Gretchen Tai: possibly the best fund manager you have never heard of

Please note: much to my surprise these returns are entirely genuine. I was originally skeptical. I am now convinced.


A little while ago I worked through HP's defined benefit pension fund - trying to work out how underfunded it is (and hence work out the true debt levels at Hewlett Packard). Most defined benefit funds are underfunded. They assume 8% returns in their actuarial assumptions and are two thirds are invested in debt. (It is of course impossible to get long term returns in debt substantially above the starting yield.)

Whilst I was looking for funded status what caught my eye were the very fine returns they had on assets - particularly in the US defined benefit fund - and particularly over the past three years. I can't quite work out how they do it.

I tried to compare the fund to other large endowments (Harvard) and also very large similar pension funds (Ford). This comparison is made harder because Harvard and Yale have 30 June balance dates, Ford has a year-end balance date and Hewlett Packard has an end of October balance date. This difference in balance date is particularly important for the 2009 year which includes more of the crisis and less of the bounce for October balancing funds than December balancing funds.

I would love to go further back - when doing this analysis - but it is a little hard. The size of the asset pool roughly doubled in August 2008 when Hewlett Packard acquired EDS and combined the asset-pool for their defined benefit funds.

This post goes through the various HP Form 10Ks and various press articles quoting the Chief Investment Officer (Gretchen Tai) and tries to piece together how they do it.

Returns to October 2009

Here is a table outlining returns of the three main pools in the year to October 2009 (source 2009 form 10K):

This disclosure reveals the US Defined Benefit Plan made $1509 million in profit on starting fair value in assets of $7313 million . That is 20.63 percent. Given the fund paid out $506 million in benefits and settlements the returns for that year were - money weighted - probably nearer to 21 percent.

From October to early March the year was not fun either. Then the market bounced with a ferocity that only happens when the consensus is almost entirely hopeless.

There is a limited disclosure on how the money was invested.

This is a fairly conventional 60-40 split - with 40 percent in equities and 60 percent in public debt securities. There was a small amount of cash. The equities included 10.9 percent allocated to private equity funds.

These numbers are exceptionally good. Here are some comparables:

	2009
S&P 500 Total Return (incl. Dividends)	9.8%
MSCI Global ex US	30.2%
Barcap iShares 20+ Year Treasury Bonds	3.2%
Barcap iShares 3-7 Year Treasury Bonds	2.1%
Barcap iShares Short Treasury Bonds	-0.1%
Barcap Intermediate Investment Grade	16.0%
SPDR Barclays High Yield Bonds	21.2%
Ishares iBoxx Investment Grade Corporate Bonds	20.6%

If you are going to get returns of 20 percent out of a diversified 60 percent bonds, 40 percent equities portfolio in this year it is going to have to be roughly one half in non-US equities (thus benefiting from that 30 plus percent return in non-US equities). The bonds are going to have be exclusively in beaten up junk bonds and beaten up corporates.

The returns however are not impossible. There were a few indices that performed even better. For instance emerging market debt returned just shy of 40 percent in that twelve month period and the MSCI emerging market equity index was up 64 percent. But those things were badly beaten up in the crisis.

A 21 percent return in the year to October 2009 on a huge sum required the calm rationality to buy the really cheap stuff when everyone is panicking. It speaks to Gretchen Tai's calm excellence.

Returns to October 2010

The 2010 returns are not as spectacular (you can't get 21 percent every year) but they are extremely impressive. The key disclosure as to the returns (from the relevant 10K) is here.

The returns were $1224 million on starting capital of $8371 million. That is a more modest 14.6 percent.

The book again targeted a 60 percent bonds, 40 percent equity mix. They had just shy of 40 percent equities but they also held roughly 5 percent in cash at year end.

For the first time there is disclosure on the private equity securities they hold. The fund contains "level 3" assets. It worried me that the good returns were from mark-to-myth accounting - but it seems not. During that year they booked zero gains on the level 3 assets. Indeed there was a detailed disclosure.

Indeed given that we know how many level 3 assets were held its useful to work out the returns on non-level 3 assets.

There were $7440 million in non-level 3 assets at the beginning of the year (8371-931). All the returns - $1224 million - were on these. That is a 16.5 percent return on the non-level 3 assets. As there were net withdrawals from the fund over the year the money-weighted returns were even higher.

Again this is darn impressive. We can compare to the usual indices:

	2010
S&P 500 Total Return (incl. Dividends)	16.5%
MSCI Global ex US	9.8%
Barcap iShares 20+ Year Treasury Bonds	4.8%
Barcap iShares 3-7 Year Treasury Bonds	5.6%
Barcap iShares Short Treasury Bonds	0.0%
Barcap Intermediate Investment Grade	5.0%
SPDR Barclays High Yield Bonds	7.6%
Ishares iBoxx Investment Grade Corporate Bonds	6.3%

Against this 16.5 percent is very impressive. There must have been some mighty nice picking. Again a big overweight position in emerging markets would help. Emerging market debt put on another 17.7 percent and the MSCI emerging market index put on almost 24 percent. Whist the Barclays high yield index was not impressive (7.6 percent) some bond indices did better (there were very high returns for some long dated inflation adjusted bonds for instance).

As a rule persistence in ownership of the things most beaten up in the crisis (emerging markets, deeply discounted junk bonds) was one way of getting these returns.

The 2010 form 10K gives - for the first time - a more detailed breakdown of assets.

The portfolio is more balanced than the returns suggest. They do own some non-US market equities but they do not disclose what proportion are "emerging market" equities. They also own a lot of corporate bonds and do not disclose what proportion are emerging market bonds. Whatever - on this sort of portfolio the returns are very fine indeed.

The 2011 returns

The 2011 returns (whilst lower still) were also impressive. The key disclosure is in the 2011 form 10K:

The returns were $1389 million on $9427 million or 14.7 percent.

However this year some of the returns came from Level 3 assets. We have the following disclosure:

In this we see that 282 million of gains came from Level 3 assets - 155 of that from assets actually disposed of (so they were gains received in cash). The starting level 3 assets were 1040 million.

So net of level 3 assets the fund gained $1107 million (1389 - 282) on $8387 million (9427-1040) of assets. That is a return of 13.2 percent.

Again this compares exceptionally favourably to the relevant indices.

	2011
S&P 500 Total Return (incl. Dividends)	8.1%
MSCI Global ex US	-7.3%
Barcap iShares 20+ Year Treasury Bonds	15.4%
Barcap iShares 3-7 Year Treasury Bonds	2.2%
Barcap iShares Short Treasury Bonds	0.0%
Barcap Intermediate Investment Grade	-0.5%
iShares 10+ Year Investment Grade	9.4%
SPDR Barclays High Yield Bonds	-4.7%
PIMCO Investment Grade Corporate Bonds	2.2%
Ishares iBoxx Investment Grade Corporate Bonds	2.1%

To get these sort of numbers your portfolio needs to be full of very long-dated bonds. This was after all the year that the long-end yield collapsed. Moreover the best returns from the previous two years were in emerging markets. They were not good in the year to October 2011. The bonds scored 4 percent but the equities were -7.

The asset mix (also disclosed in the 10K) was not much changed.

There is so much alpha generated in these three years I would create insane jealousy amongst my readers if I were to calculate it. But if a masochist wants to work it out (and hence make themselves feel inadequate) go right ahead.

Prior evidence of genius

These returns are startlingly good. And it is not the first time - indeed it is the continuation of a trend. The 2007 form 10K reveals the genius in full flight...

In the beginning of fiscal 2008 (meaning November 2007) the HP fund moved almost entirely to bonds as per this (contemporaneous) quote:

In the beginning of fiscal 2008, we implemented a liability-driven investment strategy for the U.S. defined benefit pension plan, which will be frozen by December 31, 2007 and is currently overfunded. As part of the strategy, we have transitioned our equity allocation to predominantly fixed income assets. The expected return on the plan assets, used in calculating the net benefit cost, has been reduced from 8.3% to 6.3% for fiscal 2008 to reflect the changes in our asset allocation policy. Our medical cost trend assumptions are developed based on historical cost data, the near-term outlook and an assessment of likely long-term trends. Actual results that differ from our assumptions are accumulated and are amortized generally over the estimated future working life of the plan participants.

Moving your equity portfolio almost entirely to bonds at the peak of the market is inspired. Gretchen Tai in the press downplays the genius:

"To be honest, we weren’t timing the market. HP had decided to freeze the U.S. DB plan, which at the time was 106% funded and, as a result, we decided with our senior management that an immunization strategy was the right strategy going forward even with pension expense considerations; so, in November 2007, we decided to move out of public equities and into fixed-income and hedged out interest-rate exposure 100%. Although it wasn’t our main consideration, timing of the strategy was fortunate: We were not only able to maintain our funding status through the financial crisis, but also it improved significantly due to strong returns from fixed-income portfolios as well as the interest-rate hedges.

This is the sort of out-there-genius moves that I would not even believe unless it was stated contemporaneously and backed by great numbers. But it was stated contemporaneously. [The 2008 returns were not so brilliant though - but they included the EDS plan that was acquired just before the peak of the crisis. Gretchen Tai can't be held responsible for that.]

Chief Investment Officer magazine clearly knows the important talent they had when they interviewed Ms Tai. She warrants a flattering cartoon of her dressed as some kind of post-modern superhero leader:

How does Gretchen Tai do it?

I can't find anywhere a detailed disclosure of the assets held by the Hewlett Packard defined benefit plan. However Hewlett Packard has moved most of the management of the defined contribution plan in house. This is mentioned in the above mentioned press article where she compares the returns of defined benefit plans (mostly good) to defined contribution plans (mostly poor) and says that the difference is professional management. To quote:

We also manage the company’s DC plan. HP again is being really progressive here. Marketwide, defined benefit plan returns are so much better than defined contribution returns in historical performance—mostly because you have professionals looking after DB assets, and not looking after DC plans. With $15 billion in U.S. 401(k) assets, however, we really want a fresh eye on the plan—we want it to be world class. To do this, we’ve tried to eliminate mutual funds from the investment options, to lower fees. You won’t see brand name mutual funds in our plans—we want participants to focus much more on asset allocation decisions than picking mutual fund managers. Because our plan is so large, we often can use a custom fund-of-funds approach for each offering—which allows our participants to get the benefits of diversification without doing a lot of work."

There are clearly a bunch of fund managers Gretchen outsources to - but not "brand name mutual funds". Hewlett Packard also bought the defined contribution plans of EDS in house (which saved money). To quote another press article:

HP officials spent the time in between not only analyzing the elements of both DC plans but also developing a strategy to reduce costs, consolidate record keepers and reduce redundant options. 

HP has achieved “significant savings” by consolidating providers and using the combined plan's size to negotiate lower fees, said Ms. Tai, who declined to quantify the savings. For some investment options, Ms. Tai said HP uses the same managers for its DC plan as its defined benefit plan, but she declined to identify the managers or the assets they manage.

It is a pity she "declined to identify the managers or the assets they manage". I am sure many of my readers would love to know how to find asset managers like that.

However the defined contribution plan publishes a form 11-K - which details the portfolio and the returns on it. Unfortunately that has a December balance date and so the numbers are not strictly comparable.

That defined benefit plan - for the year ended December 2011 - had almost $14 billion in assets available for distribution:


But the returns were negative as per the following table:

We have $558 million of negative returns on $14195 million of starting assets. That is roughly minus 3.9 percent.

There are a few obvious differences. The defined contribution fund contained $561 million in Hewlett Packard shares which were a very poor performer. They moved from roughly $42 to roughly $27. That alone would account for roughly half the loss - but can't account for anything like the difference in performance.

The difference in balance date clearly accounts for much more. For instance the S&P returns for the year until October 2011 were 8.1 percent. They were only 2.1 percent in the year until December. The 20 year bond was 15.4 percent in the year until October. It was 28.8 percent in the year until December.

Lower equity returns clearly matter as the defined contribution fund was carrying 4 billion in direct equity investments (a very long list indeed) and another few billion in indirect equities (mostly index funds).

The higher long-bond returns clearly don't matter much as the fund is strangely bereft of long bonds - carrying huge amounts of mortgaged backed paper (mostly Fannies, Freddies, Ginnies etc).

In other words the defined contribution fund was not as well positioned as the defined benefit funds and did not perform as well, and I can't use the defined contribution fund to solve the question of how Gretchen Tai does it.

The Ford fund as a comparison

Here are the Ford returns for calendar 2009 (from the 2009 year form 10K):

		Pension Benefits
		U.S. Plans								Non-U.S. Plans								Worldwide OPEB
		2009				2008				2009				2008				2009				2008
Change in Plan Assets (a)
Fair value of plan assets at January 1		$	37,381			$	45,696			$	14,707			$	21,396			$	2,786			$	3,875
Actual return on plan assets			4,855				(4,480	)			1,692				(2,036	)			792				(1,011	)
Company contributions			136				138				968				1,209				—				—
Plan participant contributions			27				25				80				101				—				—
Benefits paid			(3,908	)			(3,960	)			(1,456	)			(1,380	)			(62	)			(77	)
Settlements			—				—				(1	)			(58	)			(3,517	)			—
Foreign exchange translation			—				—				1,581				(4,510	)			—				—
Divestiture			—				—				—				(3	)			—				—
Other			(34	)			(38	)			(7	)			(12	)			1				(1	)
Fair value of plan assets at December 31

In that year Ford produced $4855 million on starting assets of $37381 million or 13.1 percent. That is a long way below the 20.6 percent produced by Hewlett Packard in their 2009 year.

Moreover Ford had the advantage this year of a December year end (and thus includes less of the crisis and more of the recovery in their numbers). This advantage is offset by the very weak long bond at the end of calendar 2009 as the money-printing inflation fear was peaking.

Ford also gives us an asset-mix disclosure for the US fund. It is actually fairly similar to HP (but carries more detail):

U.S. Plans		2009
		Level 1				Level 2				Level 3				Total
Asset Category
Equity
U.S. companies		$	8,675			$	26			$	15			$	8,716
International companies			8,413				48				92				8,553
Commingled funds			—				386				3				389
Derivative financial instruments (a)			(1	)			—				—				(1	)
Total equity			17,087				460				110				17,657
Fixed Income
U.S. government			2,340				—				—				2,340
Government-sponsored enterprises (b)			—				1,310				7				1,317
Government – non-U.S.			—				449				256				705
Corporate bonds (c)
Investment grade			—				8,403				85				8,488
High yield			—				1,152				15				1,167
Other credit			—				33				21				54
Mortgage-backed and other asset-backed			—				1,488				278				1,766
Commingled funds			—				338				—				338
Derivative financial instruments (a)			(8	)			(149	)			(42	)			(199	)
Total fixed income			2,332				13,024				620				15,976
Alternatives
Private equity (d)			—				—				1,005				1,005
Hedge funds (e)			—				—				1,986				1,986
Real estate (f)			—				—				1				1
Total alternatives			—				—				2,992				2,992
Cash and cash equivalents (g)			7				1,864				—				1,871
Other (h)			(62	)			26				(3	)			(39	)
Total assets at fair value		$	19,364			$	15,374			$	3,719			$	38,457

_______

That is about 45 percent equities - slightly more than HP - which should be favourable to returns because equities were the better performing asset class.

Here are the returns for the 2009 calendar year of various indices to compare:

	2009
S&P 500 Total Return (incl. Dividends)	26.5%
MSCI Global ex US	37.4%
Barcap iShares 20+ Year Treasury Bonds	-24.7%
Barcap iShares 3-7 Year Treasury Bonds	-4.7%
Barcap iShares Short Treasury Bonds	-0.2%
Barcap Intermediate Investment Grade	7.3%
SPDR Barclays High Yield Bonds	19.8%
Ishares iBoxx Investment Grade Corporate Bonds	2.5%

Equities gave 30ish percent (depending on the percentage that was foreign), junk bonds about 20 percent, corporates about 7 percent and longer treasuries were sharply negative the Ford return of 13 percent seems about right. Nothing special - but certainly not bad.

Ford's 2010 year looks considerably better than benchmark at Ford:

	Pension Benefits
		U.S. Plans								Non-U.S. Plans								Worldwide OPEB
		2010				2009				2010				2009				2010				2009
Change in Plan Assets (a)
Fair value of plan assets at January 1		$	38,457			$	37,381			$	17,556			$	14,702			$	—			$	2,786
Actual return on plan assets			5,115				4,855				1,487				1,695				—				792
Company contributions			135				136				1,236				962				—				—
Plan participant contributions			23				27				47				80				—				—
Benefits paid			(3,704	)			(3,908	)			(1,281	)			(1,456	)			—				(62	)
Settlements			—				—				—				(1	)			—				(3,517	)
Foreign exchange translation			—				—				(356	)			1,581				—				—
Divestiture			—				—				(66	)			—				—				—
Other			(66	)			(34	)			(8	)			(7	)			—				1
Fair value of plan assets at December 31		$	39,960			$	38,457			$	18,615			$	17,556			$	—			$	—

Starting assets were $38457 million and actual returns were $5,115 million. That is 13.3 percent.

In this case some of the returns are attributed to gains on Level 3 assets. There is a table of these which shows that at the beginning of 2010 there were $3719 in level 3 assets. The gains on these were 522 of gains on them . Net of this the portfolio produced $4593 million (5115-522) in gains on $34738 million (38457-3719) in assets. That is still a respectable 13.2 percent.

My usual indices show that this is indeed a very fine return:

S&P 500 Total Return (incl. Dividends)	15.1%
MSCI Global ex US	8.4%
Barcap iShares 20+ Year Treasury Bonds	4.7%
Barcap iShares 3-7 Year Treasury Bonds	4.1%
Barcap iShares Short Treasury Bonds	0.0%
Barcap Intermediate Investment Grade	2.4%
iShares 10+ Year Investment Grade	4.9%
SPDR Barclays High Yield Bonds	2.3%
Ishares iBoxx Investment Grade Corporate Bonds	4.1%

However you could still get 20 plus percent returns out of emerging markets during that time.

The 2011 returns for Ford are more modest. The usual table from the 10K shows $2887 million in gains on $39960 in starting assets for the US fund - a fairly modest 7.2 percent.

Here are the index returns for this year:

	2011
S&P 500 Total Return (incl. Dividends)	2.1%
MSCI Global ex US	-16.1%
Barcap iShares 20+ Year Treasury Bonds	28.8%
Barcap iShares 3-7 Year Treasury Bonds	6.4%
Barcap iShares Short Treasury Bonds	0.0%
Barcap Intermediate Investment Grade	1.9%
iShares 10+ Year Investment Grade	11.4%
SPDR Barclays High Yield Bonds	-3.2%
PIMCO Investment Grade Corporate Bonds	1.9%
Ishares iBoxx Investment Grade Corporate Bonds	4.9%

If you avoided global equities and were long some duration you did well that year. Pension funds are naturally long duration. That said Ford's performance was within the expected range (maybe light if you expected them to hold duration).

Summary

Gretchen Tai and Hewlett Packard perform much better than you would expect given the diversity of their portfolio. Gretchen Tai really is one of the great undiscovered asset managers.

I am looking forward to the filing of another Hewlett Packard form 10K (due within days) to find out what Ms Tai has been up to this year.





John

Trust me - I run a pyramid marketing scheme

This is a straight tip. I am slow to it - but go read Roddy Boyd's piece at the Southern Investigative Reporting Foundation. It is two weeks old - but hey - its good fun.

And now my review:

Multi-level marketing schemes are a highly profitable business for those running them. If you manage to get two to twenty thousand people selling things to their friends and giving you a cut you are going to get rich.

The road to those riches are laced with the dreams of all the people who hold tupperware or candle parties or even worse - sell weight loss schemes or insurance.

Listed multi-level marketing schemes (such as Nu-Skin) are a really strange investment. The basic proposition is that they offer investors is the claim they have a really profitable businesses conning people out of their money and getting them to cash in their friendships.

The pitch summarises: I am a crook but you can trust me. I am your crook.

That is a surprisingly common pitch in financial markets. Chinese property developers listed in Hong Kong make the same pitch - but in their case the pitch is that I am a guy with lots of guanxi. I can get a property forcibly acquired from peasants at a deflated price and have it rezoned high rise. And I can thus make a profit. But I don't have the money to develop it - so you - dear Hong Kong investor can help me out. You see I am a crook - but you can trust me. I am your crook.

It rarely ends well. The last person they always screw is the bag-holder with the equity.

Shorting multi-level marketing schemes or for that matter Hong Kong property developers however is an exercise in painful endurance. Stalingrad gets mentioned.

You can even get a real one - one that does distribute some of the loot to shareholders and can survive a long time (Avon, Tupperware). Some of the products even become respectable. [I used to share house with a lesbian Avon lady who was the best sales woman in Australia. And was surprisingly respectable to boot. And she never tried to sell me make-up.]

Spectrum: At one end there is Avon. Cosmetics are a product that overtly sell a dream and it is hard to argue anyone is defrauded.

At the other there is insurance and weight loss products.

Roddy takes us through ViSalus - the best weight-loss product MLM I have ever seen. And there are a lot of them. And he shows us some over-the-top sales techniques with sales people who look like models and party like rock stars.

And it is a good story - but I keep coming back to Mediolanum (an Italian insurance company). Nobody has ever beaten the sales culture of that place. I met Ennio Doris (the CEO) once with his not one but two beautiful translators. Life is good at the top of a sales machine.

This video is funny. But it is really funny when you realize that this is the boss of an insurance company trying (successfully) to excite a bunch of insurance salesmen. [If you have a higher resolution copy of this video please send...]



If this video is a guide then ViSalus could go for a very long time.


J

Celebrating the impending birth of the future King or Queen of Australia

Today I woke to the joyous news that the Duke and Duchess of Cambridge are expecting a baby.

The offspring will (possibly depending on gender) be the future Head of State of Australia.

Elizabeth R currently fulfils that role.

For my non-Australian readers - who are likely unfamiliar with Australian constitutional arrangements I should note that Australia is - like Great Britain - a monarchy - and we have the Queen's handsome profile on our coins.

Her Majesty the Queen's full title in Australia is "Elizabeth the Second, by the Grace of God Queen of Australia and Her other Realms and Territories, Head of the Commonwealth".

Similar constitutional arrangements apply in other former colonies of the British Empire including our near neighbour Papua New Guinea. There Her Majesty Queen Elizabeth is known in the pidgin language of Tok Pisin as 'Missis Kwin', and as 'Mama belong big family'.

My joy at the birth of our future monarch will (naturally enough) be repeated throughout the world. In Papua for instance the baby will further improve Elizabeth's claim to the title "Mama belong big family".

And that is indeed good news.




John
God Save the Queen, Queen of Australia

Hewlett Packard versus Apple advertising budget

People did not get my last post. This is more obvious.

From the last HP form 10K:

Advertising  

HP expenses advertising costs as incurred or when the advertising is first run. Such costs totaled approximately $1.2 billion in fiscal 2011, $1.0 billion in fiscal 2010 and $0.7 billion in fiscal 2009.

From the last Apple form 10K.

Advertising Costs 

Advertising costs are expensed as incurred. Advertising expense was $1.0 billion, $933 million and $691 million for 2012, 2011 and 2010, respectively.

Observation

Hewlett Packard spends more on advertising than Apple.





John

Coca Cola versus Hewlett Packard advertising

In the latest Coca Cola 10K they declare advertising expense in millions of dollars as follows:

2009    $2,791
2010    $2,917
2011    $3,256

I like to measure advertising expenses in "Coca Cola companies", a Coca Cola company being about $3 billion per annum.

Here is the advertising expense for Hewlett Packard from their latest 10K.

Advertising 

HP expenses advertising costs as incurred or when the advertising is first run. Such costs totaled approximately $1.2 billion in fiscal 2011, $1.0 billion in fiscal 2010 and $0.7 billion in fiscal 2009.

Not in my wildest dreams would I have guessed that HP would spend a third of a Coca Cola company on advertising.

I do not disbelieve the number - but I am stunned.




John

Hewlett Packard and Autonomy: notes from my Santangels presentation

A few weeks ago I presented at the Santangels conference in New York. The conference was held under Chatham House rules.

My topic: how to fake your accounts from the perspective of the fraudster (and hence how as an investor to tell if a company is faking its accounts).

At the end I suggested that even if you were right and the company was a fraud you could still short the stock and lose money - someone with deep pockets might buy the fraud. The example I gave was Autonomy which was purchased by Hewlett Packard.

Yesterday Hewlett Packard admitted that Autonomy was a grotesque fraud. They wrote off most of the purchase price.

Chatham House rules don't much matter in the face of a major scandal (and Autonomy is a major scandal). So this morning (Australian time) my email was full of press asking for on-the-record comment. I commented to both Deal Book (New York Times) and Reuters.

Jeff Matthews commentary

I tested my draft Santangels presentation on Jeff Matthews - so he had my views on Autonomy. He broke silence on his blog.

Jeff is critical of Meg Whitman's comments that they "relied on the audited accounts". He observes that I relied on the same audited accounts.

That is fair comment: I could tell the accounts were not kosher from an office in Sydney. I was not alone - Jim Chanos came to a similar conclusion. So did many people in the UK including the writers of FT Alphaville who have been sceptical of Autonomy for years.

In other words my insight was not unique: many other people (including more than one blog reader) shared similar insight. I claim no special genius.

And I was not entirely right either. I knew Autonomy was problematic. I underestimated the problems: Autonomy appears worse than the worst case I modelled.

Looking at Autonomy's accounts

For the record here is how you could tell - just by looking at audited accounts - that Autonomy was not quite kosher.

Here is the P&L from the 2010 accounts:

And here is the balance sheet:

There are lots of things to note - but I will limit myself to the simple (which I put in the Santangels presentation).

Sales were $870 million.

Receiveables were $330 million - which is four and a half months of receiveables.

Deferred revenue is $177 million - just over half of receiveables.

This is really perverse for a software company. Software companies sell stuff that is barely tangible - they sell it up front and for cash. They have very few receiveables.

They do however have an obligation to service that software for a long time after they sell it - so the unearned income is relatively large (usually a multiple of receiveables).

Autonomy was booking as income lots of cash it had not received (which is why the receiveables were large) and not booking any obligation to provide future services for that income.

This is prima-facie suspect (and you could tell simply by looking at the balance sheet). All it required was basic applied accounting.

Comments on Hewlett Packard's management 

The management (and for that matter the board) of Hewlett Packard have diverse responsibilities. Most importantly they are responsible for technology - and the technological issues are broad. They are also responsible for accounting and financial management.

I have simply no opinion on who stuffed up on the technical issues. Hewlett Packard asserts there are still some (small but) valuable businesses at Autonomy. Maybe the tech is not all bad.

But I am happy to point the finger on accounting. The accounts were self-evidently suspect. Working that out is primarily the job of a finance and accounting function at Hewlett Packard - and that function was led by and continues to be led by Catherine Lesjack. Catherine Lesjack is ultimately responsible for the financial parts of HPs due diligence on Autonomy and she failed.

This really is not rocket science. Lesjack is not up to the job. She should resign.





John

PS: There has been much criticism of Meg Whitman in the blogosphere, twitter and amongst my readers. I do not think that is fair. Autonomy was a deal done by Leo Apotheker (the previous CEO) and the current CFO Catherine Lesjack - it is them who bear primary responsibility.

J

The Alan Jones Facebook experiment

Alan Jones is a right-wing radio shock-jock in Australia - in the tradition of Rush Limbaugh or maybe even Howard Stern. He offends many people (myself included). But then I am an avowed liberal.

He has a moderate but rusted-on audience - about 160 thousand people - or a low single-digit percentage of the population. This is not the the biggest audience by number - but it is the biggest audience by hours listened because the audience is rusted on. They turn the radio on and do not turn it off. He has the largest average audience. He probably also has the most swing because the audience hews so close to his view that he moves markets and votes.

Jones is after all fabulously persuasive with a microphone and an ability to drown out all opposing views. He is truly a "great communicator".

Whether you take offence at "Jonesey" depends partly on your personal politics. Jones does not offend my (avowed conservative/libertarian) business partner (though I doubt BP ever listens to him). He has always been (in  a Rush Limbaugh sense) important to the conservative parties in Australia - he motivates right-wing voters in that swathe of outer-Sydney metropolitan seats which are crucial to electoral success in Australia. Conservatives (at least publicly) tend to like him. The conservative press rally around him.

Alan Jones unsurprisingly is opposed to our unmarried female, athiest and left-of-centre Prime Minister*.  When he said that she (along with the Sydney Lord Mayor) should be sown in a chaff-bag and dumped at sea it was interpreted as a joke. The joke went too far though when he suggested at a closed dinner that the Prime Ministers father (who died that week) had died of shame. An anti-Jones sentiment that had been simmering below the surface for some years came ripping out.

Alan Jones has long been a master of vicious personal attack politics. He is frequently sued for defamation and in Sydney (sometimes even called Jonestown) getting on the wrong side of Alan Jones can be a career limiting move. He has a soapbox and an audience and he frequently attacks his enemies.

Many years of doing this and Jonesey has many enemies - rusted on enemies.

Now Jones is victim of personal attacks mostly organized through Facebook. The tactics that "Sack Alan Jones" with 21 thousand likes on Facebook use don't look that dissimilar to Alan Jones and watching Jones criticize their tactics has a touch of irony about it. The Anti-Jones-anti-mysogeny group Destroy the Joint** (also with about 20 thousand followers on Facebook) uses similar tactics.

There were also over 100 thousand signatures on an electronic "sack Alan Jones" petition.

Now every time someone advertises on the Alan Jones show I get Facebook feed naming the offending party. Advertisers are staying away in droves. Here is a picture presented by Destroy the Joint:

It is not looking good for Jonesey now.

But not so bad either. His audience has gone up prodded a little by controversy (although advertising revenue has plummeted). And the right-wing News Corp press have been relentlessly pro-Jonesey through the whole affair - with the press even saying that the campaign has turned Jonesy into a "free speech martyr". Even the left-wing radio host Phillip Adams tweeted that "media scandals seem to have the shelf-life of yoghurt... Jones has gone from dangling in the wind to back in full swing".

Moreover some advertisers have come back. Local restaurants - ones who do not care if 100 thousand people don't like them as long as a few thousand people do - were very fast to advertise. Indeed because nobody else was advertising they did so in quantity and with great success. (A paid endorsement on Alan Jones will fill any restaurant in Western Sydney...)

Sure, some major brands have advertised and retreated - cowered by hundreds (maybe thousands) of people hitting their complaint page. Personal-attack campaigning by the anti-Jones crowd still works at least on some advertisers.

The Apple Adverts

Strangely Alan Jones started doing straight-to-the-microphone adverts for Apple - the most powerful consumer brand of all. The message was clear - if Apple are not afraid to advertise on Jones show then the blockade must be over.

It turns out that Apple did not buy that advertising. Jones was just giving away free space. The anti-Jones crusaders would argue that the Apple adverts were just part of the Jones deception - a deception that Jones is back in business.

Here is the question: can a couple of Facebook groups with 20 thousand members each and a 100 thousand strong email list maintain the rage? Is social networking more powerful than a fabulous communicator-with-a-microphone and a rusted on audience? Can personal attack campaigning be sustained on Facebook? Note that the Murdoch press (which is very prominent in Australia) is - consistent with its political leanings - backing Alan Jones.

There is a direct stock market way of playing this. Macquarie Radio Networks - the company that controls the Jones show is listed. But honestly the Business Partner and I cannot decide.

So we just had a bet. It is only $50 (we are not big-swingers here) but I think the Jones show will be gone in six months and that social networks provide very high and sustainable advertising values and negative feedback from social networks is a major-corporation nightmare.

The Business Partner - he thinks that over time people will be civil - they can't "maintain the rage". Over time the anti-Jones groups will fade and Jones will come back - maybe a touch chastened and less strong on the personal attack. But he thinks the results of those attacks (by Jones as well as by his critics) is more likely to be temporary. [Besides BP accepts Jones' line that the attack on him is an attack on free speech.]

Five and a half months from now we will declare a winner and $50 will duly change hands.

It is the Facebook mob versus Radio demagogue - a powerful but admittedly uncontrolled experiment in social media versus traditional media. From an investing perspective from this we will learn a great deal about the power and the limits to that power of Facebook.



John

PS. We argue more generally about the value of Facebook. We own a small amount of that stock which I think is unjustifiably cheap - but again the Business Partner disagrees.

*Full disclosure: I don't like our Prime Minister either - but for other reasons.

**The name of "Destroy the Joint" comes from Jonesy's assertion that women (namely the Prime Minister and the Sydney Mayor and a female police chief) are destroying the joint.

Journos and short sellers getting it wrong

The last post I suggested the Wall Street Journal may be being played by stock promoters (re Focus Media). I still think that.

Many thought I was being harsh on journalists. In particular they rightly pointed out that the shorts were spectacularly wrong on Harbin Electric and the journalists (with a notable exception) were consistently right. I never wrote about that stock but I confess to having lost money on the short - and was surprised at the takeover. My inside-Asia rumour mill was insistent the deal would be done but I did not believe them. [There inside-Asia rumour mill does not insist the Focus Media deal will be done.]

Harbin reminds me (as if I need reminding) that it can go wrong for short sellers (especially the vocal kind).

But it can go wrong for journalists as well. The stock market has a way of reminding us we can all be wrong.

In the journalists-can-stuff-up light I will repeat the single most infamous instance of journalists being played by stock promoters. This was Leslie Stahl's Sixty Minutes piece on Biovail (a Canadian pharma company with extremely dodgy accounts). Stahl swallowed hook-line-and-sinker the view that there was a conspiracy of short sellers determined to spread lies about the stock and destroy the company (and hence the value of mom-and-pop investments). It was pitched as evil hedge funds versus Main Street.

And it was entirely wrong. Biovail was faking its accounts and it eventually dismissed the CEO Eugene Melnyk. Melnyk was later banned from public companies in Canada and paid large fines in the US. But not until well after he completely hoodwinked Leslie Stahl.

All the short allegations were correct.

Sixty Minutes has now taken down the piece which means I cannot replay it to you in all its ignominy. However to the best of my knowledge they never apologized to the people they defamed.

To be fair though not all journalists fell for it. Joe Nocera of the New York Times was sceptical of the Sixty Minutes piece almost straight away. The Ludwig von Mises institute (not my usual source) sided with Nocera.

In other words there were good reasons - at the time Sixty Minutes went to air - to doubt the story Stahl presented.

Sufficient evidence and getting it wrong

We are all going to get it wrong sometimes.

Financial markets however are full of people with an incentive to report falsehoods whether it be stock promoters (as per Eugene Melnyk) or - dare I say it - the odd short-seller. Because so much money is involved you can safely assume that most sources are dripping with vested self-interest. And some are flat lying.

The hurdle rate for a financial journalist is thus high. "Anonymous sources close to the deal" is something that journalists should take with caution. Double caution in China where the fraud level is high.

When financial journalists get it wrong they facilitate criminal activity.

Just ask the haplessly played Leslie Stahl. Her report increased the profits of insider-sellers of Biovail at the expense of her Main Street audience. Oops.

I think the Wall Street Journal has been played here just like Leslie Stahl. And I could be wrong too.

Give it four weeks and I will report back.




John


PS. I have spent a lot of time trying to work out what went wrong with Harbin. Harbin Electric's accounts did not meet the plausibility test. The company was actively misleading on many occasions - and yet the deal did close and whilst the above mentioned Asia-rumour-mill tells me the deal will be a failure it will not be an abject failure.

There was something there at Harbin and it was not obvious in the accounts.

Here is my best theory as to what happened.

In some Chinese cities you were not allowed to buy land unless you had an industrial business to put on that land.

So people started fake businesses to buy and speculate on real land.

Later they reverse-merged the fake business (complete with fake accounts) into the US market.

That was for most of these fake businesses the end of it.

However in some instances (Harbin and at least one other) the land appreciated so much that the company was worth owning even though its business was largely fake.

And so a go-private transaction made sense.

The shorts were right that the accounts were nonsense. But they were wrong on the thing that mattered. There was value there - just not the value everyone thought!

You can be wrong in ways you never predicted. The unknown unknowns if you will...




J

Scepticism and good finance journalism: Focus Media edition

On the 13th of August 2012 Focus Media received a go-private proposal from its founder and a collection of private equity firms.

That was 94 days ago - a bit over three months.

In that time there has been very few announcements from the company.

Second quarter results were announced 22 August. All they said about the deal was as follows:

Announced Receipt of "Going Private" Proposal 

On August 13, 2012, the Company announced that its Board of Directors had received a preliminary non-binding proposal letter, dated August 12, 2012, from affiliates of The Carlyle Group , FountainVest Partners,  CITIC Capital Partners, CDH Investments and China Everbright Limited and Mr. Jason Nanchun Jiang, Chairman of the Board and Chief Executive Officer of Focus Media, and his affiliates (together, the "Consortium Members"), that proposes a "going-private" transaction (the "Transaction") for $27.00 in cash per American depositary share, or $5.40 in cash per ordinary share.  According to the proposal letter, the Consortium Members will form an acquisition company for the purpose of implementing the Transaction, and the Transaction is intended to be financed with a combination of debt and equity capital. The proposal letter states that the Consortium Members have been in discussions with Citigroup Global Markets Asia Limited, Credit Suisse AG, Singapore Branch and DBS Bank Ltd. about financing the Transaction and that these banks have provided certain of the Consortium Members with a letter dated August 11, 2012 indicating that they are highly confident of their ability to fully underwrite the debt financing of the Transaction subject to the terms and conditions set out therein.  

The Company's Board of Directors has formed a committee of independent directors (the "Independent Committee") to consider the proposed transaction. 

No decisions have been made by the Independent Committee with respect to the Company's response to the Transaction. There can be no assurance that any definitive offer will be made, that any agreement will be executed or that this or any other transaction will be approved or consummated.  The Company does not undertake any obligation to provide any updates with respect to this or any other transaction, except as required under applicable law.

On 23 August the company announced that the independent directors had hired advisers to help them assess any bid. To quote:

SHANGHAI, Aug. 23, 2012 /PRNewswire-Asia/ -- Focus Media Holding Limited ("Focus Media" or the "Company") (Nasdaq: FMCN) today announced that a committee of independent directors of the Company's board of directors (the "Independent Committee") has selected J.P. Morgan Securities (Asia Pacific) Limited ("J.P. Morgan") as its financial advisor and Kirkland & Ellis International LLP ("Kirkland & Ellis") as its legal counsel.

There has been no announcement since.

That is 83 days of nothing. Well not quite nothing - the company announced that they were having an AGM but did not mention the go-private proposal.

83 days is a long time for there to be no-progress on a deal which had "highly confident" funding. Surely there is some development - positive or negative - to report in that 83 days.

The Focus Media go-private deal is controversial

Even without 83 days of nothing this deal would be controversial. Muddy Waters - the research firm that exposed the fraud at Sino Forest - has been very critical of Focus Media's accounts.

I have released a many-part series exploring peculiarities in Focus Media's accounts - see Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, Part 8, Part 9, Part 10, Part 11, Part 12, Part 13, Part 14, Part 15, Part 16, and Part 17.

My many part series did not prove that the accounts are fraudulent. It did however demonstrate some peculiar things - for instance the company purchased many seemingly unrelated businesses registered in the British Virgin Islands where all of those businesses somehow had the same address at the same lawyers office. Moreover in at least one instance they closed on the purchase of a business (by purchasing its holding company) before that holding company was even registered.

Here is the rub. Either this deal is real and just very slow or this deal is a complete show pony whereby insiders are dumping huge amounts of their shares - shares valued on a multiple of earnings from highly peculiar accounts.

In one instance the stock should go to $27 - the take-out price. In the other instance the stock should go to single digits (possibly zero) because it is a show-pony dressed up to extract monies from Western investors.

83 days since the latest news, 94 days since the announcement of the deal. Remember that.

The "Fourth Estate" has not been silent

Progress of this deal is newsworthy. This is the largest leveraged buyout deal ever in China - a watershed for the Chinese private equity business. And the media abhor a vacuum.

There have been two key news stories since the deal was announced. Each has acted to support the stock.

The first story was in Basis Point (an industry magazine) and repeated by Reuters. To quote Reuters:

Citigroup, Credit Suisse and DBS Bank are leading the three-part buyout financing, which consists of a $950 million to $1 billion term loan, a $200 million to $300 million bridge-to-bond facility and a $450 million cash bridge, Basis Point reported. 

The term loan is expected to have a five-year tenor, while the bridge financings will have six- to nine-month maturities, the report added. 

The company is looking to put together an underwriter group of six or seven banks and terms of the financing are likely to be finalised in about two to three weeks, Basis Point said.

That story was dated 11 September. They said the deal would take two to three weeks to be finalized.

It is two months now and there is no news. I think we can safely conclude that the Basis Point/Reuters report is wrong at least with respect to the timing.

More recently Prudence Ho and Isabella Steger of the Wall Street Journal said that Merrill Lynch, Deutsche Bank and UBS were going to help finance the Focus Media deal. That story was sourced to "two people familiar with the transaction". In other words anonymous sources.

Those banks were to be joining the three original banks on the deal (Credit Suisse and DBS). Again sourced to "the people".

These anonymous people were very specific: "the six banks plan to provide a total of $1.65 billion in financing, made up of a cash bridge loan, a long-term loan and a high-yield bond".

The Wall Street Journal story was dated 2 November. One of the Ho/Steger anonymous sources said "the banks will sign the formal financing documents next week at the earliest".

Needless to say that has not happened either.

Has the Wall Street Journal been played?

Good anonymous sources are part of journalism - but any journalist should ensure that they are not being played with self-interested falsehoods by these sources.

It looks awful like Basis Point were played. They published the financing was likely to be finalised in "two to three weeks" and it is now two months. The information could have been good and the timetable slipped - but as there was no follow up from Basis Point it is likely the information was flat false.

It is also possible that Ho & Steger (and the WSJ) have been played as well. It might be true that Merrills, Deutche and UBS have all joined forces to close this deal (in which case the Wall Street Journal has a story). But if not the story is a journalist's train-wreck - and should cast into doubt all the work by these fine journalists.

I started writing what I thought a journalist should do with an anonymous source when the source has been lied to them - but there are people far more versed in journalist ethics than me. But forget the ethical issue - this is for financial newspapers a business issue.

The financial press is the only part of the print media that has managed to establish pay-walls around their content. And for good reason too - reading the financial press is about making money and you can justify paying for that.

But when gullible journalists are played then acting on information in the financial press becomes a way to lose money. And what is the point in paying for that?



John

Great Northern Iron and the persistence of worthwhile counterparties

Great Northern Iron is a funny traded instrument. It is a trust. The trust expires on 6 April 2015 when they will have one final cash payment and go to zero.

This is not controversial. The trust explains this on its website:

At the end of the Trust on April 6, 2015, the certificates of beneficial interest (shares) in the Trust will cease to trade on the New York Stock Exchange and thereafter will represent only the right to receive certain distributions payable to the certificate holders of record at the time of the termination of the Trust. Upon termination, the Trust is obligated to distribute ratably to these certificate holders the net monies remaining in the hands of the Trustees (after paying and providing for all expenses and obligations of the Trust), plus the balance in the Principal Charges account (this account is explained in the Trust’s Annual Report within the Notes to Financial Statements). All other Trust property (most notably the Trust’s mineral properties and the active leases) must be conveyed and transferred to the reversioner (currently Glacier Park Company, a wholly owned subsidiary of ConocoPhillips Company) under the terms of the Trust Agreement.

The exact final distribution, though not determinable at this time, will generally consist of the sum of the Trust’s net monies (essentially, total assets less liabilities and properties) and the balance in the Principal Charges account, less any and all expenses and obligations of the Trust upon termination. To offer a hypothetical example, without factoring in any expenses and obligations of the Trust upon its termination, and using the financial statement values as of December 31, 2011, the net monies were approximately $7,927,000 and the Principal Charges account balance was approximately $4,962,000, resulting in a final distribution payable of approximately $12,889,000, or about $8.59 per share. After payment of this final distribution, the certificates of beneficial interest (shares) would be cancelled and have no further value. It is important to note, however, that the actual net monies on hand and the Principal Charges account balance will most likely fluctuate during the ensuing years and will not be “final” until after the termination and wind-down of the Trust. The Trust offers this example to further inform investors about the conceptual nature of the final distribution and does not imply or guarantee a specific known final distribution amount.

The only thing that unit holders in the trust are entitled to is dividends between now and April 2015 - plus a final termination payment.

The "stock" trades are an amount higher than any amount of dividends likely to be received. It is thus an obvious short and many people have written about it (notably including Citron). Here is a typical example.

This is all well known. Buy this "stock" and you are nearly guaranteed to lose money.

Because that is so well known the stock has a 20 percent borrow cost - roughly offsetting the profit you will get from shorting it. In that sense there is a rational market.

But that is the only sense there is a rational market. People own this. They will lose money. Ponder as a might I can't think of who the suckers might be.

Except one group. Computer driven trading firms. They see the high profits (iron ore prices are not low yet) and the 18 percent dividend yield and the algorithms tell them to own this. Maybe them and some really dumb dividend chasing retail investors.

This should distress me - but it doesn't. I like ill informed people making stupid investments in the market and their persistence pleases me. They have a name: counterparties. May there be many more of them!



John