Sunday, February 20, 2011

The Art of War, or:How China plans to dominate the world economy

(This note was originally posted on Jan 31, 2011 @ StoneStreetaAdvisors)

“If you lay siege to a town, you will exhaust your strength and resources. Therefore, feed off your enemies and forage for their resources.”
~ Sun Tzu

With a war chest of $2.85 trillion, and a renewed swagger it was only a matter of time before China flexed its economic might by diving back into investing in western banks.  After ill-fated multi-billion dollar investments in Blackstone Group LP, Morgan Stanley and Barclays PLC, last week a Chinese bank agreed to buy a stake in the US arm of Bank of East Asia.

Industrial and Commercial Bank of China (I.C.B.C.), the largest of China’s “big 4” state owned commercial banks agreed to pay $140 million for an 80% stake in the United States subsidiary of the Bank of East Asia, which is based in Hong Kong and has 13 branches in New York and California. The rationale was:
“Chinese banks are aggressively seeking to expand overseas, hoping that they can support Chinese companies abroad instead of losing them to American and European financial companies.”
This was I.C.B.C.’s second investment in North America, after buying a 70% stake in the Canadian operations of the Bank of East Asia Last year. It’s most notable investment however, is the 20% stake in Standard Bank South Africa that provides it with access to mining, energy and other resource firms in Africa.
According to a recent PwC analysis: "China's appetite for overseas assets is insatiable, with natural resources remaining a key industry target, as the country aims to secure the resources it needs to fuel its engine of economic growth," Mr Brown said.  As predicted by PwC earlier in the year, apart from continued strong interest in natural resources, there has been an increasing number of acquisitions of high technology companies, as Chinese buyers look to bring know-how back to China to foster a developing economy.  There is also strong interest in machinery and equipment manufacturers, and the automotive sector.”
Nothing new there you might say, except with the Yuan appreciation, the stumbling Euro and the continued Dollar malaise, it seems outbound Chinese M&A is about to explode, after rising by more than 30% in 2010.
Two recent developments also give impetus for reassessment on how to play China:
  • Chinese financial institutions are pushing into Europe, opening bank branches(I.C.B.C is opening branches in Paris, Brussels, Amsterdam, Milan and Madrid this month), scouting for deal opportunities and even attending German banking classes(China Development Bank is one of four finalists bidding for a large stake in troubled German bank WestLB AG).
With the continent's banks in shambles and no viable alternatives, China’s quest to be the global powerhouse could very well be accomplished before it’s begun.
  • China Opens a Door on Currency Swaps, China will allow some banks to trade currency swaps for corporate clients starting March 1, extending the use of the financial derivative beyond the interbank market—a move that facilitates corporate foreign hedging as Chinese trade continues to expand and cross-border investments accelerate.
Letting corporate clients enter into currency swaps could also pave the way for China to allow foreign companies to issue Yuan-denominated bonds in China, traders said.  Could this be the precursor to letting the Yuan float (somewhat) against the Dollar?
I would keep an eye on $CNY, $CYB, $FXI, and $CHIX.
Could all these moves be the set pieces for the next phase of world war III mentioned by georgetownjack?
I know what I think!.
I will leave you with one final quote:
All warfare is based on deception. Thus:
When able, manifest inability.
When active, manifest inactivity.
When near, manifest far.
When he seeks advantage, lure him.
When he is in chaos, take him.
When he is substantial, prepare against him.
When he is strong, avoid him.
When he is wrathful, harass him.
Attack when he is unprepared.
Emerge where he does not expect it.
~ Sun Tzu

Tuesday, February 8, 2011

A Response to Arbitrage Pricing Theory - MBA Mondays with Darwin

Initially,  I meant this response as a comment to a recent blog post, Arbitrage Pricing Theory - MBA Mondays with Darwin, however as I began to write, it has taken on a life of it’s own.

I commend Darwin in his endeavor to educate the general public, however to quote Darwin himself from a previous post :

“Not only do I disagree with his opinion, but I’m concerned that his advice is actually dangerous and gullible readers will lose money as a result.”

I realize that merger or risk arbitrage is presently alluring due to the raft of deals! coming to the fore.  In Risk Arbitrage back on?, I gave the reasons why many arbitrageurs are gearing up for what could be a banner year. I would caution, however that the subject is somewhat daunting, the scope of which cannot be covered in a single blog post.

That being said, I believe a little more color would dissuade any notion that putting on a risk arb trade is as easy and profitable as Darwin suggests. Hopefully I will enable readers to have a better understanding of the process of trading a merger deal .  Risk arb hedge funds have done rather poorly for the past few years, due to amongst other things the length of time a deal takes to go through which really screws with your return.

Merger Arbitrage - Whilst I agree with the basic outline of Darwin's merger arb paragraph, I think he is doing his readers a disservice by the rather simplistic overview of Risk Arbitrage given.  The announcement of a merger deal is merely the first scene of the first act of a production that could give Wagner’s Ring Cycle a run for it’s money.

Due to the scope of the subject matter, I will merely address the points Darwin has raised. He mentions that the price never reaches the theoretical price of the offer, this is technically not true as sometimes the price exceeds the offer price. Depending on whether the acquirer is paying a large enough premium, or if the offer undervalues the target, the target stock price will react accordingly.

Perhaps there is an alternative bidder as in the deal cited - AVIS(CAR) /Dollar Thrifty(DTG).  Initially the deal was between Hertz(HTZ) and Dollar Thrifty(DTG), The terms consisted of an exchange ratio of 0.6366 HTZ + $25.92/share in cash, and a $6.88/share special cash dividend to be paid by DTG immediately prior to the transaction's closing.

But the biggest reason the prices do not converge is it is not a “done deal”. There are many hoops to jump through beyond the initial announcement.  Typical timing for a non hostile, non regulated deal is 90-120 days.  That gives it enough time to clear the HSR antitrust act hurdle, and get SEC, DOJ , FTC and respective shareholders approvals.  Should it be in a regulated industry such as utilities, as in the recent Duke/Progress merger, timing increases to 1 year on average, to clear the additional regulatory bodies.

Now we get to the sexy, exciting, risky part of risk arb. The calculations have to work for you to even consider the trade.  How is the offer structured? all cash? cash and stock? In the deal cited, AVIS(CAR) initially offered $39.25 cash and 0.6543 CAR for every DTG in July 2010. That spread blew up(DTG stock price traded at a premium to the offering price) as the market thought the offer was not reflecting the inherent value of DTG.

Lets take Darwin’s hypothetical:

"So, let’s say you went out and bought shares on Monday and within a month, the FTC ruled that the deal could go through.  That would be a gain of ~$3 per share (6%) in a month, which is well over 70% annualized."

AVIS(CAR) upped the offer to $45.79 cash and the same ratio 0.6543 in September 2010, for a theoretical offer price tonight of $53.24 vs  RTG ask price of $49.9 for a $1.69 spread or a spread premium of 3.27%.  To get the spread you have to lock it in  - so for every 1 DTG you buy , you have to sell .6543 CAR.

As a retail investor you would get shitty borrow rates - if your broker can get the borrow that is - right there your 3.27% return is more like 2%. The retail investor can bump returns up with leverage(like hedge funds) - which you also have to pay for - so that cuts further into your return. Depending on the broker, there will be a short interest credit(interest on the short sale of CAR - but again as a retail customer, its bupkiss)...

As an alternative to buying the target and shorting the acquirer,  you can utilize a buy-write(selling calls against a long stock position) or put purchase strategy to alter the risk reward profile.  In this example, Buy 100 DTG and sell a DTG Call or Buy 100 DTG, sell 65 CAR and buy 1 DTG put.  A word of caution, the put purchase strategy would cut sharply into your return, but your risk would be greatly reduced also.

I will end here as I guess 80% of you are no longer interested. For those of you that are interested, shoot me an email. I  would agree with Darwin that the deal is looking dicey but only in terms of what the eventual company would look like.  I think there will likely have to be some divestitures which might play havoc with the accretive numbers Avis is pumping out..

To wit, I am all for education, however there is no short cut or easy way. There are no cliff notes either. The work and risk involved should be made crystal clear, it is NOT easy.  Look at the mutual funds that thought they could replicate a risk arbitrage strategy. It is by no means impossible, but it takes a lot more work than the normal investor is willing to put in.

Happy Trading!

Saturday, February 5, 2011

T2 Partners’s Mea Culpa: A Study in Behavioral Finance.

T2 Partners eagerly anticipated investor letter(H/T is finally here and what a doozy it is.

Why was it eagerly anticipated? Well in early December T2 managing Partner Whitney Tilson publicly disclosed his short trade analysis on Netflix ($NFLX).

Whether that analysis was posted as a genuine critique of the stock or as an attempt to pressure the price, no one can know for sure, but there are many arguments for and against such a post.  In any case I commend him not only for putting his analysis up for scrutiny, but also for acknowledging in his most recent January investor letter that he was wrong, albeit belatedly and significantly lighter in the wallet.

From the January T2 Investor letter:
"Over time we've been quite successful shorting fads, frauds, promotions, declining businesses, and bad balance sheets. Where we have had much less success, however, especially in recent months, is shorting good businesses that are growing rapidly, even when their valuations appear extreme. Such open-ended situations, regardless of valuation, are very dangerous, so going forward we will avoid them entirely unless we have a high degree of conviction about a specific, near-term catalyst."

My first reaction was, hang on a minute, If in the future you are only going to go short based on a high degree of conviction, what was your conviction for shorting in the past? Granted, in an earlier post I suggest that success is never guaranteed, no matter your educational pedigree or tenure in the business, but a necessity in trading and investing is confidence and a high conviction in your analytical conclusions. The question is, when and how to reevaluate that conviction?

My second reaction was, judging from his original argument regarding NETFLIX ($NFLX) it seems the reason Mr. Tilson held onto the stock as long as he did, and even added to the position was due to a high degree of conviction in his analysis that $NFLX was overvalued.

Over at The Big Picture, Barry covered his 8 Basic rules for shorting stocks, and I would like to posit that a 9th rule to consider is the psychology involved in holding a short position. T2’s $NFLX saga is a worthy candidate for such a behavioral finance case study.

Behavioral finance is the study of the influence of psychology on the actions of financial practitioners and the subsequent effects those actions have on markets. Behavioral finance is interesting because it goes some way to explain the inefficiency that exists in the market, by way of human irrationality. Bye, Bye Efficient Market Hypothesis!

The basics of behavioral finance are that humans are prone to cognitive biases that cause us to throw rational, linear thought to the wind. The T2 $NFLX trade, exhibited evidence of many of these cognitive biases, in fact Mr. Tilson even brought up the very notion of being biased.

The emotional side can be even more difficult. Numerous studies of investor behavior (the field is called behavioral finance) show that once an investor has a position in a stock, there are tremendous biases to seek confirming information, ignore disconfirming information, and not admit a mistake. We don't claim to be immune from these emotions, but we've studied them extensively and do our best to block them out.

The  cognitive biases that stand out to me were overconfidence and confirmation bias - particularly underemphasizing the impact of growth(international and domestic), failure to account for sentiment surrounding the stock and overemphasizing the impact of increased content costs - and escalation bias, whereby  T2 continued to invest in $NFLX even tough it was a losing trade, perhaps to the detriment of a winning trade.

First, we think it's healthy to disclose and fully analyze our mistakes (although in this case we are not yet conceding that we've made a mistake in our analysis, but we obviously made a mistake in terms of timing our entry into the position).

This is after admitting in the very first sentence that :
We've lost a lot of money betting against Netflix (NFLX), which is currently our largest bearish bet, in the form of both a short and put position.

This is a clear indication that having knowledge or information does not always lead to taking action.

We are all guilty of these and more biases in our investing/trading lives, and it is particularly helpful for the beginning trader, finance professional, or retail do-it-yourselfer to see that even one as storied as Mr. Tilson is not immune.

Happy Trading