Sunday, November 21, 2010

Hell is empty: A review of Bethany McLean and Joe Nocera on the financial crisis

There are lots of books on the financial crisis and some are very good.  Bethany McLean and Joe Nocera have entered a crowded market - but they have done what nobody else has yet done.  They have produced a book (All the Devils are Here) in which I have yet to find a single factual error.  And they have produced a book which did not start with an ideologically driven conclusion.   This is a big achievement making this book - above others - worthy of your time.

Just to make it more joyous though they have made a book that looks like it was effortless to write and it is a fun read.  The book is thought provoking not because it badgers you but because the story is laid out with nuance - all the devils, ranging from naivety to delusion to criminality are present within realistic characters sketches of many of the key players.  This was a human crisis with human causes - not a whirlwind caused by some deity.

If I have a criticism it is that the book is too narrow.  The bond insurers are barely mentioned.  (Ambac and MBIA are names that do not appear in the index.)  The crisis is placed in an American context - and it was a global crisis.  (At a minimum it was a North Atlantic crisis.)  The role of the British banks (huge players) was not explored.  You could read this book and not have an inkling of the crisis now engulfing Ireland.  That is a tough criticism though - because if the book were broadened to that it would have either been 800 pages or lost the depth of character displayed.

But my guess is that if someone wrote that book they would find all the devils of the American crisis lurking in the European crisis.  Hell may well be empty.  Human failings are found amongst the living.  All the devils would be there too!

Monday, November 15, 2010

China Media Express: A Wall Street drama

Sorry I have not been blogging for a while.  There are a few reasons.  Firstly I have been travelling to raise money for my funds management business (now in NYC).  Also I have been working on shorts - and whenever I talk shorts I get hate mail and sometimes threats of litigation.  My experience is that the bigger the slime-bag the faster they are to call lawyers... but being on the receiving end of threats from sleazy lawyers makes blogging less fun.

Further - writing about shorts is surprisingly unprofitable.  My experience is that shorts that are widely discussed become riskier (they get crowded) and sometimes go up - whatever - they stop falling in response to bad news.  Universal Travel Group for instance is now trading above when I first blogged about it and the only substantial news has been that their fourth auditor resigned and their fifth auditor accepted the appointment.  They also got a new shareholder - an elderly retired car dealer from California’s Central Valley - who I suppose is also an expert on dot-com travel companies in China.

And so that brings me to the subject of short squeezes and one stock - China Media Express Holdings (CCME).  This is not a stock in which we have a meaningful position but which for a small-cap company seems to get more-than-its-share of attention.  When I wrote the Universal Travel post I got more than ten inquiries about this stock - another China stock listed in New York.  Why this one?  Well it is sort of attractive - indeed outrageously attractive - and unlike all the other US listed China stocks it has a reputable auditor (Deloittes) and a major shareholder with some credibility (Starr International of AIG/Hank Greenberg fame).  

CCME has a simple business model.  It places TV screens on buses in China and bombard captive passengers with adverts.  There are a lot of buses in China because China has the largest internal migration in the world.  Chinese consumers are bombarded with adverts but the really captive bus passengers are a good market.

The company is - at least according to its accounts - frightfully profitable.  In the last quarter the company had $57 million in revenue and only $13 million cost of goods sold.  Selling and administrative expenses were less than $3 million. Head office is obviously tiny.  After tax it is making $31 million per quarter.  This is the fattest margin and fastest growth media company I have ever seen.  It is pretty darn attractive.  And plenty of my smart readers own it despite rumors that it is fraudulent.  One of my smartest correspondents was long.

And a very few of my readers argued to me that it must be a fraud and were short.  Some of them were short six or more percentage points of the funds they manage.  And all wanted my opinion.

Whatever - this was a dangerous stock.  Any stock that normal non-stock-market people have never heard of but which garners this much passion is dangerous.  And at the time it was trading at a low single-digit price earnings ratio - it was either a flat fraud or the stock was going to trade up a very long way.  Indeed it was possible that it was both a fraud and going to trade up a very long way.  I had - as I stated - no opinion.  

But at least a dozen people asked me for one.  So I had a look and was left with the ambivalence which says “don’t touch this stock - long or short”.  There were only two negatives that stood out.  One was that the company once used a stock promoter that has previously been associated with some frauds.  They don’t use them any more.  The second was that the CFO was under 30 years of age, operated from a serviced office in Hong Kong and his only qualifications were a degree from a distinctly second tier Australian university.  [See correction below.  This description does not apply to the CFO but does apply to one external director.  The facts of the serviced office are however correct - the company's registered office is that serviced office in Hong Kong.]

Against this there were real positives.  Many Chinese companies listed in the US have auditors even relatively sophisticated investors have never heard of.  These guys used Deloittes.  And the major shareholder (Starr) supposedly did several weeks due diligence before they invested.  And who am I to question that?  Again I decided to leave it alone.

But the stock went up - and up - and up.  In the last three months the stock has traded between $7.58 and $22.30.  When I looked it was about $8.  

If you were six percent short at $8 - which some were - it was diabolical.  At $20 you were down 9 percent of your fund.  Moreover your position had increased by 2.5 times and your fund had reduced - so now the position would be over 16 percent of your fund.  At that point the position is threatening the existence of your funds management business.  After all it is now possible to lose 20 plus percent of your fund on a single obscure short.   This is a major drama for someone...

The big short has to cover.  At the same time the stock is attracting momentum (mo-mo) investors.  To add fuel to the fire the company throws out yet another series of perfect looking financial results.  This is deeply ugly and you are forced to buy the stock back to save your business.  If you don’t eventually your prime broker will buy it back for you - because they will protect their own.  That buying fuels the upward rise - putting more pressure on shorts and attracting more mo-mo investors.  

If you are a small holder you should - of course - sell some stock into short squeezes.  After all the buying is often artificial (forced covering, mo-mo guys) and when the squeeze ends the buying pressure ends.  The mo-mo investors often become sellers.  We have a guideline at Bronte that we will short 10-15bps of the fund into short squeezes where possible.  You shouldn’t do any more than that because you run the risk of becoming a victim of the squeeze yourself.  And it may not be possible because a borrow is not always possible.  (In the case of CCME borrow is possible but the stock rents for a double-digit percent per year.)  So we are short a little CCME - but way less than half a percent of the fund - and we are hardly committed.  For those that are interested - we are losing money.

Some of my readers however can talk about little else.  It is either the best or the worst stock in their portfolio.  Short squeezes are one of many dramas of Wall Street.  This one - repeated in a few other Chinese stocks like China New Borun - is particularly dramatic for those that are involved - and totally irrelevant for everyone else.

Thinking aloud about CCME’s business

Outdoor advertising is much bigger business in Europe than in America.  Europeans watch much less TV than Americans.  Americans drive home from work (and get bombarded by radio).  Europeans take public transport.  And that is one of the best times to advertise to them.  

Jean-Claude Decaux was the pioneer of street furniture for advertising - and you can guess how the negotiation went.  He goes to a local government (I remember when it was done in Sydney) and tells them that they will install, maintain and clean bus stops and other street furniture and they will pay the local government (or bus authority or whatever) millions of dollars for the privilege.  The cash-strapped local government swoons at the sales pitch.  And JCDecaux gets a few thousand more bus stops to display their adverts at.  

You can imagine this deal was amazingly profitable for Monsieur JCDecaux. It was a naive cash-strapped local government versus sophisticated advertising executives.  And lets face it - TV advertising requires huge numbers of people including some very highly paid creative people.  Street furniture (even if you have to scrub off graffiti) looks like a relatively cheap platform to display adverts on.  Of course it is fat margin.

Fat margins do not last forever.  People - even people that run bus companies - don’t remain stupid forever.  Every time a contract renews the bus company gets a little wiser and the margin goes down.  The long dated contracts are all eventually renew - and they renew at lower spreads for JCDecaux.  And looking at the expiry of the old fat margin contracts you can guess what Mr JCDecaux did.  He listed his company.  

Ok - China Media Express is more profitable than JCDecaux ever was.  The little upstart China Media Express is now as profitable in aggregate as the global leader.  At this rate of growth they will be far more profitable than the global leader.  But what has me really perplexed is that CCME is growing fast at increasing margins.  Last year gross profits for the third quarter were 17 million on 26 million in revenue.  This year they are 44 million on 57 million of revenue.  Margin is exploding...

JC Decaux do street furniture in Chicago (as pictured in their 2002 annual report) - and even in places like Chicago the bus companies and the local governments get smarter over time.  In China they seem to get more stupid or more corrupt.  After all the Chicago local authorities are doing better at extracting the margin from advertisers than Chinese bus operators.  Unusual.

But who am I to question this?  Delloites is the auditor and there is 170 million on the balance sheet (representing past-profits) and that is a pretty easy thing for an auditor to check.  So I am just going to conclude that the people who run Chinese bus companies are stupid.

Really stupid.  Or really corrupt.


Post script:  For the avoidance of doubt the fund I know that was heavily short CCME was covering the whole way up.  They are no longer heavily short CCME.  They did however lose meaningful money.  

They would have been only a small part of the volume.  There are probably more than one party caught in this squeeze.  Whether the squeeze is over?  Who knows.

Correction:  Several people have observed that the CFO is not sub 30 and not educated at an Australian university.  I stand corrected.  There is a young director of CCME who is also the financial controller of another listed company that fits that description.  I wrote this from memory and confused my directors.  The registered office of the company however is a serviced office in Hong Kong - the same serviced office as that young director operates out of.

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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.