With a promise to get back to our treatise on market neutral products, let’s take a minute to welcome in that delightful season … summertime. Even the most driven and serious investor needs a pause from the markets. However, in some cases, it has been so long from a true respite that the “sturm and drang” of Wall Street can sometimes overwhelm and worse, cause bad decision making. With that in mind, here is our list of pursuits one can take during the “dog days.” Forgive us if we fail to mention slogging out to some tony beach hamlet, in an effort to unintentionally re-create the stress, while staring at the ocean.

Play a child’s game: We are not talking about golf, tennis or squash (in fairness, I have been playing golf since I was a boy). However, once you set up a tee or court time, gather the requisite equipment and exchange pleasantries, you are basically back at work. How about playing wiffleball, shooting a game of “Horse” on the basketball court or arranging a pick-up game of touch football? An activity where the only point is to have fun. We have all forgotten how enjoyable it can be.

Eat something decadent: It’s summertime—eat something “not so good” for you. Some suggestions, a banana split, of course, with the works; a chili cheese dog; fried clams; or a funnel cake. There’s a start, you get the idea.

Visit a farm stand: There is nothing quite as satisfying during the summer as freshly shucked corn on the cob with a farm-grown tomato salad. Add in a grilled piece of meat or fish, a cold beer, and you have the makings a remarkable meal.

Read a long-forgotten book: I am not talking about something on the New York Times best seller list or a choice from Kirkus, we suggest reading, or perhaps, re-reading something you enjoyed when you were younger. As for me, I enjoy anything from Steinbeck.
Take an “aimless” drive: Get in the car and go for a long ride without a predetermined destination. Take your time and “drink in” the sights and sounds. If you see something interesting, stop the car and explore it. If possible, leave the mobile phone home.

Play a Board Game: Remember the days before electronic games? Dust off the old boxes and take out a board game. We like to play “Milles Borne.” Some other fun suggestions are Scrabble, Parcheesi or Yahtzee. Preferably, do this in the evening with a cold pitcher of pink lemonade.

Sit by the Ocean: Go to the shore, sit on a bench and take in the enormity and majesty of the sea. Sit for a while and suddenly, the” last sale” in your favorite tech stock doesn’t seem that important.

Go Fish: I am not talking about taking a “fifty footer” out to the canyon for tuna. How about throwing a line over the pier on a pleasant evening? Take a loved one, a refreshment and couple of sandwiches on white with chips. Andy and Opie were definitely on to something!

Go on a “ride”: For the less faint of heart, you can give your favorite roller coaster a whirl. For others, a merry-go-round or a Ferris wheel will work. One other item to mention here—cotton candy.

“JAWS”: Finally, pick a long weekend, gather your favorite people, fire up the popcorn maker and watch the quintessential summer movie …the original “JAWS”. Trust me, when Roy Scheider utters “Your gonna need a bigger boat,” you will remember how it feels to be ten years old again.

That is all for now. How about a Slushie? ….…The Thoughtful Arbitrageur.

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

Read previous TTA entries here.

Ask any hedge fund expert or Wall Street professional and they will acknowledge that the short sale is the magic behind hedged strategies. Think of the short sale of equity in the context of Superman’s Bizzaro World where everything is opposite. For instance, purchasing equity requires a capital outlay, a short sale creates capital. A long stock position entitles the owner to capital appreciation and dividends. Short sellers make money when a stock depreciates, and since they must use borrowed shares, they owe the lender dividends paid while the stock is in their possession. In the final analysis, a long equity holder has unlimited profit potential while the short seller can lose infinitely and only benefit to the extent that a stock reaches zero. In all respects, it is the inverse of a purchase, yet, when combined with a long position, it establishes the very essence of why “hedge funds” were conceived.

To fully understand the short sale, let us go through a fictional transaction using our ABC stock previously mentioned in TTA. If you recall, ABC common paid a 2% dividend (40 cents) and traded at $20 per share. If one wished to short 100 shares of ABC, they would first have to contact their clearing broker and arrange to borrow the shares of ABC. Assuming the stock was available at the clearing broker, the short seller would sell 100 shares at the market for a $2,000 credit (100 shares x $20). The short seller would then deliver to the buyer the borrowed shares. In turn, short seller would give its clearing broker the $2,000 as collateral for the borrowed shares.

The clearing broker would invest that capital in an ultra-short term, presumably safe investment, such as LIBOR or Fed overnight funds. When the transaction is unwound (the purchase by the short seller of 100 shares of ABC stock, hopefully for less than the $20 per share price at which he sold it) the shares would be returned to the lender and the collateral would be used to pay for the purchase. The broker and the short seller would split the proceeds of the interest earned by the broker during the period the short sale remained outstanding. The short seller’s end of those proceeds is called a rebate and is usually expressed as a percentage of LIBOR or Fed Funds. That is the mystery, from an accounting perspective, of a short equity sale.

As far as the clearing broker is concerned, there is a very good deal in this transaction. A broker sources borrowed stock in one of two ways. One method is to go to other brokers, or long equity holders, (mutual funds, foundations, etc.) and borrow their available shares. In this case, both broker and lender split the proceeds. The other more profitable approach is to use shares that are in the broker’s domicile, thereby earning their full share of interest accrued. However, the key is just how the broker has those shares in the first place. Usually it is because their clients own these shares in margined accounts. When a client margins a stock, they sign a hypothecation agreement. Hypothecation, for our purposes, is fancy French for a contract that allows the broker to use those shares for short, fully collateralized, “loans.” Since the loans are fully collateralized by the short seller’s funds, there is virtually no risk to the broker except in extreme circumstances. Thus, the broker lends to a client at broker loan and can collect interest from a short seller (arbitrageur) as long as the loan is outstanding.

This arrangement is beneficial to all parties concerned. The lender gets a credit for stock that would otherwise be held dormant. The borrower gains access to the stock and the broker earns a deserved fee for acting as an agent. The longer the loan is outstanding, the better it is for all. This is why the arbitrageur (convertible, option, merger or otherwise), who may retain a short hedge for months or years, is a valued client. In the case of the convertible hedge fund, the short protects the long convertible position while generating positive cash flow, a subject we will cover soon. This is a position the convertible arbitrageur may hold for a long period, continually re-hedging his position while earning interest. Suffice to say, it works for all sides of the transaction.

In effect, the rebate earned by the hedge fund helps to cover the long financing cost of the convertible security. As we will thoroughly review in future sections, the short rebate can in fact, cover most of the long debit cost. Given the yield spread between the interest earned on the convert and the dividend paid by the arbitrageur to the stock lender, the set-up becomes very attractive. To summarize, the rebate earned by the short seller makes up for most of the long financing in most market neutral strategies—that is why it is the “secret sauce” of market neutral products.

A few final caveats concerning the short:

- The borrowed stock must be freely available. If not, the consequences range from a smaller rebate to an outright demand for the stock if it becomes scarce. This situation is known as a “short squeeze.” The latter can be disastrous for the arbitrage set-up.
- The rebate percentage is, like all things financial, negotiable. A bigger fund can demand better rates creating an “economy of scale.” We will also demonstrate in the future how the rebate rate affects option pricing.
- Since the lender pays the borrower a dividend, unexpected dividend increases can be harmful to the arbitrageurs’ spread. Therefore, dividend projections loom large when viewing a market neutral set-up.

We are now ready to look at hedging. Our next TTA will begin to explain the process of hedging a long convertible security. We will explain a convertibles delta, and how volatility impacts a hedge. More than any other factor, here is where the convertible arbitrage position becomes an art form. This is where arbitrageurs earns their keep.

Baseball … as we approach Memorial Day

Baseball aficionados view Memorial Day as a time to adequately assess a baseball season. At this point, there have been approximately 40 games played, or 25% of the season. It is enough of a sample to be meaningful. With that said, here are a few of the surprises:

- The prognosticators favored the Detroit Tigers and Miami Marlins to dominate; both teams have disappointed so far.
- The lowly Baltimore Orioles and New York Mets (as a disclaimer I am a die-hard, patient Mets fan) have played competitive baseball, far above their expectations.
- Highly paid free agent Albert Pujols (in fairness arguably the best hitter of his generation) has failed to produce in his legendary fashion.
- The once-written-off-as-over-the-hill Derek Jeter is playing as well as at any time during his storied career.

What this tells us is that predictions are many times only worth the paper they are written on. Witness the disappointing debut of Facebook’s IPO. There are those that spoke of Facebook’s success in the market as a fate accompli. I guess they forgot about AOL or Web MD. For Facebook CEO Mark Zuckerberg and company, it is clearly a win. Yet, Facebook’s eventual triumph as an equity is yet to be determined.

The Tigers, Pujols or Zuckerberg may eventually knock it out of the park. Nonetheless, it has not yet worked out as neatly as the mavens prophesized. I like to save old newspaper clippings of forecasts and revisit them later. It gives me a sense of perspective. Reconsidering stories such as “the can’t miss” draft pick who floundered, the highly criticized movie that became a cult classic, the business genius whose strategy ultimately proved fruitless or the glamorous movie star we hardly remember … are life lessons worth learning.

Then there are the Jeters, the Eli and Peyton Mannings or Kobe Bryants. They prove to us that hard work, determination and humility ultimately win consistently in the end. They serve as reminders that the games must eventually be played in order to resolve the contest. You cannot determine a victor on paper. Investors will be well advised to remember this when reaching for the next hot fad while passing up a genuine value play.

Until the next time …The Thoughtful Arbitrageur

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

Read previous TTA entries here.

In our last Thoughtful Arbitrageur, we began our discussion of market-neutral products and, in particular, Convertible Arbitrage. We presented a fictional convertible security, the ABC 5% convertible bonds maturing in 10 years. This bond is call protected for three years, and pays interest semi-annually. The bond is convertible into 40 shares of ABC common which trades at $20 per share and has a dividend yield of 2%.

As promised, we will serially lead you down the path toward understanding market-neutral strategies. Keep in mind that our ABC Bond is what arbitrageurs call a “plain vanilla bond.” “Plain Vanilla” is a security which is basic to the product. Though we will review more exotic creatures later, in order to learn we must first crawl. If you review our last piece, you will be up to date. With that said, we now look at the special considerations one must ponder in order to become proficient in the convertible arbitrage field. This will set the stage for our next missive, which will center on the short sale of an equity which hedges the convertible.

Above all else, read the fine print

Every convertible has a document that spells out the contract between the purchaser and the issuer. As in catching a ball with two hands in baseball, it is good discipline to become familiar with these agreements. For a convertible bond, it is an indenture. For a preferred, it is called the offering memorandum and the articles of incorporation. As in most legal treaties, much is boilerplate. However, there are a couple of key features to be aware of:

The Conversion feature : In this section, the issuer spells out the terms of convertibility. Here, you will learn the mechanism for tendering your bond, or preferred, for common shares. Essential to this, an investor can ascertain how the mechanism is adjusted for special events. Stock splits, mergers or restructurings are among the developments that can impact the convertible holder. As in most detail oriented pursuits, with time and practice, the investor will almost be able to anticipate what the terms will look like. A great shroud of the mystery in convertible investing lifts with a comprehension of this topic.

The Call Provision: This is clearly a crucial part of the document. A convertible’s call feature effectively sets a time limit on the option portion of the security. One needs to master the terminology used in this section since “time to expiration” is of the essence in options investing. Additionally, a key feature to watch is whether a convertible security has a premature, or in the vernacular, “screw” provision. This provision allows a company to make a final call of the security just prior to a bond or dividend payment thus, “screwing” the holders out of recompense. The astute observer learns how to spot such pitfalls.

Other Representations: Finally, there are considerations that affect almost every bond, convertible or otherwise. The convert player must be aware of covenants that will protect the bond’s creditworthiness. If the issuer takes actions that may diminish the company’s ability to pay coupons, this is the where the lender is protected. Special events such as leveraged buyouts, acquisitions or spinoffs have at times crippled a bondholder. Knowing how stringent these covenants are, plays a major role in fixed income investing. Once again, familiarity and experience clearly come into play. The arbitrageur, who pays special attention to these details, is clearly rewarded. In effect, he is buying an additional liability policy.

Just like a Gemologist, know your market: The smart shopper, whether in a supermarket or a souk, knows what is available and where there is value. Just as a gemologist gauges the worth of precious stones, the clever arbitrageur appreciates the convertible menu. Among factors to consider are liquidity, availability and company history. Two identical looking bonds may in fact, trade much differently for a variety of reasons. Certain convertibles always trade dearly while others are constantly discounted.

I remember a Home Depot issue that always exhibited an unusually large premium. This was due to the fact that certain convertible buyers loved the underlying equity. There are times when a bond, or preferred, will inexplicably stay outstanding long after its call protection expires. While it would be logical to assume a call, the security continues to pay interest or dividends. This may be explained by a quirk in the issuer’s finances or perhaps for reasons only known to executive management. The trick is to know these nuances and profit from them. Here again, hard work is rewarded. That is why some of the sharpest investors, like Buffett, favor this market. An edge that can be obtained through diligence, preparation and practice is significant.

Caveat Emptor - the convertible tides shift from time to time: Lastly, there are periods of illiquidity and those of exuberance in the convertible sector. Converts may stay rich for years and quite suddenly, the world changes. This may be due to a tough economic period, volatile interest rates or geopolitical episodes. As a farmer prepares for a drought, the astute convertible arbitrageur must always manage a portfolio with tough times in mind. Keeping leverage low and sticking to better quality are just some of the ways to weather a malaise. Knowing that this is possible is power enough to shepherd you through a down market. In the final analysis, it is these cycles that create lush prospects.

We conclude this chapter on Convertible Arbitrage with this advice: It is the idiosyncrasies of the product that a true arbitrageur cherishes. After all, attention to detail and single-minded research can give the superior arbitrageur a competitive advantage. Any time you can increase return, legally and organically, opportunity beckons.

Next time, we visit the short sale, the magic sauce to market-neutral investing, as we begin to describe “the hedge.”

The Death of Sam Wo

Sam Wo’s in San Francisco’s Chinatown, closed recently due to health and safety code violations. The codes were enforced on this San Francisco institution in the name of progress. We will not speculate as to the severity of the issues; we have no right or experience. However, a neighborhood icon has unfortunately closed. The following excerpt from the San Francisco Chronicle sums it up:

“Sam Wo restaurant in San Francisco’s Chinatown closed its doors Friday [April 20] for violating a litany of fire and health codes, but the story’s not over yet for one of the city’s most storied hole-in-the-wall eateries.

“Owners of the 100-year-old Washington Street restaurant famous for its no-frills, late-night food and its you-get-what-you-get service have the chance to plead their case Tuesday morning [April 24] at a hearing with the city’s Public Health Department, said department spokeswoman Eileen Shields.

“Owner David Ho’s daughter, Julie, told The Chronicle that they plan to attend the meeting.

“‘This restaurant is my life,’ she said Friday, overcome with emotion. ‘We’re definitely closing for the weekend, but beyond that nothing is definite.’”

Ho, whose father was home resting after a long day, said lines to get in one last meal at the restaurant were wrapped around the block for most of the day Friday. While they’ll certainly have the support to stay open—the restaurant gained renown in the city thanks to the storytelling of Armistead Maupin, Herb Caen and even Conan O’Brien—it will be an uphill battle, Shields said.”

Sad it is, because Wo’s was one of those places that “oozes” character and serves as a canvas for lasting memories. Every city has them and they are the antithesis to the Olive Gardens and Ruby Tuesdays of the world. With apologies to John Donne, every place like this that dies diminishes me. Let’s hope the San Francisco civic leaders find a way to reopen Sam Wo. We need to preserve our neighborhood “joints,” so to speak. Without them, our descendants lose a link to the past and we will all become homogenized without ever realizing it.

Lastly, PBS’s Frontline has been running a series entitled “Money, Power and Wall Street.” Frontline documents the global financial crisis. It is illuminating, insightful and fascinating. I urge every reader to watch it. Bravo, PBS!

Until the next time … The Thoughtful Arbitrageur.

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

Right from the outset, The Thoughtful Arbitrageur promised to educate its audience on Market Neutral products. In particular, we spoke about convertible, merger and options arbitrage. These are strategies that have always been popular due to the fact that their performance is “usually” not correlated to the general markets. With that said, we will begin by discussing convertible securities. In order to understand Convertible Arbitrage, a topic that will be revisited and studied iteratively, we first must understand how a convertible works. These hybrid stock and bond securities have confounded, yet fascinated, professional investors for decades. However, when they are reduced down to their essence, they are comprehensible.

Think of a convertible security as a bond with a call option attached to it. Though there are many flavors in the convertible universe—domestic, offshore and exotic—we will begin with the most basic and arguably the most popular, the “plain vanilla” convert. Regular, or “plain vanilla,” converts are exchangeable for a predetermined number of shares of the issuer, for a set period of time. Convertibles are issued as bonds or preferred shares. As with equity options the right to convert terminates at a set time after issuance, either through maturity or the issuer forcing the bonds conversion. As opposed to listed options that expire on a certain date, the issuer of a convertible can elect not to force the convertible holders to convert their bonds into shares. While in most cases it economically behooves the issuer to “force conversion,” there are times when the call option may be left open for a variety of reasons. These reasons will be discussed in future missives. However, factors like these are but one of the estimable vagaries that makes investing in these hybrids intriguing.

When describing any financing vehicle we need to look at it on a “quid pro quo” basis. In other words, the best way to view any business transaction is to look at it from both the buyer’s and seller’s perspective. One also needs to possess a conceptual understanding of the product. Too often there is an intellectual confusion in understanding finance when the learner gets too focused on the “math.” I have witnessed educated traders devote countless hours trying to perfect a model that can be bought off a shelf. All along they were missing the fundamental framework that drives the value of a convert. There are certain behaviors that cannot be modeled. Our feeling is that if you appreciate and master the concept you can conquer the subject. Let us look at a fictional convertible bond: The ABC 5% convertible bonds maturing in 10 years, call protected for three years, and pays interest semi-annually. The bond is convertible into 40 shares of ABC common which trades at $20 per share and has a dividend yield of 2%. Current and outstanding ABC 10-year bonds have an 8% yield to maturity.

Why would the issuer (ABC) finance using a convertible rather than a straight bond?

There are two key reasons an investment banker can sell ABC on the idea of floating a convertible bond:

1. Notice that ABC’s current 10-year debt trades at an 8% yield to maturity. By offering a convertible feature, ABC can finance at 5%! It should also be observed that if this bond trades at approximately 80 cents on the dollar, or $800 per $1,000 maturity amount, the yield-to-maturity will equal 8%. Thus, $800 is our theoretical bond floor, as our bond should hold value at that level, thus creating a put on our investment. This is known as a convertible’s “investment value.” Of course, this is subject to interest rate and credit risk. However, this put is a crucial feature to consider when purchasing a convertible security.

2. ABC may feel that its equity is approaching full valuation. Offering the convert allows ABC to sell its shares at a higher price. Since the bond is convertible into 40 shares of common stock, the conversion, or strike price of the call option is $25 per share. We derive this by dividing the $1,000 bond price by the conversion ratio of 40 shares or 1000/40 = 25. The bond is call protected for at least three years, therefore with ABC common currently trading at $20, we have a call option on 40 shares up 25% (25-20/20) with at least a three-year life. ABC can now issue shares at $25; it makes sense for either buyer or seller depending on your view of ABC. That in effect is a fair and sensible transaction since both issuer and purchaser can realize their respective goals.

What does the buyer receive?

The buyer of the ABC convert receives the aforementioned call option on ABC, and a significant yield advantage. This is by virtue of the fact that the buyer receives a 5% payout, and the additional comfort of a bond investment, as opposed to a 2% common yield. Traditional convert owners calculate this yield advantage in a payback period, where their yield advantage earns back the call premium on the bond, when valuing a convertible. The buyer also enjoys a theoretical put on his investment by virtue of the bonds “investment value.” An investor who believes in the upside of ABC, and is seeking yield, will embrace this type of security.

Again, we will amplify this product in future pieces. We will also categorize and explain the many and varied nuances and caveats, one encounters when purchasing these hybrid creatures. At the risk of overburdening you, we will conclude our first convertible lesson. Our next piece will deal with the cautions one must consider when opting for a convertible investment. This will set the stage for understanding the “Convertible Arbitrage” and our entrĂ©e into the world of market neutral investing. We are passionate about sharing these thoughts with our readership. Not knowing the possibilities and mechanics of arbitrage and its components is like shopping in the supermarket and only looking at a portion of the shelf space. Investing is challenging enough and there is no need to leave an additional advantage to others.

Who is Dr. Breslow and why are we speaking about him?

In our mindlessly hypercompetitive world, even longevity has become an obsession. There are those who view a long life as enviable without ever asking about what a person represented during that life span. Please do not get us wrong, a healthy lifestyle is essential and should be one of life’s goals. Nonetheless, a well-rounded complete life, full of all the good and happiness that was intended for us, should be our first priority. With that thought in mind, let us take a moment to remember Dr. Lester Breslow.

Dr. Breslow died last week at the ripe old age of 97. His New York Times obituary was titled “Lester Breslow, Who Linked Healthy Habits and Long Life, Dies at 97″. He empirically showed that longevity was linked to seven habits tied to moderation. We adore a simple, yet profound idea such as this, since that is the making of genius.

Dr. Breslow who served many presidential administrations came from a humble background yet rose to prominence. He stressed social action, as well as, science to improve people’s lives. The following quote from his obituary summarizes his philosophy:

“In 1952, President Harry S. Truman appointed Dr. Breslow director of a commission to assess the nation’s health care. The panel’s report emphasized that people make their own health choices but ‘exercise them mainly under social influences.’

“In 1969, as President of the American Public Health Association, he said the public health profession must go beyond issuing scientific reports and suggest social actions to improve people’s lives. “In the long run, housing may be more important than hospitals to health,” he said.”

What stunned the public health world was Dr. Breslow’s “ground-breaking” Alameda County study that he supervised as a Director of the California Public Health Department. In it, he definitively linked longevity to the following behaviors:

- Do not smoke.
- Drink in moderation.
- Sleep seven to eight hours per night.
- Exercise, at least moderately.
- Eat regular meals.
- Maintain a moderate weight.
- Eat breakfast.

As we mentioned, simple yet genius and all based on an important fundamental concept … temperance mixed with some discipline. This is wise advice indeed regarding health, investing and life. Rest in Peace Dr. Breslow.

Until the next time … The Thoughtful Arbitrageur.

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

Spring is here … and what better way to celebrate it than by cheering on your favorite team. Baseball is finally back!

In fact, for many of us, baseball serves as a zeitgeber to awaken our souls from the long slumber of winter. In a phrase that may be hackneyed, “every team is in first place on opening day.” That is perhaps the most poignant signal that we are ready for the enthusiasm that springtime and baseball offer us.

There are numerous similarities between Fund Management and sports. Many former athletes are attracted to the business of Wall Street. A life in the industry requires quick reflexes, stamina and the desire to compete. One is judged at the end of each trading day and the results are clearly “black and white,” or should we say “green or red.” Thus, there is a great deal to learn from sports and in particular, our national pastime. Here are a few lessons:

It’s a Long Season

It is definitely a long time between “pitchers and catchers” and the World Series. The best baseball managers realize that they cannot win every game. However, they try to preserve their team’s resources similar to a general at war, as well as, win 2 out of 3 games per series. Finishing the season at a two–thirds winning percentage, possibly guarantees a post season playoff spot.
Fund Managers are well advised to learn from this tactic. You cannot make money every day. However, if your winners outpace your losers, you will most likely attain a competitive track record. A manager also needs to be fresh from January to December. That means knowing when to walk away from the tape and rest one’s thoughts. They are called the “dog days of summer” for a good reason.

Consistency, and controlling the noise, is key

Great managers spot a player with a consistent approach and pencil them in the lineup every day. Good players know that they need a “repeating swing,” they refuse to revamp their style during an occasional slump. They may make adjustments, however, the All-Star remembers what got them to the majors. Performers such as Derek Jeter or Albert Pujols know their mechanics better than anyone and thus, trust themselves. They learned this on the field as kids. They also control their emotions. By ignoring the outside noise, the professional competitor ultimately produces, wins and stays on top of his game.

A money manager who has gotten to the professional level did so because of a sound, fundamental methodology as well as, hard work. Just because the markets are trading away from you, does not call for a complete rethinking of your style. You may need to get in cash for a while and wait for the “ripe” opportunity. Graham and Dodd still make as much sense today as when they were written “many moons ago.”

It is important to shut out the noise, whether it is from financial television or curious colleagues. While it is true that rejecting sound advice is just plain stubborn, much of what we hear on television, as well as, on the phone, may be tainted by another agenda or boredom. A good manager needs to discern these two sounds. It never ceases to amaze me how some raucous pundit can scream ten new ideas, every night, during a one hour show. You are best off to tune out this sort of racket. These folks need to fill time between commercials. It is hard to come up with one, or even two great investments per year. Good investments are like good friends … they are hard to find.

Home Runs are spectacular yet ’small ball’ and defense wins games

Let’s face it, everyone loves the towering home run—it’s the stuff of legends. Winners in baseball understand that it is scoring one more run than the next guy that counts in October. Smart baseball skippers, play “small ball “and push runs across the plate. When combined with sound pitching and good defense, the wins pile up.

A good money manager sees that in a quest for a financial home run many opportunities are squandered. Worse yet, is that a home run swing is usually accompanied by a strike out. Small returns add up at the end of the year, especially if the outsized loss is avoided. A manager who has a string of profitable years, hands his investors a gain … and often a tax bill. If they give back even half of those gains in a bad year, the tax code does not rebate the capital gains paid for. In that respect, the outsized down year, or strikeout, gets doubly penalized. Good defense is clearly rewarded.

Sometimes we need to look overseas for opportunities

Baseball executives have long appreciated that there is great talent to be found offshore. Many overseas players have come to dominate the game. They also bring a different dimension and knowledge base to the table. A recent New York Times article spoke about how some Manhattan private schools are sending their baseball teams to the Dominican Republic to hone their skills during spring break. Foreign influence is undoubtedly an intricate part of the game.

A good manager should seek some sound overseas investments to compliment a portfolio. As in baseball, the caution is that you need to be sensitive and respectful of the dissimilarities found when investing in different countries. Currency and geopolitical risks come to mind to name a few. Still, the well thought out overseas play can produce better, non-correlated, returns.

Resist the temptation of performance enhancers

The “steroid story” has been a black eye for baseball in recent years. However, the allure of artificial performance enhancement has been around since sport was invented. Unfortunately, in any competitive, well-paying industry, whether sports or Hollywood, there will always exist a seedy underbelly. The parasitic element will tend to be around any talented performer. The whisper will eventually come that there is an easier way. Some great players have succumbed to that call and have paid dearly. Others have stuck to their guns and are better off for it.

It is never worth cutting corners for a better return. Sometimes it may be a clever derivative strategy, and sometimes it can be far worse. What seems innocuous at first, can lead to disaster. Stay away from the quick fix and recognize the snake oil when it is being sold to you. No amount of reward is worth getting into trouble.

Have Fun!

There is no question that professional baseball and money management are serious pursuits. Nonetheless, those that succeed at both, love what they do. When showing up at the trading desk or the clubhouse becomes dreadful, it’s time to rethink one’s career. Everyone gets tired from time to time. However, when it becomes “more bad than good,” that is a strong signal. It should be a career not a dungeon. Having fun may be the most important prerequisite in our life’s goals. We learn that from our first days of playing T-ball.

That is it for now … the “National Anthem” is playing. Let’s play ball !

—The Thoughtful Arbitrageur

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

“A rising tide lifts all boats”—that is the best way to begin this edition of The Thoughtful Arbitrageur, as we explore the uses and misuses of the beta coefficient. Commonly referred to as beta, this statistic measures systematic risk. Put more simply, beta measures a security’s correlation to the general market.

To review, going back to our B-school days, a stock with a beta of 1 will move directly and equally with market fluctuations. Therefore, if the market is up 10%, we should expect a 10% return from this asset. By extension, a security with a beta of 0 is perfectly uncorrelated to the market and a -1 beta implies that a security should move in an equally opposite direction to the overall market. Since beta also measures magnitude, a security’s beta can be much greater than 1 or -1 depending on how dramatic its movements are relative to the market averages.

Other logical caveats when applying this tool are that securities that trade in different markets are not comparable because their correlations will be different. A security that moves at a +1 to the Bovespa for instance, might have a .25 versus the S&P. Another conundrum is that a high beta stock may be less risky than one with a lower beta. While generally high beta implies greater volatility, a security with a low beta may be highly subject to risk, as its ultimate standard deviation may be much greater.

Put another way, the high standard deviation implies a stock with a much more aggressive profile away from general securities movements. An example of this may be a biotech company awaiting an FDA approval. Its beta may be close to 1 for a period of time, yet may ultimately move wildly when approval time nears. This deviation is categorized as alpha and explains an equity’s unsystematic variations, or those not explained by the market.

Managers who capture alpha in a low-risk fashion are, of course, highly sought-after since they should over time outperform their peers. Along with other measurements such as Sharpe ratios and variance modeling, investors attempt to predict fund performance, and therein lays the rub. An investor simply cannot rely on a statistical black box. There are too many cautionary tales warning against these systems. In fact, one must clearly understand what comprises a securities beta or any measure of fund performance. These are just some of the cautions when applying beta, a topic we will definitely be visiting again.

Perhaps our use of and attraction to beta comes from the fact that it is relatively easy to understand. Going back to our high school algebra days, we are simply correlating two sets of variables, one tracking an asset and the other the overall market. In fact, our brain is wired to decipher information in this configuration. We constantly compare sets of events to mentally adapt to new situations. Human beings will readily try a gelato because it looks and is served just like ice cream. We associate eating ice cream with joyful and satisfying experiences. Thus, our correlating brain signals a cause and response. In this case, it is reaffirmed when we taste that delicious gelato. However, that type of thinking can fool us at times. Like a mouse that gets caught in a trap by reaching for the alluring aroma of a piece of cheese.

More germane to the subject, is the complaint that many money managers are “beta chasers.” Asset management is a tough job—if it was easy, the rewards would not be so great. Fund executives learn early on that performance that matches an index is much more tolerated than performance that lags an index. This holds true even if the latter eventually produces better long-term returns. Since we live in a world that demands constant response to clientele, many managers overtly, or subliminally, chase beta. Ironically, it is that pursuit that sometimes leads to underperformance. With that said, here are some of the important considerations when applying the beta coefficient:

Beta is in the eye of the beholder

One can find many variations of a security’s beta, it all depends on where you look. For example, the beta you find in Value Line may vary from one reported on Yahoo Finance. Nonetheless, if you are using beta in a serious fashion, you had better start with an understanding of what you are dealing with. Some services use weekly prices, other use daily. There are variations in the time frame a service considers, and then there is the more pressing concern, what your asset is being compared to. Is the S&P representative or would the Nasdaq 100 be more suitable? At least a baseball manager who relies on a player’s batting average knows that in the abstract that .300 means 3 hits out of 10 at bats. With beta, the foul lines may change on every pitch.

Managers need to create their own versions of beta and constantly retest their assumptions. It all starts with these basic questions: Are the prices I am looking at representative? Is the sample large enough? How accurate is the sample? What are the correct benchmarks? A fund that invests in large liquid industrial companies will give a more accurate picture of beta than one where prices are more subjective, such as in private equity. A larger sample is almost always better than a smaller one. Applying these types of disciplines, one sees the caution of investing in assets with a brief, or unreliable, however stellar return.

Yet another issue is what I call the “dog walking the owner syndrome.” This is where an equity or group of equities becomes such a large part of an index, that it overwhelms the performance. At that point it begs the question, “is the market affecting my investment or is it the other way around?” These matters require a great deal of insight and repeated appraisal, and to ignore them would be foolish.

Finding the proper benchmark looms large when viewing beta. An investor needs to continually test his sample versus different indices. In this way, the manager learns just what drives performance. The chairperson of Pepsi may be more interested in her performance relative to Coca Cola, than the Russell 2000. That information, though painstakingly derived, proves invaluable.

Beware of special situations

Investors treat stocks differently at various stages of the life cycle of a company. A recent IPO may react in a contrary fashion to a well-established company. There are also different investor behaviors in a penny stock when compared to one with a $500 handle. The same company, in this case, displays different reaction to the markets depending on factors absent the fundamentals.

More crucial are special situations such as M&A, spinoffs or the potential of a securities addition or subtraction from a particular index. Not factoring in these possibilities can cause the beta watcher a great deal of angst. This argument can be logically followed by the admonition that man does not live by fundamental analysis alone. To discount external or special situations can render statistical examinations meaningless.

Low Beta may mask risk

As we mentioned earlier, a beta below 1 may be a function of a company that tracks the market in a less varying fashion, yet still has the potential for outsized returns. This is due to its unsystematic or security specific risk. Professionals, as well as the weekend investor, need to be vigilant for risks that are indigenous to a particular well-loved stock. The “Tylenol Scare” that affected the share price of Johnson & Johnson comes to mind. Until that point, JNJ was viewed as a typical “widows and orphans” stock. The vulnerability of a staple product like Tylenol, in such an unusual fashion, greatly disturbed the investing and general public. Some may argue that this type of risk is unknowable; however, that is exactly what “Black Swans” are made of. The astute investor considers the entire range of possibilities. I remember hearing a famous chief executive relaying that it was “monsters unforeseen” that kept him awake at night. In this case, a bit of paranoia is a good thing.

Lastly, the most significant reflection should be on the projection of an equity’s future beta coefficient. Smart business people understand that the past, while it may be prologue, can be nothing more than yesterday’s weather report. When assessing an investment’s potential, where it fits in one’s definition of the beta continuum is essential.

For now, we will stop here. However, beta, Sharpe ratios and other types of arithmetic based measurements will be a recurring theme, since they clearly drive markets and our ability to decide.

A brief follow-up on our Real Estate piece

We received many comments on our recent piece on Real Estate. Given how central it is to the global asset base, it does not surprise us. In fact, in the last few days there have been reports that signal lower real estate prices. One in particular from Zillow offers a dramatic reassessment of downside in the housing market. Until the entire foreclosure crisis is solved, this may continue to be the case.

Another topic mentioned was our comment of more real property ultimately finding itself in the hands of REITS or Trusts. Again, we caution that our views take into account a macro assessment. What happens in places like Manhattan or Beverly Hills is not particularly indicative. This vision is more based on what goes on in the many counties that make up the backbone of the United States. The fact is that less of a real estate burden to these folks means a more comfortable overall lifestyle. This is especially so given a declining real estate market.

The “Tara effect” was our view that many of the Baby Boom generation were influenced in their desire for “bigger and better” by popular media. Popular culture in the form of movies like “Gone with the Wind” or television shows such as “Dallas” or “Dynasty” inspired a desire for the grand entrance. These stories implied that “success and smarts” are directly equal to square footage. In fairness to “GWTW”, it is truly an American classic. Still “Tara” deserves as much onscreen credit as Vivien Leigh. In fact, look at how many of our homes are of the “Center Hall Colonial” fashion. The National Association of Builders should pay the creators of “GWTW” a royalty for every Colonial sold. The sober reality is that you cannot appreciate the upkeep and commitment through a television screen.

Encouragingly, it seems that the millennial generation may be displaying an opposite feeling toward this type of conspicuous consumption, and this may be a good thing. According to a recent New York Times article, “As Young Lose Interest in Cars, G.M. Turns to MTV for Help”, General Motors executives are dealing with the fact that most young people do not care about automobiles as much as generations past. Their ambivalence can be summed up in the following quote: “They think of a car as a giant bummer. Think about your dashboard. It’s filled with nothing but bad news.”

The piece also provided empirical evidence backing these claims. It seems that a generation that values material goods such as fancy cars and expensive housing as less important, is an inspiring sign. We well know how these “toys” can literally sap our asset base and wear us out mindlessly. Considering what our economy is currently going through, impulsive consumption seems akin to puffing away on tobacco, given what we know now about the health risks. Quite possibly, in an inadvertent way, we have taught our offspring a valuable lesson that may significantly affect future spending—”all that glitter is not necessarily gold.”

Until the next time…. The Thoughtful Arbitrageur.

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

One could argue that since the landing of the Mayflower, and perhaps before that, besides religious liberty, immigrants also pursued one other desire: the quest for land. In fact, many have argued that from an economic perspective, it was the claim and cultivation of new frontiers that spurred the Republic’s greatest expansions. Witness the late 1700s, a period centered on an agrarian culture. There was then the Western migration, which created its own major sub-economy that continues to shape our commercial landscape to this day. More recently, we observed the colonization of the suburbs and exurbs, far away from our traditional metropolitan centers. This was marked by the search for more square footage that manifested itself in McMansions and Big-Box retail warehouses. Bigger and better and more has been the hallmark of real estate expansion in this country. The value of real estate has always ultimately proven to be an increasing proposition. By each generation’s end, an investment in real property, whether residential or commercial, has sustained many families. However, we may finally be seeing this undeniable trend reversing.

For the first time since our start, America may be experiencing a downsizing and partial transference away from individual property ownership. The implications of this may dramatically change the complexion of our economic system. Quite possibly, the current credit and mortgage crisis has changed the financial habits of our populace. Where once home or commercial ownership was seen as signs of prosperity, today, it is a burden. The American Dream of a white picket fence has abruptly turned into the American nightmare; this may be the impetus for a new chapter in our relationship with the land we so love.

America’s changing attitude toward Real Estate

Statistically, speculation in real estate has always proven to be a great investment. In fact, from the early 1970s, on an inflation adjusted basis, housing has more than doubled in value until its peak in 2006. Whether consciously or not, Americans have viewed property as a growing “savings account” that also provided shelter. Along with education, these were investments that grew and nurtured the American Dream. As far as real property is concerned, all of that came crashing down with the mortgage crisis.

Since 2006, the average price of a house has fallen more than 35%. Harder to calibrate is the foreclosure rate bearing down on the value of housing stock. According to a recent Wall Street Journal article, when one considers underwater loans and loans with some equity that are facing either strategic or organic default, there may be upwards of 8 million to 10 million mortgages that are in trouble. When compared to the nation’s 55 million loans outstanding, the numbers are staggering. Keep in mind that those statistics are at “last sale,” so to speak. With this amount of “shadow inventory” hanging over the markets, it is hard to believe that real estate prices have reached bottom. It takes a great deal of faith and a strong stomach to jump into the real estate pool in a meaningful way.

More to the point is a shifting demographic in this country tilting away from real property. This is a counterbalance from the Baby Boomers’ hunger for an ever-larger home, or what I call the “Tara Effect.” Combined with cheaper building materials and available credit, the average size of a home grew beyond most family’s needs. In a period of rapidly increasing real estate prices, there was a great satisfaction to all of that additional equity. However, once the bubble burst, the average homeowner was stuck with a declining asset, an outsized mortgage and, most devastating of all, the additional upkeep. Let’s face it, bigger homes require a bigger commitment on a personal basis. Furnishing, landscaping, cleaning and energy costs alone, are enough to sap one’s spirit and bank account. Today, many of those same boomers are looking for a downsized version of that dream, and freedom from the burden they carry. The Internet age has also contributed to that problem with people freely sharing ideas. Where foreclosure was once stigmatized, it is now seen nationally as a strategic way out. We have become a country savvy in the “business” of real estate, or more pointedly, a group of “Little Trumps.”

Traditionally, it was the next generation that assumed the ownership of property, whether through inheritance or new acquisition. Today’s Generation Xers and Gen Ys, have demonstrated shifting attitudes toward home ownership. Perhaps it is because they were raised in a culture where one’s neighborhood could be considered in hundreds of miles and not street blocks. They are also use to college dormitory living, vacations by time share and turn-key apartment or townhouse living. Housing is more of a utility to them and not a goal. They do more of their purchasing via the Internet and not in a store, thus pressuring commercial property prices. Many work from their lap tops. They were raised this way. The “man in the grey flannel suit” might as well be someone from medieval days. Finally, they have experienced living in the “dream house” with their parents. They have witnessed the headaches, and given today’s prospects for price appreciation, would rather skip the ride. While there will always be those who aspire to “the mini mansion,” when viewed on a macroeconomic basis, the dynamic of real estate has been changed.

Where do we go from here? The future of real estate in the United States

Like most of our prognostications, we will follow up in future pieces. In this particular forecast, we would not mind being somewhat wrong since it may take another 36 to 48 months before the housing crisis reaches bottom. Probably, there will not be any meaningful approach to solving the foreclosure mess (the announced $25 billion settlement with mortgage banks notwithstanding) until after the election. Once this is finally addressed, and the shadow inventory is alleviated, we can envision a floor to pricing.

The future may see a proliferation of smaller homes with more sophisticated, technological amenities. It will be easier to maintain, live and eventually move from these residences. Think “Over 50 Communities” on a somewhat grander scale. In this scenario, debt levels will not be stressed, as the government and the banking sector will not want to repeat the current credit crisis. In other words, homes will be more affordable and user friendly. The downside to this value metric will be more sensible and defined.

Along with residential, look for even more commercial real property to be owned by REIT’s, as well as other trusts. More people will rather lease than own, thus limiting their own costs and commitment. In turn, these trusts will be funded by shareholders seeking greater income for retirement. Ultimately, America’s investment in real property will be transferred from one of a “picket fence concept” to a more communal and diversified one.

Every nightmare must thankfully have an end. Conceivably, what we have spoken about may be an arrangement that takes America’s love for the land through a new millennium.

Until the next time…..The Thoughtful Arbitrageur.

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

As I speak with colleagues of mine, I have clearly come up with a consensus that the “Wall Street” on which we grew up during the 80’s and 90’s, has been indelibly changed. Culminating with the 2008 crisis, this has been a transformation that seems irreversible.

Unlike the “crash of ‘87″, the “‘94 Gulf War crisis” or even the bursting of first Internet bubble, this correction is unyielding. In the past, we had the biotech and technology revolutions as antidotes. However, with the collapse of residential and commercial real estate, and a global contagion created by our zeal for novel and far-flung opportunities, we have finally hit the proverbial wall.

Perhaps, this is the ultimate symptom of the hedge fund phenomenon that began in the early 1980’s. High fees demand extraordinary returns. In a quest to find those prospects, we were forced to visit new frontiers, both geographically and product-wise. Thus began the emerging market and derivative craze. Now, we are left with a hangover that defies resilience, save for total rehabilitation.

Conceivably, this series of events began with the public offerings of major bulge bracket firms. Starting with the likes of Merrill and Hutton, and leading to the publicly traded equities of houses such as Bear, Goldman and Morgan. While the former might have worked, given their steady revenues due to recurring commissions, the model was severely stressed when transferred to firms that were more proprietary in nature. Thus, we have reached a period that calls for reconstruction.

Make no mistake, the financial industry is populated with some of the most intelligent and creative minds found anywhere on the globe. This period will be painful, all rehabilitations are, but what will emerge, if executed properly, will be a sustainable and more permanent system. Let us call it the “new Wall Street paradigm.”

This is less about a place on the southern tip of Manhattan, and more about a new strategy, where the clients and the service providers are truly separate and each party’s interests are clearly defined. This shift is inevitable, given the new regulation engulfing the post-Volcker period. The “Street” has proven adaptable in the past; there is no reason to feel it will be different this time. The reality is that given the shifting landscape toward a more sophisticated consumer base (30% of Americans over age 25 now have Bachelor’s degrees), and an ever increasing regulatory environment, there is no other choice.

This leads me to this edition’s topic: a review of Larry Bossidy’s book, Execution. Bossidy is well-known in business circles as a successful former CEO of Honeywell and Allied Signal. More relevant to his bona fides was his tenure as COO at GE, developing legendary productivity and strategic innovations working under Jack Welch. His co-author is Ram Charan, a Harvard professor who specializes in strategic development and is an advisor to Fortune 500 companies.
Together, they collaborated to write this acclaimed book on linking people, strategy and operations together in order to effect a new vision. The central tenet to their thesis is creating a business based in conceptual honesty and realism. In the final analysis, what Execution aims to teach us is central to many business hypotheses. While creating new commercial concepts may be intellectually rewarding, without execution, it becomes an exercise in futility.

I am well aware of the criticism the financial industry faced when it previously tried to utilize industrial corporate methods. I remember working for Dean Witter when they merged with Sears, and hearing the jokes about selling stocks and socks. Yet, that was in 1982, at the advent of one of the greatest “bull runs” in corporate history. In a period like that, you can throw out the play book and just reap the fertile harvest.

We now stand at a new epoch, one marked by a period of intense regulation, and a push for far greater consumer protection. It is with that in mind, that I opened Bossidy’s book.

His era was marked by America’s need to compete with more efficient Japanese and German manufacturers. GE created the successful use of the quality management tool “Six Sigma” and GE Capital. He was part of a cadre of business leaders who perceived a need for change and engaged it. In our new paradigm, financial firms will be forced to either become client- or self-focused. They will also need to be structured more like the old partnership model. This will either happen organically or by fiat. In the new paradigm, Wall Street firms will have to bear responsibility for their own risk and reward. Those firms that choose not to place their own wagers will need to exclusively and completely service an ever more knowledgeable consumer. We are headed back to the future, so to speak.

Execution deals with this by advocating a need to acknowledge a gap and close it. In one of his more salient sections, Bossidy spells out seven essential behaviors behind results oriented leadership:

- Know your people and your business.
- Insist on realism.
- Set clear goals and priorities.
- Follow through.
- Reward the doers.
- Expand people’s capabilities
- Know yourself.

As Execution expands on these behaviors, it demonstrates a demand for an honest, robust dialogue, one based in the realization of a need for a new model and the means to achieve it. By focusing on a set of clear goals, combined with the pragmatic assessment of an organization’s limits, effective execution is possible.

In later chapters, Bossidy and Charan study the link between people, strategy and operations. Here, they constantly stress the requirement to assess the skill set of one’s employees, and the crucial element of placing them in the right positions. Most accomplished are leaders who consistently seek feedback from the troops and fairly enact it. Ultimately, by rewarding the best behavior, a business can successfully fulfill its new mission.

Finally, the book speaks about the need to create a realistic business plan that considers both the external and interior environment. One centered on understanding your client’s desires and the best path to meeting those needs. In a word that has become almost faddish, the last result of a sound business strategy is one that has “sustainability.”

Getting back to finance, what today’s firm needs is a strategy that realizes a demand for educating its client, and then meeting their goals. They should do this while constantly retesting their own assumptions and recommendations. A plan that honestly creates that atmosphere will be well prepared for the new paradigm.

Execution is a well-thought-out guide for corporate change. Given our current state of affairs, a Wall Street CEO could do worse than to pick up Execution, a study of “the discipline of getting things done.”

A follow up on the Jeremy Lin phenomenon:

We are now into week four of the Jeremy Lin phenomenon, and there is much to be learned regarding the parallels between “stocks and sports.” Lin, like a soaring growth stock, has now appeared on everyone’s radar. Admirably, he has handled the new pressure to perform and delivered results. The Knicks are 9-3 since his hot streak. However, 9 -3 does not a dynasty make and Lin is intelligent enough to realize that. Professional defenses will adapt to him, and the hard reality of the hyper-competitive NBA life will continue to be a challenge for Lin. To his credit, he seems like someone prepared to withstand the onslaught.

What dismays me, is that we are already hearing the rank and file call for a Knick upheaval that would include trading Carmelo Anthony. That is just plain wrongheaded. Players like Anthony have been through many seasons and challenges; they are battle tested stars and for good reason. They have delivered throughout their careers and they will adapt to new teammates in order to win. They have succeeded because of their determination and competitiveness. Trading an Anthony, a Durant or a Bryant to make room for a new star, is like kicking Coca Cola or Microsoft out of your portfolio for the latest biotech.

We like Lin, and everything he brings to the table. His future may truly shine bright. Let’s just give this kid a chance to acclimate himself to his new status, while we still hold on to the proven warriors.

Until the next time … The Thoughtful Arbitrageur.

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

“Knowledge is power.” – Sir Francis Bacon

We promised at the outset, to deliver an amusing, yet educational experience. On that note, we unveil today’s feature: The DuPont Analysis.

DuPont deconstructs and reviews the components that encompass the essential view of a company’s health, its return on Equity (ROE). It was developed by DuPont in the 1920’s to help them manage their conglomerate, and it is brilliant! The inspiration to delve into this financial abstruse was the story of Billy Beane, as portrayed in Michael Lewis’ popular book, “Money Ball”. Beane, the general manager for the Oakland Athletics baseball team, discovers the usefulness of viewing major league prospects through the lens of statistical analysis that goes far beyond the normal batting and earned run average statistics.

Beane, who was once a baseball prodigy himself, found disappointment through unmet expectations in his own career. Upon reflection, he comes to realize that the established method of viewing prospects on simple statistics and body type is fraught with uncertainty. In his view, the fortune of a team is more determined by beauty pageant standards and less in hard reality. Beane then subscribes to a more complete examination that ultimately focuses on players that score, or prevent runs efficiently. He finds the “Rosetta Stone” that allows the small market A’s to compete with big budget giants like the Yankees. Beane’s revelation is that of any idea that is genius: simplicity is ultimately profound. The object of baseball, like most sports, is to score at least one more run than the next team. The players that best help a team do that, relative to cost, are the most valuable. In many respects, Beane’s insights can be applied to portfolio management.

The objective when investing, is to better the risk-free rate with as high a return relative to one’s risk tolerance as possible. In order to do that, one must discover fundamentally undervalued securities. The DuPont analysis is an effective tool in beginning that journey.

Many investors, professional or otherwise, overlook this simple fact. They often rely on alchemic methods such as momentum, technical analysis or premonitions. Without a sound basis in valuation, these investments are occasionally correct but eventually unsuccessful. This methodology is much like that of a gambler whose luck, in time, runs out. The other extreme is to be overly conservative, thus falling in a trap where risk taken is not appreciated or rewarded. Witness, for example, the many investors scorched on supposedly safe mortgage-backed investments. As we have previously cautioned, stick with fundamental analysis, or arbitrage opportunities for the most probable road to higher returns relative to downside potential. To that end, we explore a construct that we will feature in the future, the DuPont Identity, or Analysis.

Going back to our “Moneyball” analogy, some measures of profitability cannot be ignored. Among these are Return on Assets (ROA) or Return on Equity. These measures of a company’s ability to extract earnings out of its asset base have long been considered, among savvy investors, as a crucial gauge of a business’s success. However, both devices, like a baseball batting average, can be misleading. What DuPont does is break down the components that eventually comprise ROE and ROA. In the process, it gives the user a fine blueprint as to how a company generates earnings, and where it needs to adjust its game. We feel it is an indispensable measure and should be the starting point of any financial decision.

To return to our financial roots, ROE is simply net income divided by total equity. Since equity is the product of assets minus liabilities, you can take our word and spare yourself the mathematical gymnastics by accepting the fact that ROE equals ROA magnified by an equity multiplier. The equity multiplier is simply total assets divided by total equity. This is the amount of debt relative to equity, or leverage. For example: a company with $1 of debt per 50 cents of equity, would have a multiplier of 1/.5 or 2x. Take the debt, or leverage, down to 50 cents, and the multiplier drops to .5/.5 or 1x. In effect, DuPont takes into account the levered effect on a company’s return on assets.

We next deconstruct ROA considering it is essentially a firm’s profit margin (net income divided by sales) multiplied by its asset turnover (sales divided by assets). Finally, we get to the DuPont Identity or: ROE (Return on Equity) = Profit Margin x Total Asset Turnover x Equity Multiplier

Let’s examine these components for what they reveal:

Profit Margin (PM): Effectively a firm’s operating efficiency or how much income results from sales. A high profit margin may seem desirable, however, a company may be pricing its goods too dear, thus resulting in a higher PM at the expense of more volume. Conversely, lower expenses may increase net income, but ultimately cannibalize growth by not reinvesting profits in research and development. What we are briefly touching upon here are some of the myriad ways to understand and value a company’s PM.

Total Asset Turnover (TAT): This is a ratio of sales divided by total assets. Again, this is not as simple as it seems. If, for example, a company has generated $2 of sales from $4 of assets, we have a TAT of .5 times. Another way to view this is, to divide 1 by our TAT and we get 1/.5 =2. Thus, we need $2 of assets to generate $1 of sales. The caution here is, that a high TAT is not always a good thing. A lower value of assets relative to sales may portend that equipment is getting old and needs to be expensively updated. A smaller TAT, while on its face a negative, may in fact signal that assets are new, not yet depreciated, and intact for the long haul. Again, we see DuPont as a starting point for more meaningful discussions.

Equity Multiplier (EM): As we have already explained, this represents a company’s leverage. Like any investment, leverage must be carefully calibrated to achieve maximum results. Too little, and you have not fully realized your potential. Too much, and you can borrow your way out of business.

Therefore, we see that a firm can increase its ROE by any number of means. These would include higher asset turnover, increased margins or greater leverage. Each of these avenues, present a double-edged sword and should be considered prudently. When you look at ROE through this prism, the world is more complex, yet definable. It is with this in mind that we will, in the future, target our studies. This will give us a conclusive view as to how to truly dissect a balance sheet in a fashion worthy of a Warren Buffett. In fact, it will be a base for many of our investigations, special situation or otherwise. As a final look regarding which universes we will explore, take a look at an exploded view of DuPont borrowed from a Wikipedia file:

Here, then, is our foundation for studying many of the balance sheets we will encounter. Through this method, as the intellects at DuPont understood, is a thorough and comprehensive flowchart that leads to well contemplated financial decisions.

Perhaps this edition of The Thoughtful Arbitrageur may have been a bit mind-numbing and not as entertaining , but it is necessary if we are to advance our grasp of the financial markets. Or as your mom would say, “something valuable is worth working for.”

Jeremy Lin: Black Swan

Much has been written in the last few days about Jeremy Lin and we, too, will add our opinion. First off, we are fervent sports fans due to the purity sports offers. Athletic competition gives us a chance to view man’s unadulterated quest for perfection. Here, the warriors are stripped bare and there is no denying their achievements and failures. It is a beautiful thing to behold. In fact, this is what we adore about the Jeremy Lin story.

Lin, a supposed everyman, is one who comes to the field of battle against forces far greater than he, and wins. The play “Damn Yankees,” or the biblical story of David and Goliath” come to mind. Yet, Lin’s accomplishments are the very definition of a “Black Swan”—unpredictable events that are, in hindsight, more probable than originally thought.

Lin, while a walk-on for Harvard University’s basketball team, hardly defined the prototype of an NBA star. Many commentators marvel at the fact that he is the rare Chinese-American (his parents are from Taiwan) who is succeeding at the sport. However, Lin is not of a different species. He has the same tools, more or less, as everyone else. He just chose to make the most out of them and not let stereotyping dictate his future. That work ethic is probably what got him into Harvard and will propel his success. This story is a lesson for anyone who would let circumstance determine their fate.

That’s enough pontificating—we have to stop and go watch the Knicks game.

Sometimes it’s a layup and other times a three pointer—but it’s all fun and games….

— The Thoughtful Arbitrageur

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

We know a few things about the State of the Union Address: One, that it is mandated in the Constitution and secondly, that it is a report the President and his advisors work on for months. Most importantly, in an election year, it is a strong indication of where an administration’s heart is and what they will base their campaign on. In a country full of anxious folks looking for any discernible sign as to where we are headed, let us take a look at what we can learn from Barack Obama’s speech and its aftermath.

America’s competitiveness in the new Economy:

The President sounded downright protectionist as he spoke about bringing back jobs that went overseas. In fact he made a number of very strong statements, like this one:

“We’ve brought trade cases against China at nearly twice the rate as the last administration—and it’s made a difference. Over a thousand Americans are working today because we stopped a surge in Chinese tires. But we need to do more. It’s not right when another country lets our movies, music, and software be pirated. It’s not fair when foreign manufacturers have a leg up on ours only because they’re heavily subsidized.”

Those are definitely fighting words! While we do not believe that Obama wants tension with one of our largest trade partners (and holders of Treasury debt), we do subscribe to the notion that he is staking his claim to bringing jobs back home. Given the underemployment crisis this will be a centerpiece to his economic policies over the next four years. Look for this administration to create strong fiscal and tax incentives for businesses to bring back employment that is now outsourced. Companies that have realized efficiencies by embracing overseas labor will see their profit spread erode as the government imposes taxes on overseas based operations. In turn, they will transfer that monetary gain to those that build at home. Again, let’s go to the tape:

“We need to put a new emphasis on American manufacturing. That means refocusing our corporate tax structure to reward businesses who work to keep jobs in the United States, and end tax incentives for corporations that outsource. That means getting tough on trade enforcement and rebuilding American infrastructure.”

An ancillary effect to this policy will be a lessening of trade surplus with some of the emerging markets, as less dollars flow to those sectors. Ultimately, we should see a relatively dramatic lowering of our high unemployment rate as U.S. citizens welcome these new jobs in parts of the country where employment is getting scarce. Much like the rebuilding of a war-torn country, Midwest rust belt regions that have suffered will transform into outsourcing and low to mid tech manufacturing centers. Since housing stock is available and inexpensive in these areas, you may see a true resurgence if this strategy is executed properly. Of course, the government needs to commit funding and direction to these efforts.

The Retraining and Reeducation of America:

You need two factors in order to educate people: a system capable of meeting their needs, and willing students. There is a vast part of our populace that is tired of possessing outdated skills, especially in an economic environment that is in hyper change. Witness the transformation of the financial sector from a 25-year period of growth and innovation to one of retrenchment and gloom. More distressing are the many small towns in this country which exist on nothing more than public service and big-box retail employment. This administration correctly perceives the confluence of a need to retrain and citizens that are eager for it. As Obama said to Congress:

“Now you need to give more community colleges the resources they need to become community career centers—places that teach people skills that local businesses are looking for right now, from data management to high-tech manufacturing.

“And I want to cut through the maze of confusing training programs, so that from now on, people like Jackie have one program, one website, and one place to go for all the information and help they need. It’s time to turn our unemployment system into a reemployment system that puts people to work.”

Anticipate significant funding to flow to local and regional community colleges and on line programs. These platforms will be able to reach parts of the country that have been overlooked. What you will eventually see is high tech intellectual creation that exists outside of the coasts. While places such as Alabama may not ultimately be as prolific as Palo Alto, they can effect innovation that applies to regional needs. Areas such as energy management or automated production are what comes to mind. An apt analogy would be the transformation that occurred on television. While the big networks are still relevant, the myriad cable stations manage to find their own niche locally.

Finally, through the magic of the internet and online lectures, access to the worlds’ outstanding professors and teachers will be made available to the masses. The hunger for knowledge will be satiated by some of our brightest thinkers, as their thoughts will be available to more than just a few thousand students. The head of a major university’s technology center recently commented to us that at the best schools, it comes down to 15% of the classes taught makes the difference in the quality of the education. The rest is basically the same everywhere else. That 15% may soon be available to aggressive students living in neighborhoods far away from Cambridge and New Haven. That would not only be an egalitarian strategy—it would be plain smart.

Clean Energy:

Obama is rightly concerned about our dependence on oil, who isn’t? While there will definitely be a continued focus on natural sources of energy, such as solar and wind, we still need to work with today’s needs and infrastructure. There will be a push for the increased use and production of natural gas. Ultimately, this will keep the price of natural gas at low levels while keeping oil prices in relative check as we shift away from their current usage. This is the most direct, current path to lessening our dependence on the Middle East. In his own words:

“We have a supply of natural gas that can last America nearly one hundred years, and my Administration will take every possible action to safely develop this energy. Experts believe this will support more than 600,000 jobs by the end of the decade. And I’m requiring all companies that drill for gas on public lands to disclose the chemicals they use. America will develop this resource without putting the health and safety of our citizens at risk.

“The development of natural gas will create jobs and power trucks and factories that are cleaner and cheaper, proving that we don’t have to choose between our environment and our economy. And by the way, it was public research dollars, over the course of 30 years that helped develop the technologies to extract all this natural gas out of shale rock—reminding us that government support is critical in helping businesses get new energy ideas off the ground.”

What we have highlighted are areas where we can envision a significant new thrust that will have profound change in how we do business as a country. Of course, the president re-emphasized topics such as a strong interest in solving the housing crisis, correcting financial market abuses and increased construction spending. This rhetoric should come as no surprise as these are pressing issues that will need to be dealt with by any candidate. Of course, Obama needs to actually win the election which, right now, seems quite possible. He then has to be creative enough to enact his policies, with an opposition legislative branch, which is also likely. One thing we can be sure of however, is at least four more years of horse trading over these critical subjects.

“Arbitrage” – The Movie?

It continues to amaze me how fascinated people are with all things financial. The black hats of the westerns and gangster movies have now been replaced by hedge fund managers. When I first entered the business, arbitrage was something you needed to explain to people. Now, it is frequently used as part of our lexicon. On that note, we preview Sundance film festival standout “Arbitrage”, starring Richard Gere. Gere portrays a billionaire hedge funder facing ruin over accounting chicanery. While not giving too much of this morality tale away, Gere falls into a “Bonfire of the Vanities” type trap and seeks help from an unusual source. There is already Oscar buzz surrounding Gere’s performance. Nate Parker is also excellent and believable, and the production has been well received by critics. The film is the directorial debut of 25 year old Nicholas Jarecki who also wrote the screenplay. “Arbitrage” does not have a release date as yet.

From State of the Union to Sundance, it’s all entertainment.

Until next time,
The Thoughtful Arbitrageur

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.