be highly profitable, it is not arbitrage and can be illegal. Along the same lines is rumortrage – it means just what you think it does -, those in the market know what I mean – particularly the denizens of Foreign Exchange trading. Sometimes rumortrage works but more often than not that “strategy” results in loss or break even at best minus costs, of course.

Risk arbitrage is the systematic arbitrage of corporate events, wherein the terms of the event specify exactly what investors will receive in exchange for their holdings when the operation effectively closes. These corporate events include mergers, tender offers, exchange offers, liquidations, spin-offs, and corporate reorganizations. For a more detailed discussion of risk arbitrage click here.

One such corporate event was announced on Monday January 10th. Duke Energy (DUK) and Progress Energy (PGN) announced that their board of directors have agreed to merge the two companies, with DUK offering 2.6125 shares of Duke for every one of PGN, in a deal valued at $38 billion (inclusive of $12 billion in debt).


  • The pricing represents a 7% premium for PGN Shareholders to the stock price on January 5th and a 4% premium to the January 7th close.
  • It would also represent a 3% dividend increase for PGN Shareholders, based on DUK’s current dividend.
  • Both companies expect the deal to be accretive in its first full year and expect the deal to close by year-end 2011.

Approvals & Timing

  • Completion of the merger is conditioned upon, among other things, the approval of the shareholders of both companies, as well as expiration or termination of any applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.
  • Other necessary regulatory filings include: Federal Energy Regulatory Commission (FERC), Nuclear Regulatory Commission (NRC), North Carolina Utilities Commission (NCUC) and South Carolina Public Service Commission (SCPSC).
  • DUK’s current northern states (IN, KY, OH ) as well as PGN’s FL jurisdiction only require notice and will not have to approve the deal.

On the conference call discussing the merger, Progress CEO Bill Johnson shed some light on the merger rationale, that of reducing costs and improving the company’s credit rating to meet new environmental regulations.

With the current spread at $2.07 with a retrurn 4.6% (Duke has a dividend due on 2/9/11 of $0.245, which puts the current spread at $1.43 and the return at 3.23%).

As with the Cinergy merger in 2005, the timing for deal closure will be between 12 and 18 months. Which should keep thr annualized return in the 3.25% - 3.30% ball park based on current spread of $2.07($1.43 - DUK dividend).

Not super sexy, yet nothing to sneeze at considering 5 year treasury is yielding 1.96%.

I will update the blog, once the offer document is released and I have had time to go over it.

Happy Trading

(Full disclosure, I have a position on at $2.05 spread.)

Duke Energy and Progress Energy Service Territories.

J.P. Morgan served as lead financial advisor and provided a fairness opinion to Duke Energy, and BofA Merrill Lynch also provided a fairness opinion to Duke Energy. Lazard Frères served as lead financial advisor and provided a fairness opinion to Progress Energy, and Barclays Capital also served as a financial advisor and provided a fairness opinion to Progress Energy. Wachtell, Lipton, Rosen & Katz served as legal counsel for Duke Energy. Hunton & Williams LLP served as legal counsel for Progress Energy.


Thursday, January 13, 2011

Sturm und Drang!

This morning the Dept of Labor released the latest unemployment insurance claims:

 In the week ending Jan. 8, the advance figure for seasonally adjusted initial claims was 445,000, an  increase of 35,000 from the previous week's revised figure of 410,000. The 4-week moving average was 416,500, an increase of 5,500 from the previous week's revised average of 411,000. 

The advance number for seasonally adjusted insured unemployment during the week ending Jan. 1 was 3,879,000, a decrease of 248,000 from the preceding week's revised level of 4,127,000. The 4-week moving average was 4,056,500, a decrease of 72,000 from the preceding week's revised average of 4,128,500.

Jobless claims "jumped" was the headline from one news source:

The number of Americans filing for first-time unemployment benefits rose unexpectedly to 445,000 from 410,000 in the prior week, the Labor Department said on Thursday.

What boggles me is the unexpectedly comment, as turn on any channel or flip through any business periodical and the stark truth is revealed.  Analysts routinely say that companies cutting costs by "reducing" their workforce makes a company attractive to investors. These, mind you, are also the analysts that say that the economy is on the brink of collapse.

Investors are “rewarding” the efficiencies small businesses adopted to battle the recession because the changes have gone “hand and hand with better profitability,” said Michael Shaoul, chief executive officer of New York-based Oscar Gruss & Son Inc., which provides research to institutional investors.

Small businesses “definitely have cut costs in terms of reducing workforces,” so when “you do get demand rebounding, their margins are going to be expanding and that makes a lot of these companies attractive,” said Joseph Kremer at Fifth Third Asset Management in Cleveland, who helps oversee $250 million in small- and micro-cap stocks and recommends Old National Bancorp in Evansville, Indiana, which is acquiring Monroe Bancorp of Bloomington, Indiana. “That’s good for their efficiency, but not necessarily good for the unemployment rate.”

Despite the evidence of a moribund rebound, we will see the obligatory wailing, gnashing of teeth, headlines predicting the end is nigh, markets reacting irrationally. Pundits, prognosticators, snake oil salesmen and what not slinging their wares on one medium or another. Then comes the inevitable revision, and like a scripted drama in the news, everyone breathes a sigh of relief that the game of musical chairs can go on for a little while longer.

Right now, Peter is being robbed to pay Paul. The rate of employment, capitalism and growth are acutely linked. The increase in earnings and by extension profitability we have seen in the corporate sector over the last two fiscals years have come at the expense of higher unemployment.  Whilst we can quantify that in the larger publicly traded companies that have to report these things, small businesses are the engine room of the this nation, and right now they are figuring out how to increase efficiencies and boost margins without hiring more full-time workers.

“The recession definitely made me take a pause in terms of wanting to hire,” said Frey, 39.  
He’s unlikely to add full-time workers even after business improves because “I’ve never been more profitable,” he said. “We’re sitting on more than double the amount of cash than we’ve ever had.”
I believe the "productivity savings" experienced to date are coming to an end.  Companies will shortly resume hiring, as essentially employees are customers.  So when you next see a "breaking" news headline concerning the economy, take a breath, have a chuckle and remember - it is how the game is played.

Tuesday, January 11, 2011

Setting the table?

This morning Morgan Stanley(MS) issued a "tactical" idea for Bank of America(BAC) (Hat tip to StockBox), urging you to load up on the shares NOW!! 

Last week MS registered a new structured note, a three year 10% to 12% Contingent Income Auto-Callable Note due January 25, 2013 based on the Performance of the Common Stock of Bank of America Corporation. I detailed the workings of the nefarious plan investment hereAs I mentioned in my post, the investment being sold is a play on the coming volatility in BAC stock, with MS "winning" if the volatility in BAC stock price increases beyond a certain range.

That's why I found this "tactical idea" funny, as I thought MS was plotting to benefit from BAC's downfall. But, according to this call, MS actually thinks BAC is good for a 60 day pump rise in the stock price. This, then is probably ACT ONE in that volatility play.

Wait I forgot, investment banking departments have impregnable force fields known as Chinese walls that are meant to reduce collusion and conflict of interest issues. So obviously, the research department would not have a clue what structured derivatives dept was doing........
what was i thinking?

Perhaps, I read the prospectus wrong, yeah you know what, my bad, I read it wrong. That investment looks a sure bet, get stuck in..! 

Or maybe, just maybe they just needed a little stock "boost" before the deal closes on Jan 25th. Count 60 days, first reset day is April 22nd, that leaves a 30 day window for........? 
I'm not a cynic...... much. I know what I think, but the name of this game is think and analyze for yourself.

Happy Trading.

On to the good stuff:

Morgan Stanley: Buy Bank of America Now
From MS:

BAC.N, Bank of America ($14.40) /Research Tactical Idea

We believe the share price will rise in absolute terms over the next 60 days. Prior positive RTI recently expired with catalysts materializing of lower reps/warranties losses than market priced in. With BAC trading below book and the cheapest in our group, we see additional near-term upside because: 1) GSE settlement implications for non-agency losses (size and potential for settlement) and reduced reps/warranties tail risk; and 2) earnings release on Jan 21 where we could see NIM improving, credit continuing to improve and commentary around capital management. We estimate that there is about a 70% to 80% or "very likely" probability for the scenario. 

Saturday, January 8, 2011

Pssst psssst Hey kid, wanna buy a bridge?

Whether by fate or the mother of all %%$%#%, the day I decide to start blogging, Bloomberg LP decided to run a story on the same topic. Read my post with the link to the story here . Maybe there's more to the cookie tracking than we are being told huh? (Or maybe there IS something to be said for tracking cookies). - Hey, one can dream, right?

As I sit here poring over SEC filings, I came across a listing by Morgan Stanley, also selling a derivative on Bank of America’s (BAC) future performance.  I chuckled as unbeknownst to the sheeple clients that are being peddled these “instruments”, they are engaging in volatility trading.  Now most people think volatility is bad, but volatility is what makes the party. 

Think of volatility as the arc of a child’s swing, gentle pushes produces mild euphoria, perhaps a giggle or two.  But to get the squeals of joy/terror dependant on age of child, you would have to increase the arc/volatility of the swing.  Now think what catalyst creates the change in volatility or rate of swinging. Usually it’s a bigger, stronger person or in the case of BAC, the bevy of legal issues that awaits it as the year progresses.

That was rather a simplistic explanation, and before I get rapped by the cognoscenti, if normal distribution, Gaussian distribution, bell curve – all three mean the same thing, your swinging should be nice and symmetrical - , if skewness (in the swing analogy, how far you swing from the middle, ask yourself, do you swing back as high as you swing forward?), if kurtosis( the amount of times you swing to the same height/spot) and if fat tails(the one or two or three time you swung your kid to an angle not recommended by the swing manufacturer) leave you glassy eyed or asleep?

Stick to buying mutual funds. They really aren’t any better but we’ll save that for another discussion.   

The security being sold is a three year 10% to 12% Contingent Income Auto-Callable Note due January 25, 2013 based on the Performance of the Common Stock of Bank of America Corporation. The 80% threshold level is the contingent part; the stock must not be under that threshold on “re-spin” days. These dates are April 22, 2011, July 22, 2011, October 22, 2011, January 22, 2012, April 22, 2012, July 22, 2012, October 22, 2012 and January 22, 2013. 

If the stock price is below issue price but above threshold you will receive seven quarterly payments of 2.5% to 3% on the issue price of $10.  There is also an “early escape clause in case we miscalculated” that says if on one of the seven magic days, BAC is above the original offering price you will be repaid your investment plus the quarterly fee due. Game over.  We're taking our ball and going home. Having the temerity to win, is just not good form.

So, as long as BAC does not fall more than 20% over the next 3 years AND does go above the reference price you will be paid $0.30 quarterly for every $10 invested, except it would not be $10 as you paid 2 % in fees. In reality, you would be earning only 1% on the first payment as you have to fill the 2% hole. Should the price be below the threshold on any date, you get no coupon AND you get to keep playing! Joy oh Joy!!  Oh, and because you are only using BAC as a proxy and not really investing IN BAC, you do not “participate” in any appreciation in BACs price. 

But this is the best part – if on the 7th magic day, 7th heaven? Isn’t there a story somewhere about 7 virgins? I digress. If on the 7th magic day, the price is below the threshold, you get to “participate” in the DEPRECIATION of BAC. If the price is down 25% - you will receive 25% less than you put in. So no price appreciation participation, but what you DO get..., is the opportunity to spin the barrel and pull the trigger, SEVEN TIMES. With a SIX shooter!  
How you like them apples?

Still with me? I hope so, as it gets better. Lets recap, to earn a yield for the quarter, BAC has to be under the reference price - 20% max on the specified date. More than 20% and you get bupkis, however you get to spin the wheel again for the next quarter.  If, however on the specified date BAC is higher than the reference price, your investment is returned with that quarter's payment. 

 I read further and was astounded at the disclosures and pondered what would cause someone to discount them and to invest in an asset that, and I quote:
  • ·         We may engage in business with or involving Bank of America Corporation WITHOUT regard to your interests.
  • ·         Hedging and trading activity by our subsidiaries could potentially adversely affect the value of the securities.
  • ·         The U.S. federal income tax consequences of an investment in the securities are uncertain.
So, basically this is three card Monte, Wall Street style. You win, I take my ball and go home. It’s a draw? Fine let’s keep playing until you lose or better yet until I scr** you. But if I don’t, I’ll sic my uncle on you. Pretty gangster huh? La famiglia could learn a thing or two here.

Think about it, would you fly on an airline that has this disclaimer: Come fly with us, but don’t let the fact that our pilots aren’t trained bother you. They’re cheaper than hiring “real” pilots.

It seems that investors are making the same poor investment decisions as before, likely caused by a combination of behavioral mistakes (fear and greed) and a lack of education and sophistication necessary to properly evaluate these complex instruments. Investors underestimate the risks of equity investments, and in particular, the risks of individual stocks. 

The one thing we can be sure of is that financial institutions will continue exploiting investor mistakes innovating. The complexity of financial investments is designed in favor of the issuer, not the buyer.

Caveat Emptor!