Market (and taxpayer) sensitive redaction

Being a fund manager involves many skills.  One of the rarer ones is trying to work out what redacted government documents say.  The Department of Homeland Security has just completed a large no-bid contract to purchase Relenza – a drug made by Glaxo.  It is justifiably a no-bid contract because whilst there are competing drugs they have resistance problems.  Relenza has a monopoly over its drug protected by patent.  A no-bid contract – even of large size - makes sense. 

The Department of Homeland Security have released some details of the contract – but the key lines are redacted.  In particular the cost is redacted, as are the number of doses and even the names of the authorising officers. 

The blacked out number below is highly market sensitive.  Help.  Please.

 

 

Finally I am just a gambler on the stock market.  My concerns are private.  However you should also be concerned.  This is taxpayer money.    This is a no-bid contract with limited transparency.  I can’t think of any good reasons for blacking out these numbers.  If you thought the no-bid contracts in Iraq were a concern (and I did) then you should also consider this redaction a concern.  At least in the Iraq case there might have been a security reason for redacting the key information.  Here I can’t think of any reason other than it is standard practice for the Department of Homeland Security.

 

 

John

Astarra: Don't blame the regulator

Here is an article which blames the regulator for allowing Astarra to go on as long as it did. It is not the only such article.

The article praises the seemingly heroic blogger for uncovering the problems.

Well the article is flat wrong.

1). The regulator it seems has acted with the greatest speed and integrity in uncovering this mess. I have no complaint whatsoever about the regulator.

2). Whilst my letter was the proximate trigger for the discovery of the problems at Astarra I claim no special genius. Sure I worked it out - but it was not complicated. Moreover a reader of this blog tipped me I should look.

I used not to have a high opinion of the Australian regulator - but on this instance I have no complaints whatsoever.

Blaming the regulator in this case is just lazy journalism.




John

A dark privatised social security story: Astarra, the missing money and how examining a fund manager owned by Joe Biden’s family led to substantial regulatory action in Australia

In Mid September I wrote a letter to Australian regulators which detailed my concerns about a fund manager in Australia known as the Astarra Strategic Fund – formerly known as Absolute Alpha.  This letter resulted in regulatory action against a cluster of related funds (almost twenty), however my letter was almost entirely about only one fund in the group.  I did not make any major suggestions in the letter about other funds in the Astarra complex.  My involvement was detailed today in the Sydney Morning Herald (see stories here, here and here, with the first story on the front page below the fold).  There was no genius in my letter – everything could be found (fairly easily) on the internet – and the original tip-off came from a reader of my blog – who noticed links with a story I wrote up in March 2009.

For reasons I will explain below this fund collapse is qualitatively different and more serious than any previous fund collapse in Australia and that the Australian press have not yet detailed why this one is important.

The letter argued that it was possible that the Alpha Strategic fund was a fraud.  I did not have the ultimate proof of that so I did not make my letter public and will not do so yet.  However there is a way of proving that a fund is not a Ponzi – and that is to “show us the money”.  If the assets are really there then it should be possible to convince regulators of that fact by showing them the assets.  If Bernie Madoff had been asked to prove the existence of all the money he supposedly managed then he would have been caught because he could not comply.  An honest fund should be able to comply fairly quickly – sometimes within 20 minutes – but almost certainly within a week.

The Australian regulator asked Astarra to show them the money – and to date that has not happened.  That does not mean that the money is not there.  It is however suggestive, especially as approximately three months have elapsed whilst regulators and fund administrators have tried to “value” the fund assets.  Indeed the difficulty of valuing assets was sufficient for the regulator to cancel licenses and to place the funds in the hands of administrators. 

At a meeting last week the (regulator appointed) administrator Neil Singleton said that with respect to one fund the only proof of assets they have is a letter from a Virgin Islands company stating that the fund (presumably the Strategic Fund) held 118 million in interests in other hedge funds.  This letter did not detail any interests held and gave no mechanism for confirming that statement.  However the administrator has not stated that the assets are not there – so – like the regulator and the administrator I too will leave that question open.  The press simply says the details as to the  $118 million are “sketchy”.

Background to the Australian privatised social security system and where various Astarra entities fit in to that system

Australia has a privatised social security system.  Much of the money is with large honest players run in a nearly index manner and which have cut fees to relatively low amounts.  Those funds are run by Australia’s otherwise dying trade unions.  Privatised social security (which Australians call “superannuation”) has been the saviour of the union movement in Australia – and – through their control of funds the unions now are within a breath of control (though generally do not vote their control) of a large proportion of Australia’s industry.  

The money that is not with the union funds is in a rag-tag of funds run by large banks (for example Colonial’s wraps owned by Commonwealth Bank) or with independents and/or self-managed funds.  The money in those funds (wraps) is let to a large number of sub-funds – sometimes large, sometimes boutique funds managers who live off the large and mandated fund flows from our “superannuation system”. 

The boutique funds range from very good to awful and shonky.  Indeed I think the best no load mutual available anywhere in the world is in Australia (I used to work for the manager).  But there have been some flea-bitten dogs sold to Australians.  One thing is for sure – you cannot do privatised social security without very good fraud protection because that amount of money from unsophisticated investors is a truly massive honey-pot for scammers and flim-flam artists.  As an aside, possibly the worst thing about George W’s privatised social security proposals was that they would be supervised by Cox’s toothless and supine Securities and Exchange Commission.

Trio Capital (the “mother-ship” of the Astarra entities) is a “wrap provider” – meaning a  financial planner might use Trio to invest all their client’s retirement money.  The Astarra Strategic Fund is an individual fund under that wrap.  My letter was about the Strategic Fund – and the collapse of the Strategic Fund would not be qualitatively different from the collapse of any of about six funds that collapsed during the financial crisis.  The financial planner might have put her clients in six (or more) funds – and the loss of one of them is a blow – but in no way imperils the system. 

But (somewhat surprisingly) the entire Trio edifice has been placed with administrators – which means that the end-beneficiary has had their entire retirement savings blocked.  In some funds there is not even enough cash to pay pensions to retired people for the month of January.  Some pensioners are not having their current payments blocked but there are doubts about future payments.  [Details as to who will receive pensions for the month of January can be found on Trio’s website.]  This is qualitatively different from earlier fund failures because it is a failure of every fund that a person might have invested – a failure of the core asset protection mechanism in the Australian system.  [I cannot work out why the otherwise sensationalist Murdoch press has not written a single story on this yet.  All they need to do is find a cluster of pensioners who will not receive their pension this month and who will have no idea as to why.]

How I came to write my letter to regulators

Six months ago a reader pointed me to a fund of hedge funds (called Absolute Alpha) based in Australia. 

I looked – and within forty minutes I became very concerned – but could not prove harm to the fund’s investors.  I tipped off the Sydney Morning Herald.

The journalists at the Herald worked hard at the story but alas they too could not prove harm.  Indeed a major bank misled them as to whether the assets were in (their) safe custody.  The bank confirmed the assets were in custody – a statement they have now withdrawn.  Obviously with a reputable third party vouching for the assets any hypothesis of harm was going to be hard to sustain.  The Herald published nothing. 

I however remained suspicious – but could not easily do anything.  For there to be something desperately wrong either the bank had to be a party or grossly negligent as to their custody of the assets. 

Absolute Alpha was a boutique fund manager loosely associated with – and partly owned – by a superannuation wrap provider called Astarra.  Astarra is now called Trio.  The wrap provider did all the superannuation compliance and in turn (claimed to) invest funds with other fund managers – mostly reputable managers.   The relationship between Trio and some of the funds in which they were supposed to invest is complex. 

The amount of money in Absolute Alpha was probably under 100 million.  There were plenty of things that did not look right – but I did not think there was much I could do about it.

So I let it go – though I did not forget about it.

Later I tried to log into Absolute Alpha’s website and it was dead.*  This (falsely) indicated my worst fear. 

Again I alerted the Herald. 

Alas it was not so simple.  Absolute Alpha it seems had taken over the funds management of all the money in the Astarra wrap.  They had renamed themselves Astarra.  Astarra later renamed itself Trio.  Astarra’s website boasted of a billion dollars in funds under management. 

This was potentially very bad news.  Australia is about a twentieth the size economically of the United States – so $1 billion in funds under management was the equivalent economically of $20 billion in the US.  If my bad-case was true we had a Madoff (at least proportionately) in the making.  [Now the funds have been taken into administration the official numbers are about 40 percent of the numbers boasted on the website.  The danger was not quite as big as I thought it was.]

Anyway I wrote a letter to the Australian Securities regulator (ASIC)  laying out all my concerns and (implicitly) the method for testing my concerns were false.  [I sincerely hoped I was wrong – and hoped the regulator would prove me incorrect by identifying and valuing the assets.  I still sincerely hope all the money turns up in the British Virgin Islands.]

I have heard lots of criticism of the Australian Securities regulator.  However on this important matter their actions were exemplary.  They did what the SEC could not do and act on a “Markopolos letter” within weeks.  They did what the SEC should have done when they investigated Madoff – and attempted to confirm the existence and value of the assets. 

Three weeks later ASIC put a stop on all Astarra funds – prohibiting new money going in or any moneys going out.  They acted to protect investors.  This showed responsiveness that Mary Schapiro and American regulators can only aspire too.  The Sydney Morning Herald finally published a cryptic story on the front page.  The Sydney Morning Herald article did not suggest – and I did not reasonably think – that the problems extended further in the Trio edifice.

A few months have passed and eventually all major Trio entities were placed in administration by the superannuation regulator.  They will probably be liquidated.  The funds have been passed to (reputable) private sector “forensic accountants” – the choice of accountants being made by the securities and superannuation regulators.  They are the sort of liquidators you use when (as stated by the regulator in their press release) you are not “able to satisfy concerns regarding the valuation of superannuation assets”.

The whole mess will be explored by the accountants -  and if the assets are not there then the matter will played in court – at which point I will publish my “Markopolos letter” analysing what I got right and wrong. 

But for the moment I will leave you with what attracted me to Absolute Alpha in the first case.  It was the CV’s of the principal players.  Here they are:

Shawn Richard - Chief Executive Officer

Shawn is the founder of Absolute Alpha and a key member of the investment team.   Prior to founding Absolute Alpha, Shawn has held and continues to hold, various senior positions, including directorships of companies both in Australia and overseas.

Shawn has been involved in financial markets since 1996 and had been specialising in alternative investments for more than 8 years, both offshore and in Australia. Over this time, Shawn has established relationships with some of the most exclusive hedge fund managers around the globe.

Shawn’s offshore experience in alternative investments includes among others, structuring and analysis of derivative instruments with some of the largest private hedge funds in the United States. Shawn was also part of a small team of professionals providing risk management services to Asian institutions and regional banks in relations to their exposure in equities.

Shawn holds a bachelors degree in Finance from the University of Moncton.

Eugene Liu -Chief Investment Strategist

Eugene is the Chief Investment Strategist of Absolute Alpha. As Chief Investment Strategist, Eugene is involved in the development and evaluation of asset strategic plans, development and modelling of analytic tools, reviewing and analysing investment data to formulate investment strategies, and the investment risk management process. Prior to joining Absolute Alpha, Eugene worked with the Asset Management team of Pacific Continental Securities and World Financial Capital Markets in the US and Asia. In these roles, Eugene performed extensive financial modelling and valuation analyses of various hedge fund strategies. Eugene also led a team of arbitrage specialists who provided structured product deal flow to many of the largest hedge funds in the industry.

Eugene holds a degree in economics from Trenton State College in New Jersey.

Charles Provini (US) - Asset Consultant

Charles has been involved in hedge funds for more than 20 years and is a senior asset consultant and member of Absolute Alpha’s investment committee. Currently, he is the President of Paradigm Global Advisors, a well established hedge fund manager based in NY and he is also the Chairman of C.R. Provini & Co., Inc., a financial services firm, founded in 1991. Prior to this, Charles held various senior positions, including, President of Ladenburg Thalmann Asset Management, Director at Ladenburg Thalmann, Inc., one of the oldest members of the New York Stock Exchange, President of Laidlaw Asset Management, Chairman and Chief Investment Officer of Howe & Rusling, Laidlaw’s Management Advisory Group, President of Rodman and Renshaw’s Advisory Services, and President of LaSalle Street Corporation, a wholly-owned subsidiary of Donaldson, Lufkin & Jenrette.

Charles has been a leadership instructor at the U.S. Naval Academy, Chairman of the U.S. Naval Academy’s Honour Board and is a former Marine Corp. officer. He is frequent speaker at financial seminars and has appeared on “The Today Show” and “Good Morning America” discussing financial markets.

Charles is a graduate of the U.S. Naval Academy and has an MBA from the University of Oklahoma.

Now the first CV – Shawn Richard – is notable only for what it does not say.  It does not mention a single firm that Shawn ever worked for – and hence reduces the possibility of doing due-diligence. 

Eugene Liu’s CV is not so careful mentioning two firms, Pacific Continental Securities and World Financial Capital Markets.  Pacific Continental is easy to find – it was a bucket shop of enormous proportions in the UK.  Essentially the firm found hapless victims and steadily moved their life savings into soon-to-be worthless scam stocks for huge commissions.  This was explored widely in the UK press including beautiful articles about a salesman’s time as scam artists.  World Financial Capital Markets is a little harder to trace as a firm.  Several firms have had that name – but one firm by that name met an unfortunate end involving fraud and the principals reappeared at Pacific Continental. 

It turns out that Shawn Richard was a manager with Pacific Continental in Taiwan.

The third CV is of Charles Provini who used to be the CEO of Paradigm Global and who was (falsely) claimed to remain in that position.  When I copied these CVs off the Absolute Alpha website Provini had not worked for Paradigm for about two years.  Some of the rest of Mr Provini’s CV is raised my eyebrows too – for instance he worked as the President of Laidlaw Asset Management.  A firm of that name was cited by the UK securities regulator (the FSA) for cold-calling and selling scam funds to UK investors. 

The link to Paradigm Global was what raised my eyebrows.  Paradigm is an asset manager (for funds of hedge funds) owned by Hunter Biden and James Biden.  These are the Vice President’s son and brother respectively.  I have written about Paradigm extensively before as it has an unfortunate habit of being associated with scams.  Absolute Alpha was not difficult to do due diligence on.  It took me only 40 minutes to work out that they were needing very close scrutiny.  It does not speak well to the due-diligence of a fund of hedge funds (which is what Paradigm claims to be) that they keep being associated with cases like this.

The Biden connection was what prompted me to look at Absolute Alpha and hence what led me to write my “Markopolos letter” to ASIC and hence what rapidly led to the closure of Astarra and Trio.  It is worth asking how deep that connection is.

Are Absolute Alpha/Astarra really associated with the Biden’s firm?

At first glance the links between Astarra and the Bidens’ firm are weak.  Provini could have been marketing “vapourware” with no real association.

All that is certain is that Provini was cited on the Absolute Alpha website as an asset consultant and President of Paradigm for at least two years after he was sacked from Paradigm.  Provini is now running inconsequential penny stock companies. 

But the links run deeper than that.  Absolute Alpha also used to cite other staff members who worked at Paradigm – indeed the original “managing partner” was also a staff member at Paradigm.

Absolute Alpha used to publish a process diagram as to how they identified funds to invest in.  I have reproduced that diagram below:

 

It mentions two things which link Absolute Alpha (now called Astarra) to Paradigm global.  These are the use of the Park Score (named after James Park – the founder of Paradigm) and the PASS database – the core database of hedge funds from which Paradigm claims to make its investment decisions. 

Still, this could all have been ripped off Paradigm without Paradigm knowing. 

Alas Paradigm does not get off so lightly.  The boys from Absolute Alpha went to New York and co-marketed with people from Paradigm.  Indeed I know someone who thought that Absolute Alpha were OK because staff at Paradigm had vouched for them.  Whether Paradigm knew that Shawn and Eugene in Australia were using “Paradigm inspired” marketing material however is unknown. 

Paradigm – the Biden’s firm – had unwittingly got involved in another funds management firm which has been closed by regulators or been exposed as Ponzis.  That is four I know of now – and I have yet another one that I suspect of being unsound. 

A plea to Michelle Malkin

So much of what is published by the conservative blogosphere is non-fact based muckraking.  And yet – sitting here has been my observation that the fund of hedge funds associated with the Vice President’s family has an unnerving habit of association with scams and other funds closed by regulators.  Surely a competent muckraking conservative blogger can actually do some digging rather than pontificating from the sidelines. 

It makes me think of conspiracy theories.  Maybe conservatives in the US do not want to do this sort of financial digging because most the fraudsters and scamsters are part of the Republican movement and do not like regulators because – well – they might catch them.

But there must be honest Republicans out there.  It is time for Michelle Malkin to do some honest work.  So I will plead with her – can you please do some digging into Paradigm or find some other muck-raking conservative to do it for me. 

I for one want to get back to making money honestly.

 

 

 

John

 

*Incidentally – I was attempting to log into the Absolute Alpha website because I was discussing the whole matter with a reader from Talking Points Memo.  You know you you are.  Thank you.

Keynes on British industrial history

I will leave aside Felix Salmon calling me “socially useless” (as a short seller) until I am in a position to reveal my pithy reply.  For the moment all I will confess to socially awkward and highly indulgent. 

In the highly indulgent vein I have just finished reading Tony Judt’s truly stunning history of Postwar Europe.*  Anyway – I thought I would leave you from a quote from Keynes – made at the end of the (Second World) War.

If by some sad geographical slip the American Air Force (it is too late now to hope for much from the enemy) were to destroy every factory on the North East coast and in Lancashire (at an hour when the directors were sitting there and no-one else) we should have nothing to fear.  How else are we to regain the exuberant inexperience which is necessary, it seems for success, I cannot surmise.

For the US Air Force read the policies of Margaret Thatcher, Tony Blair and – we can hope – the ensuing discrediting of all financial management. 

 

John

 

*This improves dramatically on the last bit of Mark Mazower’s equally stunning modern history.   

Kodak, Bill Gates and efficient markets

I am just back from my summer holidays on the New South Wales South Coast.  To my (mostly) Northern Hemisphere readers I should boast about warm water, perfect waves, beaches in national parks with only one or two pairs of footprints on them and no people, fish that seem to suicide on your lines, etc – but that would just be boring.

In the middle of every day – when the heat became too much and the surf had waterlogged me I read.  On my kindle of course.  And some books which I had never read I read happily made easy mostly by the kindle’s large font options.  One of those books was Alice Schroder’s too long but otherwise excellent biography of Warren Buffett.  There was plenty there – I just want to share a single throw-away observation.

Warren Buffett has a group of his best investing friends get together once a year.  He originally called it the Graham group in honour of his mentor Ben Graham who presented at the first annual meeting in 1968.  By 1991 the group had expanded somewhat to include not only the original fabulous stock pickers but some business luminaries who could help enlighten the group on the nitty-gritty of their industries.  One regular attendee was Bill Gates of Microsoft fame.  From here I will quote Alice Schroder:

After a while Buffett asked everyone to pick their favourite stock.

What about Kodak? asked Bill Ruane.  He looked back at Gates to see what he would say.

“Kodak is toast,” said Gates.

Nobody else in the Buffett Group knew that the internet and digital technology would make film cameras toast.  In 1991, even Kodak didn’t know it was toast.

Gates was right of course – and since 1991 Kodak has been a terrible stock – and I would have counted Bill Gate’s comments as “knowledge” in as much as a statement about markets and technology could be knowledge.  But it would be an awful long time before that “knowledge” would be reflected in stock prices.  Here is a graph of the stock price since 1 Jan 1990. 

 

If you had taken Gates to heart in 1991 and shorted the stock then for almost ten years you looked like toast.  If you sold the stock because of something Bill Gates said then you looked silly for six or more years unless you purchased something better.

Indeed if you had the “knowledge” probably the best thing to do with it was to use it just to avoid the photography sector altogether.  That would mean you might outperform the market – but that outperformance was slight.  [If avoiding that sort of catastrophe was your mechanism of making money you probably needed an enormous amount of “knowledge”.]

Anyway there is little question that if you understood the implications of digital photography in 1991 you were – at least on that item – the smartest guy in almost any room.  And it did not help you make (much) money.

The market could stay wrong for a very long time.  Maybe as long as some blinkered academics could continue to believe in strong versions of the efficient market hypothesis.

 

John

When regulators can’t do math: gas pipeline edition

The Federal Regulatory Energy Commission (the FERC) is charged – amongst other things – with regulating the rate of return on interstate natural gas pipelines.  Rates on these pipelines are by-and-large regulated so as to achieve a targeted return on equity.

Quite of its own volition the FERC has called for a judicial review of on three Midwestern gas pipelines including Natural Gas Pipelines of America (NGPL).  In its last rate case (1996), NGPL’s target rate of return was set at 12 percent. 

This is a peculiar review because – unlike past reviews – the review was called by the Commission itself and without a complaint from any of the customers using the gas pipeline.  [Customers for gas pipelines tend to be large oil and gas companies or large utilities and are usually not shy about calling for a review when rates are out-of-line.]

The FERC has argued – from publicly available documents – that the returns on the NGPL are (just) over 24 percent – and hence (and these are their words) are “unjust and unreasonable”.  They use lots of emotive language and have petitioned a judicial review to get the rates cut.  You can find the full document here.   A good press summary is here. 

To put it bluntly the FERC stuffed up.  It simply got the math wrong because it does not understand rates of return and depreciation – a staggering oversight for a body charged with regulating pipelines.  Worse – on the math presented – the rates on the NGPL should be increased in order to allow for the FERC mandated 12 percent return. 

This is a pretty nasty allegation – so I need to explain the basic mathematics of regulated returns.  I will start with the simplest of models that I can.

The simplest pipeline model

Imagine a pipeline that cost $100 to build.  It lasts 2 years.  The regulators have to allow the pipeline to recover an amount (say $x per year) so that the present value of $x per year adds up to $100. 

Now $x has to be more than $50.  Why?  Because over 2 years the pipeline has to recover at least the $100 that it cost to construct.  Depreciation alone is $50 per year – and having the pipeline recover only $50 per year would mean it made no profit.

We could (naively) presume that because $100 is employed the pipeline needs to make $12 per year profit in order to get 12 percent return.  So we would set $x at $62.  That unfortunately gives us a little too much return – because – in the second year the pipeline only has $50 of capital employed (they have recovered $50 through depreciation).  You can do the math here (and you assume for simplification that the cash is all received at year end) then the $62 received after year one would be worth $55.36 discounted at 12 percent and the $62 received in year 2 would be worth $49.43.  Add those up and you get more than $100. 

I used the “goal seek” function on Excel to work out the required annual return on the pipeline under the simplifying assumption that the annual payment is received in two equal increments.  I have linked the original spreadsheet (to convince you that I have done this correctly). 

 

 

In this case note that the required cash flow each period is $59.17c.  You can discount this if you want by 1/1.12 in the first year (getting $52.80) and by that squared in the second year ($47.17) and lo – these numbers add up to $100.

Now here is the clinch – which is that we know – by initial assumption here – that the return on equity for this project over its life is exactly twelve percent. 

But what is the return on average equity in the second year? 

Return on average equity in the second year!

The cash return in the second year is $59.17 cents.  [It needs to be that every year to provide a 12 percent return on equity over the life of the project.]   The pipeline depreciates by $50 per year over its two year life.  So the measured profit during the second year is $9.17 (the return less depreciation).

Capital employed commenced the second year at $50 (being the cost less the $50 of accumulated depreciation).  It ended the second year at $0 – as the whole pipeline had been written off by then.  The average capital employed for the second year is thus $25.  Given the stated profit is $9.17 the return on average equity for the second year – as recorded – will be 36.7 percent. 

This return will be observed even though the return on the project over its life is only 12 percent. 

There is nothing sinister about an observed 36.7 percent – and more generally there is nothing “unjust and unreasonable” in the observed returns of 24 percent of the Natural Gas Pipeline of America.  These returns are simply a mathematical artefact of the allowed return on equity of 12 percent over the life of the pipeline.   The observed ROE of 24 percent does not warrant a rate case – it is as to be expected.  Indeed as the pipeline in question is more than half depreciated I would have been surprised if the observed ROE was below 24 percent – and the 24 percent ROE does not represent a problem or a failure of regulation. 

What we have here is a regulator who has failed to understand the basic math of the business which they are meant to be mathematically regulating.

The deskilling of American regulators

I am no longer surprised at the general deskilling of American regulators.  This post demonstrates that the regulator – whose job it is to regulate the rate of return on gas pipelines – has no idea at all of the basic high school mathematical implications of that regulation.  I am used to SEC officials who can’t read a balance sheet or can’t see the Madoff fraud when it is laid out in front of them.  But the rot spreads more widely.  We have bank regulators who were blind or stupid and now we have utility regulators who can’t do basic math. 

A more generalised formula for what should be the observed returns on a pipeline

Warning – seriously wonky – here I do the math to show what the observed ROE should be.  You don’t need to read this – just accept the regulator has their math shockingly wrong.  But here is a way of working out precisely how wrong!

Being a nerd I thought I would help the regulator out with their math – and indeed it is not too hard to derive a generalised formula for the right observed return on a pipeline.  But hey – why bother when Wikipedia does it for you?  Wikipedia gives the present value of a stream of n paymnets of value A as follows:

 

PV(A) is the present value of the stream of payments – which in this case should be the construction cost of the pipeline. 

i is the rate of return – which in the case of FERC should be the regulated rate of return (12 percent), and

A is the annual cash return on the project, and

n is the number of years over which the project receives its return (which should be the depreciable life of the pipeline – or in the above example 12 percent). 

Now I would never use a formula out of Wikipedia without checking it (which I did by derivation) but for my readers I thought I should just plug in the above example – where the cost of the pipeline is $100, the annual payment is $59.17, i is the usual 12 percent and n is two years.  Plug the following into your calculator – it checks out just fine:

Now we can rearrange this standard formula to determine A:

 

 

 

Now we can also work out what the year-end capital employed (E) in year j of n is.  That is trivial – it is

 

 

 

 

Income in any year (Y) is equal to the annual payment less than depreciation.  In the formula below I just assume that the original cost of the pipeline depreciates in a straight line over n years.

 

 

Now the FERC is really obsessed by the observed return on equity on the pipeline (in this case about 24 percent).  But lets work out what the observed return on equity should equal:

 

 

You can rearrange and simplify this equation any way you like – I can’t really be bothered – I am lazy.  But hey we now have enough to work out what the observed rate of return should be.  Assume that the initial cost of the pipeline is 1 (it would cancel from top and bottom of the above formula).  The depreciation in the FERC document for the pipeline is 50 years – so n is 50.  The pipeline originally cost $3.728 billion but has accumulated depreciation of $2.273 billion – so we are in 35 of 50 – so in the above formula j is 35.  We are going to allow the regulated rate of return – which is 12% – so i is 0.12.  Plug this in and we get the following:

 

 

Just to check that I am not wrong I have done the same in a spreadsheet – which I have linked here.  But the lesson is that the observed rate of return should be 33.47 percent even though the project actually only returns 12 percent over the life of the project. 

An observed rate of return on 24 percent – the rate that FERC is complaining about – is too low.

FERC is right of course – the tariffs on these gas pipelines are “unjust and unreasonable” – they unjust and unreasonably low.  On FERC’s own numbers they are not adequate to provide the lifetime 12 percent return on equity that FERC mandates.

What are the options here?

I guess the easiest options for the owners of the pipelines are to allow the FERC numbers as to depreciation and capital employed to go to the judge uncontested.  They do not seem out-of-kilt with reality.  They then should present the math straight (and there are plenty of mathematicians who will do a better job than me) and they should ask for a rate increase! 

I do not think the judge will have any problem giving it to them.  But it is not the public policy objective here – and we wound up in this spot because of the mathematical incompetence of the FERC.  It is time to stop the rot at the FERC.

Stopping the rot at FERC

And it should stop relatively quickly.  Barrack Obama appears to have appointed a competent man to be the head of the FERC.  Whilst Jon Wellinghoff may have spent most of his career as an attorney he has – according to his CV – an undergraduate degree in mathematics (University of Nevada 1971).  He should be more than capable of checking the math in this post. 

I have contacted his office and given him a copy of this post.  Jon Wellinghoff endorsed and press released the review of the rates for the various gas pipelines.  He is however more than capable of withdrawing his request for a review.  Indeed I think he has to before the FERC is made a laughing stock as the SEC was after Madoff.

I will happily announce when he has reacted appropriately. 

 

 

 

John

PS.  The pipelines who would have had their returns slashed under this review include Northern Natural – which is owned by Warren Buffett’s Berkshire Hathaway.  I have not received or asked for a consulting fee but Berkshire holders (many of whom are my readers) should be sending their thanks...

PPS.  I am serious about the deskilling of US regulators.  I have spent only a few hours thinking about the mathematics and accounting of rate of return regulation in my life – and I spotted and roughly quantified this error within five minutes.  Regulators who do this all day every day should simply not make mistakes like this.

Gratuitous advertising time: The Nick Hempton band is playing in New York

The distinctly cooler Mr Hempton (my cousin Nick) is doing a gig (with his band) at Smalls Jazz Club Saturday night. Its 183 West 10th street – and it starts at 7.30.

He may not know much about the capital needs of regional banks – but – as one good newspaper review once said – he looks like a movie star and plays like Charlie Parker.

Getting it wrong about getting it wrong about coffee

One of the joys of the blog is that I have several readers who are WAY smarter than me.  One pointed out that I did NOT get it wrong in my Peet’s short.  [To get the background you simply must read this post first.]

I thought that Peet’s was overpaying for a license to put their coffee in k-cups.  I was wrong.

But my smart reader thought that either

(a).  the license to put coffee in k-cups was written as expected (favourable to Green Mountain but unfavourable to Diedrich) – in which case Peet’s was overpaying for Diedrich or

(b).  the license was favourable to Diedrich – in which case you could bet that Green Mountain – a much richer company than Peet’s – would simply and massively overbid Peet’s to own Diedrich.

If Peet’s was overpaying for Diedrich then I was going to win on my short.

If Peet’s was not overpaying for Diedrich then they would wind up in a bidding war with Green Mountain – in which case I could cover at a profit anyway.

Now tell me why I did not short Peet’s big time when they bid for Diedrich?  Stupidity I guess.

 

 

John

Getting it wrong over coffee

Money management can be one of the most interesting careers in the world. At best it gives you lots of unstructured time to think about how the world really operates – and to make bets based on your hypotheses.  You get to conduct uncontrolled but real time experiments in the social sciences.

But never forget this is social science – not physics – and a little dogmatism about your rules or positions can result in getting it spectacularly wrong.

This was one of the more interesting places I have got it wrong lately – and so I thought I would write it up. It was also a surprising case of getting it wrong – because despite the analysis being totally stuffed I managed to scrape a (small) profit out of the trade.

The case involved three coffee companies (Diedrich, Green Mountain and Peet’s Coffee). I will explain what these companies do later – and how they are involved – but first I want to digress a little on the oddity of American coffee chains.

Starbucks failure in Australia

As an Australian the success of Starbucks (or Peet’s in San Francisco) puzzles me. Australia is blessed with a plethora of interesting and sometimes quirky, often very stylish cafes.  For those who are interested here is a photo of my local (Bronte) strip of coffee shops.  They are better than any strip I know of in New York, SFO or Chicago.  The coffee is better too – and that is widely commented on by visitors to our shores. 

It’s not that Australia is even a particularly coffee addicted country.  Per capital consumption is not huge by developed country standards and is lower than the United States.  We just have a better coffee scene.

It puzzles me why.  There are awful lot of things that the United States does (substantially) better than Australia so this is an oddity deserving some explanation. 

American coffee chains (particularly Starbucks but also some of the donut variety) have tried to break in and mostly failed.  Starbucks closed most of its stores last year after multi-million dollar losses.  They couldn’t cope with the Australian competition.  Which is odd because in most things the US is a far more competitive market than Australia – and US senior management tend to be more battle hardened than their Australian peers (see my piece on the use of American CEOs in the Australian context).  Its just the competition in cafes is far more fierce here.

I would love to be corrected – but I think the reason has to do with our wage structure.  American low-end wages are very low indeed whereas Australia has minimum wages at quite high levels.  Hiring unskilled labour to run a coffee shop according to a formula (and devoid of in-store entrepreneurial talent) works in America but does not work in Australia.  Also entrepreneurial talent in America has too many opportunities to waste itself in a coffee shop – whereas small-time competent entrepreneurs will open a small coffee shop in Australia.  [Maybe one of the good things about America is that it uses entrepreneurial talent well.]

Anyway this leads me to believe that some businesses that look bullet proof (running simple chains of shops which sell an addictive and brand loyal product) might actually be more vulnerable to quite strange social and economic trends than you would think.  Coffee shops look impregnable (and Peet’s typically trades with a 30 times price earnings ratio) but coffee shops can be beaten back by small entrepreneurial talent for reasons that are hard to articulate. 

The Green Mountain Keurig Cup

Another thing that coffee shops are vulnerable to is easy-to-make-at-home quality coffee.  Nescafe and other instant brands distribute a large amount of caffeine – as for that matter does the Coca-Cola company.  But against a well made espresso (diluted with frothy milk to taste) it just can’t cut it.  Our funds management business requires its morning coffee (which we buy from an excellent and entrepreneurial local cafe).  That said – American coffee is just not that special – and perhaps is more vulnerable than you think. 

One thing it is vulnerable to is the Keurig Cup (or K-cup).  K-cups are a plastic and coffee device you put in a special espresso machine and it makes you – instantly and with minimum mess and fuss – a very good espresso with very few traps for the unwary.  Its certainly a better drink than instant – and matches in quality a better cafe (though there are some tricks with milk frothing that the k-cup does not match).  

K-cups are a truly amazing business.  Once you have sold the machine you get to sell the cups (an addictive product no less) ad-infinitum with astonishingly fat margins.  And you don’t need to rent expensive real estate to do it.  This is like cigarettes – but with a growing market and without the litigation (and without actually killing your customers).

The first time I saw a k-cup was when a pretty young woman in a department store offered me a free coffee (brewed in a k-cup).  I noticed the razor-and-blades business model and determined that I did not want to be a sucker to that machine.  Alas – and to my endless shame as a stock picker – I did not even consider buying shares in the company which owned the k-cup business.  After all as a stock-picker you would really want to be on the receiving end of a razor-and-blade business selling a new addictive product.

That company is Green Mountain Coffee Roasters – and – since I first saw the machine the stock is up over five thousand percent.  A five thousand percent gain would – of course – somewhat have improved my finances and the finances of my clients...

The attraction of the k-cup business is not unnoticed by the market – Green Mountain trades at a PE ratio around fifty.  Still that is less than one times earnings on the price it was when I first saw a k-cup.

The k-cup license holders and Diedrich Coffee

Four companies have licenses to produce and sell k-cups.  Only one of those companies (Diedrich) is listed.  A license to sell k-cups is a license to share to some extent in Green Mountain’s very rapid growth however the terms with which you share are unknown.  As a default position I would expect that Green Mountain – the technology holder – would extract its pound-of-flesh for granting such a license and whilst a license holder might grow very fast you would not expect it to be outrageously profitable.  However – as I said the terms of the license are unknown and have never been published. If Green Mountain – in the infancy of the k-cup business – gave out the licenses on stupid terms then owning one of the four licenses to produce k-cups would be getting most of the benefit of being Green Mountain – but without even the expense of subsidizing the espresso machines or of hiring the pretty-young-woman sales people to sell new espresso machines.

It seemed however unlikely to me that Green Mountain – who have a truly fantastic product – would ever have signed a contract with Diedrich – or anyone else for that matter – which was truly unfavourable.  After all Green Mountain held the aces.

Moreover Diedrich has truly strange accounts.  It was an unsuccessful owner of a coffee shop chain (Gloria Jeans) which they sold off and the balance sheet has about 50 million in accumulated losses.  Sales were flying – but half those sales were back to Green Mountain (for whom they out manufactured product).  Moreover the accounts were truly strange in other ways (it was for instance very difficult to get a handle on tax expense).  There was a truly frightening article that appeared on Seeking Alpha which went through the accounts in great detail – and – if you took all the suggestions in that article at face value – then you would probably conclude that Diedrich was a fraud.  (The Seeking Alpha article has since been removed.)  

None of that stoped Diedrich being a truly explosive stock – indeed before I had even looked at the stock (and in about six months) it has gone from 21c to just over $30.  You don’t need too many of them in your lifetime…

Now this move looked truly bizarre given (a) the fact that it did not even own the k-cup technology and (b) the bizarre accounting as outlined in the Seeking Alpha article. 

I thought (possibly incorrectly) that Diedrich was probably a stock-promote rather than a business as per the suggestion in the Seeking Alpha article – but I did not bother to do any of the work to prove or disprove that case.  That work came later.

The Seeking Alpha article was anonymous and hard to verify (as discussed below).  

The danger of shorting frauds

The reason I did not do any of the work to confirm or deny the Seeking Alpha article was that shorting frauds (especially well publicised frauds) is possibly the most dangerous thing you can do on Wall Street.  Take for example a fraudulent oil company in Africa – but one that really has some oil.  The company has oil – so it can show flows to visiting analysts.  It has pictures and local politicians are excited to hob-nob with the management.  But there is no real way of telling whether they have 1 million barrels or 10 million barrels.  They may have 3 million barrels (which would be valuable – but not earth shattering) but tell the market they have 20 million barrels.  There really are very few ways to tell – and if they are determined they can exaggerate at will.  Moreover suppose you have worked it out (or at least have suspicions) – it doesn’t help you.  If someone is going to fake the existence of 17 million barrels of oil there is not much that stops them from faking the existence of 170 million barrels of oil.  If you are short and they “announced” a 100 million barrels (or a few trillion cubic feet of gas) and the market believes them then you are stuffed.  The stock could go for a monstrous run – and you will be forced to cover at a shocking loss. 

The problem with shorting frauds is that there is nothing to keep the fraud grounded – and hence there is nothing to limit your losses.  If you short a real company (say Dell) and Dell sells less computers than it anticipated it will tell the market.  The stock will probably go down.  If it sells more computers than anticipated at better margins the stock will go up.  But it is vanishingly unlikely to sell ten times as many computers as anticipated.  You can be short and whilst you might lose money if you are wrong you will not do serious damage.  Frauds – because there is nothing to keep the claims grounded – can cost you an enormous amount as a short.

There was a possibility that Diedrich was a fraud – but it was a high-growth with a substantial short interest.  There was simply no way that I was going to short it because the potential losses looked vast.  Given that I did not bother to fact-check the Seeking Alpha article.

The rare safe time to short a fraud

There is only one time that it is relatively safe to short a fraud – and that is when a real company is suckered into buying it.  That happens – and the cannon-example was when Mattel purchased The Learning Company.

The Learning Company (TLC) was (and remains) a children’s educational game software maker.  It has real games and real sales.  In that sense it was similar to my African oil company with a few million barrels.  It however had accounts which were peculiar – and several short sellers were convinced it was mostly fraudulent.  [I had never heard of the company so I cannot vouch for their views.] 

Eventually Mattel purchased TLC.  The purchase was made from weakness.  Mattel used to have a great franchise in toys for young boys (think Matchbox cars).  There is simply no way I could interest my nine year old in Matchbox cars anymore – not when they have a Playstation or a Wii.  Boys toys were dead and computer games killed them. 

Mattel was desperate to join the computer game revolution – and it paid a fortune for what really was a dodgy property.  The losses were in the billions.  Wikipedia tells the story quite well.  It was one of the worst acquisitions ever on Wall Street – and not only did it cost Mattel over 3.5 billion (mostly in stock) but it revealed the underlying (and fundamentally incurable) weakness in Mattel’s business.   It also cost the CEO (Jill Barad) her job.  Jill made her career promoting and marketing Barbie dolls and her claim to fame was that she was brilliant – possibly amongst the best ever – at marketing bimbos.  (A company insider once noted to me that that included herself.)  Jill was however absolutely useless at assessing a computer game company.  [Personally though I think she should have been kept on as CEO but limited to Barbie…  She really did deserve that job and did it well.] 

A short seller’s dream is when a real company – preferably one which is a little dopey and in an old industry (matchbox cars as compared to computer games) buys something hot, sexy and fundamentally dodgy. 

Peet’s bids for Diedrich

I thought I had my own repeat of Mattel and The Learning Company.  Peet’s – a well run but simple coffee chain around the Bay Area bid cash (debt funded) and stock to buy Diedrich.  Ah – here it was – a simple company with a simple model – whose margins seemed to be declining (for reasons I have not fully identified) which bids for a well promoted company with massively complex (and potentially misleading) accounts. 

To say I was excited is understating it.  This is precisely the sort of thing that excites a short seller.  At worst what would happen was that Peet’s – a company with less than 200 coffee shops (and owning only the brand and fittings) would have roughly 140 million debt and a business (Diedrich) that – depending on the contract with Green Mountain – might not be worth very much at all. 

In the bad-case Peet’s stock – trading at 30 times earnings – could lose 80 percent of its value.  [That was what happened to Mattel.]

So I did some work.  I went back to the Seeking Alpha article and tried to verify every claim in it.  Alas I could not.  There were a few simple (and innocent) explanations for some of the red-flags highlighted in the Seeking Alpha article.  However with respect to some of the claims in the article I had to acknowledge that the author had a point.  He wasn’t right with respect to everything – but he was right on some points.  Diedrich’s accounts were (and still are) pretty aggressively stated.

I shorted some Peet’s.  Not a lot – but maybe a third of the final position I hoped to have.  I intended to do a little more work (especially as the debt covenants were published).  Besides – in the Mattel case there were many quarters as The Learning Company disaster unfolded.  There were plenty of opportunities for a short seller in Mattel to test their thesis on the way down.  This was a small position – but as it unfolded I hoped to make it a big position. 

Now the observant will notice there is a missing detail.  I still do not know the terms of the contract between Green Mountain and Diedrich.  If the terms are highly favourable to Diedrich then shorting Diedrich (or the new owner of Diedrich) is spectacularly misguided.  In that case Diedrich is just a cheap way into Green Mountain’s (fantastic) business.

Not knowing the terms of that contract was the key weakness in all of my analysis.  And I knew it. 

Peet’s had a conference call when they announced the purchase.  They indicated that the terms of the contract were acceptable but they refused to detail what they were.  Paraphrasing Mandy Rice Davies “well they would say that wouldn’t they”. 

What I was looking for in future quarters (as a guide to increasing the position) was evidence that the Green Mountain contract was favourable to Green Mountain. 

Well I was wrong

I started this by stating that most of the analysis was wrong.  And it was – in a very specific way.  My biggest concern was always the contract Green Mountain had with Diedrich.  And only one party outside Diedrich knows that contract and understands its economics intimately.  That is Green Mountain. 

And they proved me wrong.  Green Mountain overbid Peet’s for Diedrich - $30 per share – all cash. 

Oops – now I know I am wrong.  Green Mountain wants to bring that contract back in house.  They want it in-house for about a quarter of a billion dollars in cash!  Remember ultimately all that Diedrich has is a few tax losses, a small manufacturing facility for K-cups, a couple of second-rate coffee brands and THAT CONTRACT. 

Peet’s overbid – bidding $32 a share ($20 in cash the rest in stock).  Green Mountain upped its bid to $32 per share ($265 million) all cash.  Remember this stock was trading earlier this year under 25 cents!  This is one hell-of-a-valuable contract.

Needless to say events have shown I was wrong about Diedrich with respect to the only thing that mattered (the worth of the k-cup contract with Green Mountain).  I covered my short and thanked luck that it was not (much) worse.

Of course this bidding war drove down the value of Peet’s stock.  So I was wrong and made a small profit.

Money management – lucky or smart?

Given I was wrong I can hardly say I was smart.  But Peet’s was not a bad candidate for a short.  It has a very thin balance sheet (almost all profits have been used to buy back stock).  It does not own the sites of its stores.  It was paying cash so it was going to incur debt with only intangible assets (its brand really) to back that debt.  And it had a 30 PE. 

Given all of that I could be wrong in lots of ways but still make a profit. 

But I should not get carried away.  I was wrong – proven wrong – and the profit is nice but it shouldn’t be used to ignore the fact that my hypothesis was simply inconsistent with observation.

Back to scratching around (often fruitlessly) for things that might make money.

 

 

John

The Ides of March and the Fed exit strategy

The dollar bears (and inflation mongers) are all over the blogosphere and press at the moment. It is almost a consensus that the US dollar is doomed and that gold is a great investment. Sure there are doubters – but few are as vocal as Paul Krugman who refers to inflation as the phantom menace.

Anyway I thought I would have a brief analytical foray.

Over this crisis the Federal Reserve increased the money supply by literally trillions of dollars and several hundred percent. In an ordinary world this would have caused very rapid inflation – but suffice to say that this is still not an ordinary world. Short term interest rates are stuck at zero and medium term rates are pinned very close to zero. People (and financial institutions) are willing to hold (and not spend) inordinate amounts of money. Liquidity preference is very high and it has absorbed all the extra money the Fed has printed.

Obviously some day liquidity preference will wane (though Japan tells us that day might be very far into the future). When the liquidity preference has waned all that money that was printed will be excess and might turn into inflation.  The Fed will need an exit strategy. Inflation hawks are already worried that inflation is inevitable. Gold is a favoured investment of many – including some hedge fund managers who I think have very fine minds.

Ok – I think the inflation hawks are wrong and I think gold will be a lousy investment. But I need to explain why.

The Fed printed money to buy lots of riskier assets. Often these were assets owned by banks and the banks borrowed the cash from the Fed secured by these assets. About a trillion of the assets were qualifying mortgages guaranteed by Fannie and Freddie. Whatever, there is a huge increase in money supply (liabilities of the Federal Reserve) offset by an equally huge increase in assets held by the Federal Reserve.

The Fed has an exit strategy – a natural exit strategy. When people’s liquidity preference wanes they will want to hold risk-assets rather than cash. And the Fed owns trillions of dollars of risk assets. The exit strategy is simply to sell those risk assets and take back (and destroy) the cash that they created during the ciris.

The right speed to do this is also – in some sense – naturally determined. The right speed is at the speed the general public wants to hold mortgages and other risk assets again.

Now all of this presupposes something utterly critical. It presupposes that the assets on the Federal Reserve balance sheet (loans to banks secured by risk assets, Fannie and Freddie mortgages and paper) are good. If the assets held by the Federal Reserve are worthless then the Fed cannot use those assets to buy back the excess money supply precisely because those assets were a wipe-out.

The Fed has an exit strategy – but only if the asset side of its balance sheet is solid.

And this brings us back to the middle of March when the system was collapsing around us. The Fed was the only source of liquidity – they were lending to big banks secured by almost anything the big banks had unencumbered. They even lent to big banks secured by (of all things) recreational boat loans.

If everyone was insolvent then those loans to banks will be no good. The Fed will have no capacity to withdraw the excessive money supply because the asset side of their balance sheet will be stuffed.

However if the crisis was a liquidity crisis and not a solvency crisis then, come the time to exit quantitative easing, the Fed will have a sufficient balance sheet to do its part.

The determining factor as to whether the end game here is inflation is whether March was a liquidity or solvency crisis.

This blog has been consistent. I do not believe the US banking system was insolvent in March. I never did believe it. And I thus believe the Fed has an exit strategy. Given that belief I think that gold is a lousy investment from here (though thankfully I have not been short it).

More generally I think there are serious problems with believing both of the following:

(a) the financial crisis was essentially a solvency crisis – the banks were mass insolvent in March and a bailout was inevitably going to impose very large long term costs and

(b) that inflation is not a large risk.

However Paul Krugman seems to believe both these things, and he has a Nobel Prize in economics and is clearly smarter than me. So please take all of this with a grain of salt.